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Authorisation Number: 1013033299916
Date of advice: 5 July 2016
Subject: Cash versus accruals
Are you entitled to adopt the accruals method of tax accounting from 1 July 2015?
If your tax method of accounting changes from a cash to an accruals basis from 1 July 2015 onwards, will any payment received to discharge trade debtors recorded as at 30 June 2015, form part of your assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?
If your tax method of accounting changes from a cash to an accruals basis from 1 July 2015 onwards, will any payment received to discharge trade debtors recorded as at 30 June 2015, form part of your assessable income under the Capital Gains Tax (CGT) provisions of the ITAA 1997?
Is each trade debtor, recorded as at 30 June 2015, an active asset for the purposes of section 152-40 of the ITAA 1997?
This ruling applies for the following periods:
1 July 2015 to 30 June 2020
The scheme commenced on:
1 July 2015
Relevant facts and circumstances
You are a sole trader who carries on a business.
You commenced business in 19XX and have been recognising income on a cash basis.
Since its establishment, the fee income generated by your business has increased significantly.
You currently employ more than five people as part of your business, most of whom are the same occupation. The others are non-professional providing administrative services.
Your employees do a significant part of the client work and contribute materially to the generation of the business' fee income.
The number of the business' clients has grown over the years and clients are billed monthly or on a transactional basis depending on the nature of the work provided.
Clients are extended credit and formal procedures are in place for collecting debts which are pursued.
The business' trade debtors have also increased substantially over the years.
Relevant legislative provisions
Income Tax Assessment Act 1997 section 6-5;
Income Tax Assessment Act 1997 subsection 6-20(1);
Income Tax Assessment Act 1997 subsection 6-20(2);
Income Tax Assessment Act 1997 section 102-5;
Income Tax Assessment Act 1997 section 104-25;
Income Tax Assessment Act 1997 section 108-5;
Income Tax Assessment Act 1997 subsection 110-25(1);
Income Tax Assessment Act 1997 subsection 110-55(2);
Income Tax Assessment Act 1997 section 118-20;
Income Tax Assessment Act 1997 section 152-40;
Income Tax Assessment Act 1997 subsection 152-40(1); and
Income Tax Assessment Act 1997 subsection 152-40(4).
Reasons for decision
In your circumstances, it is considered that, from 1 July 2015, the accruals method of accounting for your income is most appropriate.
Under subsections 6-5(2) and 6-5(3) of the ITAA 1997, taxpayers must include in assessable income, ordinary income derived.
The courts have recognised two methods for determining when income is derived:
• The cash method (or receipts method) - under this method, income is derived when it is received, either actually or constructively, under subsection 6-5(4) of the ITAA 1997; and
• The accruals method (or earnings method) - under this method, income is derived when it is earned. The point of derivation occurs when a 'recoverable debt' is created.
When accounting for income in respect of a year of income, a taxpayer must adopt the method that, in the circumstances of the case, is the most appropriate. A method of accounting is appropriate if it gives a substantially correct reflex of income. Whether a particular method is appropriate to account for the income derived is a conclusion to be made from all the circumstances relevant to the taxpayer and the income.
Taxation Ruling TR 98/1: Income tax: determination of income; receipts versus earnings (TR 98/1) sets-out the circumstances in which, in the Commissioner's view, each method is appropriate.
Paragraphs 44 to 46 of TR 98/1 are initially considered relevant to a business of your nature, as they examine business income which is derived from the provision of knowledge or exercise of skill possessed by a taxpayer.
In this regard, paragraph 44 of TR 98/1 states:
Where an individual taxpayer, as opposed to a company …, provides his/her knowledge or exercises skill as part of a business carried on by the taxpayer, the income of the business may represent a reward for the provision of those personal services. Where the income results primarily from the services rendered, or work performed by the taxpayer personally, it is generally assessable on a receipts basis.
Paragraphs 45 and 46 of TR 98/1 however note that '… the presence of any of the following factors to a significant degree, would indicate that the income is not simply a reward for the provision of personal services by the taxpayer' and consequently suggests that the accruals method may be appropriate for determining income in respect of the relevant year:
(a) the taxpayer's income producing activities involve the sale of trading stock;
(b) the outgoings incurred by the taxpayer, in the day to day conduct of the business, have a direct relationship to income derived;
(c) the taxpayer relies on circulating capital or consumables to produce income; or
(d) the taxpayer relies on staff or equipment to produce income.
Of the factors flagged in paragraph 45, paragraph (d) is of primary relevance to your circumstances as a significant portion of your income is generated by your employees. This factor suggests that, although the nature of your business may on face value relate to the provision of your personal knowledge or skill, an accruals basis may be more appropriate.
Paragraphs 52 to 59 of TR 98/1 provide a list of other circumstances that may be relevant to consider in cases where the distinction is unclear. These factors include the size of the business, circulating capital and consumables, capital items, credit policy and debt recovery and books of account.
In discussing these additional factors, TR 98/1 provides the following guidance which is considered relevant to your circumstances:
• The larger the business structure, the more likely is the reliance on employees and capital equipment to generate income and the more likely the earnings method of accounting is appropriate (paragraph 53 of TR 98/1);
• Where a taxpayer's employees directly generate significant income, the earnings method is likely to be appropriate to account for that income in the relevant year (paragraph 55 of TR 98/1); and
• The debt collection policy of a taxpayer, who readily gives credit, and who relies on amounts owing by debtors to support drawings or other payments, is a relevant indicator. For example, where a taxpayer has formal procedures for extending credit and collecting debts, the earnings basis is likely to be the more appropriate accounting method (paragraph 55 of TR 98/1).
With these additional factors in mind, it is noted that in your case the income derived from your business activities has increased significantly over time. A significant part of this income is generated from the work of other employees who are employed in your business. It is also your practice to extend credit to clients (which is reflected in the significant amount of trade debtors that you have recorded as at 30 June 2015) and you have formal procedures in place for collecting your debts. These attributes further support a conclusion that the accruals basis of tax accounting is the appropriate method to use for the income year commencing 1 July 2015.
It is also relevant to note that you currently complete your books of account and financial statements on a cash basis. This factor indicates that the cash basis may be appropriate for tax purposes however, as flagged in paragraph 59 of TR 98/1, this attribute, although relevant, is not considered to be determinative of the question of when income is derived.
Taking the above into consideration, it is considered that in your circumstances, it is most appropriate to adopt the accruals method of tax accounting from 1 July 2015.
Payments received by you on or after 1 July 2015 which relate to the discharge of your trade debtors outstanding as at 30 June 2015 will not form part of your assessable income under section 6-5 of the ITAA 1997 as these payments will not be derived by you in the year of receipt.
Under section 6-5 of the ITAA 1997, a taxpayer's assessable income includes income according to ordinary concepts that the taxpayer derived during the income year.
As previously noted, the courts have recognised two methods for determining when income is derived:
(1) The cash method (or receipts method) - where income is derived when it is received, either actually or constructively, under subsection 6-5(4) of the ITAA 1997; and
(2) The accruals method (or earnings method) - where income is derived when it is earned. The point of derivation occurs when a 'recoverable debt' is created.
For the income year ended 30 June 2015, and prior years, you accounted for your income on a cash basis.
As at 30 June 2015, you had a significant amount of debts outstanding which related to services performed on or prior to this date.
Because you were accounting for your income for the income year ended 30 June 2015 on a cash basis, these debts were not included in your assessable income for that income year because this income had not yet been received.
As detailed above, for the income year ended 30 June 2016 (and onwards), it is considered that the accruals method is the most appropriate method to bring your income to account.
Under the accruals method, when you receive a payment from 1 July 2015 onwards, which relates to a debt outstanding as at 30 June 2015 for services performed previously, this payment will not be considered to be derived in the income year in which you receive the payment. This is because the amounts were not earned in that year. As a result, such payments will not form part of your assessable income under section 6-5 of the ITAA 1997 in the income year ended 30 June 2016 (or in a later income year).
This situation was addressed in Henderson v FC of T (1970) 119 CLR 612; (1970) 44 ALJR 115; (1970) 1 ATR 596; (1970) 70 ATC 4016 (the Henderson case) where it was observed that a change in the basis of accounting should be strictly adhered to, and the income calculated should be arrived at by the proper and regular application of the elected method of accounting. The Henderson case similarly concerned an entity changing its method of accounting from cash to accruals basis. The full High Court found that the earnings arising from the provision of services supplied in the previous income year were not ordinary income in the current year, only the earnings of the current year could be included in the computation.
CGT event C2 will happen when your ownership of each debt, outstanding as at 30 June 2015, ends by the asset being discharged, satisfied or released, for example upon receipt of payment. You will make a capital gain from each CGT event equal to the payment received in respect of the outstanding debt.
Section 108-5 of the ITAA 1997 states that a CGT asset is any kind of property or a legal or equitable right that is not property.
A note under subsection 108-5(2) of the ITAA 1997 states that debts owed to you are CGT assets.
A debt owed to you is an intangible CGT asset.
A debt outstanding as at 30 June 2015 for services previously provided by you (your trade debtor) is an intangible CGT asset.
Under subsection 104-25(1) of the ITAA 1997, CGT event C2 happens when the ownership of an intangible asset ends by the asset being released, discharged or satisfied. The time of the event is when the contract is entered into, or if there is no contract, when the asset ends (subsection 104-25(2) of the ITAA 1997).
CGT event C2 will happen when your ownership of each debt, outstanding as at 30 June 2015, ends by the asset being discharged, satisfied or released, for example upon receipt of payment.
A taxpayer will make a capital gain if the capital proceeds from the ending of the asset are more than the asset's cost base. On the other hand, a taxpayer will make a capital loss if the capital proceeds are less than the reduced cost base of the asset (subsection 104-25(3) of the ITAA 1997).
In your situation, the capital proceeds from discharging a debt will be the amount paid to you by a debtor (subsection 116-20(1) of the ITAA 1997).
It is the Commissioner's view that, under subsections 110-25(2) and 110-55(2) of the ITAA 1997, the first element of the cost base and reduced cost base of the debt is nil as the provision of services is not money paid, or other property given, to acquire the debt. Further, the market value substitution rule in section 112-20 of the ITAA 1997 will not apply to treat the debt as having been acquired for its market value (refer to ATO Interpretative Decision ATO ID 2005/211).
Accordingly, you will make a capital gain and the amount of the capital gain will be the sum received in respect of the outstanding debt.
The anti-overlap provisions
The anti-overlap provisions in section 118-20 of the ITAA 1997 apply to reduce a capital gain to the extent that because of a CGT event an amount is otherwise included in assessable income or exempt income under another provision of the ITAA 1997 or the Income Tax Assessment Act (ITAA 1936).
As previously concluded in Question 2, it is considered that, in your circumstances, no amount that you receive in respect of a debt outstanding as at 30 June 2015 will be included in your assessable income under section 6-5 of the ITAA 1997. This is because such amounts are not considered to be derived under the cash method in the income year ended 30 June 2015 (and prior) nor under the accruals method from 1 July 2015 onwards. Consequently any capital gain made from CGT event C2 happening will not be reduced under section 118-20 of the ITAA 1997 on the basis that an amount is assessable income under another provision of the legislation.
Subsection 6-20(1) of the ITAA 1997 provides that an amount of ordinary income or statutory income is exempt income if it is made exempt from income tax by a provision of the ITAA 1936 or the ITAA 1997 or another Commonwealth law.
In this regard, section 11-15 of the ITAA 1997 lists those provisions dealing with ordinary or statutory income which may be exempt.
The derivation of ordinary income relating to trade debtors in your circumstances is not addressed in the provisions listed in section 11-15 of the ITAA 1997 nor is it specifically exempted by any other provision of the ITAA 1936 or ITAA 1997 or another Commonwealth law. Subsection 6-20(1) of the ITAA 1997 will therefore not apply to exempt income of this nature.
Subsection 6-20(2) of the ITAA 1997 further stipulates that ordinary income is also exempt income to the extent that the ITAA 1997 excludes it (expressly or by implication) from being assessable income.
Chapter 4 of the explanatory memorandum (EM) to the Income Tax Assessment Bill 1997 provides further explanation on the application of this provision as it states:
An example where ordinary income is expressly excluded from assessable income is section 110CA of the Income Tax Assessment Act 1936. This section states that the assessable income of a life assurance company does not include income attributable to the investment of premiums in respect of life assurance policies received from constitutionally protected funds.
An example where an amount of ordinary income is excluded from assessable income by implication is section 27C of the Income Tax Assessment Act 1936. Here only 5% of the pre-July 1983 component and 5% of the concessional component of an eligible termination payment are included in assessable income. The remaining 95% of the payment is excluded by implication from being assessable income.
In your case, the legislation does not specifically exclude the ordinary income derived in your circumstances from being included as assessable income.
The example provided in the EM that also indicates that to be excluded 'by implication' requires the Act to specifically consider the type of income and/or the particular circumstances surrounding an item of ordinary income.
In your case, the key factor which causes the ordinary income linked to your trade debtor to be not included in assessable under subsection 6-5(2) of the ITAA 1997 stems from a change in your factual circumstances which in turn causes a change in the correct method to bring income to account for tax purposes. Section 6-5 of the ITAA 1997 is a broad taxing provision and does not consider the tax implications of such a change either expressly or by implication. It is therefore considered that any ordinary income that you receive in respect of a trade debtor recorded as at 30 June 2015 will not be exempt income under subsection 6-20(2) of the ITAA 1997 or in turn for the purposes of section 118-20 of the ITAA 1997.
Accordingly, it is considered that section 118-20 of the ITAA 1997 will not apply to reduce any capital gain you make when CGT event C2 happens on discharge on each debt that was outstanding as at 30 June 2015 for services previously provided by you.
Each trade debtor, recorded as at 30 June 2015, is an active asset for the purposes of section 152-40 of the ITAA 1997.
For a CGT asset of a business to be an active asset for the purposes of Division 152 of the ITAA 1997, it must firstly satisfy one of the 'positive tests' in subsection 152-40(1) of the ITAA 1997 and then also not be excluded by one of the exceptions in subsection 152-40(4) of the ITAA 1997.
In this regard, subsection 152-40(1) of the ITAA 1997 specifically states:
A CGT asset is an active asset at a time if, at that time:
(a) you own the asset (whether the asset is tangible or intangible) and it is used, or held ready for use, in the course of carrying on a *business that is carried on (whether alone or in partnership) by:
(i) you; or
(ii) your *affiliate; or
(iii) another entity that is *connected with you; or
(b) if the asset is an intangible asset - you own it and it is inherently connected with a business that is carried on (whether alone or in partnership) by you, your affiliate, or another entity that is connected with you.
A debt is an intangible asset and is a CGT asset (section 108-5, note 1 of the ITAA 1997). Where a business provides services on credit in the normal course of its operations, the resulting trade debtors can reasonably be seen as being 'inherently connected' with that business. A trade debtor is therefore an intangible asset inherently connected with your business and hence satisfies paragraph 152-40(1)(b) of the ITAA 1997.
The question then arises as to whether the trade debtor is excluded from being an active asset by way of being a financial instrument under paragraph 152-40(4)(d) of the ITAA 1997. It is considered that a trade debtor is not a financial instrument but rather a business facilitation mechanism that assists in the conduct of your business.
Accordingly, a trade debtor recorded as at 30 June 2015 is an active asset under section 152-40 of the ITAA 1997.