Taxation Study Material

1. Characterising Ordinary Income

Ordinary income refers to any financial gain or monetary benefit that has been derived from various sources. In the context of income tax legislation, it is essential to distinguish between types of income to determine tax obligations. This classification is primarily based on the gain and flow concepts of income, defined under the Income Tax Assessment Act (ITAA) 1997.

1.1 Gain and Flow Concepts of Income

The gain concept suggests that income is synonymous with an increase in net wealth. An economist would define an increase in wealth as income. Under this understanding, amounts received may either be considered assessable under s 6-5 of ITAA 1997 or classified as capital nature, which falls outside the assessable income.

Assessable Income: Gained income as defined by s 6-5, barring exempt or non-assessable income.
Capital Income: Often includes one-off gains from the sale of capital assets, not considered as ordinary income.

1.2 Flow Concept of Income

The flow concept posits that returns generated from exploiting or using capital assets tend to be classified as income. This view was upheld in the Eisner v. Macomber (1920) decision, demonstrating that amounts received from leasing property or earning dividends from shares signify income. Examples include:

Rental income from leasing land, buildings, or equipment.
Interest income from loans and bank deposits.
Royalties from intellectual property rights.
Dividend income from corporate shares.

1.3 Defining Characteristics of Income

Income is characterized as:

Recurrent: Received regularly such as salaries, wages, and business profits.
Expected: Foreseeable revenue streams from a taxpayer’s business or job.
Periodical: Income received at regular intervals.
Repeated: Income earned repeatedly over time.

In contrast, one-off gains, such as from selling capital assets, typically do not acquire the nature of income, as evidenced in the Scottish Australian Mining Co Ltd v. FCT (1950) case.

1.4 Principle of Mutuality

The principle of mutuality states that mutual receipts (revenue collected by member clubs or organizations) are not considered income because they represent capital nature according to the decision in Bohemians Club v. Acting FCT (1918).

Accordingly, for an amount to be classified as income, it must be received in a monetary form or be convertible to cash, as demonstrated in the case of Tennant v. Smith (1892) regarding non-transferrable accommodation provided to an employee.

1.4.1 Non-Monetary Benefits

Benefits received that cannot be converted to money, such as gifts, may not constitute assessable income. For instance, in Payne v. FCT (1996), frequent flyer points were deemed non-assessable.

2. Ordinary Income (s 6-5)

Under s 6-5 of the ITAA 1997, assessable income includes income as per ordinary concepts called ordinary income. Key forms of ordinary income include:

Income from Personal Exertion: Payments for personal services, excluding any gifts or unsolicited payments.
Income from Business: Regular proceeds from business operations, excluding profits from mere capital realization. Considerable cases include Californian Copper Syndicate v. Harris (1904).
Profit-Making Scheme: Income from isolated transactions aimed at profit.
Income from Property: Includes flows like rent and dividends.

3. Income from Business

The assessment of income from business considers practical factors evaluated by the court, such as the existence of an intention to profit, regular activities, and the commercial manner in which operations are conducted. Key case law includes:

Thomas (1972), confirming small activities can still constitute a business.
Ferguson (1979), demonstrating systematic involvement in agricultural activities signifies business.

3.1 Business vs Hobby

Courts determine if activities become businesses rather than hobbies by applying specific criteria outlined in TR 97/11. While proceeds from hobbies remain non-assessable, business income is treated as ordinary income under s 6-5.

4. Derivation of Income

Income derivation significantly influences tax obligations and is classified under cash or accrual methods. Cash Method: Income is recognized when received; suitable for smaller entities. Accruals Method: Income is recognized when earned, applicable for larger corporations. Key cases in derivation context include Carden (1938) for cash, and Arthur Murray (1965) for accruals regarding pre-paid services.

5. Personal Services Income (PSI)

PSI fundamentally concerns income earned largely from individual effort, with strict guidelines on how it can be redirected or classified within a Personal Services Entity (PSE). PSI cannot be transferred or directed towards another individual, reinforcing the anti-avoidance provision under Divs 84 to 87. Certain deductions may be limited for income categorized as PSI. Notably, conditions and tests exist to determine whether activities qualify as a Personal Services Business (PSB), further affecting taxation dynamics.

5.1 Testing for PSB

An individual is regarded as conducting a PSB if one of several conditions is met, such as producing results under a contract or deriving income from multiple non-associated clients.

6. Conclusion

The understanding of statutory vs. ordinary income is pivotal for adequate income tax reporting. Recognizing when revenue is assessable ensures compliance with Australian tax law. Evaluating actions against established tests and cases plays a significant role in determining one’s tax obligations effectively.

Understanding Taxation and Ordinary Income Concepts

Understanding Taxation and Ordinary Income Concepts