Taxation law

S6-5 & FBT 3

Question 1:

Introduction

Section 6-5(1) of ITAA 1997 defines ordinary income according to ordinary concepts to include amounts to that which people would normally consider to be income. Based on various court decisions, ordinary income includes three components including income from personal exertion such as salaries and wages, income from property such as rent and dividends as well as income from business. However, it becomes difficult in some cases to distinguish whether some receipts can be considered ordinary income or capital given their complexity and hence a number of factors have to be considered in making this decision. In this case, Peta acquires a house with two old tennis courts. One of the reasons for acquiring the property is so that she could build three units on the tennis courts and sell them at a profit. However, the tennis club next door offers to buy the old tennis courts if only they are first restored to good condition. She accepts the offer and foregoes the plan to build and sell units. She spends $100,000 in preparing the tennis courts for sale which involves a great deal of work including resurfacing them and building new fences around them before selling them for $600,000 to the tennis club.

The issue is whether the receipt of $600,000 could be considered income under s6-5 for tax purposes. S6-5 of ITAA 1997 as well as other legal resources provide a great deal of information as to what ordinary income is and hence they will be useful in determining whether the $600,000 is ordinary income or a receipt of capital in which case she would be deemed to have made a capital gain.

S6-5 gives the various characteristics that define ordinary income. Income includes regular or periodic payments although depending on circumstances, one-off payments could also be income. Income includes cash payments or it should be convertible in cash (Austlii.edu.au, 2016). There should also be nexus with the earning source. If these conditions are not fulfilled, then the payment is likely not to be income although the conditions are not rigid as held in Myer case and hence decisions will range from one case to the other. s6-5 also defines income from personal exertion which is part of ordinary income to include any profit that would arise from the sale by the taxpayer of any property that the taxpayer acquires for the purpose of making profit by sale or from carrying on a profit-making undertaking or scheme.

In determining whether the $600,000 is ordinary income, it is important to determine whether it arose from a business activity or not. In Ferguson v FCT four tests were deemed necessary for a business activity (ato.gov.au, 2016). They include the presence of a profit making motive and regularity or repetition of activities although a business as a beginning and isolated activities may be deemed to be the start of a business. The activities have to be organized in a business-like manner and the amount of capital employed and volume of operations may be significant. In FCT v Montgomery (1999), it was held that the lease incentive payment was assessable income and not capital though it was a lump sum payment and isolated transaction (Dabner, 2016). Ordinary income may also include profits that arise from carrying on of a profit making undertaking or plan. This includes profits on property that was purchased with an objective of carrying out a profit making scheme. In Bernard Elsey Pty Ltd v FCT, the taxpayer had 4 blocks of land and built shops on the land and sold them (Kluwer,2016). Money was spent on construction, interest expense, marketing and council approval. It was held that the building of shops was a profit making scheme and hence assessable income rather than capital receipt. In FCT v Whitfords Beach Pty Ltd the high court applied s6-5 to determine that the profit was assessable income in that the beach front land was developed, subdivided and sold off at a substantial profit. This was despite the fact that the original intention in buying the land was for recreation purposes with no profit making motive in mind. It is seems that having a profit making motive is an important factor in deciding whether the payment is ordinary income or a receipt of capital. In Westfield v FCT, the land had initially been purchased with an intention of building a shopping center but subsequently sold at a $267,906 profit (jade.io, 2016). It was held that the receipt was a capital gain and not income since the tax payer did not have a profit motive at the time of purchase and hence this not part of the normal business activity.

Application

In the present case, it is clear that part of the reason why Peta acquired the property was so that she could build three units on the tennis courts and sell them at a profit. As such, it can be argued that she had the aim of making a profit from the portion of the property where the tennis courts were through building the units and selling them. Although this plan later changed and she sold the tennis courts to the tennis club, it can be argued that she did this since she deemed this to be a better option since it would involve less work and probably give her more profit. The second plan involved a substantial investment of $100,000 to bring the courts into a saleable condition. The activities involved in bringing the courts in to a saleable condition could be deemed business-like since they must have involved planning and record keeping which would enable her determine the price at which she would sell the courts in order to profit from the sale. Thus, although the payment is lump sum, it could be deemed payment from a profit making scheme.

Conclusion

From the above discussion, it is clear that Peta had a profit making motive in purchasing the property. Although the transaction is an isolated one involving a lump sum payment, the process of bringing the courts to a saleable condition involved substantial investment and business like activities. Thus, despite the transaction lacking most of the characteristics of business or income, it can be concluded that the payment amounted to ordinary income owing to the original profit making motive that Peta had. Thus, the receipt of $600,000 is ordinary income under s6-5 based on the discussion above.

Question 2

The advice to ABC of its FBT consequences that arise out of the information, including calculation of any FBT liability, for the year ending 31st March 2016 will depend on whether the various benefits are considered fringe benefits and hence attract fringe benefit tax. This has been analyzed as follows;

  1. Salary – under section 136, FBTAA, all items taxable under the ITAA are exempt from FBT. In this case, Alan’s salary will be taxed under ITAA and hence ABC will not be required to pay FBT on Alan’s salary since this is not a benefit but payment for the work he does for the company.

  2. Payment of Alan’s mobile phone bill of $220 per month that he uses for work related purposes only- the payment of the telephone bill is a fringe benefit. Given that it attracts GST, it is a type 1 benefit. This is because the employer is entitled to input tax credits in respect of the fringe benefit value at the time of providing the benefit. Thus in calculating the grossed up amount, the following formula would be used;

(FBT rate + GST rate)/ (1-FBT rate) * (1+ GST rate)* FBT rate

This comes to 2.0647.

Thus, the FBT amount arising from the payment of telephone bill for the year would be given by 2.0647* (220*12) = $5,451.

However it should be noted that the phone is entirely used for work related purposes. Thus, there is no benefit that goes to Alan and hence this is a normal expense to Alan that should be used in computing the company’s net income. Thus, there will be no FBT liability for ABC with regards to the payment of the telephone bill.

  1. Payment of Alan’s children’s school fees ($20,000 per year) which are GST free- This is a payment of Alan’s personal expenses by the company and hence this is a fringe benefit that should attract fringe benefit tax. Given that the school fees are GST free, this is a type 1 fringe benefit. Thus, the grossed up amount will be calculated as follows;

Fringe benefit = 1/ (1-FBT rate) or 1.8692

Thus, the Fringe benefit amount with regard to school fees is =1.8692 *20,000 = $37,384

The tax thereof would be = $37,384* 46.5% =$17,383.56

Thus, the company would have to pay FBT amounting to $17,383.56 with regard to paying for Alan’s children’s school fees.

  1. Provided Alan with the latest mobile phone handset that cost $2,000 including GST- According to s58X, FBTAA, mobile phones are considered exempted fringe benefits. As such, the company will not have to pay any FBT for providing Alan with the mobile phone (ato.gov.au, 2016).

  2. At the end of the year, ABC hosted a dinner at a local Thai restaurant for all 20 employees and their partners. The total cost of the dinner was $6,600 including GST- given that there were 20 employees, the company spent $330 on each of the company’s employee in hosting the dinner. S62, FBTAA states that in-house fringe benefits, expenses, property or residual of a value less than $1,000 does not attract fringe benefit tax. Since the dinner was hosted by the company for its employees, the company will not have to pay FBT for hosting Allan in the dinner since the company only spent $330 on him which is far much less than $1,000.

Conclusion

Based on the above discussion, the company would be required to pay $17,383.56 for the benefits provided to Allan.

b) My answer to (a) will differ If ABC only had only 5 employees. This is because the company would have hosted the employees for the dinner at a cost of $1,320 for every employee. This would mean that the company would now have to pay FBT on this expense in accordance with s62 since this amount is more than $1,000 and hence it is not FBT exempt. The amount spent on every employee for the dinner would thus be a type 1 fringe benefit owing to the GST component. Thus, the FBT amount attributable to Allan would be calculated as follows;

Fringe benefit amount = 2.0647* $1,320 = $2,725.40

The FBT thereof would be = 46.5*$2,725.40 = $1,267.31

Thus, unlike in (a) above where the company would have paid no FBT, ABC would pay $1,267.31 with regard to Allan’s participation in the dinner if it only had 5 employees. Thus in this case, the company would have to pay an amount of $18,650.87 as FBT.

c) My answer to (a) above would differ if clients of ABC also attended the end year dinner. This is because in this case, an employer and employee relationship does not exist. Thus, ABC would not be subject to tax. This is a business relationship between ABC and the clients. According to s 21A, ITAA 36, the recipient of the benefit would be subject to income tax on the value of the benefit in accordance with ITAA s6-10 on statutory income. In this regard therefore, each client would be required to pay income tax on the benefit. The income paid would depend on the number of people attending the dinner. However, the employees would still not be required to pay FBT since for them, the employer and employee relationship already exists.

References:

Austlii.edu.au, 2016, Income tax assessment act 1997-Sect 6.5, Retrieved on 14th September 2016, from;

http://www.austlii.edu.au/au/legis/cth/consol_act/itaa1997240/s6.5.html

ato.gov.au, 2016, Taxation ruling TR 97/11, Retrieved on 14th September 2016, from;

http://law.ato.gov.au/atolaw/view.htm?DocID=TXR/TR9711/NAT/ATO/00001

Dabner, J2016, FC of T v Montgomery: An opportunity lost, Retrieved on 14th September 2016, from;

http://www.austlii.edu.au/au/journals/JlATax/1999/30.html

Kluwer,W2016, Bernard Elsey Pty. Ltd. V. Federal commissioner of taxation, High court of Australia, 10 0ctober 1969, Retrieved on 14th September 2016, from;

http://www.iknow.cch.com.au/document/atagUio555356sl16895552/bernard-elsey-pty-ltd-v-federal-commissioner-of-taxation-high-court-of-australia-10-october-1969

jade.io, 2016, Federal commissioner of taxation v. Whitfords beach pty.Ltd, Retrieved on 14th September 2016, from;

https://jade.io/article/67040

ato.gov.au, 2016, Fringe benefits ta-rates and thresholds, Retrieved on 14th September 2016, from;

https://www.ato.gov.au/Rates/FBT/