Taxation Week 3 CHP 3 Notes

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Taxation Week 3 Notes - Assessable income/income tax 3.1 Explain the importance of the concept of assessable income to the income taxation system. Characterizing income is necessary for calculating income tax payable. Determining whether a receipt is assessable income has a direct impact on the tax a taxpayer will pay. Assessable income is comprised of two components. o ordinary income, and o statutory income. Ordinary income is income according to common law and principles. Statutory income is income prescribed by law. The Tax Formula Taxable income = Assessable income - Deductions Assessable Income Assessable income = Ordinary Income + Statutory Income
3.2 Apply the tests for determining whether an amount is ordinary income. Ordinary Income Ordinary income has no precise statutory definition, and each item must be considered in light of the common usage and meaning of the term. Derivation Basic principle: ordinary income must be derived or realized by the taxpayer. Depends on if the taxpayer is required to report their income on a 'cash' (receipts) basis or an 'accruals' (right to receive) basis. The general principle is that the correct reporting method is the one which gives the most accurate reflection of the taxpayer's 'true income'. Derivation - Cash/Receipts A cash/receipts basis is used to determine when an individual derives assessable income for individuals. A cash basis is also considered appropriate when determining the receipt relates to personal services by an individual. Derivation - Accruals An accruals/earnings basis is generally accepted when receipts have been derived in contexts involving trading businesses or professional activities run like a business. Bigger businesses for example would normally be considered to have derived their income on an accrual basis. Derivation General derivation rules in respect of certain classes of ordinary income include:
Nexus with earning activity. Basic principle: ordinary income must have a sufficient nexus with an earning activity. A sufficient nexus will be found where the receipts are products of personal exertion, property, employment or services and may extend to: o Voluntary or gratuitous payments o Payments for past or future services o Payments from a third party o Isolated (i.e., irregular) transactions An insufficient nexus will be found where a receipt is not considered to have a significant relationship to income- earning activity to be considered ordinary income. For example: o Gifts o Hobby proceeds o Windfall gains o Lottery wins. Prizes and gifts Sometimes assessable as ordinary income especially where they relate to the activities of the taxpayer used to generate income. Tips and gratuities Assessable both as ordinary income and as statutory income under ITAA97 s 15-2. Cash or convertible to cash Basic principle: receipt must either be cash or convertible to cash. The convertibility to cash requirement does not apply to non-cash business benefits. Mutuality Basic principle: receipt cannot be a payment to oneself. 3.3 Apply the tests for determining whether an amount is statutory income. Statutory income is defined as, [a]mounts that are not ordinary income but are included in your assessable income by provisions about assessable income, are called statutory income. See ITAA97 s 6-10(2). Common examples include: o Allowances o Royalties o Profits from profit-making schemes 3.4 Differentiate between income and capital. The Income/Capital Distinction Fruit tree analogy Ordinary income excludes capital receipts. The tree can be considered the capital asset. Proceeds from the sale of the tree would normally be considered a capital receipt. Proceeds from the sale of the fruit from the tree can be considered equivalent to the income derived from a capital asset.
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