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MLC 703 Principles Of Income Tax Law Assignment

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MLC 703 Principles Of Income Tax Law Assignment

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MLC 703 Principles Of Income Tax Law Assignment

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Course Code: MLC 703
University: Deakin University is not sponsored or endorsed by this college or university

Country: Australia

Ignoring Capital Gains Tax, discuss whether the sale of the apartment block generates ordinary income. 
Since both taxation Acts, the 1936 and the 1997, are referred as ‘Income Tax Assessment Acts’, it is essential to not only understand Income but to critically assess it for arriving at a suitable result of the question posed in this case study of Kristie. In ITAA, 1997, two type of income are discussed under Sections 6-1, 6-5 and 6-10.
Ordinary Income
Ordinary Income has not been defined in any of the Acts, but can be best understood by the Court Rulings in the following Law Cases.
Scott v Commissioner of Taxation (NSW) (1935) SR (NSW) 215
Tennant v Smith (1892) AC 150
FCT v Cooke & Sherden 80 ATC 4140
FCT v Dixon 86 CLR 450
FCT v Blake 84 ATC 4661
Income derived by providing personal services is also Ordinary Income.

Statutory Income

Incomes other than ordinary incomes which are included in the Assessable Income of the taxpayers are termed as Statutory Incomes. This is the applicable definition in the case of Kristie. But before making an assessment, it should be clearly understood whether income derived by Kristie was a Business Income or an income from an Isolated Transaction. Both these factors are briefly discussed for arriving at a justification.
Business Income
Here two basic issues arise. First, whether the receipt is from a business which is being carried on regularly or the activity is either a hobby or a one-off receipt as was distinguished in the following Case Laws.  
FC of T v Walker 85 ATC 4179
Ferguson v FCT
FCT v Stone (2005) 22 CLR 289
Isolated Transactions
An isolated transaction will be considered as income producing if it is –

Of Commercial nature.


Conducted with the intention of profit making at the time it was conceived.  

These issues were clarified in Case Laws of Whitfords Beach Pty Ltd v FC of T (Whitford’s Beach) and FC of T v Myer Emporium Ltd (Myer Emporium) where the courts successfully determined the profit making intention of the taxpayers.
The circumstances of the above discussed case laws (Whitford’s Beach and Myer Emporium) involved deals concerning capital assets, but the transactions were of business in nature. This was also established in the case of Scottish Australian Mining Co Ltd v FCT by the court. On the basis of all these factors, it is safe to assume that although Kristie made an isolated financial dealing, it was done with an intention of making profit. Hence, the earned amount will be treated as Ordinary Income and assessed accordingly.  
Being an individual tax payer and also being a sole trader, Dave can use any one of the two methods available to him for evaluating his Capital Gains Tax (CGT). The methods are ‘The Indexation Method’ and ‘The Discount Method’. All investments made by Dave in his factory for manufacturing doors will be treated as Capital Assets as per Section 104 of ITAA, 1997. CGT was introduced on September 20, 1985 by the ATO and became applicable to all capital assets owned by a taxpayer and which were acquired by a taxpayer after this date. For assets acquired till 20-09-1999, the taxpayer can use only the Indexation Method. The Capital Gains Tax (CGT) is calculated on assets and the Capital Gains Incentive (CGI), using the Indexation Method is allowed provided the asset is held by the taxpayer for a minimum period of 12 months. The Cost Price of the asset is calculated by indexing it with Consumer Price Index (CPI) by using the following formula –
 Indexation Factor = CPI for Quarter 01-07-1999 to 30-09-1999 /
                                 CPI for Quarter in which the asset is acquired 
The system of CGI was changed with effect from September 20, 1999, when the Indexation Method using CPI Indexing was replaced by a new method of discounting the asset by 50%. This was termed as the Discount Method. Using this method, all capital gains are reduced by 50% for calculating the Capital Gain and finally the CGT is calculated on the reduced amount. Assets brought after September 20, 1999 have the option, provided they have been held by the taxpayer for more than 12 months, to use either the Indexation Method or the Discount Method. Hence, Dave can use both the methods for evaluating his CGT liability and chose the method which gives the least liability for paying the CGT amount.  
Dave acquired the factory on 1 February 2013, so for calculating the Indexation Factor use of the CPI for quarter ending March 2013 will be made and as per the CPI Chart this factor is 102.4. Using the formula
Indexation Factor = CPI for Quarter 01-07-1999 to 30-09-1999 /
                                 CPI for Quarter in which asset is acquired
The indexation factor would be = 123.4/102.4 = 1.205 
Small Business Concessions
Dave can avail the benefits provided under the Small Business Concessions. He can make a selection from the following four concessions which comprise the four main ‘benefits’. Dave will have to see which concession is most effective for him and for which he can fulfil all the required criteria and can be highly beneficial. However, Dave must understand that the below discussed concessions can be availed by him only when the basic threshold test explained in Subdiv 152–A is satisfactorily implied. An entity is a small business entity if it is a Sole Trader, a partnership, a company or a trust and provided that it has:

carried on a business during all or part of an income year, and
aggregated turnover of less than $2 million.

Aggregated Turnover
To make an assessment of aggregated turnover, one must take into account the annual business turnover of the entity for an income year and combine it with the annual turnover of any other business entity which is connected with the main entity as an affiliate. It is essential to follow the aggregation rules for working out and including the other business’ annual turnover into the aggregated turnover of the main entity. The purpose of this rule is to stop large business entities from splitting their business turnover in an inappropriate manner and make use of the small business concessions. 
Assessing if it is a Small Business
Dave can apply any one of the following three methods to make an assessment whether he can become a small business entity and avail the concessions discussed below.
Method 1 – Using Previous Year’s Aggregated Turnover
Dave can used the aggregate turnover of previous income years and in case he proves that the aggregated turnover was less than $2 million in the previous income years, he can declare his business entity to be a small business entity for the current income year.
Method 2 – Estimating Current Year Aggregated Turnover
In case the estimated aggregated turnover of current year is less than $2 million, then also Dave can declare his business as a small business entity for the current income year. But Dave can only use this method if the aggregated turnover of his entity is less than $2 million in any one of the last two income years.
Method 3 – Using the Current Year Turnover
In case Dave has the actual aggregated turnover available for the current income year and this is less than $2 million, his entity can be treated as a small business entity for the current income year.
However, to apply any one of these three method, Dave must:

use the same method for any of his connected or affiliated business entities
keep a record of the method used for working out the aggregated turnover.

The four principal CGT concessions in relation to small business are the:
Subdiv 152–B: Small Business ’15-year Exemption’
If the owner/promoter is aged above 55 years or is older and is retiring, and his business owned an asset at least for last 15 years continuously, he is not required to pay CGT on selling the asset.
Subdiv 152–C: Small Business ‘50% Active Asset Reduction’
If the owner/promoter has owned an asset and used it for conducting his business (known as an ‘active asset’), he will pay tax only on 50% of the capital gain amount when the asset is sold.
Subdiv 152–D: Small Business Retirement Concession
There is a CGT exemption on the sale of a business asset, up to a lifetime limit of $500,000. If the owner/promoter is under 55 years of age, amount received from sale of the asset must be deposited into a complying superannuation fund or into a retirement savings account.
Subdiv 152–E: Small Business Rollover
In case the owner/promoter sells a small business asset and subsequently buys another asset as a replacement, he can rollover the CGT liability, into the value of the new replacement asset. In this way, the owner/promoter will not have to pay any CGT amount until the replacement asset is sold. 
As Dave is not able to prove that his business entity is a small business entity in any of the income years, he can still access the:

Capital gains tax concessions provided his total asset value passes the $6 million maximum net asset value test.
Fringe benefits tax concession if his combined ordinary and statutory income proves to be less than $10 million. 

Negative Gearing
The subject matter is society oriented, complex, as well as politically motivated. If the issue is considered for its social values, then in all fairness it can be termed as a “Necessary Evil” which needs to be monitored closely and always kept on a tight leash. If complexity is to be considered, it simpler than most laws and should be commended for the administrative efficiency with which it has been regulated over the years. As far as political motivation is concerned, it would not be out of context to mention that it not helps the governments in earning safe revenues, it also contributed to the government coffers through direct and indirect taxes. In support of my above arguments, I would like to place the following elements of understanding Negative Gearing and it functioning.
Understanding Negative Gearing
In simple language, when the net rental income of an investment property is LESS than the total interest paid by the owner on the borrowed funds, the investment is termed as negatively geared. Economists will term it as regression but it is in fact a loss which the administration turns into a profit for itself. Look at it this way. The LOSS of revenue is borne by the owner/investor of the property. This loss is deductible from his assessable income and can be termed as revenue loss to the administration in terms of less income tax collection. But how is the loss incurred by the owner/investor? It is in terms of the expenses and the two major expenses incurred by the owner/investor are interest on the borrowed funds and the Council Taxes paid to Local Governments. The lending institutions pay higher taxes (being companies) than the individual taxpayers, hence the Federal Government is in fact earning more revenue and the Local Governments are also earning revenues through Council Taxes. Although it is widely used, at least in Australia, by property investors, negative gearing is also finding use in other financial instruments, including market shares and government bonds. 
Working of Negative Gearing
As I pointed in the above paragraph, the real effect of negative gearing is to turn a negative into a positive. To take forward my point of view in favour of negative gearing, let me elaborate “investment”. Every investor’s main aim of making an investment is for making profits, although it happen in all cases. Let us keep our focus on real estate investments. It can be unexpectedly hit by a downtrend in the rental market and can be subjected to the unforeseen expenses, which were beyond the conception of the investor when he planned of purchasing the investment property. These can include those numerous reasons which accelerated the cost of the investment and hence outweighed the income which was expected from the investment. The outcome is a negative outcome. But negative gearing gives the investor a chance of using this to his advantage through a low tax burden. All investors, including the wage earners, can turn around this loss from their investments by offsetting the income they receive from salary or wages. This makes the taxpayer happy and encourages him to invest more in real estate to take more advantage of negative gearing. Thus, in the short term the investor saves on tax and in the long term makes a capital gain on his investment. Negative Gearing is a win-win situation for both – the investor as well as the government. 
Pros and Cons of Interest-only Loans
I have a mixed outlook on this factor and is what I referred to, in my opening paragraph, as a “Necessary Evil”. Interest-only loan on a rental property can help the taxpayer to deduct all the mortgage payments (including depreciation deduction in case of a company) as an expenses. Even in cases where the house appreciates every year and is giving a positive cash flow to the investor, it is shown to be losing money as far as taxation matters are concerned as the taxpayer will pay less tax on his salary and other incomes. 
This is the pros of “negative gearing” in Australia, although the expression is quite similar to “negative cash flow” but for an Australian Taxpayer, a negative gearing refers to the tax advantage he gets when his investment property shows a negative cash flow. On the positive side, more investors turn to real estate investments because of these tax advantages as they pay for the negatively geared homes. As both these factors increase the property prices, the investors get more interested in buying rental properties. The factor encouraging them is the monthly payment and with interest-only loans, investors can borrow more money and hence invest more in rental properties. Although investors are increasing their debt, they are also increasing their gains as the houses appreciate in value over time. The only con that I found in the interest-only loans was that when property values fall, the homeowners will not be in a position to earn capital appreciation and their equity will reduce substantially. In my opinion, a high percentage of interest-only loans may soon turn into a speculative bubble and hence should be kept on a leash. 
Negative Gearing is good for Australia
Actually, negative gearing topic in Australia is a highly debated one in the business, social and political circles. In fact its popularity as a classic argument is because of it being between the ‘have nots’ and the ‘haves’, of affordable housing. In case a dispassionate view of the debate is taken, it becomes hard to judge which side has more merit. Politically, the debate keeps shifting between the two sides, depending on which side the debater is – in the ruling party or the opposition. The opposition is clear that it cannot be considered as a productive policy and has clear negative effects, some of which are being highlighted below.

The incentives allows the investors to value the property at a higher price
The prices would be lower without the tax incentives.
This high level of pricing puts the homes out of reach for the genuine buyer.
A bigger portion of population has to wait and this in the longer term increases the demand for welfare sponsored homes as more people rely on social security after their retirement.
The incentives being given to investment properties is leading more money out of the productive investments to be used as capital for infrastructure development thereby creating more jobs.
It can be the cause of increasing the risk of speculative market behavior and may result in creating a price bubble which on bursting will have long-lasting negative effectsv

Now, the ruling party offers the counter argument with their view as was put by Scott John Morrison, Australia’s current Prime Minister, recently and I quote –”You’ve got a quarter of the investment property – the rental property in this country – is owned by mum & dad investors. Now, you need people to own rental stock otherwise people’s rents go up.” Unquote. What the honorable PM is suggesting is that if the government does not incentivize the investors for investing in investment properties and then rent it out, there is bound to be a shortage in supply of rental properties forcing the rents to rise steeply thereby making it difficult for the tenants to pay rent. 
On similar lines as the PM, Ben Kingsley, the founder & CEO of Empower Wealth Advisory, does not consider negative gearing to be used as a strategy at all. According to him it should be treated as a means of allowing the investors in buying the best investment property they can afford and earn a good return on their investments. His argument is that negative gearing is like setting up a start-up. He says and I quote – “Negative gearing is like forecasting losses in the first few years of starting a business. The data shows that the best properties are usually in better locations with good amenities. Those properties come at a premium and you will have to fund the earlier stages of the investment,” Unquote. 
In my opinion, it would be good for Australia to draw emergency plans as to how the administration, at State as well as Federal level, would handle a worst case scenario. Government should not wait for the worst – prices are already going down – and should formulate plans for reducing the damage in case the country has to face the worst case scenario. The worst case scenario could emerge fast if the government does not look closely at the following two factors –

The governments start pulling out one property from the available stock of properties for the additional property which an investor buys. This will reduce the available stock of properties from the stock of properties available in the market to a genuine buyer.
Statistics of the Australian Bureau of Statistics (ABS) show that over 90%of commitments for financial investment by investors is for the already existing properties in the market. Less than 10% of commitments for financial investment goes for new properties to be built-up.  

ATO homepage: Taxable Income of Individuals. , accessed 8 September, 2018.
Austlii. , accessed 8 September, 2018.
Barkoczy, S., Foundations of Taxation Law, 3rd ed. (Sydney: CCH Australia Limited, 2011).
Barkoczy, S., Rider, C., Baring, J. and Bellamy, N., Australian tax casebook, 10th ed. (Sydney: CCH Australia Limited, 2010).
Braithwaite, J. Markets in Vice, Markets in Virtue. (Annandale, NSW: Federation Press, 2005).
Brammall, B., Tyson, E. and Griswold, R.S. Getting Started in Property Investment For Dummies – Australia. (Milton, QLD: John Wiley & Sons, 2013).
Chapter Twelve: Current Liabilities and Employer Obligations. , accessed 8 September, 2018. 
Duffy-Jones, Dr. R. and Rogers, Dr D. (ed). Housing in 21st-Century Australia: People, Practices and Policies. (Farnham: Ashgate Publishing, Ltd., 2015). 
Hayes, J., “How Negative Gearing Gives Positive Results”, Australian Financial Review, 20 June 2001.
Hamson, D. & Ziegler, P. (1986), “The Implications of Negative Gearing Restrictions and Capital Gains Taxation on Investment”, 3 Australian Tax Forum 369.
Hanegbi, R. (2002), “Negative Gearing: Future Directions”[2002] DeakinLawRw 17; 7 Deakin Law Review 349.
Lomas, M. How to Create an Income for Life. (Milton, QLD: John Wiley & Sons, 2012).
Mellish, M. & Hepworth, A. “RBA Targets Negative Gearing” Australian Financial Review, 15 November 2003.
Negative gearing is not unique to Australia. Several OECD countries including New Zealand, Canada and Japan provide a full negative gearing concession to offset taxes from other income sources. Other countries such as the U.S., Germany, France, Switzerland and Sweden allow partial offsetting against the loss from housing investment
Nethercott, L., Devos, K. and Richardson, G., Australian taxation study manual: questions and suggested solutions, 20th ed. (Sydney: CCH Australia Limited, 2010).
Park, C. Housing Australia. (Melbourne, VIC: Macmillan International Higher Education, 2017).
Taxpayers Australia. , accessed 8 September, 2018.
Tax Institute of Australia. , accessed 8 September, 2018.
Tomlinson, R. and Spiller, M. (ed). Australia’s Metropolitan Imperative: An Agenda for Governance Reform. (Clayton South, VIC: Csiro Publishing, 2018). 
Walkley, P. (2003), “Negative Thinking” 121 The Bulletin 62 (Issue No.6383).
Barkoczy, S. 2011, Foundations of Taxation Law, 3rd ed. CCH Australia Limited, Sydney.
Barkoczy, S., Rider, C., Baring, J. and Bellamy, N. 2010, Australian tax casebook, 10th ed. CCH Australia Limited, Sydney.
Brammall, B., Tyson, E. and Griswold, R.S. 2013, Getting Started in Property Investment For Dummies – Australia. John Wiley & Sons, Milton, QLD.
Braithwaite, J. 2005, Markets in Vice, Markets in Virtue. Federation Press, Annandale, NSW.
Duffy-Jones, Dr. R. and Rogers, Dr D. (ed). 2015, Housing in 21st-Century Australia: People, Practices and Policies. Ashgate Publishing, Ltd., Farnham.
Lomas, M. 2012, How to Create an Income for Life. John Wiley & Sons, Milton, QLD.
Nethercott, L., Devos, K. and Richardson, G. 2010, Australian taxation study manual: questions and suggested solutions, 20th ed. CCH Australia Limited, Sydney.
Park, C. 2017, Housing Australia. Macmillan International Higher Education, Melbourne, VIC.
Tomlinson, R. and Spiller, M. (ed). 2018, Australia’s Metropolitan Imperative: An Agenda for Governance Reform. Csiro Publishing, Clayton South, VIC.

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