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2012 Reed International Books Australia Pty Limited trading as LexisNexis.

Ancillary for Understanding Taxation Law 2012 by Gilders, Taylor, Walpole, Burton and Ciro

Understanding Taxation Law 2012 by Gilders, Taylor, Walpole, Burton, Ciro


Suggested answers to Activities and Questions by Frank Gilders
Chapter 4: The Derivation and Measurement of Income
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Questions 4.2
On the basis of Cardens Case, when is s 6-5 ordinary income derived by the
following?
1. an employee
2. a brick manufacturer
3. a bank
4. a freelance journalist
5. a sole practitioner accountant.
1. Employee: derived on a cash basis, including back-pay and advance payments. Such payments
are essentially for personal services (Carden); see also Brents case 3.15 and 4.32.
2. Brick manufacturer: all the features discussed in Carden are present; an accrual basis is
appropriate.
3. Bank: in Carden, Dixon J referred to something analogous to a stock of vendible items. It does
not stretch the analogy too far to suggest loanable funds are covered. Other considerations
advanced by Dixon J are evident. An accrual basis applies.
4. Freelance journalist: in the way such a business is practised, the receipts represent in
substance a reward for professional skill and personal work : Cardens Case. A cash basis
applies.
5. Sole practitioner accountant: Dunn and Firstenberg apply. A cash basis is appropriate.

Questions 4.3
Cardens and Hendersons cases are sometimes cited as authority for saying that only
one method of returning is appropriate for a particular taxpayer.
Is that statement strictly correct?
Henderson shows that a taxpayers circumstances may warrant a change in the basis of returning
when the manner in which it is practised changes so its not true to say that only one method is
appropriate. One method is appropriate for a given class of income in a given set of circumstances.
Certain classes of incomerent, interest, dividendsare derived when received.
For a taxpayer earning different classes of income, it will be appropriate to consider each class and
the circumstances of its derivation. For example, a manufacturing company will return trading income
on an accrual basis but interest on investments on a cash basis. A bank will return interest on an
accrual basis.

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2012 Reed International Books Australia Pty Limited trading as LexisNexis. Ancillary for Understanding Taxation Law 2012 by Gilders, Taylor, Walpole, Burton and Ciro

So its more correct to say theres one method of returning for a particular class of income by a given
taxpayer in a given set of circumstances.

Activity 4.1
Bloggs is an accountant who practised as a sole proprietor until 28 February 2011, at
which time he joined the partnership Bloggs, Cloggs & Doggs, a large accounting firm
with national affiliations. Financial information for the year ended 30 June 2011 is as
follows:
A BloggsPublic Accountant
Fees received 201011

$52,000

Accounts receivable
01/07/10

6,000

28/02/11

11,000

Expenses

10,000

By 30/06/11, accounts receivable stand at $9,000.


BC&DChartered Accountants
Fees received 201011

$150,000

Accounts receivable
01/03/11

nil

30/06/11

25,000

Unbilled work in progress


01/03/11

nil

30/06/11

3,000

Expenses

25,000

Partners in BC&D share profits and losses equally.


Calculate Bloggss taxable income for the year ended 30 June 2011.
Bloggs
Applying Dunn and Firstenberg, Bloggs should return on a cash basis for the enterprise, A Bloggs
Public Accountant. Applying Henderson, BC&D should return on an accrual basis: see Dormer
discussed in 4.9.
Note that it is the entity BC&D that uses an accrual basisnot the individual partners. An argument by
Bloggs that he has changed from a cash to an accrual basis will not hold up. He derives his share of
the BC&D income as it is appropriated. The collections of outstanding debtors in A Bloggs will
continue to be assessable as received.

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2012 Reed International Books Australia Pty Limited trading as LexisNexis. Ancillary for Understanding Taxation Law 2012 by Gilders, Taylor, Walpole, Burton and Ciro

Bloggs
Assessable income: 52,000 + 2000 = $54,000
Deductions: $10,000
$44,000 + share of partnership net income [$50,000]

BC&D
Assessable income: 150,000 + 25,000 = $175,000*
*Note that WIP has not matured into an enforceable debt. It is not income. Neither is it trading stock
(as WIP would be in the case of a manufacturing entityHenderson).
Deductions: 25,000
150,000 3 = $50,000 to B, C and D

Activity 4.2
Dr Why
1. Dr Why is a sole medical practitioner. She provides the following financial
information for the year ended 30 June 2012. Calculate her taxable income.
Cash received from patients

$130,000

Accounts receivable 30/06/2011

25,000

Accounts receivable 30/06/2012

30,000

5,000

Medicare reimbursements

45,000

Salaries paid

40,000

Drawings

10,000

Sundry expenses

30,000

Does a cash or accrual basis apply? Applying the considerations in Cardens Case, who generates
the income:
(i) the business, and therefore the profit is Whys income; or
(ii) principally Why herself?
A cash basis is appropriate.
Assessable income: 130,000 + 45,000 = $175,000
Deductions: 40,000 + 30,000 = $70,000
Taxable income: $105,000

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Corner Pharmacy
2. Corner Pharmacy is a chemist shop. It provides no credit sales but accepts major
credit cards. It sells items off the shelf and the proprietor fills prescriptions for cash and
for payments made under the Pharmaceutical Benefits Scheme (PBS). Three
assistants are employed. The following financial data is provided:
Cash sales

$300,000

Credit card sales

150,000

Credit card reimbursements

160,000

PBS:
Opening balance

$25,000

Closing balance

30,000

Billings

200,000

Receipts

195,000

Stock:
Opening stock

$150,000

Purchases

500,000

Closing stock

200,000

Salaries

60,000

Rent

50,000

On the assumption that cost of sales and other outlays are allowable deductions for
tax purposes, calculate the pharmacys taxable income.
Applying Carden and Henderson, an accrual basis is appropriate.
Assessable income:
Cash sales:

300,000

Credit card sales:

150,000

PBS billings:

200,000
$650,000

Deductions:
Taxable income:

450,000 + 60,000 + 50,000 = 560,000


$90,000

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4.6
Consider ITAA97 s 6-25:
6-25 Relationships among various rules about ordinary income
(1) Sometimes more than one rule includes an amount in your assessable
income:

the same amount may be ordinary income and may also be included in
your assessable income by one or more provisions about assessable
income; or

the same amount may be included in your assessable income by more


than one provision about assessable income.

However, the amount is included only once in your assessable income for an
income year, and is then not included in your assessable income for any other
income year.
Does s 6-25 address the problem at issue in Country Magazine Pty Ltd
specifically?
Does s 6-25 support the view that it is implied by the Act that an amount is
assessable only once?
Does s 6-25 address the problem of one-off adjustments of the type at issue in
Hendersons case?
The specific issue raised in Country Magazine 4.17, 4.18 was whether, in the course of changing its
treatment of Subscriptions in Advance, the taxpayer was entitled to deduct from one years income
an amount that had been added to the prior years income. The change was made following the
decision in Arthur Murray. In the High Court, Kitto J held that a taxpayer cannot turn what is
assessable income of one year into assessable income of another year. It is significant that, in
Country Magazine, the amount in dispute was in both years ordinary income. The dispute centred on
when it was derived.
ITAA97 s 6-25(1) is concerned with different assessing rules such that the same amount is brought to
assessment by different provisions. There is an evident contrast between Country Magazines
concern with an amount assessed under the same provision in different years and the s 6-25(1)
concern with the same amount assessed under different provisions in the same year.
On this view, s 6-25 would not save the taxpayer in Country Magazine because the circumstances it
anticipates were not present in the facts of that case.
The best that might be said of s 6-25 is that it is consistent with a view that an amount is assessable
only once. However, as the provision is expressed, its timeframe is restricted to a given year, not a
given amount.
Whether there is a broader assumption that a taxpayer is assessable only once on a particular
quantity of income is yet to be indorsed by the courts. Dixon J anticipated the possibility of double
taxation of the same amount in Cardens Case (see 4.8), and the decisions in Henderson and Country
Magazine are consistent with what Dixon J there called rigid adherence to the rules. The decision in
Dormer (see 4.9) suggests that (for a continuing business) it might be sensible to combine the results
of more than one year to obtain the assessable income of one year, but, with respect, this would
seem not to be a course open to the Federal Court. In Commercial Union Australia Mortgage Co (see
4.19), Lindgren J expressed the view that it could not have been the legislations intent to permit the

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2012 Reed International Books Australia Pty Limited trading as LexisNexis. Ancillary for Understanding Taxation Law 2012 by Gilders, Taylor, Walpole, Burton and Ciro

escape of income. The corollary is that it could not have been the intent to tax the same amount
twice. However, the fact that there are (limited) specific provisions for combining results of more than
one yearITAA36 s 170(9), 4.30and the fact that s 6-25 does not specifically address the issue
lend weight to a view that there is no rule against double taxation.

Questions 4.7
1. A life insurance agent sells life policies on a commission basis. Commissions are
paid by the insurance company upon receipt from the insured of the first years
premium. However, if the policy is surrendered within four years the agent is obliged to
repay part of the commission as determined by a formula which is based on the period
the policy has been in force.
When is the commission derived and how would you suggest repayments be treated
for taxation purposes?
2. Pegasus Pty Ltd is in the business of thoroughbred horse breeding. Rather than buy
thoroughbred stallions, Pegasus buys and owns a number of rights to service
(nominations) with various stallions. During the period 31 March to 30 June the
following events occurred:
(i) Amounts of $100,000 were received as non-refundable deposits of 10% on certain
nominations. The balance would be payable in the next financial year on
confirmation of pregnancy.
(ii) An amount of $20,000 was received for the outright sale of a nomination. No
refund was payable other than in the event that the service could not be
performed.
Advise Pegasus what amounts are derived in the year ended 30 June.
1. Commissions
Applying the considerations outlined in Cardens Case, commissions earned by an individual agent
would be derived when received. In IT 2626, the Commissioner states that where an agent (as distinct
from a broker) earns commissions from money payable to an insurer, commission is derived when the
gross insurance premium is received. If the gross amount is paid directly to the insurer, the
commission is derived by the agent when received from the insurer.
One way to treat repayments is to estimate the amount likely to be repaid and bring to account net
commissions as assessable income. The reality is (IT 2626) that if the policy is cancelled, the agent is
allowed a deduction in the year of payment.

2. Pegasus
This question should focus on the derivation question and, specifically, the application of the Arthur
Murray principle to the facts in Pegasus: Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314; 9
AITR 673; 14 ATD 98.
As indicated (see 4.16), it is possible to distil two grounds in that decision. The first is the simpler view
that, if the possibility of a refund exists, doubt may be expressed about the certainty of the earning
process. The second, and arguably better view, is that where prepayments are received and future
obligations are assumed, income for tax (as well as accounting) purposes cannot be said to be
derived (realised) until those obligations are discharged. There is a good deal of support in the
judgment of Barwick CJ, Kitto and Taylor JJ for the wider view which applies to both the supply of
goods and services; for instance, at ATD 100:

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according to established accounting and commercial principles, in the case of a business selling goods
or supplying services, amounts received in advance of the goods being delivered or the services being
supplied are not regarded as income. We have not been able to see any reason which should lead the
courts to differ from accountants or commercial men on that point.

Nevertheless, the likelihood of a refund in full or in part if the goods or services are not provided
persists as a critical consideration in such cases. See Case C86 71 ATC 385 for an example of the
Commissioners acceptance of what is thought to be the correct application of Arthur Murray.
In the present case, the Arthur Murray principle does not apply. The deposits are derived as received
(or become payable), not because they are non-refundable, but because they are earned in that
nothing relating to the deposits remains to be done by Pegasus. If the deposits were described as
booking-fees (which they may well be in reality), the position is possibly clearer. The entitlement to a
service is secured. A further amount becomes payable on success.
If the 90% balance was paid in advance, the Arthur Murray principle would apply to that amount.
The sale of nominations is also derived when received (or payable).

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Questions 4.9
1. Matthew is a consultant engineer. Although he practises as a sole proprietor, he
employs a qualified draftsman (salary $70,000 pa) and an office assistant ($25,000).
From time to time, he employs part-time professionals and also subcontracts tasks to
other engineers. Some details of his finances for the 201011 year are as follows:
Debtors 1/7/10

$32,000

Debtors 30/6/11

54,000

Billings 201011

375,000

Provision for bad debts 1/7/10

13,000

Provision for bad debts 30/6/11

38,000

Bad debt recovered 201011

6,000

During 201011, Matthew provided consulting services to Eastern Home


Improvements (EHI). No account was rendered. Instead, EHI completed an extension
to Matthews private residence and met all relevant costs. Matthew had previously
submitted specifications for the extension to reputable builders and received quotes as
follows:
Builder #1

$41,000

Builder #2

35,000

Builder #3

72,000

Required (You should cite relevant court cases and sections of the Acts):
Should Matthew return his consulting income on a cash or accrual basis?
What factors are relevant to deciding that issue?
What is his assessable income? You should discuss this with regard to:
the fees generally;
the bad debts provision and the bad debts recovered; and
the EHI matter.
Matthew: cash or accrual basis?
Some discussion is required of Cardens Case and the factors there considered relevant of the
question of cash versus accrual accounting of income. Firstenberg, Dunn and Barratt are also
relevant: see 4.6-4.12.
In Dunns case, Davies J considered that for a sole proprietor accountant employing several people
(but no other professional accountants), a cash basis was appropriate. However, Davies J said that
there was no rule of law or binding authority that sole proprietors be assessed on a cash basis. It
depended on the nature and circumstances of the taxpayers enterprise and current perceptions and
practices in the taxpayers profession. In Firstenbergs case, a solicitor in sole practice with one
employee was held appropriately to return on a cash basis. Payments in such instances were rewards
for professional skill, similar to a salary. Barratts case involved a partnership of five medical
practitioners providing pathology services generating $2m in annual fees and employing a number of
technical staff through a service trust. The Full Federal Court held that an accrual basis was
appropriate.

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In Matthews case, there are two employees and although there is no inventory of saleable items
purchased or manufactured (as would be the case in a merchandising or manufacturing business),
there is a connection between outgoings (in the form of employees salaries) and income that
suggests the employees are an important part in the earning process. It further suggests that
Matthews own income is detached from the business profit and does not correspond to a salary (as
was the case in Firstenberg). It is also clear that his in-house accounts are prepared on an accruals
basis and, although that factor is not determinative, it is an indication of practices in the taxpayers
profession. It is possible to distinguish Matthew from the circumstances in Dunn and Firstenberg and
that suggests an accrual basis.
On the other hand, the factors pointing to an accrual basis in Hendersons case are not present and it
is reasonable to conclude that either basis is appropriate. As the High Court said in Henderson,
ultimately these matters are resolved by the courts.
What is his assessable income? You should discuss this with regard to:
1. the fees generally;
2. the bad debts provision and the bad debts recovered; and
3. the EHI matter.

Fees
Reconstructing the accounts:
Debtors
O/bal
Billings

32,000
375,000

Cash recd
Balance

407,000
C/Balance

353,000
54,000
407,000

54,000

If on a cash basis:
Assessable income: $353,000 (which would include the $6000 amount recovered).
If on an accrual basis:
Assessable income: $375,000 (plus $6000 recovered).

Bad debts
If on a cash basis, bad debts are not relevant in the calculation of ordinary income. Section 25-35
simply cannot be satisfied. The amount of $6000 recovered is assessable as cash received. However,
there is a CGT event C2 capital loss arising on the cancellation, release or discharge of the debt. It
could also be argued there is a loss of circulating capital deductible under s 8-1.
If on an accrual basis, two points need to be made:
(i) A claim for a bad debt under s 8-1 requires that the loss be incurred. Accounting provisions
generally (eg, provisions for annual leave) are not incurred: James Flood; Nilsen Development
Laboratories.
(ii) A claim under s 25-35 must satisfy the conditions of that provision: that is, the debt must be
bad and written off as bad. A provision is an estimate; it is not a bad debt.

Bad debt recovered


If on a cash basis, the recovery of the bad debt is simply cash received, derived at that point in time.
[If a deduction was allowable under s 8-1, this would be an assessable recovery under Subdiv 20-A.]
If on an accrual basis, the recovery is an assessable recoupment in terms of s 20-20(3) and 20-30(1).

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EHI matter
The arrangement with EHI is a s 21A non-cash business benefit that is deemed to be convertible into
money (if such deeming is necessary) and s 21 deems the money value of the consideration to have
been paid or given. The issue then becomes: how much is assessable? Possible answers are the
highest amount, lowest amount, medium or average. Alternatively, it might be argued that, since
Matthew is an expert in these matters, his own estimate of the value is acceptable. This could be the
value of the consulting services he provided to EHI. There is clearly no one, correct answer.

Paladin Pty Ltd


2. Paladin Pty Ltd is a private company incorporated in 1995 and engaged in the
development and sale of computer hardware.
The company makes sales on terms that require a 10% deposit and the balance
payable in equal monthly instalments over three years at 10% interest pa. Income in
respect of term sales is brought into accounting income over the term of the
agreement. This is the first year that sales have been made on this basis. Previously
terms were net 30 days.
This year (201011) the company commenced to provide a facility whereby customers
can enter into a maintenance agreement in respect of new hardware purchased. The
agreement is for three years and Paladin undertakes to provide maintenance servicing
when required at no additional cost to the customer. The cost of the agreement is
$10,000 pa, payable in advance. The agreement provides that it is non-assignable and
non-refundable in the event of disposal of the hardware. However, the companys
sales representatives state that there will be an abatement of the maintenance
agreement charges if equipment, the subject of the agreement, is traded-in for new
equipment with Paladin during the term of the agreement.
In the companys books of accounts, income in respect of term sales is brought into
accounting income over the term of the agreement. Deferred income at 30/6/11 is
$225,000 which amount includes interest of $82,500. Income in respect of
maintenance agreements is brought into accounting income over the period of the
maintenance agreement. Deferred income liability at 30/6/11 is $74,500.
It has been estimated that, of this amount, possibly $30,000 of contracted service will
not be met because customers have disposed of equipment to third parties.
Required:
Advise the company whether its deferral of term sales income is acceptable for tax
purposes.
Advise whether the Arthur Murray principle applies to the maintenance agreement
payments.
Advise how the $82,500 interest and the estimated amount of $30,000 are to be
treated for tax.

The enduring test of derivation comes from Cardens Case in which it was held that a taxpayer should
return on a basis calculated to give an appropriately correct reflex of true profit. Generally, this will
mean that an accruals basis is appropriate where there is something corresponding to stock in trade,
eg, a manufacturing concern or large professional practice: Hendersons case. On the other hand, a

Solutions for Gilders et al, Understanding Taxation Law 2012, Ch 4

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2012 Reed International Books Australia Pty Limited trading as LexisNexis. Ancillary for Understanding Taxation Law 2012 by Gilders, Taylor, Walpole, Burton and Ciro

small operator with nothing analogous to vendible items, or those in receipt of property income will
find a cash basis appropriate: Firstenbergs case. However, it is not possible to defer income because
an instalment method of sales is adopted: J Rowe & Sons. Accordingly, the deferred income amount
of $225,000 is derived for tax purposes at the point of sale whereas the interest is not derived until it
accrues or is received. Paladins assessable income should be increased as follows:
Add [Rowes case]

225,000

Interest

(82,500)

142,500

The question of advance payments was specifically considered in the Arthur Murray case. It is
significant that in that case there was no provision for a refund (although occasionally one was given)
and therefore the case will have wide application.
The companys accounts reflect the decision in Arthur Murray. The amount of $74,500 is not income
derived. No adjustment is necessary.
Arguably, the estimate of $30,000 also requires no adjustment. The company is still contracted to
provide services even if none are provided. The amounts will become income derived as the contract
expires. Once a method of returning is accepted, there is no basis for adjusting it: Hendersons case;
Cyclone Scaffolding.

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