2 Week 2—Assessable, exempt and NANE income

– the introductory concepts of residence,

source and derivation
Introduction
The previous module introduced the taxing formula, and the elements in this formula are developed in the next
few modules. This module begins the task of determining what constitutes income according to ordinary
concepts in the taxing formula. Preliminary to this is a discussion of residence, source and derivation.
You should not lose sight of the main aim, being able to relate the matters back to see their application in the
taxing formula.

Objectives
On completion of this module, students should be able to:
• explain the concepts of residence, source, and derivation, and their application in determining assessable
income

Requirements for assessability

Section 6–5 of the ITAA 1997 is a critical section in determining which amounts are included in assessable
income. There are several issues to be considered:
• who are resident and non-resident taxpayers?
• where is the source of income?
• when is income derived?
• what is included in ordinary income?
• what is exempt income?
• what is non-assessable non-exempt income?

Residence

Textbook Foundations of Taxation Law

Ch. 11
Optional reference Australian Master Tax Guide
paras [21–000]–[21–050]

The terms ‘resident’ and ‘non-resident’ are defined in s. 6(1) of the ITAA 36, non-residents being those not
classified as a resident. [Australian resident is defined in s. 995–1 ITAA 97 in terms of the ITAA 36 definition.]
The Commissioner has issued Tax Rulings which give guidance as to the view taken by the tax office in relation
to the factors to consider in determining residency. (IT 2650 permanent place of abode outside Australia and
TR98/17 residency status of an individual entering Australia).
Individuals
The tests to apply from the definition in s. 6(1) ITAA 36 are:
• whether the taxpayer resides in Australia
• whether the taxpayer is domiciled in Australia, or has a permanent place of abode outside Australia
• whether the taxpayer who is present for more than half of the year of income has a usual place of abode
outside Australia
• the ‘Australia House’ test or Commonwealth superannuation test for Commonwealth employees overseas.
When applying these residency tests the resides test is to be applied first. If that test is met, there is no need to
consider the 3 remaining statutory tests. If any of the residency tests are satisfied the person is a resident.
Common law test (resides test)
Factors to consider include the actual presence of the taxpayer and family, maintaining of a home, employment,
business, and social relationships, but no one factor is conclusive. Where a person resides is a question of fact to
be determined from the circumstances in each case.
In C of T v Miller (1946) 73 CLR 93, the court found that ‘reside’ had a very wide meaning, a dictionary
meaning being to ‘dwell permanently or for a considerable time, to have one’s settled or usual abode, to live in
or at a particular place’.
In Levene v IRC (1928) AC 217, the House of Lords found that a taxpayer with no fixed place of abode could be
a resident of the UK, even though only present for short periods, by having regard to the ‘habits of life’, the
regularity and length of visits to the UK, and freedom from attachment abroad.
In IRC v Lysaght (1928) AC 234, the taxpayer was a resident of the UK even though living in Ireland, the
determining factor being the obligation to make short regular visits to England.
Shand v FCT (2003) ATC 2080 concerned a taxpayer who split his time between Australia and Kawait. The
tribunal considered that he was still a resident of Australia because he had not abandoned his residence and
place of abode in Australia.
Domicile test
A taxpayer is resident if domiciled in Australia, unless the taxpayer has a ‘permanent place of abode’ outside
Australia. Domicile involves two elements, being the fact of residence, and the intention to remain in the place
of residence, both elements being essential. As to the meaning of permanent place of abode:
• FCT v Applegate—permanent did not mean everlasting, so the taxpayer had a permanent place of abode
outside Australia.
• FCT v Jenkins—permanent abode outside Australia even though the taxpayer had left Australia for a
definite period of time.
Part year resident test
A taxpayer present in Australia for more than half of the income year, either continuously or intermittently, will
be resident unless it can be satisfied that:
• their usual place of abode is outside Australia; and
• they do not intend to take up residence in Australia.
The test for ‘usual place of abode’ is generally seen as less strict than ‘permanent place of abode’.
‘Australia House’ test or Commonwealth superannuation test
This test is of limited application, being primarily intended for government employees posted overseas.

Temporary resident
From 1 July 2006, a taxpayer who holds a temporary visa under the Migration Act 1958 will be a temporary
resident. Such persons will be entitled to an exemption from Australian tax on capital gains and some foreign
source income amounts. Such temporary residency will occur irrespective of residency status under the normal
tax rules.
Company
From the definition in s. 6(1) ITAA36 there are three tests in determining if a company is a resident:
• it is incorporated in Australia; or
• it carries on business in Australia and its central management and control are in Australia; or
• it carries on business in Australia and control of voting power is held by shareholders who are resident in
Australia.
Meeting any one of these tests is sufficient to make a company a resident company for Australian tax purposes.
Incorporation in Australia
This provision specifically overrides general law to make a company a resident of Australia if it is incorporated
in Australia.
Carrying on business and central management and control in Australia
Central management and control is where the directors meet to conduct the business of the company—Koitaki
Para Rubber Estates Ltd v FCT (1940) 2 AITR 136.
In Malayan Shipping Co Ltd v FCT (1946) 71 CLR 156, the court found that central management and control in
Australia was enough to constitute carrying on business in Australia.
Carrying on business and control of voting power in Australia
The tests for individuals will need to be applied to determine where the controlling shareholders are resident.

Source

Textbook Foundations of Taxation Law

Ch. 11
Optional reference Australian Master Tax Guide
paras [21–060]–[21–070]

From s. 6–5 ITAA 97, Australia taxes non-residents on income derived from sources in Australia. The ITAA
provides no general rules or definition of source, although certain types of income are deemed to have an
Australian source.
[Section 995–1 ITAA 97 defines income as having an Australian source if it is derived from a source in
Australia—this does not appear to add a great deal to our understanding.]
Essentially the source of an amount to be included in assessable income emanates from the type of income
involved. This may not always be easily identified. As noted by Jordan CJ in CT(NSW) v Cam & Sons Ltd
(1936) 4 ATD 32, ‘A source may, and commonly does, consist of several factors. The character of the source
may depend upon which of the factors is dominant.’
The source of an amount arises from the type of income, but is not always easily identified. Source is a question
of ‘where’, and there are three general possible sources:
• where the work is performed,
• where the contract is signed or entered into,
• where payment is made.
Business income
Business income may be seen as the result of a combination of all three factors above. In each case it is a matter
of determining which is the most significant of these factors.
If the critical feature of the business is buying and selling goods under contract, then the place of contract may
be identified as the source. If there is no single feature of the business which is critical, the source may need to
be apportioned over more than one place.
Sales income
For sales of real property such as land, the source will be where the property is located.
For other tangible property such as goods, and intangible property such as copyrights, there is no general rule,
and all three factors must be considered to determine which is the most significant.
Personal employment and services income
The general rule for employment income is that the source is where the work is performed, as per FCT v
French. An exception arose in FCT v Mitchum, where the place of performing the work was found to be not as
significant owing to the creative powers and special knowledge involved, which meant the work could have
been performed anywhere.

Interest income
The source is the place where the funds are advanced and the obligation to repay arises, generally being where
the contract is made. The importance attached to the place where the contract is made and the funds advanced
was illustrated by the Full Federal Court in FCT v Spotless Services 95 ATC 4775.
Where the economic activity giving rise to the interest payment occurs within Australia then the interest should
be given an Australian source. Under the withholding tax rules, interest is subject to withholding tax if
generated by economic activity in Australia.
Dividends
The residence of the company paying the dividends is irrelevant, and what matters is the source of the profit
from which the dividend is paid. This is the immediate source, as determined in Esquire Nominees Ltd v FCT.
This was upheld in Thorpe Nominees Pty Ltd v FCT (1988) ATC 4886, where income was held to have an
Australian source despite some of the activities being undertaken in Switzerland.
Unfranked dividends paid to non-residents will be subject to withholding tax, the rate being dependent on
whether there is an International Treaty.

Derivation

Textbook Foundations of Taxation Law

Ch. 14
Optional reference Australian Master Tax Guide
paras [9–000]–[9–120]

Section 6–5 ITAA 1997 includes gross income ‘... derived directly or indirectly ...’. In FCT v Clarke (1927) 40
CLR 240, Isaacs ACJ used the dictionary meaning to ascribe to derived a meaning of ‘obtained’ or ‘got’ or
‘acquired’.
The concept of derivation may be seen as a question of ‘when’ income arises.
Two tax accounting methods, by which a taxpayer may derive income are accepted for income tax purposes:
• cash or receipts basis
• accruals or earnings basis.
Cash basis of derivation
Under this method, assessable income includes cash amounts actually or constructively received during the
year of income, regardless of when the amount may have been earned.
Constructive receipt, in s. 6–5(4)/6–10(3) of the ITAA 1997 covers those amounts not actually received by the
taxpayer, but which have been dealt with on the taxpayer’s behalf or at the taxpayer’s direction. The common
example is bank interest which is reinvested or accumulated in the account.
Sections 6–5(4)/6–10(3) only bring to account those amounts which are already income. In Brent v FCT the
court held that where an amount had not been paid, ss. 6–5(4)/6–10(3) did not apply; this being a situation of a
debtor who refrained from making payment.
Accruals basis of derivation
Under the accruals method, income is derived when the amount is earned and becomes owed to the taxpayer.
The amount is derived once it is receivable or recoverable, as long as it has been earned. The taxpayer need not
actually receive the amount for it to be assessable income.
Which basis to use
Whether a taxpayer will account for income on a cash basis or an accruals basis will be determined by the
nature of the taxpayer and the nature of the receipt. Guidelines are provided in Taxation Ruling TR 98/1.
Trading income
Business income from trading activities is generally derived on an accruals basis, as per J Rowe & Son Pty Ltd v
FCT, where the full sale price was assessable income at the time of sale for sales made on a term-payment basis.
If the business offers a prompt payment discount, the full sale price is derived at the time of sale, and the
discount is an allowable deduction to the business if the customer takes advantage of the discount.
Work in progress is not counted as income derived until there is a claim to payment of an ascertained amount.
Even if there has been a supply, no income is derived until there is a recoverable debt—FCT v Australian Gas
Light Co.
Amounts being received but not earned by a business have not been derived and are not included in assessable
income—Arthur Murray (NSW) Pty Ltd v FCT. In this case the factors were that the money paid in advance was
sometimes refunded if the lessons were not taken; and the amount for untaught lessons was identifiable in the
books of the taxpayer.

Income from professional practice

The cash basis is more appropriate for income from professional skill and personal service—DCT(SA) v
Executor Trustee & Agency Co of SA Ltd (Carden’s case) (1938) 63 CLR 108 (sole medical practitioner); FCT
v Firstenberg (1976) (sole practising solicitor); and FCT v Dunn (1989) (sole practising accountant).
For a very large firm of chartered accountants the accruals or earnings method was the appropriate method—
Henderson v FCT. The difference was that much work was done by support staff rather than personal services
by professionals. The broad principles applied in Henderson were followed in Barratt & Ors v FCT, where the
court held that a large pathology practice derived income on an accruals basis.

Salary and wages

Payments in the nature of salaries and wages are generally derived when received, no matter when the work, to
which the payment related, was performed.
Interest and rent
Interest and rent are generally derived when received, either actually or constructively, the major exception
being for interest earned through carrying on a money-lending business or as an integral part of trading
operations.
Dividends
For dividend income to be derived the dividend must be paid. This normally occurs at the time the payment is
received by the shareholder.

Conclusion
The material covered this week relates to the ‘who’, ‘where’ and ‘when’ of assessable income. These are
critical preliminary concepts to be considered in determining income. We will move on next week to consider
the ‘what’ of income to determine what amounts will actually be considered to be income amounts.