Journal of Australian Taxation
|
|
Home
| Databases
| WorldLII
| Search
| Feedback
Journal of Australian Taxation |
|
THE
REVIEW OF BUSINESS
TAXATION'S
"OPTION 2" – PROBLEMS
IN
CONCEPT AND IN PRACTICE
By
John Glover[*]
Option 2's "cash flow/tax value"
approach to computing tax liabilities according to accounting principle is not
a desirable
change. An example is used to test the rejection of traditional
legal concepts, focusing on the replacement of the capital and income
distinction with statutory rules. Inconsistency is suggested between the Review
of Business Taxation's "benchmark" of a
comprehensive income tax
base, on the one hand, and its concurrent acceptance of the "realisation principle" for capital gains, on the
other. Established tax values are disregarded under Option 2 - to the extent
that those
values require the appropriate matching of items of income and
expense. Excessive allowable deductions are a striking consequence.
Option 2 is
then viewed in a wider context. Systems of tax and financial accounting are
shown to serve different purposes. One-year
taxation periods and containment of
tax avoidance cannot be accommodated within the objectives of the "cash
flow/tax value"
approach. Given that the Australian tax system assumes the
rule of law, changeable and indefinite accounting principles are of nature
unsuited to the measurement of income for tax purposes.
The Review of Business Taxation's
("RBT") "Option 2" approach to the calculation of taxable
income makes a dramatic
leap in the design of Australian income tax laws.[1]
Changes in cash flows and in the tax value of assets and liabilities over a tax
year are proposed as the measure of business income
and loss. Net income under
Option 2 will equal a taxpayer's excess of receipts over payments in the
reporting period, plus or minus
the net change in the tax value of assets and
liabilities, excluding private or domestic amounts.[2] A
table of asset tax values replaces much of the function of "capital" characterisation under the existing law. Several
legislative schemes for capital allowances under existing legislation are
gathered together in one
place.[3] Many familiar aspects of the present tax
system will be superseded, including the judicially derived "concept of
income"
and the familiar Income Tax Assessment Act 1997 (Cth) ("ITAA97") s 8-1 control test for
determining allowable deductions.
According to the RBT, Option 2 will be
"structurally consistent with both economic and accounting approaches to
income measurement"
and provide a "high level unifying principle that
cannot be found anywhere in the current income tax legislation".[4]
For this, the "strategy" was said to be "bringing tax value and
commercial value closer together", in order to
facilitate
"internationally competitive as well as economically efficient business
arrangements."[5]
It is argued in this article that the
proposed move from traditional legal concepts is undesirable. Option 2
proposals are examined
particularly in relation to the allowability
of deductions. The significance of matching deductible expenses with their
associated income is noted, as well as the reason why
capital characterisation excludes certain items from deductibility
under the present law. Treatment of borrowing expenses is used to test the
compromise between
rival principles reached by the RBT. An example highlights
how Option 2 allows full deductibility for partially unmatched borrowing
expenses. It is suggested that Option 2's shortcomings are endemic to the
method of financial accounting, when applied to the measurement
of income for
tax purposes, and only existing categories provide a workable solution.
"An essential element of income
measurement", the RBT reminds us, "is the deduction of expenses
consumed in the course
of producing gains."[6] Accounting income can only be established
after adequate correlation of expense and revenue items.[7]
Expenses exhausted in an accounting period must be separated from expenses
which are unexpired and represented by assets on hand
at the period's end.[8]
Generally accepted accounting principles require that the value of assets
representing unexhausted expenses at the end of a reporting
period is dealt
with appropriately in order to provide a correct reflex of an entity's economic
performance over the period.[9] Assets constitute accounting revenue to the
extent that the entity controls the future economic benefits or savings in
future outflows
that the assets represent.[10]
Option 2 has been described by the RBT as a generalised treatment of income, assets and liabilities
which is "structurally consistent with both economic and accounting
approaches to
income measurement".1[1] Net income, under the cash flow/tax value
approach, will equal a taxpayer's net receipts (after deduction of payments)
and the net
change in the value of his or her assets and liabilities.[12]
All private receipts, payments assets and liabilities are to be excluded in
determining the value of net income. The idea is certainly
straightforward in
theory. One adds up all amounts received during the
income year, and subtracts all the amounts that were paid. Then one adds the
closing tax values
of assets held and liabilities owed at year's end and
subtracts the tax values of all assets held and liabilities owed at the start
of the income year.[13] Tax value of an asset at year's end is
determined by the table in s 6-40 of the Draft Legislation.[14]
Making tax law conform to financial
accounting concepts is not a new idea. In 1934, the Ferguson Royal Commission
on Taxation considered
the adoption of generally accepted accounting principles
in the federal tax legislation then about to be re-enacted.[15]
Both executive and judicial authorities in the United States between 1920 and
1960 supported conformity of tax and financial accounting.[16 ]The
US President's Task Force on Business Taxation in its 1970 report concluded
that the then increasing divergence between net income
for financial accounting
purposes and taxable income for federal income tax purposes resulted in
unnecessary complexity and controversy.[17] Conformity is
primarily a concern in Anglo-Saxon countries such as Australia, Canada, the
United Kingdom and the US. Financial statements
based on accounting rules are
routinely used to determine the basis of income tax assessments in continental
European countries such
as France, Germany and Italy.[18]
Capital assets are described in the
accounting standards as future economic benefits of a lasting nature.[19]An asset is owned by, or is "specific to
an entity", where the entity has control over the future economic benefits
that
the asset confers and is able to enjoy those benefits and deny or regulate
the access of others to the same.[20] The effect of
expenditure to provide or improve an entity's capital assets will often be
unexhausted at the end of a reporting period.
Both accountancy principles and
the comprehensive income definition suggest that the value of any unexpired
benefits should be added
to the measure of an entity's performance over the
period for the computation of liability to tax.[21] However, for
taxation purposes, this will usually not occur. A principle based in fairness
is interposed:
"[T]ax accounting departs from financial accounting rules" in order to take account of whether the taxpayer, notwithstanding the accrual of income or expense in the economic sense, has actually received the income from which to pay the tax, or has actually incurred the expense which would diminish his ability to pay it.[22]
Considerations of convenience, as well as
fairness, require that taxes be levied at times when taxpayers are likely to
have the means
to pay.[23] Often taxpayers will not have the liquidity
to meet tax liabilities when value accrues to their assets without realisation. Tax based on increased asset values is
deferred until an actual receipt, (or now) a recognised
accrual, or the equivalent of either occurs.[24] Unrealised
gains and losses which accrue in respect of non-revenue assets over the years
prior to their being "cashed out" are not
included in the annual tax
base. This will be referred to as the "realisation
principle". The fact that most asset gains must be realised
before being taxed is probably the main reason why a fully comprehensive income
tax base cannot be implemented.[25]
Revenue or capital characterisation
functions in tandem with the realisation principle.
"Capital" is a label traditionally applied to assets, increases in
the value of which fall outside the income
tax base because of the realisation principle. Not until the occurrence of defined
"CGT events" will increases in the value of most assets be included
in the
tax base. [26]
A corollary of this concerns allowable
deductions. If the values of most of an entity's capital assets do not increase
the measure
of the entity's economic performance until their realisation, neither should expenses incurred on those
assets be deductible from the performance measure. [27]
Tax symmetry requires as much. Mismatches will occur if capital assets excluded
from gross income are the subject of allowable deductions.
An unacceptable
revenue loss occurs when deductible expenses are not associated with
corresponding taxable items.
Capital characterisation
of an expense works a kind of rough justice. It identifies non-revenue assets
excluded from assessable income by the realisation
principle and excludes a corresponding category of expenses from the formula
for allowable deductions.[28] Distinguishing
revenue from capital expenses is a response to inconsistencies between the realisation principle and the comprehensive income
definition. Tax recognition is denied both for gains in value of unrealised capital assets and expenses on such assets.
Two conflicting principles are involved. On
the one hand, tax justice would suggest that capital expense claims should be
allowed
in full in the years they are incurred and that taxpayers should be
annually assessed on the value of their unexhausted assets. Considerations
of
fairness, on the other hand, suggest that tax liabilities should not be imposed
in respect of gains that taxpayers have not received.
Inconsistency of the comprehensive income and
realisation principles emerges from the construction
of the Option 2 scheme which supplants the need for capital characterisation.
This is the "tax value of an asset" table contained in s 6-40 of the
Draft Legislation. The following depreciation and accruals
bases of asset valuation which are set out - referring both to existing and
intended legislation.
|
Item |
Asset |
Value |
|
1 |
Trading stock |
Lesser of cost/net realisable value "default Rule" - Div 48 |
|
2 |
Depreciating asset |
(The familiar) declining value and other formulae - Div 40 |
|
7 |
Financial asset |
Cost/market value/accruals methodology – Div 45 |
|
9 |
Non-routine leases/rights |
Cost or accruals methodology - Subdiv 96-B |
The items are the present and intended
formulaic schemes of asset valuation. Centralisation
is one virtue of this table. The body of non-standard asset values is gathered
together and signposted most usefully. Comparable
schemes under the existing
law were once (and are still at the time of writing) spread across the Income
Tax Assessment Act 1936 (Cth)
("ITAA36") and the ITAA97 in a somewhat disorganised
way. It should be noted that most asset classes have not been dealt with in the
table so far extracted. The great majority of assets
are typified and dealt
with below under the descriptions of residual items in the table in s 6-40. No
further reference to value accruals is made.
|
Item |
Asset |
Value |
|
5 |
Membership of tax entity |
Cost (with market value election) |
|
8 |
Routine lease or right |
Nil, or amount due and payable |
|
10 |
Right to have your tax paid |
Amount of the tax |
|
11 |
Asset capable of ownership (not above) |
Cost at the time of reporting |
|
12 |
Goodwill |
Cost if acquired from another and otherwise nil |
|
13 |
(Other) asset acquired from another taxpayer |
Cost of acquisition |
|
14 |
Any other asset |
Nil |
Cost, face value or nil are the asset values
which obtain in all residual cases. Value changes which occur in relation to
these assets
after they are acquired are either ignored, or enter the income
equation when the assets are realised.
The comprehensive income tax base chosen as a
"benchmark" by the RBT does not recognise unrealised gains and losses. This point was emphatically
made.[29]
For not even Henry Simons, a committed advocate of comprehensive income taxes, had included unrealised
appreciation of the value of an asset in his income base.[30]
A gain must have come home to the taxpayer in a realised
or ready realisable form as a precondition to
liability. However, nothing in the Option 2 income formula suggests that realisation will be required before liability for asset
revaluation occurs. Income will equal annual
receipts (less costs) plus changes in the value of
underlying assets (and liabilities).[31] In denying the
effect of capital characterisation in Option 2 and
accepting the realisation principle, the RBT adopts
an uneasy half-away position on the way to implementing a truly comprehensive
income base. There may be
an inconsistency in the RBT giving effect to the realisation principle, on the one hand, and basing the
income tax on net cash flows and changes in tax values, on the other.
Option 2 determines taxable income on the
assumption that recognised non-private expense
deductions in a given year are matched either with receipts in that year or recognised changes in the tax value of assets (other than
money).[32]
If there is no receipt, and either no asset is produced as a result of
non-private expenditure, or the tax value of such an asset
is nil, then the
expenditure directly reduces taxable income - unmatched by any gain. Matching
of assets with expense items is essential
to the working of the scheme.
Taxable income (or loss) under Option 2 is
determined in two main steps.[33] First, one deducts
all non-private amounts paid from amounts received during an income year.
Secondly, one subtracts the closing
tax values of assets and liabilities from
the opening tax values of the taxpayer's assets and liabilities.[34]
Payments subtracted from receipts in the first step are matched, for the most
part, by either revenue receipts or changes in the
tax values of assets and
liabilities in accordance with contemporary accounting practice.[35]
So if a taxpayer pays a debt existing at the
start of the tax year, that payment is deducted in the first step of the income
calculation
and the closing balance of liabilities is correspondingly reduced.
Section 6-20 in the Draft Legislation defines
the meaning of "liability" as follows:
(1) A liability is a present
obligation to provide future economic benefits.
(2) The obligation need not be legally
binding, and the taxpayer to whom it is owed need not be a taxpayer to whom the
benefits are
provided.
(3) The balance of the contributed capital
account of a tax entity is taken to be a liability that the tax
entity owes.
This section replicates the relevant
definition in the accounting standards with a fair degree of accuracy.[36] A
"liability" in accounting terms is a presently existing obligation to
act or perform in a particular way.[37] Obligations are owed
to parties who are external to the entity under the liability. Two things are
implicit in this. First, the obligee and obligor must
be at arm's length. Secondly, the category of liability cannot be created or
collapsed other than by the ordinary
assumption of an obligation and its
discharge. For such is the nature of legally enforceable obligations in
commerce. They are undertakings
entered upon the exchange of good and
sufficient consideration. Accounting standards have not as yet been applied to
the containment
of tax avoidance. Liabilities, as will be seen, have a manipulable nature. When a liability becomes deductible
without the need to show any nexus between its assumption and the production of
assessable
income, the category is ripe for exploitation by aggressive tax
avoiders.
Australian subsidiaries of overseas parent
companies might assume present liabilities to make large payments to the parent
companies
at the end of a financial year. These liabilities could then be
forgiven at the start of each new accounting period.[38]
The taxable income of Australian corporate subsidiaries might be artificially
lowered in this way. The overseas parent company, for
its part, would not be
under a corresponding liability under the tax systems in any of Australia's
main trading partners. It will
not be taxed on the value of the asset
constituted by the liability which its subsidiary owes.
If the taxpayer purchases trading stock which
is sold in the same income year, the purchase price is deductible and sale
proceeds
enter the calculation as a taxable receipt. The purchase price of a
depreciable asset is deductible and its written down value is
represented by a
positive change to the tax value of the taxpayer's assets at year's end. To the
extent that payments are unmatched
by receipts or changes in asset values, they
are written off in the year in which they are made. This is a point where
Option 2 is
not on strong ground. No satisfactory basis on the level of
accounting principle has ever been shown for the association of revenue
deductions
and revenue. Attribution of tax value to assets acquired by deductible payments
is correspondingly incomplete. Assets
are only ascribed a tax value to
counterbalance the payment to acquire them if the assets fall within the
descriptions proposed for
any of the enumerated "items" in the s 6-40
table of the Draft Legislation. A catch-all category of "other"
assets that has a nil tax value signals that there is
a class of assets that
makes no contribution to the matching exercise. These are very incomplete rules
for when payments should be
represented by receipts or changes in the balance
of assets and liabilities.
The contemplated absence of an income
item/tax liability to match each deduction allowed within a reporting period
disregards an important
feature of the Australian (and comparable) tax systems.[39]
Australian income tax is levied annually. Tax rates, loss allowances and many
preferences are computed on the basis of economic performance
within a tax
year. Association of matching revenue and expense items in different tax years
is an outcome to be avoided in tax accounting.
The time-value of money is not
safeguarded. Manipulative tax planning is encouraged. Tax policy analysts in
the US have warned that:
[F]inancial accounting often ignores the time value of money in its conventions regarding when receipts and outlays are accounted for ... ignoring the time value of money can produce dramatic skewing effects regarding the amount of tax payable.[40]
Option 2's approach to the matching of
allowable expenses with income derived in the same or subsequent income periods
can be illustrated
in the following example.
Joe is a self-employed accountant who works
in an expanding, outer suburban area. He earns $180,000 in fees in the year
ended 30 June
2001. Joe's expenses include $35,000 in wages that he pays to his
receptionist, $20,000 for office expenses and $40,000 in instalments
on a $500,000 mortgage loan that Joe took out to purchase his business
premises. Loan instalments include both interest and
principal amounts and the value of his indebtedness has decreased by $15,000 to
$470,000. A local estate
agent advises Joe that the value of his premises has
been rising steadily since he acquired them for $500,000 in 1999. In the past
year alone, their worth has increased by about $40,000. Joe has no other
non-private assets or liabilities.
Joe's Option 2 income for the year pursuant
to the Draft Legislation is as follows:[41]
Step 1 Add up all amounts you received during the income year:
$180,000 (professional fees)
Step 2 Subtract from the step 1 result all amounts you paid during the income
year:
$180,000 - [$35,000 wages + $20,000 expenses
+ $40,000 instalments] = $85,000
Step 3 Add to the step 2 result the closing tax value of each asset (other
than money) that you held at the end of the income year:
$85,000 + $500,000 (closing tax value of
premises) = $585,000
Step 4 Subtract from the step 3 result the opening tax value of each asset
(other than money) that you held at the start of the income year:
$585,000 - $500,000 (opening tax value of
premises) = $85,000
Step 5 Subtract from the step 4 result the closing value of each liability
that you owed at the end of the income year:
$85,000 - $470,000 (closing balance of
indebtedness) = ($385,000)
Step 6 Add to the step 5 result the opening tax value of each liability that
you owed at the start of the income year:
($385,000) + $485,000 (opening balance of
indebtedness) = $100,000.
Taxable income = [professional fees] - [wages
+ expenses + instalments] +
[reduced debt]
= $180,000 - [$35,000 + $20,000 + $40,000] +
[$15,000]= $180,000 - [$95,000] + [$15,000]
= $100,000
Joe's treatment under Option 2 is in many
ways similar to what it would be under the present system. He is entitled to
reduce his
taxable income by wages, rent and mortgage interest expenses. If Joe
is additionally entitled to deduct repayment of the mortgage
principal, then,
to a corresponding extent, an amount is added back to his income as a taxable
reduction in the value of his non-private
liabilities. It is the interest
component which is problematic. Whilst the interest payment is deductible in
effect and reduces Joe's
taxable income, there is no counterbalancing revenue
item in the year in which the payment is made.[42] Any additional (unrealised) value of the premises at the end of the year
gives rise to no tax liability within the scheme of Option 2. Joe's premises
are attributed
with a tax value at the end of the year equal to the cost price
that Joe paid in 1999.[43] Until a CGT event occurs in relation to the
premises, there is no tax liability to counterbalance (or "match")
Joe's subtraction
of the borrowing expense from his taxable income.
The timing of when relevant CGT events occur
is something largely under Joe's control. Dealings with ownership interests in
his business
assets can be undertaken at times which suit his fiscal
convenience. CGT treatment for Joe entails the advantages of both
a timing benefit, resulting from the tax he has deferred, and a
"discounted capital gain" tax-preference, when matching liability
is
ultimately faced.[44] Postponement of tax liability and conversion
of ordinary into tax preferred income both seem possible in his case. The
effect would
be accentuated if Joe decided to negatively-gear further borrowing
made in order to acquire the shop next door. Interest expenditure
for this
purpose would be deductible as part of Joe's business and not a private or
domestic expense. Or consistently with the "private
use of assets"
Recommendation 4.13(d) of A Tax System Redesigned, Joe might use a company or
some other interposed entity for
the generation of private negative-gearing
gains on a comparable basis.[45]
Assume now a variation to the example.
Instead of owning his premises and paying
them off, Joe leases the premises in return for an annual $30,000 lease
payment. Other outgoings
of $35,000 for a receptionist and $20,000 by way of
office expenses are the same as before.
Calculation of Joe's Option 2 income in this
variation would differ at step 2. Rent would be paid instead of instalments of the mortgage loan. Steps 3, 4, 5 and 6
(applying to assets and liabilities) would then have no content. For Joe, we
have assumed,
has no non-private assets or liabilities other than his business
premises and the loan taken out to acquire them.
Taxable income = [professional fees] - [lease
payments + wages + expenses]
= $180,000 - [30,000 + 35,000 + 20,000]
= $180,000 - $85,000
= $95,000
Joe's taxable income, in this event, has been
slightly reduced. Total expenditure subtracted from his incomings is now
greater. The
rights that Joe has acquired under the business lease have a nil
tax value and there is correspondingly no asset value to include.[46]
Joe's tax liability under Option 2 is the same as what it would be under the
present system. This is because all expenses are exhausted
in the tax year in
which they are incurred. This variation serves as a control device. Changes
entailed by the cash flow/tax value
approach to calculating assessable income
are not significant where there are no asset or liability values to be
adjusted.
Assume another variation to Joe's income tax
affairs.
Joe owns the business premises, as in the
example, and is paying off the loan he took out to finance their acquisition.
He additionally
spends $15,000 in legal costs to prevent another accountant
from commencing business nearby with his name and distinctive style.
The
expenditure achieves its object, as it has done several times before. An
accountancy business broker advises Joe that the semi-monopoly
he has achieved
in the area contributes to a considerable premium that the practice is now
worth over normal valuation.
Calculation of Joe's Option 2 income in the
second variation resembles that in the example, except that step 2 now involves
subtraction
of an additional non-private expense by way of legal costs. The
corresponding sub-total for this step is reflected in steps 3, 4,
5 and 6. In
the result, Joe's cash flow and taxable income for the year are further reduced
as follows:
Taxable income = [professional fees] - [wages
+ expenses + instalments
+ legal expenses] +
[reduced debt]
= $180,000 - [$35,000 + $20,000 + $40,000 +
$15,000]
+ [$15,000]
= $180,000 - $110,000 + $15,000
= $85,000
Value has been added to the goodwill of Joe's
business. He has also paid $15,000 in legal costs which have reduced his
taxable income.
However, no recognised increase in
asset value counterbalances the expense that Joe incurred.[47 ]Though
the payment is deductible, in effect, and Joe's taxable income has been
proportionally reduced, the accretion to the value
of goodwill which followed
from the expense will not be recognised in that year.
Joe obtains a tax-timing benefit to the extent that the increase in the asset
value of his business does not counterbalance
the allowable expense that he
incurred. Not until a (tax preferred) capital gain occurs in relation to the
business premises will
the additional value created by the legal expense
re-enter Joe's tax equation. This is a consequence of the "tax value of an
asset or liability table" at s 6-40 of the Draft Legislation, which
provides that the tax value of goodwill is:
(a) To the extent (if any) that the goodwill
includes goodwill that you have acquired from another taxpayer - the cost of
the acquired
goodwill when you acquired it; and
(b) Otherwise - nil.
Accretion to Joe's goodwill has no recognised tax value, given that
it was the consequence of legal proceedings he commenced and was not acquired
from another taxpayer.
The above example and variations isolate what
may be a problem for Option 2. Interest on borrowings to acquire assets which
will receive
capital gains treatment is deductible in full at the time when the
relevant expense is incurred. The corresponding income item is
postponed and
tax preferred. Commentary by the RBT has adverted to the problem.[48]
Before assessing this and other difficulties
with Option 2, it must be observed that appropriate recognition of interest
expenses
is not straightforward in tax systems which acknowledge the
separateness of capital and income gains. For years, in Australia, courts
and
tribunals have troubled over whether interest is like any other outgoing and
how to determine its fiscal nature.[49] Little can be
assumed beyond the facts of individual cases. A few prefatory considerations
will be advanced. Money borrowed is only
a means of exchange. Inherently, money
has no fiscal nature. Revenue or capital characteristics of a borrowed sum
follow from the
way in which it is applied. One traces the use to which
borrowed funds are put.[50] Interest on a loan
will be deductible under s 8-1 of the ITAA97 according to whether the borrowed
funds are used for the purpose of producing assessable income, or conducting an
income-producing
business. Munro denied the deductibility of interest on
borrowing which was secured over the taxpayer's business premises,
because the Court found that the real use of the borrowed funds was unrelated
to the production of the taxpayer's assessable income.[51]
Borrowings for business purposes raise
particular considerations in tax law. Often the entire capital base of a
business is financed
through a loan. If a sufficient nexus exists between the
capital assets of a business and the generation of income, interest on funds
borrowed to acquire those assets may still be a deductible expense.[52]
This has a slightly counter-intuitive ring to it. Surely borrowings related to
the "profit-yielding subject" of a business,
rather than "the
process of operating it", are of a capital nature - pursuant to
Dixon J's celebrated structure/process test for distinguishing income and
capital in the Sun Newspapers Ltd v FC of T decision?[53]
In the following year, however, Dixon J in Texas Co (Australasia) Ltd v FC
of T referred to an "Australian system" where "some kinds of
recurrent expenditure made to secure capital or working capital
are clearly
deductible".[54]
Costs of borrowing may be attributed with a
revenue nature even though their use can be traced to the acquisition of
capital assets.
The reason for this lies in the "ephemeral nature" of
loans themselves. Interest, the cost of borrowed funds, is payment
for the use
of money.[55]
The use to which borrowed funds are put depends on the perspective from which
the process is observed. Borrowing may simultaneously
facilitate (the
deductible) conduct of a business and (non-deductible) acquisition of that
business's capital assets. Both revenue
and capital natures are exhibited. The
fiscal nature of the outgoing depends on the perspective of the beholder. It is
a form of
parallax. Courts adopt the practical solution of not tracing the loan
proceeds farther back than the first level of their application.
If income is
produced or expected in the course of business operations, the words of the general
deductions provision are sufficiently
satisfied and additional purposes are
ignored.[56]
Australian accounting standard AASB 1036
requires that borrowing costs (including interest) be recognised
in one of two alternative ways. In some cases, borrowing costs can be written
off as an expense in the financial year in which they
are incurred. Borrowing
costs, in other cases, must be capitalised as part of
the "carrying amount" of an entity's "qualifying assets".[57]
For the purpose, "qualifying asset" means "an asset which
necessarily takes a substantial period to get ready for
its intended use or
sale".[58]
The standard requires that borrowing costs be
capitalised, rather than written off, if they are
attributable to the acquisition, construction or production of a qualifying
asset. Attribution
depends on whether the same costs would have been avoided in
the event that the expenditure on the qualifying asset had not been
made.[59]
There is a functional correspondence between
a qualifying asset, defined by the standard, and a capital asset, defined by
tax law.
Both ideas serve the purpose of excluding certain expenses from the
measure of an entity's economic performance in the year that
the expenses are
incurred. A timing lag is usually involved. It is not expected that the value
of excluded expenses will be enjoyed,
or fully enjoyed, in the year that they
are incurred.
Conformably with AASB 1036, one might expect
the RBT to provide that interest payable on loans to acquire qualifying assets
will not
be subtracted from taxable income until the asset is used or sold. But
this is not the case. Recommendation 4.15 in A Tax System
Redesigned entitled
"General deductibility of interest" provides:
(a) That interest expenditure be viewed as
the cost of maintaining access to the capital funds underlying a business and
hence be
deductible in calculating the taxable income in the year incurred
except:
(i) [where it a
private or domestic expense];
(ii) [where incurred
to earn exempt income];
(iii) [when the
interest is prepaid]; or
(iv) [where the
borrowing relates to land owned by an individual not used for income-producing
purposes].
Business interest expenditure is immediately
deductible for all borrowings except those within excepted classes. A Tax
System Redesigned
justifies this on the basis that interest is best viewed as:
the cost of maintaining access to the capital funds underlying a business. The financial liability base of a business can be viewed similarly to, but separately from, the real asset base of a taxpayer. Given that interest expenditure does not directly change the asset base of the taxpayer, it is appropriately deductible in the year that it is incurred.[60]
Option 2 is concerned with business and not
private activities. It is anticipated that business taxpayers will deduct
interest expenses
attributable to assets on an annual basis even though no
matching income gain is generated until the asset is realised.[61]
There is no requirement that a nexus exists, however tenuous, between the asset
acquired and the production of business income.[62]
The RBT intends that an interest expense will
not be deductible if it is within the Recommendation 4.15 exceptions. The last
one is
of present significance. Interest deductions will be disallowed:
(iv) in respect of
borrowings relating to land which is used by an individual but not used for
income-producing purposes (other than the
realisation
of a capital gain) – see Recommendation 4.13(d).[63]
Certainly it is a major departure from the
present system to allow an annual deduction for interest in respect of assets
which produce
no income. The idea is contrary to received tax values.
Correspondingly, the authors of Option 2 may have been concerned with the
potential hole that unrestrained interest deductibility would create in Option
2's cash flow/tax value base. The present system's
revenue and capital
distinction may be a crude device to match expenditures with future economic
benefits, but it does operate "across
the board" in respect of all
taxpayers and all asset types. Exception (iv) to the RBT's Recommendation 4.15 is a very partial measure.
The problem is that taxpayers may seek
current year deductions for borrowing expenses which relate to assets
productive of recognised income only on realisation. The mismatch has troubled the Commissioner for
years.[64]
Growth units in unit trusts, shares, rare artworks and antiques are the sort of
assets concerned – though land, particularly
vacant land, is probably the
best example. Perhaps this is why in respect of land alone the RBT has recognised the mismatches which
arise in the cash flow/tax value base. The exception in Recommendation 4.15(a)
in para (iv) is limited to
investments by individuals, effectively in vacant land.[65]
Negative-gearing of the same land and other assets classes are untouched.[66]
A measure of capital gains treatment in place of cash flow/tax value taxation
is applied in respect of the borrowing expense in the
exception so described. A
regime for this is proposed as part of Recommendation 4.13, headed
"private use of assets".[67]
Land and buildings (other than a
taxpayer's main residence) held by an individual
(d) That, in respect of land and buildings,
other than a taxpayer's main residence, held by an individual and acquired
after 30 June
2000, the following treatment apply:
(i) include expenditure directly attributable to the land in the
tax value of the land to the extent that the land is not used for
income-producing
purposes (other than the realisation
of a capital gain);
(ii) [depreciate
structures];
(iii) [apportion
expense between land and structures];
(e) That in respect of land and buildings
held by an individual at 30 June 2000 the existing tax treatment continue to apply.
Inclusion of interest in the "tax value
of the land" excludes the expense from treatment as a cash flow payment in
the year
that the payment was made. It is a small, almost arbitrary,
recognition of a problem that exists in respect of all
taxpayers and (almost all) asset types.
It has already been noted that interest
deductions referable to capital assets represent a problem which exists in the
present law
and under Option 2. This section of the article considers the
general ways in which the problem is contained under the present law.
Section
8-1 of the ITAA97 contains the well-known formula:
8-1(1) You can deduct
from your assessable income any loss or outgoing to the extent that:
(a) it is incurred
in gaining or producing your assessable income; or
(b) it is
necessarily incurred in carrying on a business for the purpose of gaining or
producing your assessable income.
Words of this provision were transposed from
the ITAA36 with very little change.[68] The language of
accountants was avoided, following a decision taken at the time that the ITAA36
was drafted.[69]
"Losses or outgoings" were given deductible status - not the
"expenses" referred to in the language of accountants.
Section 8-1 of
the ITAA97 is a little cryptic. It omits to address the point of
incurring a loss or outgoing. Nowhere in the section does the
"purpose" word appear in a sense which bears on deductibility.[70]
Functioning of the provision is suggested by
a textual analysis of its terms. It is a subtle provision. The participles
"gaining"
or "producing" are expressed in the present
tense. Contemporaneity is made the controlling idea
by the drafter's choice of words. Events whereby a loss or outgoing is
"incurred" are linked
by a preposition and must share a temporal
nexus with "in gaining or producing your assessable income". Deductible
losses
or outgoings must have occurred whilst "gaining or producing"
can plausibly be expressed in the present tense – though,
to satisfy
this, the two do not need to have shared the same tax year. Contemporaneity
is not that strict.[71] Rather, the nexus refers to "the scope
of the operations or activities and the relevance thereto of the
expenditure."[72] An outgoing must be incurred in the
course of gaining or producing the taxpayer's assessable income, in the
sense of within that activity's (temporal) scope.[73]
Subjective purpose of a taxpayer in making a deduction claim is relevant in a
subordinate way. It assists in the denial of claims
which manipulate the s 8-1
legal control tests and might otherwise be maintainable.[74]
The present system, in short, has a legal control test for allowable expenses
which functions independently of economic and accounting
theory. Expenditure
items are either implicitly matched with income or excluded from its operation.
Australian taxpayers have frequently sought
to correlate items of income and expense in order to obtain revenue advantages.
A taxpayer
may seek to deduct an expense incurred to obtain income which is tax
or "timing" preferred.[75] Individual
taxpayers, like Joe in the above example, may seek to deduct the full measure
of interest paid on a loan taken out to
finance the acquisition of a capital
asset, though only 50 percent of a capital gain it generates will be assessed.
A variety of
other timing advantages may be sought. Both corporate and
individual taxpayers sometimes use immediate deductions to offset against
current income from another source, even though the gain that the expenditure
produces will be deferred for many years. Timing preferred
gains may be moved
offshore in various ways, or taken in a tax sheltered form by some other member
of a corporate group.[76] During the time which elapses before a
timing preferred gain is recognised for tax purposes,
the taxpayer enjoys the free use of the value of the tax liability which has
been deferred. Tax eventually paid
may be denominated in currency which has
depreciated since the deductible expense was incurred – representing a
further discount
for the taxpayer who astutely correlates incoming and outgoing
items within the law.
Consider the character of the expenditure in Fletcher
v FC of T[77] and the
commercial reality of the association of revenue and expenditure in that case.
The taxpayers were partners who sought to
shelter land development profits made
on the central cost of New South Wales. They decided to make
"investments" in a 15
year annuity plan, whereby they made annual
tax-deductible payments for annuity rights in the first five years and received
in return
increasing annual payments. Loan agreements were simultaneously
entered by the partnership to fund each annual instalment
of the annuity's purchase price. The annuity provider and a related company
which loaned the funds to the partnership entered an
annual "round
robin" transaction. The effect of these arrangements was to provide the
partnership with a tax deduction
in respect of the loan funds which
considerably exceeded the annuity payments which the partnership received. The
outward flow of
funds from the scheme to the partners slowly increased as the
annuity payments increased. By the end of ten years, the inward flow
of cash to
the partnership "tallied precisely" with the partnership's outward
flow of funds to the loan provider. Thereafter
the annuity became valuable. A
very substantial net income of the partnership would arise in the scheme's last
five years.[78]
However the agreements provided a mechanism whereby they could be terminated
before the partnership obtained any net income from
the scheme. In the event of
its default, the partnership was under no further liability to repay principal
or interest to the loan
provider. The partnership could vacate the arrangement
some time before the last five years - at a time when it was on equal terms
with the annuity and loans providers.
Legal analysis of the facts in terms of s 51
of the ITAA36 dealt with the "purpose" of the partnership in
incurring the
expenditure. On appeal to the High Court, deductibility of the
annuity payments was held to depend on whether, in the nature of the
arrangements, the partnership intended to exercise the option to terminate the
annuity before it became commercially valuable.[79] Considerations for
allowing and disallowing the deduction claim were nicely balanced. The
Commissioner had not established that the
"round robin" transactions
were ineffective to achieve their legal result. Instead, a superadded criterion
of subjective
purpose was implied into s 8-1. This legal test was the way in
which the taxpayer's claim was ultimately defeated.[80]
Fletcher exemplifies the sort of tax avoidance to which the accounting
categories of the existing law have been subjected. Under the scheme,
the
taxpayer's expense payment was matched with an income-producing asset which had
an ambiguous and possibly inadequate value. Option
2 would classify the annuity
rights in Fletcher as a "financial asset" under item 7 in the
Draft Legislation's s 6-40 table. Proposed s 45-80 then contains a
(complicated) accruals formula for determining what the asset value of the
annuity rights would be at any time
during the life of the arrangement.
However, the partnership's right to deduct the annual instalments
of the annuity's purchase price is unaffected under the cash flow/tax value
method. This is what led to the mismatch which brought
the case to court.
Disequilibrium between the deductible instalments of
the price and the value of the annuity rights in the early stages of the
arrangement is left untouched. Indeed, Option 2 would
appear to confirm the
partnership's right to avoid tax by subtracting payment of the annuity's
purchase price from its taxable income
otherwise arising. Old problems
continue. Arguably a legal control test like s 8-1 is needed to defeat this
type of scheme.
"Expenses", in modern financial
accounting, generally refer to the outflow of resources.[81]
An expense is recognisable only where two conditions
are satisfied. Both a probable inflow or other enhancement or saving in
outflows of future economic benefits has occurred and the same must be
measurable reliably.[82] Virtually all overseas
conceptual frameworks have been noted to adopt probability as the general
expense recognition criterion – combined, in most
cases, with a more
stringent recognition requirement.[83] The calculus in SAC
4 is explicitly probablistic, which reveals something
about the nature of the matching exercise in financial accounting. Correlation
of expenses and revenues
in financial statements is more an exercise of
judgment than a deduction from objective evidence.[84]
Paton and Littleton describe the difficulties involved:
[T]he problem of properly matching revenues and costs is primarily one of finding satisfactory bases of association – clues to relationships which united revenue deductions and revenue ... Observable physical connections often afford a means of tracing and assigning. It should be emphasised, however, that the essential test is reasonableness, in the light of all the pertinent conditions, rather than physical measurement.[85]
Adopt, for a moment, the perspective of
persons who manage, extend credit to, or invest in businesses. Does it matter
to them whether
an item of income is derived in the same period as when a
particular expense is incurred? The more important consideration is whether
the
accounts are a "fair and true" reflection of a business's
profitability as a whole. Accounting norms have been said
to "exude an
enticing siren song" for persons insufficiently schooled in tax values.[86]
They exude an apparent precision and exactitude missing from the concepts of
tax accounting.
One must not, however, lose sight of the tax
values at stake. In particular, regard must be paid to the time value of money
–
in a system which measures tax liabilities annually and where taxation
deferred is taxation foregone. Practical and theoretical differences
have been
noted between the existing law and the Option 2 approaches to the common tax
difficulties in the example and variation
two. Such differences in income
measurement reflect long standing variances which exist between tax and
financial accounting. Tax
and financial accountants regard the problems of
fitting capital and qualifying assets within their respective regimes in quite
a
different light. Tax accountants, in accord with generally accepted
accounting principles and Australian accounting standards, try
to squeeze
increases in asset value into the annualised
categories of the tax system – though in many cases this is not possible
and increases in asset values are not recognised
until they fit. Financial accountants are more comfortable with accruals. An
asset's increasing values can and should be recognised
over as many years as is required.
Tax accounting is primarily concerned with
the determination of taxable income in a fair, timely and efficient way.
Consistency is
considerably more important than precision in measuring income
for tax purposes.[87] Fairness considerations are of high
significance. Subjective judgments, estimations and the making of provisions
for future events
are alien to the task.[88] Annual taxation
liabilities must be established as a matter of law. A measure is taken of what
has transpired, not what is contingent
or even likely to occur.
Financial accounting, by contrast, has objectives
which cause it to be more prospective in approach. In the early twentieth
century,
accountants mainly prepared commercial balance sheets to serve as
guides for creditors - often bankers considering loan applications.
Then, as the century progressed, compiling
financial information for present and prospective shareholders became an
equally significant
part of the accounting role.[89]
Conservatism and prudence were appropriate orientations in all roles. Setting
aside provisions for likely future events is a prudent
necessity in order to
give a "fair and true" account of an enterprise's profitability over
a period. By contrast, the tax
accountant's "snapshot" of performance
in a one-year tax period is likely to mislead.
Different treatment of employees' accruing
leave entitlements provides an example of this point. Financial accountants
will appropriately
make provision in an accounting period for an employer's
future liability to pay leave earned during that period, even though the
leave
is not paid or payable by the period's end.[90] Employee leave
entitlements are a cost matched with revenue generated during an accounting
period in order to provide a correct reflex
of the taxpayer's economic
performance during that time. However, s 26-10 of the ITAA97 states that
deductions for employee leave
entitlements are only available in respect of
amounts actually paid to the persons to whom they relate in the relevant income
year.
Financial accountants measure economic performance. Tax accountants
measure money flows. Though each approach is referable to a one-year
reporting
period, different results will follow.
Financial accounting standards require that
likely future events be valued and included in the computation of a year's
performance.
Tax accounting principles, together with legislative enactments,
are confined in scope to legal events which have occurred in a reporting
period
and to increases in asset values that have become recognisable
during that time.[91]
Conformity of tax and financial accounting
has been the subject of debate for years. Sheldon Cohen, a former US
Commissioner for Internal
Revenue, has observed that,
[o]ne of the most common criticisms made by businessmen is that the determination of their annual federal income tax liability is not based on the accounting system that they use for their financial statements.[92]
The RBT states that the Australian business
tax system would be streamlined if only one set of accounts needed to be
prepared for
both tax and financial purposes.[93] Certainly the
removal of a requirement that taxpayers keep two sets of books would seem to
simplify the accounting task.[94] One financial
accountant says that the integrity of the self-assessment system would be
strengthened if variances between tax and
financial accounting were only to
result from legislative policy decisions.[95] The RBT puts the
matter even higher. Alignment of taxation law with accounting principles will
"optimise" commercial decision making:
so that business investments are made on the basis of sound commercial considerations, as free as possible from distorting tax influences.[96]
Meeting tax liabilities and administering the
system will be simpler, fairer and more efficient and the unworthy tax avoider
will
have no place - a pleasant prospect for the authors of the RBT –
though the realism of this has been doubted by many of those
who have written
about tax and financial accounting. Some of their reasons are gathered under
the following headings.
Use of a single set of accounting principles
in both tax and financial accounting may not create additional certainty
because of the
inherent nature of the accounting principles. Appearances are
deceptive. The body of Australian accounting standards is packaged
in a way
which is at odds with the generality of individual standards and the extent to
which variant practices are permitted. Surprisingly
little specific is
prescribed in the multi-volume set, now arranged with code-like formality.[97]
Only to a limited degree are the standards an articulated structure of norms
based on common practice. Commentators until lately
were apt to deny that
agreement on accounting principles would ever be possible.[98]
Financial accounting as a discipline was said to be too various and disparate
in its response to economic conditions to be reduced
to rule. Then, in
Australia, a change occurred. The quasi-governmental Accounting Standards
Review Board was commissioned in 1984
to secure a measure of general acceptance
for accounting standards and make recommendations for their legislative
recognition.[99]
Compliance with "approved accounting standards" then became
obligatory for company auditors pursuant to the Corporations Law -
subject to their overriding discretion to dispense with compliance if it would
not give a "fair view" of a company's
affairs.[100]
This discretion was removed in 1991.
From a different perspective, the control and
uniformity possessed by accounting standards may only be illusory. The
standards embody
rules which are couched in unenforceably
vague and general terms. Where reporting and disclosure are concerned,
accounting standards have been described as "conceptually
unsustainable,
anodyne directives ... primarily ritualised
platitudes".[101]
Openness of texture in the standards becomes
particularly apparent when one considers the remarkable number of
"acceptable"
permutations allowed from the several accounting
treatments for individual items that the standards authorise.[102]
There seems to be no agreed sense of the terms "accrued" and "accrue"
amongst accountants - despite the centrality
given to these concepts in the
Option 2 Draft Legislation.[103 ]Accounting
standards, whilst appearing to have a wide, obligatory application, are of more
limited use in preventing "creative"
or "cosmetic"
accounting for the purpose of manipulating regulatory schemes. Little guide is
provided where treatment of
an item is disputed between a taxpayer and the tax
authority.[104]chemes of the type
used in Fletcher transgress no accounting norms.[105]
The US Supreme Court in Thor Power Tool Co
v Commissioner[106]as concerned with
the tax accounting practices of a manufacturer of hand-held power tools and
accessories. An overvaluation of the corporation's
inventory in its books of account was one of the agreed facts.
"Excess" inventory was written down
to scrap value - even though some
of these items continued to be sold at original prices. Taxable income in the
year of the write-down
was dramatically reduced. Although the write-down
conformed to then "generally accepted accounting principles" and
"best
accounting practice", as the US Code required,[107]
the Supreme Court nevertheless agreed with the Commissioner and disallowed the
write-down in its entirety. It had this to say about
accounting standards:
[A] presumptive equivalency between tax and financial accounting would create insurmountable difficulties of tax administration. Accountants have long recognised that "generally accepted accounting principles" are far from being a canonical set of rules that will ensure identical accounting treatment of identical transactions. "Generally accepted accounting principles", rather, tolerate a range of "reasonable" treatments, leaving the choice among alternatives to management ... Variations of this sort may be tolerable in financial reporting, but they are questionable in a tax system designed to ensure as far as possible that similarly situated taxpayers pay the same tax. If management's election among "acceptable" options were dispositive for tax purposes, a firm indeed, could decide unilaterally – within limits dictated only by its accountants – the tax it wished to pay. Such unilateral decisions would not just make the Code inequitable; they would make it unenforceable.[108]
Certainty and simplicity together affect
administration and compliance costs. Tax systems, in the nature of things,
should be economical
to administer and convenient for those whose duty it is to
comply.[109]
Conformity of tax to financial accounting would prima facie avoid the need of
many business taxpayers to obtain both tax and financial
accounting assistance
in the preparation of their annual accounts. The entire exercise could be
conducted as one. However, as the
expense of auditors would very possibly
increase in proportion to their new responsibilities, only a small economy
might be apparent
at the end of the day.
Costs of administering the tax system from
the regulator's perspective would possibly be affected quite negatively. It has
been suggested
that time consumed in unscrambling the variety of methods
permitted to accountants for the reporting of identical transactions would
increase under the accounting standards regime.[110]
In making an inference from simplicity to lowered tax
administration costs one must acknowledge that:
[T]ax returns would still need to be processed, and it is unlikely that conformity would affect the efficiency with which they are processed. The need for tax audits would also remain. However, costs would be reduced to the extent that conformity reduced taxpayer/IRS/ATO disagreements. Reductions in disagreements require reductions in uncertainty of correct treatment and in grey areas. It also requires a change in CPA's perceptions about fairness of tax accounting methods. Conformity might produce increased perceptions of fairness, although this is not assured ... however it is unlikely that [conformity] would produce a reduction in choices and areas of uncertainty.[111]
The work of accounting standard setting
bodies will be invested with a new importance if income tax liabilities and
accounting standards
are linked. Decisions by the Australian Accounting
Standards Board ("AASB") could potentially equal changes to income
tax
legislation, assuming that the financial accounting treatment of a receipt,
payment, asset or liability item conclusively determined
its tax treatment.
Alterations in accounting theory will potentially affect the size and timing of
income tax liabilities.
Two observations can be made. First, no
Australian government is likely to cede a large part of its revenue authority
to the AASB
without bringing that body under its control, either wholly or in
part. This will mean a loss of independence, both for the AASB
and the
accounting profession generally. Development of accounting standards after the
acceptance of Option 2 would doubtless involve
the balancing of non-accounting
considerations to a much larger degree. Secondly, on democratic grounds, after
the acceptance of
Option 2 there needs to be a procedure for determining
taxpayers' claims to have accounting standards changed or overturned. The
AASB
is not an elected body. An accounting standards court with jurisdiction to
amend or override the AASB's pronouncements may be
required.[112]
Fairness, tax justice, perhaps should
arguably be the first imperative in all tax systems.[113]
Advantages of certainty, simplicity and authority arguably are all subordinate
to what fairness and equity require. Fairness to taxpayers
is an explicit
objective in many of the existing features of income tax legislation -
particularly those that bear on the timing
of tax events and the measure of
income derived.[114] The realisation principle examined in this article is another
example.[115]
Capital assets are recognised at cost until a realisation event occurs. There is no financial accounting
justification for this. Accounting standards recognise
qualifying assets for the much more instrumental purposes that applicable
accounting policies prescribe.[116] Option 2's
allowance of decreasing adjustments for such things as exempt income,
contributions to charity, accelerated depreciation
and research and development
expenses would not go far towards implementing the existing tax fairness
regime.[117]
If the timing of tax events and their measurement is the main practical
variation, the difference at a deeper level is one between
law's normative
categories and accountancy's purely descriptive reference.
Tax accounting and financial accounting
perform different work, for different users and have different imperatives. Excessive
deductions
allowed under the Option 2 formula pose a serious threat to tax
values associated with matching items of income and expense. Systems
of tax and
financial accounting respond quite differently to the exigencies of one-year
tax and reporting periods - which is understandable
when one considers the different purposes that each serves. Based on financial
accounting, Option 2 simply is not
suited to the measurement of income for tax
purposes. Existing categories are better suited to the task.
[*] Associate
Professor, Faculty of Law, Monash University. An
earlier draft of this article was delivered as a paper at the 13th
Annual Australasian Tax Teachers Association Conference, Sydney, 2001. The
author is indebted to conference participants and Charles
Birch for their
suggestions.
[1] Outlined in
RBT, A Tax System Redesigned (1999) 155-163 ("A Tax System
Redesigned") and RBT, A Platform for Consultation (1999) 43-44
("A Platform for Consultation").
[2] Subject to
"tax policy adjustments": see RBT, A Tax System Redesigned:
Explanatory Notes (1999) 3.11 ("Explanatory Notes").
[3] See the table
in RBT, A Tax System Redesigned: Draft Legislation (1999) s 6-40
("Draft Legislation").
[4] A Tax System Redesigned, 157.
[5] A Platform for
Consultation, 6.
[6] Ibid 37.
[7] See Y Grbich, "Ralph's Radical New Income Tax Base - Does it
Work?" [2000] UNSWLawJl 23; (2000) 23 UNSW Law Journal 282, 282; J Godfrey, A Hodgson
and S Holmes, Accounting Theory (4th ed, 2000) 627-647; RG Schroeder, M Clark and LD
McCullers, Accounting Theory: Text and Readings (4th ed, 1991) 72; and V Kam, Accounting
Theory (2nd ed, 1990) 283-296.
[8] Schroeder et
al, above n 7, 73.
[9] See Australian
Accounting Research Foundation: Statement of Accounting Concepts, Definition
and Recognition of the Elements of Financial Statements (1992) [109]
("SAC 4").
[10] Ibid [111]-[112].
[11] A Tax System Redesigned, 38.
[12] Explanatory Notes, 3.11.
[13] Ibid 3.25.
[14] See Draft Legislation, s 6-40; and A Tax System Redesigned, Figure
4.2.
[15] See the Third Report of the Royal Commission on Taxation
(1934), 551ff ("Third Report"), discussed further at note 69 below.
[16] See H Weinman, "Conformity of Tax and
Financial Accounting" (1981) 59 Taxes: The Tax Magazine 419, 420.
The US Supreme Court relied on accepted accounting principles in Eisner v Morcomber [1919] USSC 119; (1920) 252 US 189 (realisation
principle); and in United States v Anderson (1926) 299 US 422 (accrual
method suitable for tax purposes), discussed in D Geier,
"The Myth of the Matching Principle as a Tax Value" (1998) 15 American
Journal of Tax Policy 17, 75-113.
[17] J Nolan, "The Merit in Conformity of Tax to Financial
Accounting" (1972) 50 Taxes: The Tax Magazine 131, 131.
[18] See European Tax Handbook (IBFD 2000), 192-194 (France);
215-217 (Germany); 325-327 (Italy); and T Porcano, D
Shull and A Tran, "Alignment of Taxable Income with Accounting
Profit" (1993) 10 Australian Tax Forum 475, 476.
[19] SAC 4, para 14.
[20] Ibid paras 15 and 24.
[21] A Platform for Consultation, 11: "the comprehensive income tax
base would recognise all unrealised
gains and losses".
[22] Weinman, above n 16, 430; see also W Raby and R Richter, "Conformity of Tax and Financial
Accounting" (1975) 139 Journal of Accountancy 42, 44.
[23] A Smith, An Inquiry into the Nature and Causes of the Wealth of
Nations in E Cannan (ed) (Vol 2, 1950) 351.
[24] For instance, an accrual under Pt XI of the Income Tax Assessment
Act 1936 ("ITAA36").
[25] A Platform for Consultation, 29, the RBT refers to the realisation principle as a "liquidity or cash flow
constraint". It stands in the way of a comprehensive income model together
with
"a volatility constraint", "a valuation constraint",
"a loss offset constraint" and "an international
competitiveness
constraint". See also P Kenny, "Realisation
versus Accruals: Capital Gains Taxation in Australia", 13th Australian Tax
Teachers Association Conference, Sydney, 2001.
[26] See ITAA97, Div 104.
[27] See R Parsons, Income Taxation in Australia (1985) 12-24.
[28] See ITAA97, s 8-1 and note 68 below.
[29] In A Platform for Consultation, 11, the point was underlined:
"[recognition of unrealised gains and losses]
... which is not being proposed". There is an exception to this,
relating to accruals taxation of financial instruments - see A Tax System
Redesigned,
340-341.
[30] See H Simons, Personal Income Taxation: The Definition of Income as
a Problem of Fiscal Policy (1938) 55.
[31] A Platform for Consultation, 28.
[32] Explanatory Notes, 3.11.
[33] See note 10 above.
[34] A simplification of the "method statement" in s 5-60 of the
Draft Legislation.
[35] As codified in Subdiv 6C of the Draft
Legislation.
[36] See SAC 4, para 48.
[37] Ibid para 51.
[38] Subject to Pt IVA of the ITAA36; see Grbich,
above n 7, 26 and generally on liabilities, A O'Connell, "Option 2: Will
it Change What is Included in Assessable Income?"
(2000) 29 Australian Tax Review 68, 75-76 and 79-80.
[39] J Dodge, J Fleming and D Geier, Federal
Income Tax: Doctrine, Structure and Policy (2nd ed, 1999) 36-37.
[40] Ibid 730.
[41] Draft Legislation, s 5-55.
[42] A problem also for the existing system: see discussion of the
traditional response at note 50 below.
[43] Draft Legislation, s 6-40.
[44] Pursuant to ITAA97, Div 115, acknowledged in A Tax System Redesigned,
4.18. Section 115-40 provides that the discount percentage
for Joe would be
50%. Under ITAA97, Div 152, Joe could also enjoy the 15-year exemption (Subdiv 152-B), the 50% reduction (Subdiv
152-C), the retirement concession (Subdiv 152-D) and
the roll-over (Subdiv 152-E).
[45] See discussion of Recommendation 4.13(d) and "capital gains
treatment" for certain private gains made by individuals at
note 63 below.
Capital gain made by entities will be taxed at the consistent entity rate of 30
per cent, rather than at the lower
"discount capital gains" rate, but
with increased possibilities for tax deferral and tax-effective distribution.
[46] Draft Legislation, s 96-200, Item 6.
[47] Ibid s 6-40, Items 13 and 14.
[48] In A Platform for Consultation, 44-45; and A Tax System Redesigned, 190-191.
[49] See, for instance, The Broken Hill Proprietary Company v FC of T
2000 ATC 4659 (interest or purchase price); FC of T v Brown 99 ATC 4600
(interest after business ceased); Steele v FC of T 99 ATC 4242 ("Steele");
Travelodge Papua New Guinea Ltd v Chief Collector of Taxes 85 ATC
4432 ("Travelodge") (interest before business commenced); FC
of T v Energy Resources of Australia Ltd 96 ATC 4356 (interest-like
discounts on bills of exchange); Australian National Hotels Ltd v FC of T
88 ATC 4627 ("Australian National Hotels") (insurance
premiums/interest on exchange rate risk); Case 13 (1951) 2 CTBR (NS)
(borrowings by trustees of deceased estate); Case 46 (1944) 11 CTBR; Case
33 (1945) 12 CTBR (interest on shareholders' debts assumed by companies);
and Case 2 (1957) 7 CTBR (NS) (whether interest is part of purchase
price).
[50] The "tracing" test is associated in Australia with FC of
T v Munro [1926] HCA 58; (1926) 38 CLR 153 ("Munro") and Hallstroms Pty Ltd v FC of T [1946] HCA 34; (1946) 72 CLR
634, 648 – "what the expenditure is calculated to effect from a
practical and business point of view"; see also the recent
analysis of
Lord Hoffman in Wharf Properties Ltd v Commissioner of Inland Revenue
[1997] UKPC 4; [1997] AC 505, 511 (per Privy Council).
[51] [1926] HCA 58; (1926) 38 CLR 153, 171 (per Knox CJ); 196-197 (per Isaacs J): see S Chapple, The Vexed Problem of the Deductibility of Interest
Expenditure", 13th Australian Tax Teachers Association
Conference, Sydney, 2001.
[52] Steele 99 ATC 4242, 4250-4251 (per Gleeson CJ, Gaudron and Gummow JJ); 5272 (per
Callinan J; Kirby J dissenting) applying Australian
National Hotels 88 ATC 4627, 4632-4634 (per Bowen CJ and Burchett J).
[53] [1938] HCA 73; (1939) 61 CLR 337, 359-364.
[54] [1940] HCA 9; (1940) 63 CLR 382, 468.
[55] See the analysis of Bredmeyer J in Travelodge
85 ATC 4432, 4441.
[56] Both the majority and the minority in Steele 99 ATC 4242 concurred
on this: 4251 (per Gleeson CJ, Gaudron and Gummow JJ); and 4267 (per Kirby J).
[57] Accounting Standard AASB 1036 (1997), paras
4.1 and 4.2.
[58] Ibid para 11.1.
[59] Ibid para 4.2.
[60] A Tax System Redesigned, 191. Note that the
"capital" word qualifies "funds underlying a business",
despite the "errors" resulting
from "the importation into tax
law of the distinction between capital gains and revenue gains" listed in
A Platform for
Consultation, 45.
[61] A Platform for Consultation, 44.
[62] A link discussed in relation to the present system by Kirby J
(dissenting) in Steele 99 ATC 4242, referring to Wharf Properties Ltd
v C of IR [1997] UKPC 4; [1997] AC 505, 511 (per Lord Hoffman).
[63] A Tax System Redesigned, Recommendation 4.15(a)(iv).
[64] See the authorities referred to in note 49 above.
[65] Land not used for income-producing purposes other than the generation
of capital gains, in respect of which the regime for "discounted
capital
gains" under ITAA97, Div 115 would apply. Note that the
Draft Legislation, s 12-20 provides that land (other than the taxpayer's main
residence) is never a private asset –
hence the deductibility of
borrowing expenses is otherwise not precluded.
[66] Negative-gearing is excluded because the land is then used for an
income-producing purpose; in relation to other assets see the reservations
of
the RBT in A Platform for Consultation, 45.
[67] None of this material appears in the Draft Legislation.
[68] See Explanatory Memorandum to the Income Tax Assessment Bill
1996, 42: "[clause 8-1] essentially restates subsection 51(1) of the Income
Tax Assessment Act 1936. Interpretation of that provision has
evolved over many years in the courts. The Bill rewrites subsection 51(1) with
a clearer structure
but does not disturb its language and is not intended to
affect previous interpretations."
[69] See Third Report, above n 15, [551]: "[W]e received a great deal
of evidence in regard to the deductions allowed in respect
of a trade or
business ... The most extreme view expressed was that the admissibility of a
deduction should be determined by the
custom of accountants ... That test is
impracticable. Other witnesses took a more reasonable view".
[70] See Parsons, above n 27, 6.2.
[71] Steele 99 ATC 4242, 4251 (per Gleeson CJ, Gaudron
and Gummow JJ): "contemporaneity
is not legally essential, and whether it is factually important may depend on
the circumstances of the particular case."
[72] Amalgamated Zinc (De Bavays) Ltd v FC of
T [1935] HCA 81; (1935) 54 CLR 295, 309 (per Dixon J).
[73]Lunney v FC of T [1958] HCA 5; (1958) 100
CLR 478, 498-499 (per Williams, Kitto and Taylor JJ;
Dixon CJ agreeing).
[74] See Fletcher v FC of T 91 ATC 4950, 4960-4962, curiam.
[75] See G Cooper, R Krever and R Vann, Income
Taxation: Commentary and Materials (3rd ed, 1999) [8-950].
[76] See Grbich, above n 7, 26.
[77] 91 ATC 4950.
[78] Ibid 4955, curiam - reflecting the
relatively high interest rates prevalent at the time that the 15 year agreement
was entered.
[79] 91 ATC 4950, 4957-4958, remitting this factual matter to the
Administrative Appeals Tribunal – which found that the deduction
claim
failed, as the scheme was not intended to last until it became commercially
valuable: 92 ATC 2045.
[80] 91 ATC 4950, 4955-4956.
[81] G Pierson and A Ramsay, Financial Accounting: An
Introduction (1996) [3.2.5], referring to SAC 4.
[82] SAC 4.
[83] SAC 4, Addendum A24; cf (US) FASB Concepts
Statement No 5 (1984), para 81 and (UK) Accounting
Standards Board, Draft Statement of Principles (1992), para
24.
[84] Weinman, above n 22, 428: "accounting
is an art and not an exact science".
[85] W Paton and W Littleton, An
Introduction to Corporate Accounting Standards (1940) 15.
[86] Geier, above n 16, 24.
[87] See W Raby and B Raby,
"Consistency, Matching and Economic Performance" (1996) 71 Tax
Notes 923, 923.
[88] See S Cohen, "Accounting for Taxes, Finance and Regulatory Purposes
– Are Variances Necessary?" (1966) 22 Taxes: The Tax Magazine
780, 785.
[89] Ibid 783.
[90] In accord with Accounting Standard AASB 1028 (1994), paras 11-13.
[91] As well as the recognised accruals for
Option 2 described in Items 1, 2, 7 and 9 in s 6-40: see note 32 above; and
Cohen, above n 88, 783-784.
[92] Cohen, above n 88, 780.
[93 ]A Tax System Redesigned, 155.
[94] Porcano et al, above n 18, 500.
[95] Nolan, above n 17, 768.
[96] A Platform for Consultation, 6.
[97] See the CPA Australia and The Institute of Chartered Accountants in
Australia, Accounting and Auditing Handbook 2001: Statements of Accounting
Concepts and Australian Accounting Standards, UIG Abstracts, Auditing
Standards and Statements.
[98] See A Blaikie, "The Relevance of
Accounting Principle to the Income Tax Assessment Act" (1981) 15 Taxation
in Australia 690, 691; and C Westworth,
"Accounting Standards – a Framework for Tax Assessment" (1985)
2 Australian Tax Forum 243, 245-247.
[99] Following a "spectacular series of crashes of
corporate financial empires": see R Craig and R Clark, "Phases in
Australian
Accounting Standards Setting: Control, Capture, Co-existence and
Coercion" (1993) 3 Australian Journal of Corporations Law 50, 53-54.
Objectives stated in Accounting Standards Review Board, "Procedure for the
Approving of Accounting Standards"
(1985) ASRB Press Release 2000,
5.
[100] See Corporations Law, s 304.
[101] Craig and Clark, above n 99, 58.
[102] Ibid 59.
[103] See W Raby, "The
Meaning of 'Accrued' – Accounting Concepts Versus
Legal Concepts" (1992) 67 Tax Notes 777.
[104] Discussed in Porcano et al,
above n 18, 501-502.
[105] 90 ATC 4559; see note 77 above.
[106] [1979] USSC 16; (1979) 439 US 522.
[107] Ibid 532 (per Blackmun J for the Court).
[108] Ibid 544.
[109] See Smith, above n 23, 351-352.
[110] See Cohen, above n 88, 786.
[111]Porcano et al, above n 18, 503.
[112] Ibid 504-505.
[113] Though in A Tax System
Redesigned, 13 "tax equity" was put the second to "optimising economic growth"; see generally Raby, above n 103, 777.
[114] See discussion of the example and variation two and Raby and Richter, above n 22, 44.
[115] See note 25 above.
[116] AASB 1001; eg ensuring that
the substances of underlying transactions are reported, that relevant
financial information is provided, which reliably convey the facts.
[117] See Explanatory Notes, 57-62 and Table 3.7.
AustLII:
Copyright Policy
|
Disclaimers
|
Privacy Policy
|
Feedback
URL: http://www.austlii.edu.au/au/journals/JlATax/2001/1.html