Taxation law assignment: Questions based on Principles of Income Tax Law

Question

Task: The present taxation law assignment covers the following parts:

Part 1 A: Ignoring Capital Gains Tax, discuss whether the sales proceeds from the apartments generate ordinary income.

Part 1 B: Advise Ken as to the CGT consequences regarding the 2019-20 tax year. In doing so please discuss Ken’s ability to utilise the CGT Small Business Concessions. Please also include a discussion of the Net Capital Gain made by Ken for the 2019-20 tax year.

Part 2: Should the Australian Capital Gains Tax system have a 50% discount available to taxpayers?

Discuss this with reference to the criteria for evaluating tax policy:

• Economic efficiency
• Simplicity
• Equity/fairness

You should feel free to discuss any other relevant matters.

Answer

Part 1

Answer 1A
The present case scenario explored in the taxation law assignment is related to whether the sale proceeds received from selling of the apartment is assists towards the generation of the ordinary income.

As per Section 6.5 of the Income Tax Assessment Act 1997, the assessable income of the person includes income as per the ordinary concept, which is referred to as ordinary income. In other words, it can be said that income that is generated from the ordinary concept is considered as ordinary income . Further, income generated from all sources, whether inside Australia or outside of Australia, in the course of the financial year, is included in the assessable income as an ordinary income . There are usually three elements that form the part of ordinary income such as –

• Income generated from personal exertion such as salary or wages.
• Income generated from the property such as rent, dividend, or amount of interest³.
• Income generated from running business activities such as retail sales.

As per the legal case, Scott v FCT, when the receipt is considered as an income, then it should be ascertained as per the ordinary concept, except only if it is specifically mentioned in any other statute . Further, an amount of income would be considered as ordinary profit only if it is received by the entity in that specific year. As per Section 6.5 of the cited Act, when income has -

¹ Income Tax Assessment Act 1997

²Siddhartha Biswas, Chakraborty Indraneel, and Hai Rong. ‘Income inequality, tax policy, and economic growth.’ 2017 The Economic Journal 127.601, 688-727.

³John Hasseldine, and Fatemi Darius. ‘Tax practitioner judgements and client advocacy: the blurred boundary between capital gains vs. ordinary income.’ 2018, eJTR 16, 303.

⁴ Scott v Federal Commissioner of Taxation [1966] HCA 48

been derived by the entity then in such case it is considered as the amount has been received by the entity. On the other side, capital receipt, profit from recreational activities, non-cash receipts, gifts, are not considered as ordinary income⁵ .

In the given case scenario of taxation law assignment, it has been observed that the primary business of Nikki is related to a clothing store and she received income from selling of apartment to the public by a prominent real estate agent. Thus, it cannot be said that it is the income derived from the ordinary concept; it is because the selling of an apartment is not the primary business of Nikki. It has been seen that capital receipt does not form part of ordinary income, and receipt of selling of apartment comes within that criteria only. Based on this, in the total assessable income of the Nikki, such income would not form part of the profits under the heading of income and gain generated from business activities and professional activities, rather than it would be considered as capital gain profit.

Answer 1 B
The given case scenario examined in the taxation law assignment is related to the consequences of the capital gain tax concerning the 2019-20 tax years.

As per the Australian Taxation System, capital gain tax is a tax levied on the capital profit generated on the disposal of any capital asset, with several specific exemptions, the most prominent one being the residential house. Capital gain tax operated through considering the net capital gain as the taxable profits in the year in which assessee sold or disposed on the capital assets . Further, a capital gain may be short term or long term. If the assets are sold within one year from the date of its acquisition, then in such case it results in the short term capital gain, and vice versa. Further, if the sale proceeds of assets sold are more than its acquisition cost, then it-

⁵Steve Ford, and Dibden Andrew. ‘Gifted assets, valuation and ordinary income.’ 2019, Taxation in Australia 53.10, 560.

⁶Karen Handley, Wright Sue, and Evans Elaine. ‘SME reporting in Australia: where to now for decision?usefulness?.’ 2018 Australian Accounting Review 28.2, 251-265.

leads towards the profit of the sale of capital assets and vice versa . In other words, it can be said that, if a person or business sells its assets like property, furniture, then they generally generate capital gain or losses⁸.

Reduction of the capital gain – CGT concession

There are some capital gain tax concession has been provided under the Income Tax Assessment Act to the small business, by which they can decrease the capital gain on the business assets. In this aspect, conditions of small business are explained as follows –

Normal requirements for the small business CGT concessions – In order to avail qualification for the four small business capital gain tax concession, it is required that person should fulfill the basic condition, which is common in all four concessions.

Step 1 – It is essential to satisfy one of the following condition presented in the next section of this taxation law assignment –

• An individual, company, trust, or partnership is considered a small business entity if it is running business activities and has a total turnover of less than $ 2 million.
• If a person satisfies the maximum net asset value test. According to this, the total net value of the capital gain tax asset owned by the person and specific entities should not be more than $ 6 million before the CGT event. Further, the inclusion of assets is not limited to business assets only¹⁰.

⁷Justin Douglas, and Land Pejoska Amy. ‘Regulation and small business.’ 2017 Economic Round-up 2017, 1.

⁸Peter Bowal, and Brierton Thomas D. ‘The Exemption Approach toward Rights: A Review of the Boeing Australia Decision.’ 2018 Can. B. Rev. 96, 57.

⁹Renuka Somers. and Martins Patricia. ‘A matter of trusts: Case study: Litigation settlements and CGT SBC.’ 2016, Taxation in Australia 51.4, 208.

¹⁰Mark West, and Lam Dung. ‘Small business restructure roll-over-Opportunities and traps.’ 2016 Taxation in Australia 50.9, 521.

Step 2 – The asset is given in the question must satisfy the active asset test. As per this test, it is required by the person to hold it in the course of business activities, and it may be tangible or intangible assets¹¹. The assets are considered as active if it is owned by an assessee for a minimum period of 7.5 years, if it was held for more than 15 years or if it is owned for less than 15 years, then it should be held by an assessee for at least half of the test period¹².

Small business 15-year concession: In this, if the age of the business owner more than 55 years, then there is no assessable capital gain on the selling of the assets of a business which has been held for 15 years.

Small business 50% active asset reduction: As stated in the taxation law assignment, by this, a person could decrease the capital gain on the asset of business by 50%, which is separate to the CGT discount.

Small business retirement exemption: Any capital gain generated from the selling of the business asset would be exempt for the limit up to $500000. If the age of a person is less than 55, then such exempt amount should be entering into either compliance with superannuation fund or retirement saving account.

Small business rollover: In this, a small business could defer the amount of capital gain on business assets, they are not required to include the profit in the income until a change in the condition generates a CGT event that then brings such gain into the next taxable event¹³.

Provisions related to selling of the house

¹¹Helena Yuan. ‘Review of structures for SMEs.’ 2017 Taxation in Australia 52.6, 302.

¹²Tim Mazzarol, and Clark Delwyn. ‘The evolution of small business policy in Australia and New Zealand.’ taxation law assignment 2016 Small Enterprise Research 23.3, 239-261.

¹³Ben Ralston. ‘Does payroll tax affect firm behaviour?.’ 2020, Economic Papers: A journal of applied economics and policy 39.1, 15-27.

If the selling price of a house is more than its cost base, then such difference is considered as capital gain and vice versa. Although, if it is claimed by an individual that such house is the primary place of residence, then the capital gain of such property is exempted from the tax.

What is the net capital gain made by Ken in this case of taxation law assignment?
In the present case of taxation law assignment, aggregate turnover is around $ 3 million; therefore, he does not satisfy by the criteria of small business entity concession. Further, if the net asset value of Kin is less than $6 million, then he may entitle some exemption in capital gain. The computation of the net asset value of the business of Kin as follows –

Table 1 Net Asset Value as of November 2019

Based on the above calculation done in this taxation law assignment, it can be seen that the business of Kin falls under the small business entity concession, and thus it was allowed to claim a 50% deduction of the sale of a business asset.

Table 2 Capital gain/loss

Receipt on upfront lease payment is considered as a capital receipt as it would provide benefit for more than one year. Similarly, the non-compete fee is also considered a capital receipt. In the legal case, FCT v Star City Pty Ltd, upfront payment of the lease is considered as capital expenses based on the substantial nature of expenditure¹⁴.

Herein taxation law assignment, in the above computation, 50% of the original capital gain remains. Capital gain on the selling of house property is as follows –

Table 3 Capital gain on the selling of house property

¹⁴FCT v Star City Pty Limited [2009] FCAFC 19

In this, there is not any capital gain discount remains on the selling of house property as a small business entity could avail concession only on the selling of business assets.

Part 2
As per the Income Tax Assessment Act 1997, there are two methods of computation of capital gain, named as Indexation method, and Discounting method. As per the Division 115 of the cited Act, the capital gain tax applies to individuals, trust, and superannuation entities. However, such a method does not apply to companies. Before this, taxation on capital gain usually based on the marginal rate of income tax, and there was no concept of 50% discount of capital gain tax. In the year 1999, at the time when the representation of the CGT discount was taken into account, there was not any precise evidence to help the opinion that it would essentially assist towards increment in the revenue¹⁵. In assertion to this, current empirical predictions of the capital gain realization imply that 50% discounting policy on the capital gain tax for eh taxpayer in Australia is probably have been a revenue-losing policy. It can be said in this taxation law assignment that CGT discount also leads towards unfairness, inefficiency, comprehensiveness, in the taxation, which is explained as follows -

Arguments against the CGT
Equity
One of the main causes for the introduction of regimes is equity for taxation of capital gains and this happened after a short period of changes that have been observed in the Australian CGT regime in 1999 by introducing 50% CGT discount. Both the horizontal and the vertical aspects of-

¹⁵Chris Evans, Minas John, and Lim Youngdeok. ‘Taxing personal capital gains in Australia: An alternative way forward.’ 2015 Austl. Tax F. 30, 735.

the equity have been offended by the introduction of discount in 1999 . The concept that the same amount of tax is required to be paid by the taxpayers with the same economic wealth is considered as Horizontal equity. A tax reference is provided by the CGT discount for the majority of the taxable capital gain and thus it breaches the horizontal equity¹⁷. For instance, loss of less than quarter of the proceeds is to be borne by a share market or property investor with a gain of A$1 million made over 5 years when compared to an employee who will lose nearly half in tax by earning A$1 million over the same 5 year period. Therefore, the principle of horizontal equity is not in agreement with the direct consequences of the CGT discount regime.

While considering a vertical equity perspective also the 50% CGT discount being an essential rate preference is found as inequitable as the high-income taxpayers were targeted for the most significant advantage. According to the Vertical equity concept undertaken in this segment of taxation law assignment, it is required that a large amount of tax should be paid by the taxpayers who are more capable to pay it. This is in response to a progressive tax system which is designed with principles of vertical equity by considering the capability to pay by taxpayers. The most equitable CGT regime is that where the normal rates are considered for taxing capital gain instead of rate preference¹⁸. At higher levels of income, the discount preference existed in the CGT will be the cause of marginal tax rates which are merely theoretical. There will be a decrease in the effective marginal tax rate faced by the taxpayer with the increase in the proportion of discount in the assessable income. With this, an inconsistent outcome in a tax system is considered here which purports to be progressive. Consequently, the principle of ability to pay, a fundamental characteristic of a progressive tax system gets violated in Australia by the level of the 50% discount for personal taxpayers.-

¹⁶Brett Freundenberg, and Minas John. ‘Reforming Australia's 50 per cent capital gains tax discount incrementally.’ 2018 eJTR 16, 317.

¹⁷Faruk Balli, et al. ‘Consumption smoothing and housing capital gains: evidence from Australia, Canada, and New Zealand.’ 2020 Applied Economics, 1-17.

¹⁸Shigehiro, Kostadin Kushlev Oishi, and Schimmack Ulrich. ‘Progressive taxation, income inequality, and happiness.’ 2018 American Psychologist 73.2, 157.

Efficiency
The efficiency is referred to as the economic efficiency concerning a tax system designed. A tax system is considered as efficient in economic terms to the extent that the behaviour of the taxpayer does not get altered with that¹⁹. The removal of 50% CGT has gained more efficiency as the deadweight cost linked with the tax planning which aims at characterizing income as capital gain is also got removed from the tax system. The taxpayers are encouraged to devise schemes so that they can re-characterize their capital gain income as ordinary income due to the large difference between the tax rates. The economic behaviour is considerably distorted in Australia in all sort of ways by the presence of discount²⁰.

The notion of tax neutrality is another point of concern concerning the CGT discount in this case of taxation law assignment. It is not desired that the investment decision of taxpayers get unintentionally distorted through the potential for the tax system. The design of the tax system consists of an important principle known as tax neutrality that requires the choices of the taxpayer concerning investment or consumption to be neutral. The productive capacity of an economy can be impeded or reduced by the tax system with the instances of neutrality breaches. The reason behind the removal of the modern tax system from the ideal models is that any of the tax policy criteria may get intentionally violated by the government. This could be done with the belief that the government will be able to attain policy goals that are desired. For instance, to encourage higher expenditures the principle of tax neutrality can be violated by introducing tax concession with regards to expenditure on research and development. However, incentives may be provided for aggressive tax planning through these tax concessions. The level at which the allocation of resources gets influenced is to be considered for making a judgment on a tax as per the tax neutrality principle. Taxes are considered to be as normal if it does not interfere with the allocation of resources in the market.

¹⁹Janet Stanley. ‘The interface between family well-being and government policy in Australia.’ 2020 Cross-Cultural Family Research and Practice. Academic Press, 373-387.

²⁰Hazel Blunden. ‘Discourses around negative gearing of investment properties in Australia.’ 2016, Housing Studies 31.3, 340-357.

Simplicity
A tax system consists of obvious simplicity benefits if the capital gains and other forms of assessable income are taxed at the same marginal rates. The present CGT regime will fail to do this for personal taxpayers²¹. Further, the concept of 50% CGT discount which seems to be very simple can bring significant complication at the time of practice. These complications comprise of the severe legislative complexities came across during the interaction of the discount provisions of Div 115 of ITAA 1997 and rules concerning specific forms of entity, for instance, the trust provision and the indirect interaction with the small business concession in Div 152. Moreover, this also includes a sequence of detail integrity measures to be present. This comprises of design to ensure in the case where a corporate entity is used to hold newly acquired assets, the discount is unavailable²². Thus, it is clarified in this taxation law assignment that the twelve-month holding rule necessary to avail the discount is has been potentially evaded. Various complexity of the application of the provisions in practice has been illustrated through the elimination of the discount for foreign residents in 2013. The discount percentage to be applied to a discount capital gain will be based on the four factors in the case where a CGT event occurs after 8 May 2012. These factors include whether or not the individual was a resident on the date in case if the asset was held on 8 May 2012; whether the asset was acquired after 8 May 2012 or it was held on the same date; whether an individual is a non- resident on 8 May 2012 has determined the portion of the discount capital gain that accrued on and before that date by applying the market approach and whether the individual was resident during so much of the period that the asset was held after 8 May 2012. CGT is a relatively complex tax that enforces inconsistent compliance cost on personal taxpayers. It has been established through the previous research that in Australia CGT compliance cost are significant²³. These are relatively high as-

²¹Wayne Mayo. ‘Time to upgrade Australia's company tax system from imputation to integration.’ 2018, Austl. Tax F. 33, 753.

²²Stephen Barkoczy, and Wilkinson Tamara. ‘Suggestions for Reforming Australia’s Early Stage Investor Program.’ 2019 Incentivising Angels. Springer, Singapore, 99-107.

²³Mark Burton. ‘Extending the tax expenditure concept in Australia.’ 2018, Austl. Tax F. 33, 281.

compare to revenue collected, compliance cost of other taxes and tax payable. There is an under-billing for CGT work in Australia and the compliance cost of the CGT regime is a matter of concern to practitioners. With an average sum of under-billing at 30%, it has been disclosed by the practitioners that it would not be possible for them to recover the complete cost from their clients relating to their professional work on CGT. In the case where it has been accepted that CGT is an essentially complex tax creating cost recovery problems for the practitioners along with imposing compliance cost on personal taxpayers, one of the most effective methods of attaining simplicity is to reduce the number of taxpayers liable to pay this tax with the introduction of a provision²⁴.

Based on the above aspects analysed in this taxation law assignment, it has been suggested that Australian Capital Gain Tax system should not have a policy of 50% discount of the capital gain tax to the taxpayer. The reason behind the same is that horizontal, as well as vertical aspects of the equity, have been offended by such a discount. A capital gain tax system, in which tax on the capital gain levied at the ordinary rates, would be more equitable as compared to the system in which rate preferences is allowed. Further, the presence of discount in Australia also slanted economic behaviour in a significant manner . At last, a 50% capital gain tax discount also comprised of agonizing judiciary comprehensiveness. Based on this, it is suggested that 50% CGT discount should be eliminated.

²⁴Nestor Castaneda, Doyle David, and Schwartz Cassilde. ‘Opting Out of the Social Contract: Tax Morale and Evasion.’ 2020 Comparative Political Studies 53.7, 1175-1219.

²⁵Víctor Mauricio Castañeda. ‘Tax Equity and its Association with Fiscal Morale.’ 2019 International Public Management Journal, 1-26.

Bibliography
Balli, Faruk, et al. ‘Consumption smoothing and housing capital gains: evidence from Australia, Canada, and New Zealand.’ 2020 Applied Economics

Barkoczy, Stephen, and Tamara Wilkinson. ‘Suggestions for Reforming Australia’s Early Stage Investor Program.’ 2019 Incentivising Angels. Springer, Singapore

Biswas, Siddhartha, Indraneel Chakraborty, and Rong Hai. ‘Income inequality, tax policy, and economic growth.’ 2017 The Economic Journal 127.601

Blunden, Hazel. ‘Discourses around negative gearing of investment properties in Australia.’ 2016, taxation law assignment Housing Studies 31.3

Bowal, Peter, and Thomas D. Brierton. ‘The Exemption Approach toward Rights: A Review of the Boeing Australia Decision.’ 2018 Can. B. Rev. 96

Burton, Mark. ‘Extending the tax expenditure concept in Australia.’ 2018, Austl. Tax F. 33

Castaneda, Nestor, David Doyle, and Cassilde Schwartz. ‘Opting Out of the Social Contract: Tax Morale and Evasion.’ 2020 Comparative Political Studies 53.7

Castañeda, Víctor Mauricio. ‘Tax Equity and its Association with Fiscal Morale.’ 2019 International Public Management Journal

Douglas, Justin, and Amy Land Pejoska. ‘Regulation and small business.’ 2017 Economic Round-up 2017

Evans, Chris, John Minas, and Youngdeok Lim. ‘Taxing personal capital gains in Australia: An alternative way forward.’ 2015 Austl. Tax F. 30

Ford, Steve, and Andrew Dibden. ‘Gifted assets, valuation and ordinary income.’ 2019, Taxation in Australia 53.10

Freundenberg, Brett, and John Minas. ‘Reforming Australia's 50 per cent capital gains tax discount incrementally.’ 2018 eJTR 16

Handley, Karen, Sue Wright, and Elaine Evans. ‘SME reporting in Australia: where to now for decision?usefulness?.’ 2018 Australian Accounting Review 28.2

Hasseldine, John, and Darius Fatemi. ‘Tax practitioner judgements and client advocacy: the blurred boundary between capital gains vs. ordinary income.’ 2018, eJTR 16

Mayo, Wayne. ‘Time to upgrade Australia's company tax system from imputation to integration.’ 2018, Austl. Tax F. 33

Mazzarol, Tim, and Delwyn Clark. ‘The evolution of small business policy in Australia and New Zealand.’ 2016 Small Enterprise Research 23.3

Oishi, Shigehiro, Kostadin Kushlev, and Ulrich Schimmack. ‘Progressive taxation, income inequality, and happiness.’ 2018 American Psychologist 73.2

Ralston, Ben. ‘Does payroll tax affect firm behaviour?.’ 2020, Economic Papers: A journal of applied economics and policy 39.1

Somers, Renuka, and Patricia Martins. ‘A matter of trusts: Case study: Litigation settlements and CGT SBC.’ 2016, taxation law assignment Taxation in Australia 51.4

Stanley, Janet. ‘The interface between family well-being and government policy in Australia.’ 2020 Cross-Cultural Family Research and Practice. Academic Press

West, Mark, and Dung Lam. ‘Small business restructure roll-over-Opportunities and traps.’ 2016 Taxation in Australia 50.9

Yuan, Helena. ‘Review of structures for SMEs.’ 2017 Taxation in Australia 52.6

Case laws
FCT v Star City Pty Limited [2009] FCAFC 19
Scott v Federal Commissioner of Taxation [1966] HCA 48

Act
Income Tax Assessment Act 1997