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Income Theory and Case Law – Week 2

Week 2: Income – Theory, Case Law and Application

This week continues the journey from week one by introducing income as the central taxable concept. The lecturer emphasizes that the first four weeks are theory-heavy, focusing on case law and legislation, and applying that theory to questions. In week one the focus was on residency questions; students were told to expect a large residency question in the assignment, which is due in week ten. For week two, the focus shifts to income: applying case law to assessable income and determine how to answer related questions. There are about fifteen case law examples this week, compared with roughly one primary reference for residency in week one. The teacher notes there will be five or six references that are particularly important for income questions, so the coverage is more dispersed but broader in scope. After week two, two weeks will cover deductions, followed by more technical and practical work from week five onward. The teacher also mentions that recording of last week’s session is available under the announcements, with a hyperlink and passcode to revisit the residency discussion. Solutions for week two are released at the start of the week to offer students flexibility, so week two solutions are already available for review.

From the outset, the instructor frames income as a contested area: taxpayers seek to classify money received as not income, while the tax office seeks to classify it as assessable income. The session then introduces the core objective: to understand taxable income as taxable profit, i.e., assessable income minus allowable deductions. A crucial distinction is drawn between taxable income (for tax purposes) and financial reporting income (for accounting purposes). Likewise, the instructional distinction is made between allowable deductions for tax purposes and expenses for financial reporting; the two domains do not always align.

Two key statutory references structure the discussion: 6.5 (ordinary income) and 6.10 (statutory income). There are also carve-outs and exemptions, including 6.15 (exclusions) and non-assessable non-exempt (NANE) provisions. The practical focus narrows to ordinary income versus statutory income, while acknowledging there are exemptions within each area. When calculating tax payable, the general equation is to compute taxable income (or taxable profit) as accessible income minus allowable deductions, and then apply the tax rate with offsets: ext{Tax payable} = ig( ext{Taxable income}ig) imes ext{Tax rate} - ext{Tax offsets}. In practice, taxpayers also consider the marginal rate for ordinary income and the capital gains tax (CGT) regime, including the notable 50% discount on capital gains, which makes capital gains tax more favorable compared with ordinary income tax.

The material emphasizes three essential questions that must be satisfied for something to be income for tax purposes: there must be compensation provided, there must be something received, and it must be linked to employment or services rendered. In business contexts, income is distinguished from a hobby by the intention to profit; a hobby lacks the profit-making intention, and therefore different tax treatment may apply. The concept of mutuality is introduced via clubs and societies: within certain structures (for example, clubs that are membership-centred and operate for the benefit of members rather than as a profit-seeking enterprise), income attributable to members is not taxed as income to those members. The existence of NANE exemptions is acknowledged but not elaborated in detail here.

A practical decision tool is presented as a flowchart: if income is ordinary, it is included in accessible income unless a specific exemption applies; if it is statutory, it is assessable; and there are carve-outs within each branch for exempt portions. The lecturer warns against confusing ordinary income with statutory income and reinforces the three-part test for income: compensation, allocation (receiving something), and link to employment or services.

The concept of capital vs income is a central theme. Income is taxed at ordinary marginal rates, while capital gains can benefit fromCGT concessions (notably the 50% discount for individuals). The classic “tree” analogy (from Eisner v. Macomber) is used to illustrate the distinction: the fruit (income, e.g., rent) comes from the tree (the asset, e.g., the house); selling the tree yields a capital gain. This analogy is extended to dividends (the fruit from shares) and interest from term deposits (the fruit from cash/invested assets within a tree framework). The essential question is whether the taxpayer is disposing of the tree (capital) or the fruit (income).

A set of landmark cases anchors the week’s exploration of capital versus income. The Merv Brown v. FCT case is highlighted as a key reference: here, the taxpayer imported clothing under government quotas and sold it; the court treated the proceeds from the quota as capital because the taxpayer sold the income-earning mechanism rather than revenue from ongoing income. This demonstrates how “selling the income-earning capability” can convert a transaction to capital. GP International is also discussed: establishment costs paid by a contract payer to cover capital expenditure were treated as income, because the payer’s payment served to enable the income-earning activity. Edgerton Warburton introduces periodic payments (annuities) as a mechanism that can convert a capital disposal into income when the payments are periodic and perpetual; the structure of payments (periodicity) can be decisive in classifying payments as income.

Mutuality is another important theme, illustrated by the Bohemian case and the broader treatment of clubs and member-based benefits. The principle is that you cannot extract income from yourself through a membership or mutual arrangement, so income derived directly from members’ purchases or dues is not necessarily taxable in the hands of the members. This concept also informs partnership discussions and not-for-profit club arrangements. The Cook v Sheridan case introduces the notion that non-monetary rewards (e.g., prizes that cannot be converted to cash) may not be income if the recipient cannot realize cash from the prize; conversely, if a prize can be sold or converted to cash, it is more likely to be treated as income. The ATO’s decision in the A.T.A. (competition prize tied to sales) case highlights the principle that a prize linked to performance and convertible to cash generally constitutes income. The teacher emphasizes having both types of references in the back pocket for exams and notes that even a general reference to Section 6.1, 6.5, or 6.10 can secure some marks if the exact case law isn’t recalled.

Several more nuanced case studies are introduced to show the spectrum of capital versus income outcomes. The Stones/Stone case focuses on reward for service and whether a payment is tied to employment activity. If there is a nexus to employment and the payment is driven by that employment, it is more likely to be treated as income. Government grants and scholarships are mentioned in passing as potentially exempt in some circumstances, but the course does not go into the fine-grained specifics here. The discussion includes prizes, winnings, and the line between occasional winnings (not income) and regular, professional gambling (income). Employee allowances (travel, uniforms) are recognized as income; FBT (fringe benefits tax) considerations are acknowledged for later weeks.

The CML case broadens the discussion by showing that a life insurer may invest cash to fund policy payouts and that such cash management may be treated as income depending on the ordinary course of business. Maya Emporium and Westfield are used to illustrate the role of original intention. Maya’s one-off transaction was income because there was an intention to profit, even though it was a one-off transaction; Westfield, by contrast, held that profit arose from the same activity originally envisaged and, if circumstances led to a change in that activity, the gains could be treated as capital rather than income. This juxtaposition is frequently tested in exams: a question will require stating whether a particular scenario aligns with Maya or Westfield and to justify the outcome using the two cases plus the general profits-on-isolated-transactions principle from TR 93/3.

Other notable cases discussed include Cyclone Scaffolding (sale of scaffolding not in the ordinary course of business was capital), Memorex (sale of computers as part of a business operation yields income due to turnover regularity), Scottish Australian Mining (land subdivision to maximize return deemed income due to change of asset value), Whitford’s Beach (land rezoning followed by substantial profit treated as income because value-added activity occurred), and Dixon’s case (makeup pay as compensation for an injured employee that enhances incomeability). The discussion of gambling also emphasizes that, while most gambling activities are treated as non-income, there are circumstances where gambling can be treated as a business, requiring systematic tracking and longer-term activity.

The discussion then turns to the distinction between employee and business contractor status and the Personal Services Business (PSB) regime. The lecture presents the practical benefits of being a business owner who can split income with a spouse and claim broader deductions, contrasted with the limitations of being an employee. The examples consider tax efficiency in a university teaching context, illustrating when a contractor can be treated as a PSB by satisfying tests: the results test (payment for an outcome rather than time worked), tools and equipment provision, liability for defects, and the 75% income rule tied to the specific tests described (or the alternative 80%/20% and multiple premises tests if the four tests aren’t met). The concept of deemed employment is introduced, explaining how after a certain period, contractors may be reclassified and gain employment entitlements (superannuation, leave) under current rules. A simple numerical illustration demonstrates potential tax savings from splitting income in a PSB structure; however, the lecturer cautions that many professional staff will find it difficult to meet the PSB tests, and a private ruling from the Australian Taxation Office (ATO) can be sought for determination.

The final segments address cash vs accrual accounting within tax law. Tax accounting does not align exactly with financial accounting standards: illegal activities still require tax reporting and payment if income is earned, and cash-based or accrual-based accounting choices depend on the context. The TR, Henderson, and related rulings establish when cash basis is appropriate (non-business income such as rent or small professional practices) and when accrual is used (large firms or situations requiring recognition of revenue when earned rather than when received). In tax reconciliations, prepayments, work-in-progress (WIP), and accrued revenue often do not appear in the tax accounts as they do in financial accounting. Dividends, similar to other revenue streams, are generally not taxed until payment is received. The material also touches on ATI (adjusted taxable income), which is used for purposes such as HELP debt repayments and Medicare surcharges, and various exempt entities (charities, religion, and not-for-profit clubs) that enjoy specific exemptions but can still be subject to tax on other activities.

Lastly, the instructor introduces the triptych of ways to structure tax affairs: tax planning (legitimate), tax avoidance (defensible but potentially risky, often involving adjusting income vs. capital or using entity structures), and tax evasion (illegal). Part IVA (Part 4A) is presented as a “catch-all” anti-avoidance provision that targets schemes, arrangements, or schemes intended to obtain a tax benefit where the dominant purpose is to avoid tax. Three elements are required for Part 4A to apply: a scheme or arrangement, a tax benefit, and the dominant purpose of the arrangement. The Heart case is cited as illustrating the concept of a loan repayment scheme intended to misdirect payments for tax advantages. If a plan is deemed to be anti-avoidance, the ATO can partially or wholly disregard arrangements; penalties can be severe. The overall takeaway is that tax planning should stay within the legal framework; anything resembling an anti-avoidance scheme can trigger Part 4A penalties.

The session closes with practical recommendations: build a cheat sheet of key cases and principles, and review the week two solutions in the course modules (week two solutions) to practice multiple-choice questions that resemble the midterm assessment. An example is shown where a case study describes specific circumstances and asks what the correct assessment would be, including suggested references to the relevant case law. The instructor encourages questions and announces that the two-week focus on deductions will follow, signaling a structured progression through the tax topics over the coming weeks.

Key Formulas and References (LaTeX)

  • Taxable income (taxable profit) relation:
    ext{Taxable income} = ext{Assessable income} - ext{Allowable deductions}.

  • Tax payable (illustrative):
    ext{Tax payable} = ig( ext{Taxable income}ig) imes ext{Tax rate} - ext{Tax offsets}.

  • Capital gains tax concession for individuals:
    A commonly cited concession is the CGT discount: ext{Discounted gain} = frac{1}{2} imes ext{Capital gain}.

  • Main sections in income: 6.5 (ordinary income) and 6.10 (statutory income), with 6.15 (exemptions).

  • Common concepts introduced include ordinary income vs statutory income, mutuality, and NANE (non assessable non exempt). ATI is referenced as a separate concept used for certain levies and surcharges.

  • General tests for Personal Services Business (PSB) status include: the results test, tools and equipment test, liability for defects test, and the 75% income rule (with an alternative 80%/20% and premises test). A private ruling from the ATO can also determine PSB status.

  • Part IVA (anti-avoidance): scheme/arrangement, tax benefit, and dominant purpose. If a scheme is found, the arrangement can be disregarded for tax purposes and penalties may apply.

Notable Case References Mentioned

  • Merv Brown v. Federal Commissioner of Taxation (capital vs income – selling income-earning capability).

  • GP International (establishment costs treated as income in certain circumstances).

  • Edgerton Warburton (annuity converts capital to income via periodic payments).

  • Bohemian (mutuality – cannot derive income from yourself via members).

  • Cook v Sheridan (prize not convertible to cash may not be income).

  • ATA case (competition prize tied to sales – if convertible to cash, typically income).

  • Morehouse v. Dualin (reward for service – nexus to employment).

  • Brent’s case (author wrote a story about someone else; still income if enough effort to produce it).

  • Stones case (Olympic athlete grants as income if tied to employment activity).

  • CML case (life insurer’s investment of cash – income depending on ordinary course of business).

  • Maya Emporium vs. Westfield (intent to profit vs. change in intention and its effect on determining income vs capital).

  • Cyclone Scaffolding, Memorex (assets sold within or outside ordinary business turnover).

  • Scottish Australian Mining; Whitford’s Beach (property development and rezoning outcomes classified as income).

  • Dixon’s case (makeup pay as compensation for loss of income).

  • Heavy Minerals case (insurance payment as income when replacing income).

  • Waratah Rugby Club (mutuality and sporting club exemptions).

Practical Takeaways for Exam Preparation

  • Expect case-based questions where you need to classify a fact pattern as accessible income or capital, citing the relevant case law (at least one strong reference, e.g., Merv Brown for income vs capital).

  • Be prepared to apply the ordinary concepts test (compensation, receipt, link to services) and distinguish it from statutory income.

  • Use the tree analogy to reason about whether a transaction results in income or capital gains, and remember that the tax treatment can hinge on the intended purpose and the nature of the asset.

  • For PSB-type questions, remember the three to four tests for status, with the main four tests plus the 80/20 and related alternatives as backup.

  • Understand cash vs accrual accounting in tax, including the treatment of prepayments, WIP, and dividends, and how reconciliations between accounting numbers and tax numbers are performed in practice.

  • Be aware of anti-avoidance frameworks (Part IVA) and the consequences of schemes that aim to reduce tax, including the three-part test for the existence of a scheme, a tax benefit, and a dominant purpose to avoid tax.

  • Review the week two solutions to practice applying these concepts to concrete questions similar to a midterm format.

How to Use These Notes

  • Use the case summaries as reference anchors when you encounter a case-style question. If you’re unsure of a particular fact, use a general income reference (e.g., 6.5 or 6.10) and explain your reasoning; you’ll still gain some marks.

  • Build a personal cheat sheet that captures the core rules, the key cases, and the typical fact patterns they address. This will help you quickly apply the theory during exams.

  • Practice with the week two solutions to simulate exam conditions and to reinforce the application of theory to scenario-based questions.

Ethical and Practical Implications

  • The distinction between income and capital has broad societal and policy implications, particularly in the context of capital gains discounts that favour wealth accumulation in capital assets over ordinary income. Tax planning and the choice of business structure (employee vs. contractor vs. PSB) have real-world consequences for tax efficiency and worker rights, including entitlements and protections.

  • The anti-avoidance framework (Part IVA) serves as a guardrail against aggressive planning that would erode the tax base, emphasizing that genuine economic substance and intention matter in tax planning.

If you have questions about any specific case or concept from today, feel free to ask and we can walk through a worked-example together.

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Notes on Week 2: Income Theory, Case Law and Applications