Business Guide – 6. Australian Tax System · Chapter 6. Understanding Tax ... losses can be offset against other income earned by an individual, ... Commissioner of Taxation does

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HOUSE BUSINESS GUIDE – 6. AUSTRALIAN TAX SYSTEM

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Chapter 6. Understanding Tax System

This chapter is a general introduction to tax, which is a complex and dynamic area of law.

You should obtain independent advice from an appropriately qualified tax adviser. To simplify the explanation, we use a company as a tax payer for this chapter. Tax structure Whether you are buying an established business or franchise, or setting up a new business from scratch, the tax and structuring issues for the purchasing entity need to be planned early and with appropriate tax advice. Although this issue does not impact on your business in early stage, it may have a very large impact down the track if the business is successful. Also, there will often be significant taxes incurred in the process of changing structures later. For example, capital gains tax, GST and stamp duty may be imposed. Sole trader An individual operating a business taxed at their marginal tax rate. An income in excess of $180,000 will incur the top marginal tax rate of 45 per cent plus Medicare levy of 1.5 per cent. Operating losses can be offset against other income earned by an individual, but if you also derive income from different business activities, you need to check the loss quarantining rules that apply to losses from non-commercial business activities. Partnership A partnership has to lodge a separate tax return, but each of the partners is still subject to tax, i.e. each individual partner will result in being subject to tax at their marginal tax rate. Trust Discretionary trusts or fixed trusts will not normally be taxed. The income is to be distributed to the beneficiaries (or unit holders) and subject to tax in their hands. The losses remain in the trust’s hand and cannot be used by trust beneficiaries to reduce their income tax payable. Company A company is taxed at a flat rate of 30 per cent. When the net profit is distributed to the shareholders after tax, then further tax can be payable by the shareholders (franked dividend). A franked dividend paid to an individual will be taxed at that person’s marginal tax rate, with a refundable franking credit given for the tax already paid by the company.

6.1 Income Tax Income A company will be required to pay income tax at the rate of 30 per cent on its profit. In simple term, the income tax is calculated as following:


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Company tax payable = Taxable income × 30 per cent of tax rate

Taxable income = Assessable income – Allowable deductions

Under the tax legislation, the definition of what is ‘assessable income’ is broad and includes a range of different types of income your company could make, such as:

Any fee income on any services you provided to your clients Sales of stock Dividends received from your shares Rent received on any premises you rent out to other people Interest you receive from financial institutions Royalties received for licensing intellectual property or brands, or from franchisees The gain you make when you dispose of any equipment


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Figure 1. Assessable Income 1

1 Source: Foundation Tax – Introduction to the Australian Tax System, The Tax Institute 2009

Assessable Income

Ordinary Income

Statutory Income

Income from Personal Services

Income from Property

Income from Business Activities

Derived from personal Exertion and include: Salaries & Wages Allowances Commissions Bonuses Director fees Key issues include: Treatment of compensation and insurance receipts; Alienation of personal services income; Treatment of reimbursements Income from disposal of assets

Derived from use and enjoyment of property and include: Rental & lease income Royalties Interest Annuities Key issues include income derived from use versus disposal of assets

Derived from carrying on business and can include gains from isolated transaction. Key issues include: Identification of an active business; Nexus between business and income; Has business commenced or terminated; Treatment of compensation and insurance receipts

Income which is made assessable by specific provisions of the tax law. Examples include: Capital gains Recoupment of tax depreciation claims; Foreign currency gains; Dividends


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Deductions Your taxable income can be reduced by claiming allowable deductions. Allowable deductions are certain types of expenses which you have paid during the year and which the ATO recognises as being related to your business. In order to be deductable the expenses must:

Not be a personal in nature or capital expenses, and Should be spent in order to earn income or have a close relationship with the earning of

income. Sometimes an expense will be both personal and work related. In this case, you should

estimate the proportion of use for work purposes and only claim that portion as a deduction. Allowable business deductions are summarised below:

1. Business related expenses including,

Motor vehicle expenses Bank charges Business equipment Home office expenses Interest and borrowing expenses Legal expenses Accounting expenses Membership and subscriptions Business insurance Salaries and wages Internet Work related travel expenses Superannuation contributions for employees Depreciation on plant and equipments Black hole expenses (e.g. business setup but limited 1/5 each year)

2. Trading Stocks (Inventory)

The general taxation rules relating to trading stock can be summarised as follows:

Sales of trading stock give rise to assessable income Purchases of trading stock are deductible. Note however, that a deduction is not available

for the purchase of trading stock until the year in which the trading stock first becomes on hand or is sold to another

Where closing stock on hand is greater than opening stock, the difference is assessable income.

Where opening stock is greater than closing stock on hand, the difference is a deduction. The value of opening stock must be equal the value of last year’s closing stock. Closing stock on hand can be valued using cost price, market selling price or replacement

cost. You can vary the valuation method year by year.


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3. Business Losses There are two different types of loss in taxation, revenue loss and capital loss. A revenue loss will arise when your total deductions are greater than your income in a tax year. You are entitled to deduct revenue losses incurred in one year (the accumulated losses carried over) against assessable income earned in later years. Revenue losses can be carried forward indefinitely. A capital loss may occur when you sell an asset for less than its ‘cost base’. The cost base includes the original purchase price plus any acquisition costs such as stamp duties and legal fees. Capital losses may be offset against your capital gains, so are taken into account when you calculate your net capital gain for the year. If you have a net capital loss, you cannot offset the loss against your other income. Instead, the capital loss is carried forward indefinitely until it can be offset against a capital gain. Please see capital gains section for more information. Before a company can recoup tax losses sustained in prior years, it must satisfy a ‘continuous ownership test’ that requires that more than 50 per cent of the company’s shares be owned by the same persons in the period from the start of the loss year to the end of the year in which loss recoupment is sought. Where there is insufficient continuity of ownership, the ‘same business test’ is applied. This provides that a company must be engaged in the same business in the year of recoupment as that which was carried on immediately before the change in ownership if prior-year losses are to be recouped.

4. Capital Expenditure and Depreciation When you buy plant and equipment which has a useful or effective life of more than one year, you cannot claim a deduction for the amount you spent to buy that plant and equipment, or the costs associated with buying them. These are called balance sheet items which is subject to capitalise and to be depreciated for the years of the effective lives. The following items are classified as ‘capital expenditure’.

Buying a computer, fax machine, desks or motor vehicle and the costs delivering and installing those items.

Buying an investment unit or the conveyancing fees paid when you buy the unit. Depreciation, also referred to as capital allowance, permits you to claim a portion of the cost of the asset as a deduction over a number of years. For example, a laptop computer will have 3 years of useful life before it becomes to obsolete or technologically out-of-date that you have to replace it. If the laptop computer costs $600, you could claim a depreciation deduction of $200 each year for the three years. The effective lives of capital items are published by ATO with which you can rely on for the calculation of depreciation. A low- value pool is available for all depreciating assets costing less than $1000. The low-value pool is depreciated over four years using the diminishing value method. There are special rules for small business taxpayers that meet certain requirements. For example, there is an immediate write-off for depreciable assets costing less than $1000 that are fully used for a taxable purpose.


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A cost limit applies for depreciation purposes in respect of motor vehicles. That part of the purchase price in excess of the cost limit is not deductible. Such vehicles are referred as luxury vehicles. The cost limit for luxury vehicles 2011/2012 is $57,466. Personal Services Income (PSI) A business is generally entitled for income tax deduction (and GST credits) for the expenditures incurred during the business in order for earning income. There must be nexus between income earning and the expenditure to be deductible in tax purpose, and for certain expenditure, the Commissioner of Taxation does not allow as deductions (e.g. entertainment, fines and meals etc). This is the general rule. So under this rule, you are entitled to claim tax deductions as well as GST credits for what you incur for earning the business income under your business structure. However, there is a special tax regime called personal services income (PSI) to prevent individuals from reducing their tax by alienating their PSI to an associated company, partnership, trust or individual (sole trader), or by claiming inappropriate “business” deductions. Where it applies, the PSI regime has the following main effects:

PSI is included in the assessable income of the individual whose personal efforts or skills generated the income, notwithstanding that it may have been alienated to another interposed entity such as your company.

There are restrictions on the deductions that may be claimed by the individual or

interposed entity, so that they broadly correspond to the deductions available to employees, e.g. expenses relating to the individual’s private residence, certain travel expenses and payments made to spouses or other associates.

Interposed entities may have additional PAYG withholding obligations.

The PSI regime does not apply if:

The income is not PSI (income which is mainly a reward for an individual’s personal efforts or skills is the individual’s personal services income (PSI), regardless of whether it is income of another entity (e.g. a company, trust, partnership)

The income is derived as an employee or office holder, or The income is derived as part of a personal services business. There is a series of tests for

determining whether such business exists. Although the PSI regime is intended to level the playing field between an employee and a contractor who has PSI, it does not deem contractors to be employees and does not alter the legal relationship between the parties (ITAA97 s.84-10) So the matter is: “Whether your income is derived from personal services “BUSINESS” i.e. PSB”


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To qualify for the PSB regime, you need to pass tests below.

1. Result Test For an individual to satisfy the result test in a particular income year, the individual must satisfy the following three conditions in relation to at least 75% of his or her PSI during the year.

The income is for producing a result. The individual is required to supply the plant and equipment or tools of trade (if any)

needed to perform the work. The individual is, or would be, liable for the cost of rectifying any defect in the work

performed. Where physical rectification is not possible, this condition will be satisfied if the individual is liable for damages in relation to the defect.

2. The 80% Rule and Additional Tests

If the result test above is not satisfied, it is necessary to consider the 80% rule. If 80% or more of an individual’s personal services income (PSI) in the income is from one entity, the income will be subject to the PSI regime unless the individual obtains a personal services business determination from the Commissioner. If 80% or more of the PSI is not from one entity, the income will be exempt from the PSI regime if the individual satisfies any of the following tests:

1. The unrelated clients test An individual or personal services entity meets the unrelated clients test in an income year if the service provider gains income from providing services to two or more entities that are not associates or the service provider

2. The employment test An individual service provider meets the employment test in an income year if at least 20% of the individual’s principal work for the year is performed by an entity or entities engaged by the individual. The entities cannot be non-individuals that are associates of the individual. The entity (PSE) meets the employment test where the 20% criterion above is met and the entity or entities engaged are neither:

Individuals whose PSI is included in the PSE’s income, nor Non-individuals that are associates of the PSE

3. The business premise test An individual or a PSE (Service Providing Entity) meets the business premise test in an income year if, at all relevant times during the year, the service provider maintains and uses business premises:


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At which they mainly conduct activities from which PSI is gained; Of which they have exclusive use (this would typically require ownership or a lease); That are physically separate from any premises that the service provider or service

provider’s associate use for private purposes; and, That are physically separate from the premises of the service provider’s client or client’s

associate.


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The following diagram shows the tests required to qualify as Personal Services Business (PSB).2

Step. 1 Personal Services Income

Does the taxpayer receive income tat is mainly a reward for personal efforts or skills? No

Yes

Step. 2 Result Test

Does the taxpayer meet all of the conditions of the result test? Yes

No

Step. 3 The 80% rule

Yes

Does 80% or more of the individual's personal services income in an income year come from one client?

No

Step. 4 Other tests

Does the taxpayer satisfy one of the following tests?

Unrelated clients

or

Employment Yes

or

Business Premises

No Not sure

The personal services income legislation applies unless the taxpayer obtains a personal services business determination from the Commissioner

The taxpayer may need to apply to the ATO for a determination that the personal services income legislation does not apply

Not Sure

The personal services income legislation does not apply.

2 Source: Australian Master Tax Guide 2011, page 1580.


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6.2 Goods and Services Tax The Goods and Services Tax (GST) was introduced on July 1, 2000. It is fair to say that most businesses put in some effort to ensure that their systems and procedures were able to cope with the change to a GST and it is also fair to say that many of those businesses have not looked at their GST compliance since that time. The increase in ATO audit activity means that you need to be more aware of how the GST affects your activities and how your business processes capture the GST payable and receivable to ensure that the right amount of tax is being paid. GST is an indirect tax and is fundamentally different to other direct taxes such as income tax and capital gains tax. GST has been described as a multi-stage, credit offset transaction tax. It has also been described as a tax on final consumer. At its simplest, GST is a tax paid on transactions called supplies. Supply means all forms of supply and not just sales of goods or services. It also includes the creation, grant and surrender of rights; entering into obligation; agreeing to do something; and agreeing not to do something. Note that a supply of money is not a supply unless the money is consideration for a supply of money. That is, when you pay money for a newspaper there is only one supply, being the supply of newspaper to you. The money which you give the newsagency is not a supply. However, the interest you pay on a loan is supply since it is consideration for a supply of money. There must be consideration for the supply. It needs not be in money but must be capable of being expressed in money. Consideration includes goods, services and other things given in exchange for a supply, such as in a barter or contra. The supply must also be made in the course or furtherance of an enterprise that the entity making supply carries on. It is the entity which is registered for GST. An enterprise has a wider definition that a business. Taken together, an entity making a supply for consideration in the course or furtherance of an enterprise has the widest possible meaning and, in simple language, means that just about anything you do in your business is caught by the GST. Unlike direct taxes, GST is normally paid by the recipient of a supply but the responsibility to collect and account for the tax lies with the supplier. In most cases, the recipient is not concerned whether or not GST has been properly charged. There are requirements imposed on the supplier to disclose the GST charged and, generally, prices should be quoted on a GST inclusive basis. The single most distinctive feature of GST is that the tax is creditable. Registered entities which pay GST on acquisitions are entitled, in most cases, to offset that GST against the GST they are liable to pay on the supplies they make. The GST actually remitted to the ATO is therefore the difference between the GST payable on supplies and the GST input tax credits on acquisitions. There are two main categories of GST exemption: GST-free and input taxed. GST-free supplies


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Certain food Health Education Childcare Exports and other suppliers that are for consumption outside Australia Religious services Non-commercial activities of charitable institutions, and raffles and bingo conducted by

charitable institutions, etc. Water, sewerage and drainage Supplies of going concerns International transport Precious metals (in specified circumstances) Supplies from inward duty-free shops Grants of land by governments Farmland International mail

Input taxes supplies

Financial supplies Residential rent Existing residential premises Precious metals (in specified circumstances) School tuckshops and canteens Fundraising events conducted by charitable institutions etc.

Registration All entities carrying on an enterprise (or a number of enterprises) must register for GST if their annual turnover exceeds, or is expected to exceed, $75,000 ($150,000 for not-for-profits). Registration involves getting an Australian Business Number (ABN). Along with an ABN, GST-registered entity must complete a Business Activity Statement (BAS). The BAS is used to report not only GST but also PAYG Withholding tax, PAYG instalment, FBT instalment, Wine Equalisation tax and Luxury Car Tax. Accounting for GST Entities with an annual turnover below $2 million, and some other entities in limited circumstances, can opt to account for GST on a cash basis. Other entities will account for GST on an ‘accrual basis’. Under the cash basis, GST is attributable to the tax period in which payments are made or received. Under the accrual basis, GST is attributable to the tax period in which an invoice is issued or, if earlier, in which any of the consideration is received. Under the accrual accounting, the entity needs to pay close attention to control of debtors and creditors. Careful consideration of the timing of the issue of invoices and of major expenditure can minimise the cashflow effect of the GST. There is on crucial issue in connection with invoices. Under the accruals system, GST is payable on supplies in the tax period when an invoice is issued. An invoice is any document notifying an


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obligation to make a payment. However, under both the cash and accruals systems, input tax credits are only available if the entity holds a tax invoice in respect of the acquisition. A tax invoice is an invoice that contains specific information: the words ‘tax invoice’, the name and ABN of the supplier, the name, address or ABN of the recipient, the product or service supplied, and its GST inclusive price. Input Tax Credits (ITCs) ITCs are available for the GST incurred on creditable acquisitions; that is, on taxable supplies received by the entity. The acquisition must relate to the enterprise(s) that the entity carries on. Creditable acquisitions might include stock for resale, capital expenditure on items such as plant and equipment, property rent, lease charges, overheads such as utilities and stationery. Any acquisition which is a genuine business expense, and on which you paid GST, is likely to be a creditable acquisition. However, there are three main categories of exception to this. ITCs are not available for GST incurred on expenditure which:

Is incurred on certain specified costs which would not be deductible expenses for income tax purpose

Is of a private or domestic nature Relates to making supplies which would be input taxed.

Where the input taxed supply is a financial supply, there is some leeway, in the form of a de minimis limit called the Financial Acquisitions Threshold (FAT). The entity is still required to identify the GST incurred on expenditure which relates to the financial supplies but, if that input tax is less than the lower of $50,000 per annum or 10 per cent of total input tax for the year, full ITC can be claimed. There is further leeway if the financial supply is a borrowing, GST on acquisitions which relate to borrowing is creditable if the borrowing relates to supplies that are not input taxed. For example, if an entity borrowed money to purchase new equipment, an ITC would be available. However, if the entity had borrowed the money to enable it to buy shares or a residential property, it would have to consider the FAT. Sale of Going Concern Under normal circumstances the disposal of assets used in a business will be a taxable supply. However, special provisions exist to provide GST-free treatment where the assets are disposed of as a ‘going concern’. There are number of criteria to be satisfied but the principal one is that there must be a written agreement between the parties that the supply is of a going concern. If there is no written agreement, the supply cannot be GST-free under these provisions. In order to qualify as a going concern, the seller must supply to the buyer all things necessary for the continued operation of the business.

6.3 Capital Gains Tax The capital gains tax (CGT) applies to the disposal of assets acquired (or deemed to be acquired) after 19 September 1985. For assets acquired before 21 September 1999 and held for at least twelve months, gains are calculated after indexing the asset’s cost base to the rate of inflation. Tax


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on capital gains is levied at the taxpayer’s income tax rate. Individuals, trusts and certain superannuation funds may qualify for a discount on the amount of gain included in assessable income as long as the asset is held for at least 12 months. CGT assets are defined widely to include most property and rights, and CGT applies to events such as disposal occurring in relation to a CGT asset. Rollover relief The CGT legislation provides limited ‘rollover relief’ i.e. a deferral of CGT in some situations. The rollover reliefs occur where:

An asset is transferred by an individual to a wholly owned company; or A company is interposed into an existing business structure; or Certain assets are replaced with similar assets.

Exemptions and concessions In some situations where a capital gain would otherwise arise, an exception or exemption may be available, to either reduce the capital gain or loss or allow you to disregard it. The most common exceptions and concessions arise in relation to assets acquired before 20 September 1985, the availability of the CGT discount and the disposal by non-residents of assets that are not ‘taxable Australian property’. the other common exemptions are gains on disposal of:

Your main residential home Certain compensation or damages for any wrong or injuries suffered by the taxpayer Winnings from betting, a lottery or other form of gambling, or a game with prizes. Cars, motorcycles and similar vehicles Collectables acquired for under $500 Personal use assets acquired for under $10,000 Assets used to produce exempt income Inheritance, when received, by beneficiaries of a deceased estate.

There are also various CGT concessions available for small business (that is, where the net value of the assets of the tax payer and connected entities is not more than $6 million) including:

An exemption from CGT for assets owned for at least 15 years A 50 per cent reduction in CGT for active business assets An exemption from CGT if proceeds of sale are used in connection with the tax payer’s

retirement A rollover where the business is sold and another business is acquired

6.4 Fringe Benefits Tax Fringe benefits are generally non-cash parts of an employee’s package, such as employer-provided cars, free or low interest loans, free or subsidised residential accommodation or board, free or discounted goods and services, and expenses paid on behalf of an employee. Currently, the FBT rate is 46.5 per cent. The paid fringe benefit tax, however, is income tax deductible for the employer.


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6.5 Withholding Taxes Withholding taxes generally apply to interest, dividends and royalties paid to non-residents. Withholding taxes are withheld by the company that is to make the payment of interest, dividends and royalties. Interest Interest paid by a resident of Australia to a non-resident is normally subject to a final withholding tax of 10 per cent; this is a final tax and therefore the non-resident is not required to include interest income in an Australian income tax return. If interest income is the only Australian source income derived by the non-resident, no Australian returns is required to be lodged. Dividends Non-residents are subject to withholding tax on the unfranked portion of dividends they receive from an Australian resident company. The dividend withholding tax rate is 30 per cent, subject to Australia’s Double Tax Agreements (DTAs), which generally limit the rate to 15 per cent. For example, the US Protocol provides for a rate of 0 per cent where a US corporate investor, satisfying certain public listing requirements, holds 80 per cent or more of the voting power of an Australian company; a rate of 5 per cent will apply where a US corporate investor holds direct voting interests of at least 10 per cent in an Australian company, otherwise a 15 per cent rate will apply. Royalties Australian income tax law provides that tax is chargeable on all amounts received ‘as or by way of royalty’. For purposes of income, royalties typically include amounts ‘paid or credited’ for the use of or right to use copyright, patents, trademarks, industrial equipment, or for the supply of scientific or commercial knowledge or information. The term ‘royalty’ is broadly defined and can extend to rental payments for the use of certain equipment. All royalties that are expense of an Australian business, and are paid or credited to a non-resident, are deemed to have a source in Australia. Therefore, a non-resident will be subject to Australian tax on such royalties, irrespective of where the property giving rise to the royalties is situated, or where the services giving rise to the payment are performed. Australia has a system of withholding tax to collect tax on royalties paid or credited to non-residents. The royalty withholding tax (at the general rate of 30 per cent) is a final tax. Where the recipient is a resident of a country with which Australia has concluded a DTA, the terms of the treaty will determine the rate. Most double taxation agreements to which Australia is party provide a rate of 10 per cent royalty withholding tax. The US Protocol and the UK, Japanese and French double taxation agreements provide for a general rate of 5 per cent of withholding tax.


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For further information please contact our team: Website: www.quantumhouse.com.au Email: [email protected] Phone: 02 8068 6545 Fax: 02 8004 5332 Disclaimer: Although the views expressed in this document represent the general views of Quantum Business House, readers must rely on their own professional advice in respect of specific circumstances.

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Business Guide – 6. Australian Tax System · Chapter 6. Understanding Tax ... losses can be offset against other income earned by an individual, ... Commissioner of Taxation does