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8. Chapter 8 Income Tax: Issues Related to Business and Professional Income

8.1. The broad concepts of income and expenses in deriving income have been dealt with in Chapter 7. These concepts apply in the determination of net income from business and professional activities irrespective of the form in which these activities are conducted, whether as individuals or through trusts, partnerships, or companies. In this chapter, the numerous particular problems which arise in ascertaining the net income of a business or profession are considered.

8.2. The first and overriding principle, in the Committee's view, is that income tax should be levied on true profits flowing from the business or professional activity during its whole period of operations. If this is not achieved the rates of tax, be they progressive as for individuals or proportionate as for companies, become meaningless and misleading as an indication of the weight of tax. The true after-tax profits remaining and available for maintenance or expansion of the activity cease to be readily apparent and become distorted. Further, meaningful international comparison of the incidence of tax on business operations is made very difficult and the results are subject to qualifications which often cannot be quantified. Additionally, if the base is not true profits, ostensible concessions or incentives in specific areas may in fact be excessive or alternatively of less value than the figures suggest.

8.3. The Committee has received, as have previous committees charged with inquiries into income tax, numerous submissions on the ascertainment of net incomes of businesses and professions. Many of the matters now raised have been previously ventilated and pressed without result, some even as far back as the Spooner Committee in the early 1950s. Others have been considered not only by that committee but also by the Hulme Committee (1954–55) and the Ligertwood Committee (1959–61).

8.4. Most submissions point to the failure of income tax legislation to allow deductions for expenses which, under normal commercial practice, are deducted in arriving at profits before income taxation. In some cases a deduction for the expense is not available for income tax purposes; in others it is available in an accounting period other than that in which it is normally charged using generally accepted accounting principles. In the end result, the profits subject to tax tend to be higher than those determined for commercial purposes.

8.5. A further factor, to which brief reference has already been made in Chapter 6, is the overstatement of net income as a result of inflation, and claims for more equitable treatment on this score increase as the pace of inflation quickens. When the rates of income tax were very much less than they are at present, the consequences of net incomes determined by reference to the income tax legislation being higher than profits before tax arrived at on a commercial basis were not as severe. The overstatement of net income arising from inflation, taken with this increase in rates of tax, is giving rise to growing concern and disquiet.

8.6. It has again been proposed that the overstatement of net income arising from business activities would be avoided if the Income Tax Assessment Act were to be amended to provide that, subject to certain specific provisions, net income for tax purposes should be the profits determined on a commercial basis by applying generally accepted accounting principles.




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8.7. At first blush such a scheme may appear to have attractions, but these fade on closer examination. There has, it is true, been considerable progress in recent years towards the acceptance, by companies particularly, of authoritative statements on accounting principles which should be followed in arriving at disclosed profits. However, it is clear that many instances remain within the authoritative standards where alternative procedures continue to be available, and in many types of business organisation the standards accepted generally by the larger publicly-listed companies have yet to be attained.

8.8. In addition, to place the basis for determination of net income on which taxes are to be levied outside the jurisdiction of the revenue-raising authority could not be seriously considered in Australia and has not been adopted, to the Committee's knowledge, in any other country. The proper approach therefore must be to seek to narrow, as far as is possible, the differences between net income as determined under the revenue legislation and as determined by commercial standards.

8.9. The division adopted in this chapter is to deal in Section I with problems which arise in determining the accounting method—cash or accruals—to be followed in computing net income. Section II discusses the appropriateness of the general approach of the Australian law to arriving at net income when the accruals method of tax accounting applies. Attention is drawn to the failure of the law to ensure that, except to a limited extent, matching items of income and expense are brought to account in the same tax year.

8.10. Section III examines a number of the instances of costs or outgoings which are not deductible for income tax purposes in the same accounting period as that in which they fall to be treated as an expense by a business. These instances include provisions or accruals for employee benefits (long-service leave, holiday pay and sick pay) and provisions for product warranties and doubtful debts.

8.11. Section IV deals with allowances for depreciation and amortisation of fixed assets. Special consideration is given to depreciation of buildings, a subject raised in numerous submissions.

8.12. The special provisions of the Act relating to the valuation of trading stock are examined in Section V, as are also possible extensions of their scope. Section VI is concerned with the offsetting of losses arising in one income year against net income of other years. The existing restrictions on the recoupment of losses have important implications for the overriding principle that income tax should be levied on profits of the whole period of operations of a business.

8.13. Section VII takes up the important subject of the overstatement of net income flowing from the effects of inflation on business income and discusses briefly some of the measures being advanced to arrive at real profits and net income in periods of high inflation.

8.14. Section VIII is concerned with the treatment for tax purposes of a number of costs of business operation, including expenditure on repairs, anti-pollution expenses, and travelling and entertainment expenses.

8.15. This chapter is concerned with the treatment of business and professional income generally. The treatment of several particular industries—mining and primary production, for example—and the special provisions which at present apply in those fields of activity are considered in later chapters.




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I. Cash or Accruals Basis

8.16. Income tax law recognises two accounting bases, cash and accruals, for the determination of net income, which broadly correspond with the cash and accruals bases in financial accounting. What is included in ‘income derived’ and in ‘outgoings incurred’ will depend on the basis of tax accounting which is held to apply. If it is the cash basis, income is not derived until an amount has been received: it is not enough that it is receivable. Similarly, an outgoing is not incurred until there has been a payment: it is not enough that the outgoing is payable. On the other hand, where the accruals basis applies, income is derived when an amount is, in the language used in the cases interpreting the law, ‘due’, even though it has not been received and is not immediately receivable. There is an outgoing incurred if there is a ‘definitive commitment’ to pay, even though payment has not been made and there is no immediate liability to pay.

8.17. Accruals tax accounting differs from accruals financial accounting in ways which are considered in some detail in subsequent sections of the chapter. In theory, both seek to strike a balance for an accounting period between income earned and the costs and expenses incurred in relation thereto which will reflect the true result whether it be a profit or a loss. Cash tax accounting, on the other hand, is concerned with little more than striking the net result of a balance of receipts and payments.

8.18. It would seem to follow, as a matter of general principle, that all businesses and professions should be required to return their net incomes on the basis of accruals accounting. It has been recognised, however, that for some professions and small businesses a cash basis is more appropriate. This may be because most of the income generated flows from the taxpayer's personal labour or effort, because receivables and payables are modest and do not differ greatly in amount, because stock held is small, or because the taxpayer is unlikely to keep the more sophisticated records which will be necessary if he is to return on an accruals basis. The choice of cash rather than accruals in these instances will make little difference to the amount of net income in a tax period; yet the simplicity of the tax system for the taxpayer concerned is so much greater.

8.19. The Committee believes that a cash basis should continue to be available to a large proportion of those currently using it. To impose more sophisticated accounting would have little effect on net income but would add greatly to the compliance costs of those involved in a change from their existing method. The factors detailed in paragraph 8.18 may well be a better guide to the drawing of a dividing line than a general classification based on type of business or professional activity. The fact that most of the income from a business or profession is generated by the taxpayer's own effort might be made the dominant test. This would embrace the majority of doctors, dentists and barristers, as well as many other sole practitioners and small professional partnerships; it would also cover sole traders in the service industries.

8.20. Where the activity includes the employment of tradesmen or professional staff together with supporting administrative staff, the use of a cash basis is clearly inappropriate. In these instances, it is rarely employed in settling interests between partners or in arriving at an appropriate price for the sale of a business. Here, an accruals basis, which brings to account amounts owing and sums payable and a value for work in progress, if any, is needed to assess net income.




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8.21. Where the business is carried on by a company, the need to lodge returns on an accruals basis should not impose any added burden as company legislation requires the maintenance of full accounting records.

8.22. The Committee believes that the use of the accruals basis of accounting should be the general rule in computing the net income of a business or professional activity. Exceptions ought to be specified in the Act or Regulations. The definition of the exceptions should be founded on the extent to which the net income reflects the payment for the individual taxpayer's personal efforts, the scale of operations, the normal level of debts due, debts payable, work in progress and stock in trade. Businesses conducted through a company (except where the company is merely acting as a trustee) should use the accruals basis. No restriction should be placed on any taxpayer adopting an accruals basis if he chooses to do so even though he may qualify for cash-basis treatment.

8.23. The adoption of this general rule will impose a requirement for additional accounting on many taxpayers. However, side-benefit should flow in the way of improved management of the business. And in the event of a broad-based indirect tax being imposed, such as a value-added tax as recommended by the Committee, many small businesses will in any case need to lift the standard of their accounting.

8.24. The question remains as to the special provisions needed to cope with the switch from a cash to an accruals basis, which may arise from a change in law to give effect to the Committee's recommendation or because of an election by a taxpayer to adopt an accruals basis under that law. In most instances the use of the cash basis will have resulted in a lower net income and the accumulated understatement may be a substantial figure for some taxpayers. When many professional firms were required to change from a cash basis to the present quasi-accruals one several years ago following a Court decision, the Commissioner ruled that, in computing net income of the first year under the accruals method, a deduction was to be allowed for the value of debts due to the firm, and a deduction was not allowable for amounts owing to creditors for expenses, as at the commencement of that year. The Committee believes this precedent ought to be followed. It should be provided that a deduction will be allowed in the year of change for the value of debts due and stock in trade, and deduction denied for trade liabilities, as at the commencement of the year, subject to the change to the accruals basis being made prior to a specified date.

8.25. Where a change is made after the specified date, the accumulated understatement of net income should not escape tax. However, it would not be equitable, where progressive rates of income tax apply, to seek to tax the whole of the accumulated income omitted in the year following the change. To do so would also result in serious liquidity problems for most taxpayers. Accordingly, the Committee recommends that when a taxpayer after the specified date is required to or elects to change from a cash to an accruals basis, the total of net income previously excluded from tax at the commencement of the year of change should be included in his taxable income in the succeeding five to ten years, the actual period depending on the amount involved. A minimum adjustment to income of a succeeding year of $1,000 should be fair in most cases.

8.26. Where the entity changing its basis is a partnership, it will be the interest of each partner in the total net income omitted which will need to be adjusted in the way indicated. A subsequent change in a partner's interest in the partnership should have no effect on his liability to tax on his proportion of the omitted income: its value will


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normally be reflected in the true worth of his interest in the total net assets of the partnership, whichever tax basis is being used.

II. Accruals Tax Accounting and Financial Accounting

8.27. Many submissions claim that accruals tax accounting under the Australian law is too rigid. It is said that in determining the net income of a business, tax law should take as its starting-point the results of the business for the period determined by generally accepted principles of financial accounting. Tax law should then require adjustments to the results where a particular rule of tax accounting has no parallel in financial accounting, or where the principle of financial accounting that has been adopted differs from the rule of tax accounting.

8.28. The approach suggested would lessen the rigidity of tax accounting only if financial accounting is more flexible in the choices it offers and adjustments are not required by tax accounting. In the Committee's view flexibility in this sense is desirable in some contexts. However, it is for the tax law to define the choices. The law could not resign its function of determining the base of income tax in favour of the professional bodies and business or trade organisations which play a large part in formulating generally accepted principles of financial accounting.

8.29. The criticism of the rigidity of the existing law may be stated in another way. Accruals tax accounting, it is claimed with real justification in some respects, is much less effective than financial accounting in striking a balance which reflects the true profit or loss of a business activity. To the extent that this is true, the Committee would agree that tax accounting rules should adopt the financial accounting principles. However, a difference between a rule of tax accounting and a rule of financial accounting can be no more than a valid reason for re-examining the rule of tax accounting. It cannot dictate a change in the tax rule.

8.30. The change in approach that is being sought would in any case involve a radical redrafting of the existing law and this should not be contemplated if the purpose of the change can be achieved without it. Old law is, to this extent at least, good law. Overseas experience suggests that a major redrafting of the law would not significantly reduce the complexities of the tax.

8.31. The differences between tax accounting and financial accounting can be overstated. Some of the early pronouncements in legal authorities that tax law is not concerned with the profits from transactions, except where there is some express provision, are contradicted by the treatment the law accords to contracts extending over several years. It has been decided that a charge made to a client of a business, even though it be received, should not be treated as income until the services for which it is the reward have been performed: this is a tax recognition of a principle of financial accounting. The provisions of the Act in regard to the allowance of depreciation and accounting for trading stock are intended to ensure that net income of a business for an accounting period reflects the profits of that business for the same period.

8.32. Attention has tended to focus on those differences between accruals tax accounting and financial accounting that lead to net income being overstated, which is what happens when a deduction for income tax purposes is deferred until an expense is paid while for financial purposes it is brought to account as it accrues. On occasions, however, the law allows a deduction in the year in which the cost or outgoing is met even though, in the particular case, the cost clearly refers to or is connected with an


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item of income to be derived in a later year. Thus, for example, interest is generally available as a deduction in the year in which it accrues, irrespective of the fact that it may relate to cost of establishing a new industrial complex in course of erection or to development land held for resale. Under financial accounting principles, interest paid in these circumstances will frequently be added to the cost of the asset concerned. A finance institution may in its financial accounts accrue interest on fixed-interest securities; but it is permitted to exclude such amounts from tax accounting on the grounds that the income has not in fact been received. A grazier may purchase a quantity of superphosphate just prior to the end of a financial year and become entitled to deduct the cost from his net income, even though the whole benefit from his expenditure will not fall to be included in his net income until a subsequent period.

8.33. Differences between accruals tax accounting and financial accounting which increase net income subject to tax sometimes arise from legal authority limiting the meaning of a cost or outgoing incurred in deriving income so that an anticipated expense or an expense subject to some contingency is not allowed as a deduction. Into this category fall accruing costs of employee benefits such as long-service leave and the extension of depreciation allowances to allow for obsolescence of fixed assets. These are examined in detail later in this chapter, as also are several differences of a permanent nature such as depreciation of buildings.

8.34. There is one other difference operating in favour of the taxpayer which must be mentioned because of its fairly general application. It relates to the failure to take to account the value of work in progress in certain professional activities. The professions mainly concerned are those of solicitors, accountants and architects. In those cases where a large staff is employed, the costs incurred in any year will frequently relate in substantial degree to services rendered which have not been billed by the end of the year. Work in progress and unrendered charges and costs may constitute the largest asset of the business and its existence needs to be taken to account to arrive at profits for financial accounting purposes. There is little reason why it should not be similarly taken into account in reaching net income.

8.35. Clearly it is not practicable to seek to eliminate every difference currently arising or to correct the lack of symmetry in every business transaction. Some of the differences spill over to the taxation of income outside the business area. For example, the deduction allowed a finance company for interest accrued but unpaid on debenture loans would require each debenture-holder to include in his net income accrued interest as at the end of a tax year if symmetry were to be achieved. This obviously is not feasible.

8.36. However, several of the differences referred to in this section appear to call for legislative action.

Holding Charges

8.37. The Committee recommends that holding charges (in the form of interest, rates, land tax, etc.) on land held for resale, being akin to trading stock, should not be allowable as a deduction to the extent that the charges relate to land held at the end of an income year. The charges so excluded would form part of the value of trading stock.

Work in Progress

8.38. The fact that professional firms do not bring to account the value of work in progress or unrendered charges, except where the work performed at a year end has


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given rise to a recoverable debt, results in their net income being computed on a quasi-accruals method.

8.39. One result is that net income tends to be understated under normal conditions when activities are increasing and costs rising. An associated problem is the considerable room for dispute as to whether the services performed or work carried out at the year end have in fact given rise to a recoverable debt the value of which needs to be included in net income of that year.

8.40. Those professional firms which base their charges to clients on time incurred on the assignment by principals and staff now maintain records from which the value of work in progress is computed at regular intervals for purposes of internal management. There are probably many other firms, however, which do not now find it necessary to keep these additional records. Accordingly, to require all professional persons or firms to bring to account a value for work in progress in determining net income would be onerous and add significantly to administrative costs for at least some taxpayers. But there seems no good reason why a professional person or firm should be debarred from computing net income on a full accruals basis as a matter of choice.

8.41. The Committee recommends that professional persons or firms, whether incorporated or not, be given the right to elect to take account of the value at cost of work in progress at the beginning and end of an income year.

8.42. The Committee proposes that the principle set out in paragraph 8.24 relating to changes prior to a specified date should apply to an election to bring in work in progress.

8.43. This procedure will, it is true, result in the opening value of work in progress escaping tax. But the change in basis for treating work in progress for those firms which elect will tend in most instances to increase their net income and the taxes payable without lifting the cash flow of profits available to taxpayers. Also the change will tend to increase annual taxation revenue, despite the failure to tax the opening value of work in progress.

8.44. Where a firm makes an election to bring in work in progress after the specified date, it is proposed that the opening value of work in progress should fall to be taxed by the spreading procedure, outlined in paragraph 8.25, to be applied when a taxpayer changes from a cash to an accruals basis.

Tax on Basis of Financial Accounting Principles

8.45. While the decision in the Arthur Murray Casenote has led to a more factual approach to the determination of income of a year, there remain elements of rigidity in the present law. This rigidity has already been referred to, as has also the claim that on occasions accruals tax accounting fails to arrive at a balance reflecting the true result from a business activity.

8.46. While the Committee rejects the proposal that net income be computed using generally accepted accounting principles, it acknowledges that it might well be in the interests of both the Revenue and taxpayers if the Act were more flexible in its requirements both as to computation of gross income and as to deductions for related expenses. In practice, flexibility has been given by administrative decision of the Commissioner and his officers.




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8.47. The Committee feels it would be desirable for the Commissioner to have statutory authority to compute the net income from a business activity using one or more of the generally accepted accounting principles approved by recognised Australian professional accounting bodies, where the taxpayer so requests and the Commissioner is of opinion that to do so would be reasonable having regard to all the circumstances.

III. Provisions and Accrued Expenses

8.48. It is under the general heading of provisions and accrued expenses that the major differences arise between net income and results determined under financial accounting: the latter takes to account numerous provisions and accruals that need to be made to match income and expenses which have been incurred or are anticipated in earning that income. These additional charges made against financial results include accrued employee benefits such as long-service leave and holiday pay, provisions necessary to reduce debts receivable to their anticipated realisable value (doubtful debts), and provisions for product warranties and for known contingencies.

8.49. The principle basic to the general deductions section of the Act (now section 51) since its introduction in 1915 is that deductions are allowable for outgoings incurred. But these do not necessarily include provisions for future expenditure.

8.50. One objection raised to relaxing this general deduction provision to eliminate some of the differences which now exist is that the bases of the estimates of provisions and accruals are suspect and tend to err in the taxpayer's favour. This objection may be valid in the case of certain provisions, for example doubtful debts and product warranties. It has no real force, however, in relation to an employee's vested right to long-service leave and holiday pay, where his entitlement is fixed by a governing statute or an industrial award.

Long-service Leave and Holiday Pay

8.51. Both long-service leave and holiday pay are regulated for all employees by either legislation or industrial agreement. There is considerable uniformity in the legislation and awards as to the circumstances in which the leave is payable. The variations between legislation and awards are concerned mainly with the rate at which leave is accumulated and paid. So while the leave requirements are not identical throughout Australia, they are nonetheless uniform to a substantial degree.

8.52. Table 8.A summarises what are understood to be the minimum periods of service to qualify for long-service leave under current State legislation or Federal awards and weeks of leave granted.

8.53. From inquiries made by the Committee it appears that most major employers of labour, and many smaller employers, have established provisions to cover the liability for long-service leave, the liability usually being determined on the basis of the employee's current salary. Inquiries also show that many employers start to make provision after the employee has completed five years' service. Since legislation and industrial awards govern the accrual for long-service leave and require detailed records to be kept of each individual's entitlement to long-service leave, calculation of the provision is made reasonably simple.




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TABLE 8.A: LONG-SERVICE LEAVE ENTITLEMENT

             
N.S.W.  Vic.  Qld  S.A.  W.A.  Tas.  Federal 
1. First entitlement, where entitlement flows principally from termination by the employer or sickness, death or domestic reasons of the employee (years of service)  10  10  10  10 
2. First entitlement, where termination by employee (years of service)  10  15  10  15  15  15 
3. Entitlement vests absolutely (years of service)  15  15  15  10  15  15  15 
4. Amount of leave after entitlement vests absolutely (weeks of leave)  13  13  13  13  13  13  13 
5. Record of entitlement of each employee required to be kept  Yes  Yes  Yes  Yes  Yes  Yes  Yes 
note note  

8.54. The Spooner and Ligertwood Committees, which examined this question, both recommended that provisions for long-service leave be allowable deductions. They had different views, however, on procedure for deductions. The Spooner Committee recommended that a deduction be allowed for the taxpayer's estimate, while the Ligertwood Committee favoured allowing the deduction for employees with ten or more years' service.

8.55. The Committee agrees in principle with the recommendations of its predecessors and accepts the equity of the claim made in numerous submissions that a deduction should be allowed for the value of long-service leave entitlements which have accrued to employees at the end of a financial period. The difficulty lies in determining the entitlement to be used in calculating the figure and the transitional safeguards to be provided to protect the Revenue. There are no reliable figures on the probable total value of employees' long-service leave entitlements accrued in the private business sector, but the figure probably exceeds $1,500 million. Clearly a reduction of taxable income of this order in one financial year could not be contemplated. Transitional arrangements are obviously called for.

8.56. As Table 8.A shows, an employee working under New South Wales legislation and having his services terminated by his employer is entitled to a pro rata payment of long-service leave if he has completed five years' service, though the more general requirement in Australia is that he must have completed ten years' service to qualify. Where, on the other hand, an employee takes the initiative in terminating his service, he need have served for only seven years under South Australian legislation but more generally for fifteen years. In deciding which entitlement should be accrued, most employers and their advisers would feel that the dominant factor should be the period of service after which the employer would be required to make a payment to an employee in the event of his services being terminated by the employer. To omit to make any provision until an entitlement vested absolutely (in the vast majority of cases after fifteen years' service) would be to fail to match income with costs related to that income.




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8.57. The Committee believes that, at the very least, a deduction should be allowed for the total amount, at each year end, of the employees' entitlements to long-service leave which have vested absolutely. This limited deduction would not, however, eliminate the failure to match income with expenditure. Accordingly, the Committee recommends that, subject to transitional provisions, a deduction be allowable for the total amount of employees' entitlements at each year end, calculated according to each employee's entitlement should his services have been terminated by his employer at that date, but only to the extent that a deduction in respect thereof has not been allowed against a taxpayer's income of a prior year. Transitional provisions are considered later.

8.58. An argument commonly made against the kind of proposal being put forward here is that a deduction for a provision calculated by reference to payments in a future year is liable to be excessive unless the provision is calculated by discounting the future payments to their present value. In the Committee's view this discounting is unnecessary. The failure to discount will be offset in part by the calculation of the provision on the basis of the present wages of the employee and not his anticipated remuneration when leave is taken. In most instances promotion and award increases will have lifted his current wages when he takes his leave. For example, a man who at 30 June 1974 had completed ten years' service and whose gross wages at that date were $120 per week would have accrued long-service leave of 8 ? weeks—in money terms, $1,040. If, at 30 June 1975, his gross wage rises to $150 per week—a not unlikely occurrence—the value of his long-service leave accrued at this later date will be $1,430, an increase of 37.3 per cent in one year.

8.59. The rights of employees to receive and the liability of their employer to meet holiday pay appear to be more certain and uniform than the conditions relating to long-service leave. Except in the case of some casual workers where a holiday pay loading is incorporated in weekly rates of pay, legislation requires an employee to be granted paid holidays, now generally at the rate of four weeks' leave for each complete year of service, and payment in cash of a pro rata sum in the event of his ceasing employment at any time. Employment for even one day carries an entitlement to pro rata holiday pay.

8.60. From an employer's viewpoint, the cost of meeting the liability for holiday pay of staff is just as much a cost of labour as the wages or salaries paid regularly. Here too the relevant legislation imposes a requirement to maintain records disclosing the holiday pay entitlement of all employees on an individual basis.

8.61. The Ligertwood Committee concluded that a deduction for accrued holiday pay was not warranted, mainly it seems because of the relatively small sums of money involved. Since it reported in 1961, however, legislation has extended the benefit considerably. Amongst other things, the benefit has increased from two weeks for each year of service to four weeks, and in most cases there is currently a loading of 17½ per cent. The accrued liabilities of employers is now quite a substantial sum and it has become general practice to take the liability to account in computing financial results.

8.62. This Committee has not been able to locate any reliable statistics on the total estimated value, at a given date, of the accrued holiday pay liability of the private business sector. But the figure may well exceed 50 per cent of the total liability for accrued long-service leave.

8.63. The Committee recommends that, after a transitional period aimed at easing the impact on income tax revenue, a deduction be allowed for the total amount at


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each year end of the accrued liability for holiday pay entitlements of employees, calculated according to their vested rights under industrial awards or other legislation. In practice, the deduction allowable from the net income of a year would be limited to the increase in the accrued liability at the year end over the figure at the commencement of that year: a decrease in the liability would result in net income of that year being increased to offset the deduction claimed for holiday pay actually met and forming a component of wages and salaries paid in that income year.

8.64. The need for a transitional period for the implementation of the Committee's recommendations in respect of long-service leave and holiday pay has already been referred to. Of the various alternative courses open, it appears that a gradual introduction of allowances over a period of ten years would be the most appropriate. It is therefore recommended that, in the first year of change, the deduction allowable be restricted to 10 per cent of the accrued liability for each benefit, determined as previously recommended, and at the end of the second year to 20 per cent, and so on. It is further recommended that the right to obtain a deduction for these accruals be subject to an election by the taxpayer. For example, a taxpayer may, through omission or having regard to the smallness of his accrued liability for one of these benefits, elect not to claim a deduction for his accrued liability until, say, the third year of the transitional period. The law should provide that in that year he is entitled to a deduction for the full 30 per cent of his total accrued liability and, if further postponement occurs, to the higher percentages applicable to the following years until he becomes entitled to the full 100 per cent allowance against his net income for the tenth year. A taxpayer who does not elect to claim a deduction for his accrued liability should continue to be entitled to a deduction for the actual payments made in each income year.

8.65. Transitional arrangements along the lines suggested would cushion the impact on income tax revenue arising from allowing deductions for these business costs— costs which clearly should be taken to account to arrive at true net income for a tax accounting period. Special provisions will be needed to ensure that no undue benefit is received by either the vendor or purchaser of a business which changes hands.

Other Provisions for Liabilities

8.66. A number of submissions have been received requesting allowance of a deduction for provisions for other liabilities made in arriving at commercial profits. Firstly, there is the matter of the provision for a liability arising under a warranty given when a product is sold: for example, a manufacturer may undertake to replace defective parts for a specific period. The major difficulty in the case of provisions for warranty is in determining, in objective fashion, what constitutes a reasonable provision at any year end.

8.67. Several years ago income tax legislation in the United States was amended to allow a deduction for a provision for product warranties. However, the amounts claimed in the first year of operation proved so high and the effect on revenue so great that the deduction had to be abandoned, with retroactive effect. Because of the difficulty of assessing a reasonable provision for any business at each year end, the Committee does not favour an amendment of the law in respect of provisions for warranties. This is in line with the recommendation of the Ligertwood Committee.

8.68. The second liability or contingency for which a deduction has been sought concerns a possible loss under an impending law suit. The legal proceedings may not be resolved for several years and the decision may give rise to a substantial loss. Here too the impossibility of making any objective assessment of the amount that might be


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claimed as an appropriate provision appears to the Committee sufficient reason for not allowing a deduction.

Provision for Doubtful Debts

8.69. Another difference between tax and financial treatment frequently arises in the case of provision for doubtful debts. Business prudence normally demands that adequate provision be made for doubtful debts in determining the results of any period. In addition Australian company legislation requires directors to take reasonable steps to ensure that adequate provision is made for losses which may arise in the recovery of debts owing at the end of a financial period. However, income tax law permits a deduction only for bad debts written off. The amount of provision necessary to provide for doubtful debts is a matter of judgment, experience with bad debt differing from one industry to another and from year to year.

8.70. It would be possible for the law to prescribe limits, varying from industry to industry, as to the amount of a provision which might be deducted. But inconsistencies could hardly be avoided, and there would inevitably be arguments as to what proportion of the outstanding debts of a company operating in several fields related to each industry classification. For these reasons the Committee does not recommend that a provision for doubtful debts be allowed as a deduction.

IV. Depreciation and Amortisation of Fixed Assets

8.71. If the cost of a fixed asset used to produce income is not fairly spread over the period of use, by allowing deductions each year, the tax base will be distorted by the failure to match expenses with income. Criticisms of the present law relate to the unfairness of the spreading for those assets for which the law does allow depreciation and to the absence of any deduction for certain other fixed assets, principally buildings. In addition allowances have been sought for certain expenditure which, though not wholly falling within the usual definition of fixed assets, is nonetheless of a capital nature. This includes costs of acquiring know-how, of company formation and issues of shares, of feasibility studies; it also includes some expenses of moving the site of business operations. The denial of depreciation deductions to a taxpayer who has incurred expenditure on an asset he does not own—for example, improvements to leasehold property—also has been criticised.

8.72. The depreciation provisions of the Act were examined both by the Spooner Committee and, in rather more detail, by the Commonwealth Committee on Rates of Depreciation (the Hulme Committee). The terms of reference of the Ligertwood Committee did not extend to the matters dealt with by the Hulme Committee; but it examined the lease provisions of the Act, including the question of allowances for expenditure by a lessee on improvements to leasehold property.

8.73. Many of the matters raised in submissions are identical with those brought to the attention of the earlier committees, particularly the Hulme Committee: for despite the recommendation of these committees that allowances be available for the recoupment of the cost of certain assets of a capital nature, the law has remained unchanged. Consequently, the differences between net income and accounting profits which arise in relation to depreciation and amortisation continue. In the years that have elapsed since the recommendations of the Hulme Committee, the grounds for the criticism of the differences in treatment have not weakened; rather, they have been strengthened by technological progress and by the now almost general acceptance by business that


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failure to provide adequate depreciation for buildings results in overstatement of profits. The omission to tax capital gains, particularly on land, which it might be thought has mitigated to a degree the absence of depreciation allowances for buildings is now proposed to be rectified.

8.74. The discussion which follows is arranged under four broad categories of assets in respect of which changes in the law are sought. These are plant and equipment, buildings, leasehold improvements and other assets and costs. The questions which arise are considered in relation to the recoupment of the historical cost: the extent to which regard should also be paid to the increased cost of replacement due to inflation is briefly mentioned in Section VII. The special provisions applying to primary production and to the mining and petroleum industries are considered in Chapters 18 and 19.

Plant and Equipment

8.75. Practically all units of property classified in financial accounting as fixed assets and in respect of which depreciation is at present allowed fall under the broad heading of plant and equipment.

8.76. The annual percentage rate of depreciation allowable in respect of each unit of property is determined by the Commissioner on the basis of the estimated effective life of the asset, assuming it is maintained in reasonably good order and condition, and an annual percentage allowance is fixed accordingly. Standard rates of depreciation are determined by the Commissioner in respect of various types of assets. The standard rates make no allowance for obsolescence. Although the Commissioner may allow a variation from the standard rates where special circumstances or conditions relating to a particular unit of property justify such a variation, his determination, it seems, must be made on the physical life of the asset. Australia is one of the few countries which does not have regard for obsolescence in determining rates of depreciation.

8.77. The Hulme Committee considered whether it was practicable and desirable, in determining annual rates of depreciation, to take obsolesence into account and reached the view that it should be recognised as a relevant and material factor. It added, however, that the method of making an allowance for obsolescence and the degree of the allowance had given it some difficulty and concluded that the only feasible approach was to introduce a degree of flexibility by allowing the taxpayer choice of a rate of depreciation within a band of rates.

8.78. The need to make due allowance for the factor of obsolescence has again been pressed in many submissions to the present Committee, including a number from particular industries in which, owing to the speed of technological advances, the matter is of major concern. Where the period of the estimated effective life of any equipment proves, in practice, to have been excessive, a deduction for the cost not covered by allowances in prior years is available when the equipment is scrapped or abandoned. However, this defers a deduction and does not give an even spread of the recoupment of the capital cost over the effective life of the equipment.

8.79. Complaints about the inflexibility of the standard rates continue, though it may well be that a proportion of these are not soundly based. The Commissioner and his officers permit variation from the standard rates where a taxpayer produces satisfactory evidence that, in his particular case, the specified standard rate is inadequate.


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Submissions rarely record whether an application has in fact been made for permission to adopt higher than standard rates.

8.80. The essential feature of rates of depreciation is that they are estimates of effective working lives. The allowances flowing from them are in reality estimates also and not precise figures of the portion of an asset's cost relating to a year of income. Considerable clerical recording and effort are frequently involved in computing depreciation allowances, particularly in manufacturing industries, due to the differing rates to be applied to the separate units of property. The clerical effort in checking or reviewing the computations by Departmental officers is also heavy. One method of reducing this would be the adoption of a composite rate to be applied to all depreciable fixed assets of a business, other than motor vehicles and buildings. This method recognises the futility of incurring clerical costs in performing precise calculations of allowances for various categories of property attracting different rates, when approximately the same total allowance can be determined by simple and less expensive procedures and the result under either approach is in any event only an estimate.

8.81. The Committee recommends that the schedules of standard rates of depreciation incorporate composite depreciation rates for specified industries which may be adopted, in lieu of standard rates, for all depreciable assets other than those excluded in fixing the composite rate. It further recommends that, in fixing the composite rate for a particular industry, a loading be added to take account of obsolescence.

Buildings

8.82. The Act allows deductions for depreciation of ‘plant’ used for income-producing purposes but, with certain limited exceptions, not for depreciation of ‘buildings’. The exceptions are income-producing buildings forming an integral part of plant; buildings used only for scientific research related to the business of the taxpayer; structural improvements on land used for the purpose of agricultural or pastoral pursuits; and buildings erected by mining enterprises as part of the development of a mining property.

8.83. One argument that has been used to support the present situation is that land and buildings appreciate in value rather than depreciate. The Hulme Committee, in observing that the Commonwealth income tax law did not allow depreciation on buildings, stated that the reasons which appeared to have previously weighed against the granting of such an allowance were those to be found in the following extract from the Report of the Ferguson Commission (1932-34):

‘We received many requests that depreciation should be allowed in all cases. There are many buildings, however, which with repairs and maintenance, all of which are of course allowed as deductions, will last for hundreds of years. There is the further consideration that many substantial buildings in good localities have not depreciated in value—on the contrary the property as a whole has appreciated owing to an increase in values of the sites on which the buildings stand … We recommend that depreciation on buildings be restricted to buildings forming an integral part of plant …’

8.84. The Hulme Committee reported that in none of the matters which came before it had it encountered more widespread representation, or more unanimity of opinion, than that an allowance should be given for depreciation of buildings. It


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recommended that depreciation be allowed in respect of the cost of all income-producing buildings but drew attention to the practical problems of including existing buildings.

8.85. It recommended that existing buildings be included where, if depreciation using the prime cost method had been available at the time the building was constructed, there would still be some portion of the construction cost unrecouped. However, to overcome the problem of ascertaining the actual construction costs of older buildings, it devised a complex scheme for calculating the cost of existing buildings where actual construction costs were not known. Construction costs of buildings erected between 1939 and 1955 (the year in which the recommendations were made) could, it was thought, be ascertained. It was proposed that buildings erected before 1939, which tended to be more standardised than are buildings erected today, should be given a deemed cost of construction calculated by applying a standard cost for that type of building in 1939 to the building's internal floor area and then relating the result to an index of relative levels of building costs in earlier years. Since the rates of depreciation suggested for brick, stone or concrete buildings assumed a normal life of sixty-seven years, the existing buildings (in 1955) which would still have qualified for depreciation could have been constructed as long ago as 1888.

8.86. Depreciation on industrial and commercial buildings used in the production of income is allowed in many overseas countries including Belgium, Canada, Italy, Japan, Netherlands, New Zealand, South Africa, Sweden, the United States, and West Germany. The United Kingdom is an exception, the deduction being limited to industrial buildings. However, the Millard Tucker Committee on the Taxation of Trading Profits (1951) and the Royal Commission on the Taxation of Profits and Income (1955) both recommended that the depreciation allowance be extended to include commercial buildings.

8.87. In reaching this conclusion, the second of these United Kingdom inquiries reported:

‘380. No doubt commercial buildings involve an ultimate wastage of capital in the same way as industrial buildings do. From that point of view there is no reason to distinguish between them. But we recognise that there are other arguments to be considered. There is an argument that any allowance for capital that is lost in the using up of a fixed asset is anomalous in an income tax system which refrains from treating as taxable a realised capital surplus. This unbalanced treatment, for long confined to plant and machinery, has now been extended to cover other types of assets, in order to stimulate capital investment of a kind desirable in the national interest. It is only in the new context of shortages and high prices combined with a wider range of assets to which capital allowances apply that the anomaly of principle could be of any material importance. But in that context it is not impossible that what is right for industrial buildings is wrong for commercial buildings.

381. The Board are opposed to this recommendation. We summarise their reasons:

  • (1) Commercial buildings last a very long time; they are not nearly as much subject to obsolescence as factories are.
  • (2) Over very long periods they tend to appreciate rather than depreciate in value, so that if allowances were given they would very often have to be withdrawn when a sale took place.
  • (3) At the present time there is no economic importance in stimulating the construction of commercial buildings.
  • (4) The proposal would involve drawing a line between commercial buildings and dwelling-houses that would inevitably be regarded as unsatisfactory, particularly in the common case of the house over the shop. Complicated provisions would, moreover, be required to deal with changes of user.



  •   ― 94 ―
  • (5) The proposal would add considerably to the work of the Department.

382. Although these arguments must be taken into account we do not believe that in the long run they can be decisive. So far as they are not concerned with administration they amount to saying that businesses would not find it worth while to claim the allowance, or that there would be no economic reason for a Chancellor to implement the recommendation. That may well be so, and we should agree to this extent that we do not regard a change from the present system as in any sense an urgent requirement. But we could find no fiscal justification for distinguishing between commercial and industrial buildings and we think both should get the allowance. Accordingly, we endorse the recommendation of the first Tucker Committee.’

8.88. The Institute of Chartered Accountants in Australia and the Australian Society of Accountants, in a joint statement, ‘Depreciation of Non-current Assets’, issued in April 1974, recommended as follows:

‘Buildings. For the purposes of calculating depreciation, the historical cost of a freehold property (or other value substituted for historical cost in the accounting records) should be apportioned between the land itself and the building(s) erected on the land. The resultant depreciable amount attributable to the building(s) should be written off as an expense by means of periodical depreciation charges over the estimated useful life (lives) of the building(s).’

8.89. The experience of this Committee is very similar to that reported by the Hulme Committee and referred to in paragraph 8.84. Numerous submissions have been received which are unanimous in condemning the present restriction of the allowances to buildings to the extent that they form integral parts of manufacturing plant. The representatives of various kinds of business have urged that at least their own particular class of buildings should qualify for relief.

8.90. The basic arguments in favour of allowing depreciation on buildings as a taxation deduction stem from a recognition that a material asset has a finite useful life which may be shorter than the physical life of the asset. All buildings and other structures on land are just as subject to the need for eventual replacement as is working plant, and with the rapid rate of technological change the effective working life of these items is becoming shorter. This fact is reflected in a practical manner in the continual demolition of existing buildings to make room for new ones, usually of increased capacity and more suitably designed for modern conditions.

8.91. The argument which persuaded the Ferguson Commission to recommend against an allowance for building depreciation—that any loss in value of a building tends to be offset by appreciation in the value of land—has, in general, long since been rejected. A further argument—that the imposition of a capital gains tax on profits arising from the realisation of real property is a necessary counterpart to the allowance of building depreciation—has also been rejected. The reasons for the rejection of both these arguments were stated in the Hulme Committee report and have been dealt with at some length in pronouncements by the major professional accounting bodies in Australia and overseas. The principal reason is that they overlook the fact that buildings are consumed and replaced in the course of business operations unrelated in any way to changes in the value of the underlying land. Many business activities are conducted on land owned for very long periods. Rarely is industry carried on efficiently in buildings erected more than fifty years previously. Commercial buildings of the same vintage originally used for offices or accommodation are seldom now suitable for that purpose without expenditure of a capital nature on reconstruction.




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8.92. In the Committee's view allowances for depreciation of buildings are called for. Their introduction, however, raises certain problems:

  • (a) For what classes of building should depreciation be allowed?
  • (b) Should all buildings be included or only those completed after a certain date or after the proposal is introduced?
  • (c) How should changes in the ownership of depreciating buildings subject to depreciation be treated?
  • (d) How should the demolition and destruction or damage of buildings be treated?
  • (e) Is a phasing-in period necessary to cushion the effect on tax revenue?

8.93. Classes of buildings which should qualify. The Committee sees no valid reason for excluding particular classes of buildings from the allowances and therefore recommends that depreciation be allowable in respect of all income-producing buildings whether they be industrial or commercial. In this context commercial would include residential accommodation. While the case for allowances may be stronger for industrial buildings, which generally have a shorter effective life than other buildings, and possibly also for accommodation buildings such as hotels and motels for the same reason, allowances are justified whenever a building is used in producing income. Moreover, real difficulties would arise in identifying industrial buildings if the allowances were confined to such buildings, or in identifying accommodation buildings if allowances extended only to industrial and accommodation buildings.

8.94. The inclusion of existing buildings. Some restriction on the scope of buildings entitled to allowances, related to time of erection, would seem to be inescapable. The broad alternatives are to give allowances in relation to (i) all existing buildings, together with all new buildings and additions to buildings; or (ii) buildings and additions erected after a specified day (say 1960); or (iii) buildings and additions erected after a very recent date (say 1974). The problems involved in giving allowances in respect of all existing buildings are immense, especially when it is proposed that all income-producing buildings should qualify. On the other hand, the restriction of the allowance to relatively new structures must give rise to inequity: for example, a rented house finished in 1975 would qualify but one next door completed in 1973 would not. The exclusion of existing buildings would also distort the property market.

8.95. Choosing between the alternatives is not easy. The major reason why nothing has been done in this area for so long, despite the recommendations of earlier committees, is probably the administrative difficulties associated with the proposals that have been made. Hence, administrative feasibility must be the major consideration, even though some inequities may result. The Committee therefore recommends that all buildings which were completed, and were used or were available for use, in the production of assessable income after 30 June 1974 (referred to hereafter as the ‘qualifying date’) and any additions to buildings where the additions were completed and used or available for use after that date, should qualify for depreciation. The rates should be based on their estimated effective lives as determined by the Commissioner. Contractual completion date rather than cost incurred to a specified date should be more readily ascertainable in the case of most buildings and a modestly retrospective date, coinciding with the end of a fiscal year, is proposed.

8.96. There will be formidable problems in determining the apportionment of the cost of a building to individual home units, own-your-own units and strata titles to property. An official study will be needed to work out special provisions for these


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cases, and initially it may be appropriate to defer granting allowances for buildings to which the title is held in one of those forms.

8.97. There is evidence in the published reports of a number of public companies that some taxpayers hold the view that because of the purpose for which a property is held, the value attributed to a building, or some other reason, depreciation of the building does not need recognition. There could be little merit in introducing a difference between tax accounting and financial accounting in these instances. In some overseas countries certain allowances are available only to the extent that the costs concerned have been recognised in a taxpayer's financial records. A similar provision might well be appropriate in relation to allowances for building depreciation proposed by the Committee, at least in respect of companies.

8.98. Treatment on change of ownership. The segregation of the proceeds of the sale of a building from the proceeds of the sale of the land on which it is erected gives rise to special difficulty. This was recognised by the Hulme Committee in its proposal that there be no balancing charge in respect of depreciation on the sale of a building, but not, however, in its proposal that there be a balancing allowance on such a sale.

8.99. In the view of this Committee, the difficulty of ensuring a fair and realistic segregation, within the proceeds from the sale of a property, of that part of those proceeds applicable to a building dictates that there be neither a balancing charge nor a balancing allowance. Segregation within sale proceeds would give rise to added complications if it were necessary to dissect further the sum allocated to buildings, so as to identify that part of the sum applicable to a building erected prior to the qualifying date and that part applicable to additions to it made subsequently.

8.100. Accordingly, the Committee recommends that in the event of the disposal of a building, the new owner should be entitled to depreciation on the basis that he succeeds to the unrecouped amount of the original cost of the structure. His annual allowances would be in accordance with the depreciation schedule for that property applying at the date of purchase. The purchase price of the property would be irrelevant in regard to depreciation allowances, the sale proceeds of the building being deemed to be its written-down value. Where there has been non-income-producing use in any year, the written-down value will have been reduced by a ‘notional’ depreciation allowance in that year.

8.101. Implicit in these proposals is the principle that all proceeds received on the sale of a property which are in excess of the written-down value of the building must represent the value of the land on which the building stands. The total of depreciation previously allowed to the vendor will, however, diminish the cost base of property for capital gains tax purposes. Where property is sold for less than the written-down value of the building—an unlikely event, no doubt—the assumption that the building was sold for its written-down value is of course contradicted by the facts, and there may be a case in this circumstance for the application of a balancing allowance. The buyer would be treated as having acquired the building at the price he paid for the property. If this is not done, the seller will be allowed only a capital loss in respect of what should be an income deduction.

8.102. It should be noted that these proposals are not intended to vary the present treatment of depreciation of buildings under the special provisions of the Act relating to mining, petroleum, primary production and forestry operations.

8.103. Demolition and damage. There would need to be exceptions, in the case of demolition or damage to a depreciated building, to the general rule that balancing


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adjustments are not made. Problems of segregating amounts received between land and buildings would not arise here (though segregation would need to be made between a building erected prior to the qualifying date and additions made subsequently). In the case of demolition or destruction, the difference between the written-down value of the building and the salvage or insurance proceeds would be allowed as a deduction in the year of demolition. If the proceeds exceeded the written-down value, the excess, up to the sum of the depreciation deductions previously allowed to the taxpayer, would be a balancing charge. Any amount of the excess not then treated as a balancing charge would reduce the cost base of the land for purposes of capital gains tax, unless the taxpayer elected to apply it in reduction of the cost of a building erected in replacement. Where there is only partial damage, any insurance recoveries would be offset against the cost of any restoration not deductible as a repair. Any amount not so absorbed would be treated as a balancing charge to the extent of depreciation previously allowed to the taxpayer and thereafter applied to reduce the cost base of the property for purposes of capital gains tax. Insurance recoveries in respect of restoration amounting to repair are income under existing law and the repair cost deductible. Balancing deductions would not be allowed, since depreciation will continue to be available on the original schedule.

8.104. Effect on revenue. The loss of tax revenue that would result if income-producing buildings were to qualify for allowances has been a major factor in postponing the introduction of such allowances. But this factor should not be permitted to override the correction of an inequity in the form of an overstatement of net income by a large body of taxpayers. Some phasing-in of the allowances is nevertheless called for. If, contrary to the Committee's proposal, a major portion of existing buildings were to qualify, phasing-in could be achieved by commencing with a low rate which would increase to a realistic figure over a period of five to ten years. A phasing-in is automatically achieved under the Committee's proposal that the allowances be restricted to buildings completed after the qualifying date.

Leasehold Improvements

8.105. Brief reference is made in Section VIII to leases in general. Here discussion is limited to leasehold improvements carried out by a taxpayer at his own expense in connection with his business activities and for which an allowance, either by way of depreciation or amortisation, is not available. A number of submissions have been received on this point.

8.106. A taxpayer sometimes has no option but to incur costs in erecting buildings on leasehold, and it has been claimed that an allowance should be available which recoups the costs over a reasonable period. Buildings erected at an airport by an airline to service passengers, cargo and aircraft are one example.

8.107. The Ligertwood Committee made a series of recommendations relating to a deduction for part of the cost of improvements carried out by a lessee on leased property used for the production of assessable income and for the inclusion of an equivalent sum in the assessable income of the lessor. The effect of these recommendations would have been to allow the lessee a deduction, spread over the period of the lease subsequent to making the improvements, of an amount agreed by the parties as being the estimated residual value of the improvements at the end of the term of the lease. There would have been corresponding inclusions in the assessable income of the lessor. However, that Committee was mainly concerned with overcoming the abuse of the then provisions of Division 4 of Part III of the Act. The recommendations of the Ligertwood Committee were not acted upon but the abuses were ended by the


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termination in 1964 of the operation of Division 4 in respect of new improvements. Whatever merit there may have been in the recommendations of the Ligertwood Committee they do not seem to be appropriate in the context of the general allowance of depreciation on buildings which this Committee recommends.

8.108. At least when the lessee has erected the building at his own expense on Crown land or on land of a public authority or a body not subject to taxation, it would be reasonable to deem him to be the owner of the building in question and to provide that he should receive the depreciation allowances. However, this approach would exclude any allowance to a lessee where the leasehold improvements have been carried out on privately owned land and accordingly may be thought to be unduly restrictive.

8.109. The Committee recommends that, for the purpose of allowances for depreciation of buildings, a lessee should be deemed to be the owner of any leasehold improvements carried out at his own expense if he uses the property for income-producing purposes. He should be entitled, during the period of his possession as lessee, to allowances to recover the costs he has incurred at the same rate as would apply to equivalent expenditure by the owner. It is not proposed that on his ceasing to have possession as a lessee he should obtain a balancing allowance as to do so would possibly open the way for abuse of the allowance. The treatment of any unrecouped cost for capital gains tax purposes would be a matter of detail of that legislation.

Other Assets and Costs of a Capital Nature

8.110. The existing law has been criticised for its failure to make allowances available for the cost of assets not falling within the ambit of the depreciation provisions and for the costs of a capital nature incurred in business operation but having limited enduring value. The items include costs of acquiring know-how and trade rights, some expenses of moving the site of operations, feasibility studies and costs of capital-raising.

8.111. With the introduction of capital gains tax, thought would need to be given to whether some of these costs should qualify for amortisation allowances, similar to those available to primary producers under section 75A (paragraphs 18.23–18.25). Alternatively, losses arising from expenditure of this nature could be made to fall within the definition of capital losses for capital gains tax purposes, though there would often be problems in fixing the time when losses of this nature are to be treated as having been incurred.

8.112. The Committee is inclined to the view that at least some of these costs could be conveniently dealt with by a provision similar to section 75A, which would make the costs allowable, over a period of years, against income.

V. Trading Stock

8.113. The matching of income and expense, which is necessary if net income is to reflect a ‘true’ profit from business operations, requires a method of deferring costs which relate to stock held at the close of a year of income. The present method is set down in the provisions of the Act in respect of trading stock. If net income is to reflect ‘true’ profits, there is also a need for provisions by which an anticipated loss of the sale of stock may be brought to account. This, too, is met by the trading stock provisions. Those provisions have a third function: they make possible the anticipation of a profit by writing up the value of stock to its market selling value. This anticipation, though not related to the determination of a ‘true’ profit of a year of income, makes


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possible a spreading of income of a number of years. In this function the trading stock provisions act to support the loss carry-forward provisions and, in the case of individual primary producer taxpayers, to support any provisions relating to the averaging of incomes.

8.114. Trading stock is defined in the Act as including anything produced, manufactured, acquired or purchased for purposes of manufacture, sale or exchange and also includes livestock (section 6 (1) ). Other provisions relating to trading stock include the following:

  • (a) A taxpayer carrying on any business is to bring to account the value of his trading stock on hand as at the beginning and the end of each year of income in order to ascertain his taxable income (section 28).
  • (b) The value of the stock at the beginning of a year is the value ascertained under the Act at the end of the previous year (section 29).
  • (c) The value of each item of stock, other than livestock, on hand at the end of the year may be, at the option of the taxpayer, its ‘cost price or market selling value or the price at which it can be replaced’ (section 31 (1) ). The latter terms are not defined in the Act. A fourth basis of valuation applies where the taxpayer, on application, satisfies the Commissioner that, by reason of obsolescence or any other special circumstances (e.g., slow turnover items), a value other than one provided by section 31 (1) is appropriate for that item.
  • (d) Disposals of trading stock otherwise than in the ordinary course of business are to be brought to account at the market value of the trading stock on the date of disposal (section 36).
  • (e) A notional disposal at market value is deemed to occur where, for any reason, there is a change in ownership of or the interests of persons in trading stock (but specifically including change by reason of formation, dissolution or variation of a partnership) and one or more persons who owned or had an interest in the stock before the change has a continuing ownership interest after the change. There is relief from this requirement, if the parties so request, where a person or persons having an interest in the partnership before the change have at least a 25 per cent interest after the change (section 36A).
  • (f) A market valuation of trading stock applies on devolution of trading stock on death of a taxpayer; but relief is again given where the trustee of the estate and the beneficiaries (if any) agree and give notice that the valuation should be on the basis of a continuing business (section 37).

8.115. A number of aspects of the trading stock provisions call for consideration. These relate to the assets to which the provisions might apply, the methods of valuing trading stock and of identifying stock which remain on hand at the end of a year of income, and the operation of those provisions which in some circumstances will deem a disposition of trading stock to have been made at market value.

Definition of Trading Stock

8.116. The present definition of trading stock is giving rise to difficulty in determining whether it embraces several classes of assets which are on occasions dealt with as stock in hand for financial accounting purposes. The assets in question generally fall into one of three groups:

  • (a) land held for resale;



  •   ― 100 ―
    (b) plant spares and consumable stores;
  • (c) shares, debentures and similar assets.

8.117. Land held for resale. In defining trading stock section 6 (1) uses the expression ‘anything …’ and sections 29 and 31 refer to ‘each article’ of trading stock. The question arises, whether land is to be regarded as trading stock. Opinion is divided, though it is understood that in practice the Commissioner treats land purchased by a dealer in land as trading stock. If land does not fall within the definition of trading stock, disposals by a land dealer other than in the ordinary course of business would not have to be valued at market value (section 36). Such a disposal would include, for example, a gift of land by a taxpayer, who might otherwise have been assessable on the sale of the land, to his wife. Where real property is held for resale by a taxpayer who is engaged in a business of trading in real property, the asset should, in the Committee's view, be treated for income tax purposes as trading stock and the definition should be amended to give this result.

8.118. Plant spares and consumable stores. The problem of plant spares held in stock for future use is of a different nature. The items do not fall within the present definition of trading stock as they are not acquired or manufactured for the purpose of sale. In addition, they are not articles depreciable as ‘plant’ because they are not ‘installed ready for use’. Thus while the cost of items actually used in repairs during the income year are deductible, any loss on sale or scrapping of spare parts for which the taxpayer has no use is a capital loss and not deductible. Consumable stores such as oils, lubricants, protective clothing, cleaning materials, etc., which are used in manufacture but do not form part of the finished product also do not constitute trading stock for the purposes of the Act: they may be deductible in full in the year of purchase. In this regard the taxation treatment differs from the accounting treatment where such stock have a significant value. The Committee recommends that provision be inserted in the Act which will permit supplies on hand, including plant spares, to be treated on the same basis as trading stock.

8.119. Shares, debentures and similar assets. Another area of doubt is whether the definition of trading stock extends to shares, debentures and similar assets. This question was considered by the Ligertwood Committee which proposed that the definition should not be extended to include such assets: to do so would permit the deduction of unrealised losses on some of them without regard to unrealised gains on others.

8.120. A decision of the High Court in 1971 has substantially resolved this question in relation to shares,note but the Committee believes the position of all these assets needs clarification.

8.121. There are circumstances where the profits on sale of property may be assessable income, even though the taxpayer is not classified as a dealer in such property and the property is not within the definition of trading stock. An example is where the varying of investments and turning them to account is an essential feature of the business: it has been held that the profit on realisation of portfolio investments by banks, life insurance companies and some investment trusts is assessable income under section 25 of the Act. In the Committee's view these assets should be treated as trading stock if they are to be subject to income tax. If they are not treated as trading stock, these profits should be subject to capital gains tax.




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8.122. The Committee sees merit in the point raised by the Ligertwood Committee, referred to in paragraph 8.119. When shares, debentures and similar assets are treated as trading stock for income tax purposes, the basis of valuation elected under the trading stock provisions should be applied not to individual assets but to all assets falling within a particular class: for example, to all debentures or to all shares.

Methods of Valuing Trading Stock

8.123. The valuation of trading stock is discussed here in the context of general business. The special provisions of the Act in respect of livestock are dealt with separately in Chapter 18.

8.124. Under the present provisions of the Act each article of trading stock may, at the option of the taxpayer, be valued at its cost price or market selling value or the price at which it can be replaced. There is also provision for valuing trading stock at a lower figure where the taxpayer requests this and the Commissioner can be satisfied that, due to obsolescence or other special circumstances, a lower value is more appropriate.

8.125. The terms ‘cost price’, ‘market selling value’ and ‘the price at which it can be replaced’ are not defined in the Act and have been the subject of litigation and discussion over the years. It is therefore proposed to consider each term separately and the problems associated with it.

8.126. Cost price. Cost is regarded as identifiable or historical cost and the elements which make up cost are:

  • (a) The purchase price of goods and, in the case of manufactured stock, materials used in manufacture.
  • (b) Direct expenditure incurred in bringing the stock into its existing condition and location.
  • (c) Depending upon the circumstances, indirect or overhead expenditure attributable to the stock.

In large businesses it is often either impossible or impracticable for the actual cost of each article of stock on hand to be ascertained. This is recognised by both the accounting profession and the Revenue, and certain methods or formulae have been devised which produce an estimate of the cost of trading stock. These include:

  • (i) First-in-first-out (FIFO).
  • (ii) Average cost.
  • (iii) Standard cost.
  • (iv) Adjusted selling value.
  • (v) Last-in-first-out (LIFO).
  • (vi) Base stock.

The accounting literature on stock valuation is extensive, and it is not therefore proposed to describe each of these methods in detail.

8.127. The Revenue does not accept the LIFO and base stock methods, and, understandably, accepts standard costs only where the standards are reviewed regularly to equate with current prices.




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8.128. The major area of disagreement between the taxpayer and the Revenue as regards valuation at cost is the extent and nature of overhead expenses which need to be included in the cost of manufactured products and items in process of manufacture. Other problems include the meaning of ‘cost’ in special situations: for example, in relation to imported goods when foreign exchange rates change in the interval between purchase and payment; in relation to second-hand cars when discount on a new car is given by higher trade-in on a second-hand car (recently solved but only by Commissioner's compromise); and in relation to by-products. These problems arise out of the many possible interpretations of ‘cost’ when applied to different businesses.

8.129. In practice there is quite often disagreement of a technical nature regarding costs to be included. Because of the variety of methods of valuation applicable to particular types of businesses, it would not be possible to lay down statutory definitions. This was the view reached by the Spooner and Ligertwood Committees, and also by the Carter Commission in Canada.

8.130. A number of submissions have drawn attention to the difficulties currently being experienced in valuing stocks at cost figures acceptable for income tax purposes. These are some of the points which have been raised:

  • (a) There is some inconsistency in the rulings given by departmental officers as to the extent that overheads are to be included in determining cost.
  • (b) The appropriate method of calculating manufacturing cost depends on the nature of the business.
  • (c) The valuation of trading stock which is in accordance with accepted accounting standards consistently applied should be acceptable for tax purposes.

8.131. Generally the Commissioner requires, when the basis of valuation of a taxpayer's stock comes under review, that cost be determined on a full absorption basis that takes to account all production overhead expenses whether they be fixed or variable. However, it seems that many taxpayers for both financial accounting and tax purposes use a direct cost basis which allows only for production overheads varying according to volume of production. Direct costing excludes a value for many overhead costs normally brought to account on a full absorption cost basis. When the basis adopted is consistently applied from year to year in the case of a continuing business, the effect of the method used on net income of a year is not usually significant.

8.132. Having regard to the many and varying factors which need to be given due weight in determining the appropriate method for arriving at cost, particularly of manufactured stock, the consistent application of a generally accepted method of valuation may well be an adequate test of the reasonableness of the value. It would be most undesirable, from an efficiency viewpoint, were a large body of taxpayers to find it necessary to value their stock on two different bases, one for financial accounting and the other for tax accounting.

8.133. The Committee makes no recommendations for amendment of the present provisions relating to the valuation of trading stock at cost. It believes, however, that many taxpayers in business would benefit were the Commissioner to publish information dealing with the interpretation and operation of the law on stock valuation. This should help to remove some of the uncertainty that now exists.

8.134. It would be helpful if there were a requirement that where the valuation of trading stock has an important bearing on the determination of net income, taxpayers should disclose their methods of valuation and whether or not the method has been


  ― 103 ―
consistently applied. This raises the question of special provisions to cope with situations where taxpayers decide it is necessary or appropriate to vary their method of valuation.

8.135. Where a taxpayer changes his method, it has been the practice to require that the new method be also applied to valuation of stock at the commencement of the year of income. Where this results in opening stocks being valued at below the closing value of the previous year, the taxpayer loses a deduction for the amount by which the opening stock value in the year of change is decreased. The Committee recommends that special provision be made so that differences such as these arising from a change in method of valuation will be spread and brought to account over a period of, say, five years. A somewhat similar recommendation has been made in respect of a change in the basis of taxation from cash to accruals (paragraph 8.25).

8.136. Market selling value. By market selling value is meant the price at which the item could be expected to be sold in the market in which the trade of selling by the taxpayer is conducted. It contemplates a sale in the ordinary course of business and not a forced sale. No allowance is made for a possible fall in market price in the future, even when such an eventuality is reasonably anticipated.

8.137. Market selling value ceased to be an acceptable method of stock valuation for financial accounting purposes many years ago when it was replaced by the concept of valuation at ‘net realisable value’, provided it is less than cost. Net realisable value has been defined as the price at which it is estimated that the stock can be realised in the normal course of business, either in its existing condition or as embodied in the product normally sold, after allowing for expenditure to be incurred before and in the process of disposal. In estimating this price, regard is to be had to excess and obsolete stocks, the trend of the market and the prospects of disposal.

8.138. The main ground for rejecting net realisable value as a basis for tax treatment is that it involves estimates which would be difficult for the Revenue to confirm. However, the problems in this area should be no greater than currently apply in computing net income under the accruals method (for example, in estimating the liability of a general insurance company for outstanding claims). The Committee therefore recommends that the Act be amended to substitute net realisable value for market value as one of the alternative bases of valuation of trading stock.

8.139. Replacement price. Replacement price means the price at which the taxpayer can buy the goods on the last day of the year of income. This basis appears to be a satisfactory alternative and the Committee believes it should be retained.

Disposal of Trading Stock

8.140. A number of problems are occurring in the operation of the special provisions of the Act dealing with the disposal of trading stock otherwise than in the ordinary course of business. Where a taxpayer disposes, whether by sale, gift or in some other way, of trading stock which is an asset of his business activity and the disposal is not made in the ordinary course of that business, the value of the asset so disposed of is included in his assessable income at its market value (section 36).

8.141. This provision extends to disposal of trading stock flowing from a change in ownership or of interests following the formation, dissolution or variation of interests of a partnership; but the parties concerned may elect that it shall not apply if the persons holding not less than a 25 per cent interest prior to the change continue to have an interest of not less than 25 per cent after the change has been implemented. Where


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the parties so elect, the value of the trading stock shall be the figure at which it would have been valued if no disposal had occurred and the year of income had ended on the date of the change (section 36A).

8.142. The major weaknesses in the existing provisions appear to flow from the limitation of their application to assets of a business carried on by the taxpayer.

8.143. For example, a taxpayer who may, on disposal of property, have been liable under section 26 (a) may gift the property to another person. Section 36 will not apply, as the taxpayer was not carrying on a business of which the property was an asset. The other party will not be taxable on the profits on disposal of the property as, having acquired the property as a recipient of an unsolicited and unencumbered gift, he could not be said to have acquired it for resale at a profit.

8.144. The Committee believes that an additional provision is necessary to extend the requirement for bringing to account as assessable income the market value of any asset disposed of, where the profit on disposition is subject to tax and the asset disposed of was not included in the assets of a business carried on by the taxpayer. A new provision modelled on the existing subsection (4) of section 26AAA would be worth considering.

8.145. It is desirable that there be two exceptions, available at the election of the taxpayer, to the general rule that, on disposal otherwise than in the ordinary course of business, trading stock and other assets should be valued at market price. Firstly, the rule should not apply to transfers of assets between companies forming part of a company group. Secondly, it should not apply when assets are transferred in the course of an amalgamation, reconstruction or merger of one or more companies.

8.146. Consideration also needs to be given to the devolution at death of assets other than trading stock and from which any profit realised prior to death of the taxpayer would have fallen to be taxed. Under the present law trading stock must, on the death of a taxpayer, be brought to account at its market value (section 37); there is a proviso, however, by which the trustees and beneficiaries may give notice of their agreement to the Commissioner that the value of trading stock forming part of the business assets of the deceased shall be their value determined on the basis that the deceased had not died, with the result that any difference between tax value and market value is not brought to account for tax as at the date of death (section 37). This proviso is of considerable assistance to the beneficiaries of a deceased taxpayer who had been carrying on primary production and valuing livestock at average cost values. In the Committee's view, the proviso should be retained.

8.147. The question arises whether there should be a provision, equivalent to section 37, which will bring about a deemed realisation at death for income tax purposes in the case of an asset of the kind referred to in paragraph 8.144, i.e., an asset whose disposition will generate a taxable profit but which is not an asset of a business carried on by the taxpayer. It would be somewhat illogical if there were no provision to this effect when, under the Committee's recommendations, there will be a deemed realisation of other assets at death for capital gains tax purposes.

8.148. The difficulties arising from the operation of the special provision (section 36A) relating to changes in interests of partnerships carrying on business and with assets which include trading stock, growing crops, etc. are somewhat different.




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8.149. Section 36A was introduced into the Act in 1952 following a recommendation of the Spooner Committee. The basic rationale was to avoid the inequitable taxation of unrealised profits which arose from the application of section 36 where there was a continuity of interest in the members of a partnership following a variation, dissolution, etc. of an old partnership. Unfortunately it seems that in addition to correcting the old inequity, section 36A, as at present worded, has also created a ready means of income-splitting.

8.150. For instance, a sole trader disposing of livestock, having a market value far higher than its average cost value as used for income tax purposes, to a family partnership would, but for section 36A, be required to bring the disposal to account at the then market value of the stock. Where the sole trader holds a substantial interest in the new partnership, it is reasonable that he should not be called upon to pay tax on a profit largely unrealised. However, by a two-stage arrangement it has been found possible to transfer the whole interest in the stock to a family partnership or family company without incurring tax on the excess of market value over income tax value. By this method the tax liability on the excess can be transferred from a person paying a high marginal rate of personal income tax to other members of the family paying at lower marginal rates when the profit is realised in the normal course of business.

8.151. The Committee recommends that the principles adopted in New Zealand income tax legislation in relation to the disposition of an interest in trading stock be embodied in the Australian law. In New Zealand the following wording is inserted after sections of the Act dealing with disposals of the entirety of trading stock:

‘The foregoing provisions of this subsection shall with necessary modifications apply in any case where a share or interest in any trading stock is sold or otherwise disposed of by any taxpayer.’

A taxpayer disposing of a share or interest in trading stock is required to bring to account his share of the market value of trading stock so sold or transferred. The purchaser or transferee of the interest is deemed to have purchased the share of the trading stock at the same market value. Problems which might otherwise arise of assessing continuing partners in a partnership on profits which have not been realised are overcome by permitting their interest in trading stock on hand at the balance date following the acquisition to be valued on the same basis as would have applied had there been no change in the constitution of the partnership.

8.152. The following is an example illustrating the operation of the New Zealand principles. A, a grazier, operating as a sole trader enters into partnership with B on 31 August 1973, each having a half-interest in partnership profits and capital. A transfers to the new partnership his livestock which had an average cost value of $10,000 and a market value of $16,000. The provisions operate as follows:

  • (a) A brings to account his disposal of livestock to the new partnership at market value: $16,000.
  • (b) The partnership brings to account its opening livestock at 31 August 1973 at the same figure: $16,000.
  • (c) At the end of the income year, 30 June 1974, the partnership is entitled to value its closing livestock at what would have been A's average cost had he carried on the business for the full year.
  • (d) The result may be summarised as follows. A's income for the year includes the full profit of $6,000 on the disposal of the partnership. However, his share of partnership income is reduced by the loss on writing down livestock from


      ― 106 ―
    its market value to his average cost, which virtually eliminates any unrealised profit on livestock flowing from his continuing half-interest in it. B's share of partnership profits is also reduced by the writing down of the value of livestock He obtains a deduction for the full cost of his interest in this asset of the new partnership.

8.153. The adoption of provisions based on those in force in New Zealand should eliminate a major weakness in the existing provisions. It is appreciated that this new approach will permit a deferral of income arising from the reduction from market value to average cost, for example in respect of B's income in the illustration above. However, any loss to Revenue on this count should be largely offset by tax payable on the profit realised on the interest in trading stock disposed of, which currently is being largely deferred by the operation of section 36A.

8.154. Where a share or interest devolves by the death of a taxpayer, the principles of the present section 37 of the Act considered in paragraph 8.146 should apply.

VI. Recoupment of Losses

8.155. The overriding principle that income tax should be levied on ‘true’ profits from a business during the whole period of its operation is an administratively impossible ideal. Annual tax accounting is clearly necessary if tax is not to be indefinitely deferred and the flow of revenue made uneven. Where a loss is suffered in one year, some expression of the overriding principle will be achieved if the loss is carried forward and applied against income of subsequent years. Carry-forward of losses is allowed by the present law for seven years, and, in the case of primary producers, for an indefinite period. But a full expression of the overriding principle would only be achieved if losses could be indefinitely carried back to earlier years and applied against the income of those years, generating tax refunds to the taxpayer. A workable tax system requires that an assessment must at some time be treated as final: the physical problem of record-keeping is the ultimate control.

Carry-back of Losses

8.156. For many years carry-back of losses has been permitted in a number of overseas countries. In the United States losses may be carried back for three years; in Canada, the Netherlands and the United Kingdom (in effect) for one year. Currently there is no provision for carry-back of losses in New Zealand, France, West Germany or Sweden. In some countries special rules apply on cessation of business operations: in Sweden and the United Kingdom there is provision for carry-back of losses in these circumstances for two and three years respectively.

8.157. Carry-back of losses was considered by the Spooner Committee and again by the Ligertwood Committee. Many submissions requesting an amendment to the Act to permit losses to be dealt with in this way have been made to the present Committee. The Spooner Committee, while acknowledging that loss carry-back had much to commend it, foresaw formidable practical difficulties and recommended against amending the Act. These difficulties were principally the problem of collecting adequate tax revenue in periods of depressed incomes, the prevention of the early finality of assessment due to the increase in amended assessments of prior years resulting from the operation of carry-back provisions, and the inherent complications


  ― 107 ―
of amended assessment of private companies and trust estates. The Ligertwood Committee agreed with the findings of the Spooner Committee and again rejected the proposal that carry-back of losses be permitted.

8.158. In the years following the reports of these two committees it seems that the problems of business arising from the absence of any carry-back provisions for losses have increased and this view is supported by the submissions received. To some extent the difficulties flow from the inability to obtain deductions for accrued employee benefits such as long-service leave and holiday pay. In the income year in which a business activity ceases, the profits of that income year are frequently insufficient to meet the deductions which become available from the payment of employee benefits. In addition, an anomalous situation can arise in respect of private companies. For example, a private company may incur a profit for, say, the year ending 30 June 1973, which will give rise to a liability for undistributed profits tax if a sufficient distribution of that profit is not made prior to 30 April 1974. Suppose now that the company incurs heavy losses in the year to 30 June 1974 which make the payment of a dividend imprudent and in breach of company legislation. From a practical viewpoint the company has no profits available to distribute. However, it incurs a liability for undistributed profits tax at the flat rate of 50 per cent because it has failed to make a sufficient distribution of its profits for the year ended 30 June 1973. The Act takes no cognisance of the fact that the company is incapable of paying a dividend.

8.159. The Committee's recommendations relating to a deduction for accrued employee benefits will overcome some of the problems arising from the absence of provisions for carry-back of loss, but as a result of the phasing-in proposals it will be some years before a full deduction is available. The recommendation in Chapter 16 on transfer of losses between companies will in some instances also assist in the recoupment of losses.

8.160. The difficulties foreseen by the earlier committees do not appear to be sufficiently formidable to justify the continued absence of any loss carry-back. Loss carry-back will, it is true, involve some dislocation to Revenue; but this dislocation should be comparatively minor having regard to the total revenue from taxation now flowing to the Australian Government. The degree of lack of finality in assessment depends largely on the period for which losses may be carried back: a short carry-back period should not cause undue administrative difficulty.

8.161. Apart from ensuring much greater regard for the overriding principle that the tax base should reflect ‘true’ profits, carry-back has advantages in terms both of the cash-flow of business and of government economic management. The refund of tax which will result from the operation of loss carry-back should provide a business with cash funds at a time when they are most needed. Also where a downturn in the fortunes of the business coincides with a general business recession, the cash funds will provide a source of spending which should assist in stimulating economic recovery.

8.162. The absence of any provisions for carry-back of losses is partly responsible for the practice, described in paragraph 16.142, of selling the shares of ‘loss-companies’. The Committee, in Chapter 16, expresses its agreement with the measures that have been adopted to control this practice. The proposal to allow a carry-back of losses, in removing the unfairness which the practice sought to overcome, strengthens the case for the measures directed against the sale of loss companies.




  ― 108 ―

8.163. The Committee recommends that the law allow a carry-back of losses for all taxpayers other than trust estates and it believes that a period of two years should not cause undue administrative problems. It does not favour these carry-back provisions being made available to trust estates: to do so would require lengthy and complicated special provisions to ensure that the benefit of any loss carried back was in fact received by persons entitled to the benefit.

Carry-forward of Losses

8.164. Currently the Act restricts the allowance of losses to those incurred by a taxpayer in the seven years following the year of income (section 80(2)). There is one exception to this general rule in that primary producers may carry losses forward indefinitely (sections 80AA to 80 AC).

8.165. As a result of representations made to it, the Spooner Committee considered the question of the removal of the seven-year limit and made a qualified recommendation in favour of the indefinite carry-forward of losses. The qualifications were, firstly, that a deduction would not be allowed for a loss incurred in a year of income prior to the year of income ended 30 June 1944; and secondly, that a taxpayer claiming a loss incurred more than seven years before the year of income should be required to establish the amount of any loss and also establish that it had not been allowed as a deduction from assessable income in any intervening year or been offset by exempt income. The point was also considered by the Ligertwood Committee, which dismissed the issue with the brief comment: ‘No evidence was presented to us that the seven year period is generally inequitable or inadequate, and in the absence of cogent reasons to the contrary, we consider the period of seven years now provided should be retained.’

8.166. Overseas practice varies considerably. In the United Kingdom, South Africa and New Zealand losses may be carried forward without restriction; Norway permits ten-year carry-forward, the Netherlands and Sweden six-year; Canada, France, West Germany and the United States allow a five-year period. According to the Carter Commission, the existing five-year period applying in Canada was insufficient for new businesses that required long periods to develop and a liberal carry-forward of losses was essential to overcome limitations of the annual period of measurement. It therefore recommended that losses be allowed to be carried forward indefinitely.

8.167. Numerous submissions have been received by this Committee requesting either that there should be an indefinite carry-forward period or alternatively the existing period should be extended to ten years or more. One reason given was that in the chemical, mining and other capital-intensive industries losses incurred during establishment years and in times of continuous expansion frequently cannot be recouped within the present limited period of seven years. Another reason was that the trend to larger manufacturing operations, combined with the development of new products and processes, are having the effect of extending the period of initial losses. Closely related is the claim by general insurance companies that in providing the greatly increased total covers required in a growth economy and in an economy experiencing heavy inflation, insurance companies stand to incur substantial losses which require periods in excess of seven years to recoup.

8.168. The Committee recommends that the Act be amended to permit all taxpayers to carry losses forward indefinitely. In implementing this change, it should be provided that losses qualifying for allowance on the indefinite basis be limited to losses incurred subsequent to a date seven years prior to the first year of application.




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Exempt Income

8.169. The present law requires that in calculating both the amount of a loss available for carry-forward and the income against which a loss may be applied, exempt income must be brought to account. Bringing to account exempt income in this way has been criticised on the ground that it partly neutralises the concession intended to be given by the exemption.

8.170. In one situation the exemption of income is given not by way of concession but as a means of preventing double taxation of income. There is a general provision whereby income derived from a foreign source which is taxed in the country of source is exempt from Australian tax. The provision is considered in Chapter 17. Bringing this income to account in applying the provisions in regard to carry-forward of losses could be seen as, in effect, taxing the same income a second time without any allowance for the tax already paid. If, of course, the income has only been subject to modest taxation abroad, there may be thought to be reason why it should not be relieved from taxation in Australia; but the loss carry-forward provisions do not differentiate in terms of the amount of tax paid abroad.

8.171. In Chapter 17 the Committee has proposed that the method of preventing double taxation of foreign-source income be replaced by a system under which the Australian resident brings that income to tax but receives credit for the foreign tax. If this system is adopted there can of course be no objection to the income being brought to account in the operation of the loss carry-forward provisions. And the new system will overcome another criticism of the existing system. A loss which has been suffered in operations that would have generated a tax liability abroad had they been profitable, is not available for application against income subject to Australian tax. The existing system thus requires a foreign profit to be brought to account in the operation of loss carry-forward but not a foreign loss. The system proposed by the Committee will allow the bringing in of a foreign loss.

Effect of Dividend Income

8.172. One further point remains to be dealt with. It concerns the provisions of the Act aimed at preventing the double taxation of dividends flowing through intermediate companies. The Act provides (section 46) that a rebate of company tax is allowable in respect of dividends received by one company from another. The section generally operates to render dividends received by one company from another virtually free of tax in the hands of the receiving company. However, the dividends received form part of the net income of the receiving company; and in the event of the receiving company incurring a trading loss, this loss is applied against dividend income and is not available for deduction against trading profits of other periods.

8.173. There are two ways in which the result may be viewed, both of which suggest that the tax payable by the company is excessive. The first view is that to the extent to which the loss is offset against dividend income, the dividends ultimately bear double taxation. The second view is that to the extent to which the losses are so offset, no allowance in made for that proportion of the loss in computing company tax and in fact the loss is never recouped.

8.174. The Committee believes that it ought to be a fundamental principle of company tax that dividends flowing through intermediate companies should not incur double taxation and, further, that the full benefit of trading losses should be available for offsetting against other trading profits. Accordingly, it recommends that in computing the recoupment of losses of companies, amounts representing dividends


  ― 110 ―
received from other companies should be excluded from the net income of the relevant years. There would continue, of course, to be need to counter dividend-stripping opportunities.

VII. Implications of Inflation for Business Income

8.175. In the earlier sections of this chapter the discussion has been mainly concerned with the differences which arise between net income and financial accounting profits, both determined using historical cost methods of accounting. In Chapter 6 brief reference has been made to the effect of inflation on business income and the need for the effect to be recognised in levying taxes, particularly in periods when inflation is severe. A number of submissions have requested that the tax law permit depreciation allowances to be based on replacement cost in lieu of historical cost and trading stocks to be valued using bases not now acceptable to the Revenue.

8.176. It is increasingly being recognised, that conventional accounting methods fail to take account of the increased costs of replacement of fixed assets and fail too to exclude stock appreciation in computing profits which form the basis of net income and reported financial results.

8.177. The extent to which conventional accounting methods overstate profits by failing to have regard to depreciation at replacement cost and stock appreciation in periods of high inflation is very significant. On the basis of figures issued by the Commonwealth Statistician for stock appreciation and its own estimate of depreciation at replacement cost, the University of Melbourne's Institute of Applied Economic and Social Research has recently estimated that when allowance is made for these two factors profits before tax of non-finance companies for the year 1973–74 drop from $4,325 million to $2,953 million. Since company tax is assessed on the higher figure, the rate of such tax is in effect equivalent to 66 per cent of the lower figure.

8.178. Accounting methods for adjusting business profits for inflation were discussed in Germany in that country's period of high inflation after the World War I. It was subsequently examined spasmodically in other countries but received increased attention in the early 1950s when the rate of inflation became a worldwide problem.

8.179. Since then, the professional accounting bodies in Canada, the United Kingdom, the United States and Australia have devoted considerable attention to finding an acceptable alternative to historical cost accounting. In June 1969 the Accounting Principles Board of the American Institute of Certified Public Accountants issued a statement entitled ‘Financial Statements Restated for General Price-Level Changes’, which explained the theory and practice of general price level restatement. It sought the presentation of restated accounts as a means of conveying supplementary information not available in historical accounts.

8.180. Early in 1972 the Confederation of British Industry appointed a committee on inflation and accounts under the chairmanship of Sir David Barron. This committee issued an interim report in January 1973 and a final report in September 1973. The following extract from the final report is worth noting:

‘The work of the Committee in the six months since the interim report was published has only strengthened its opinion that financial statements should be adjusted to take account of inflation… The longer present historical accounting alone is continued the more will companies and the public be deceiving themselves. The continued erosion of real capital and company earnings while inflation continues at its present pace will almost certainly lead to more critical difficulties to be faced eventually. The Committee attaches great


  ― 111 ―
importance to moving as quickly as possible consistent with allowing sufficient time for the process of education’.

8.181. It is understood that neither the United States nor the Canadian professional accounting bodies have made positive recommendations to date. In January 1973 the Institute of Chartered Accountants in England and Wales, in conjunction with other United Kingdom accounting bodies, issued a draft statement entitled ‘Accounting for Changes in the Purchasing Power of Money’. It proposed that historical cost accounts be restated in terms of pounds of current purchasing power and that the restated accounts be issued as a supplementary statement attached to the conventional financial statements. In May 1974 the draft was adopted as a provisional statement of standard accounting practice.

8.182. In December 1974 the Institute of Chartered Accountants in Australia, together with the Australian Society of Accountants, issued a draft of an accounting standard entitled ‘A Method of Accounting for Changes in the Purchasing Power of Money’, which was almost identical with the provisional standard recommended by the United Kingdom accounting bodies. In issuing the draft, the Australian bodies did not recommend the United Kingdom method of adjusting profits and financial statements for the effects of inflation. Rather, it was published as an initial step in arriving at an acceptable solution.

8.183. A cardinal problem involves tax adjustments to be made where a significant portion of the capital employed in an enterprise is financed by medium-or long-term borrowings. An approach which concentrates on the need of the business entity to make adequate provision from profits for costs of replacement and for stock appreciation will tend to ignore the gains arising from the repayment of borrowings in money which has fallen in value. On the other hand, an approach which concentrates on the interests of the holders of equity capital will have regard also to those gains.

8.184. There appears to have been a tendency for revenue authorities in most countries to remain aloof from the efforts to find an alternative to conventional accounting methods which will produce ‘true’ profits in periods of high inflation. Nevertheless, some concern has recently been shown in the United Kingdom with the appointment in early 1974 of the Committee on Accounting for Inflation (Sandilands Committee) which has not yet issued its report.

8.185. Some recognition of the problems facing business in times of inflation has been given in a number of countries by the introduction of special allowances in respect of depreciation of fixed assets, though frequently these allowances have been employed primarily as a tool of economic management. The allowances vary in form: in some instances as investment allowances in the year the asset is acquired, in addition to normal depreciation allowances; in other instances in the form of substantial initial depreciation allowances. In the United Kingdom, for example, a taxpayer may claim 100 per cent of the cost of new plant installed.

8.186. For some time now, the need to retain sufficient profits to assist in financing the higher costs of replacing fixed assets has been acknowledged by many of the larger industrial organisations. Some have carried out revaluations of their assets at regular intervals, substituted the higher values for the historical cost values and thereafter provided for depreciation on the written-up figures. However, a tax deduction is not available for the additional depreciation thus set aside in computing financial accounting results. Others have calculated the estimated additional depreciation needed on a replacement values basis and have taken this further sum into account


  ― 112 ―
when considering profits available for distribution to shareholders. However, many businesses have largely ignored the problem, with the result that no account has been taken of the increased costs of replacement.

8.187. With inflation at high levels, the effect of stock appreciation forming part of profits falling to be taxed and the related problem of providing funds to finance the increased value of stocks are now matters of major concern. The need to have regard to stock appreciation in computing taxable income has recently been recognised in the United Kingdom where, in November 1974, a special measure was proposed. Broadly, where the increase in value of trading stock and work in progress during the financial year 1974–75 exceeds 10 per cent of a company's profit, the company is permitted to reduce the value of these assets at the close of the year so that the increase in trading stock does not exceed 10 per cent of profits. The measure is confined to companies and to instances where the increase in stocks exceeds £20,000. It results in a deferment of the tax payable on the amount by which the year end stocks are reduced. It is not as yet clear when the deferred tax will fall due for payment, but industry has been assured that it will not be payable in the subsequent income year.

8.188. In the United States where the LIFO method of valuing trading stocks is permitted, it seems that a growing number of companies are adopting this alternative basis which tends to restrict the extent to which stock appreciation arising from inflation forms part of current profits.

8.189. In Australia, at least until very recently, there have been virtually no measures to alleviate either the impact of tax or the pressure on business for finance in the current period of rapid inflation. However, in December 1974 the Australian Government announced the appointment of an independent panel to conduct an inquiry into inflation and taxation and to report by May 1975. The panel's second term of reference is:

‘To examine the effects of rapid inflation on taxation paid by companies and other enterprises and in particular: (a) to examine the various choices available to taxpayers under the provisions of the income tax law relating to the valuation of trading stock and to assess the advantages and disadvantages of providing other bases of stock valuation for income tax purposes; (b) to consider the advantages and disadvantages of alternative methods of providing allowance for income tax purposes for depreciation of plant and equipment, including allowance of deductions for depreciation calculated at flexible or accelerated annual rates; (c) to make recommendations in relation to these matters’.

8.190. A further measure proposed is the introduction of a new depreciation allowance which doubles the depreciation deduction for the current financial year in respect of new plant installed in manufacturing and certain other industries. However, this special allowance is very much less than that available in most overseas countries.

8.191. Further action to bring net income for tax purposes closer to ‘true’ profits in periods of high inflation is now urgent. In view of the inconclusiveness of endeavours by business and the accounting profession to find an acceptable alternative for conventional accounting despite considerable research and exposure of the issues involved, it would be unduly optimistic to expect that the problem will shortly be solved by a change in accounting procedures. In any case, new methods are unlikely to meet the circumstances of the whole range of business activity: though acceptable to many businesses, they may prove to be inappropriate for use in computing net income for tax purposes.




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8.192. In the circumstances the appropriate course would appear to be the adoption of measures which operate on a broad scale and which recognise to a degree the overstatement of net income currently occurring. Policies which merely result in a deferment of tax, such as the United Kingdom provision in respect of trading stock and the granting of initial allowances in respect of depreciation on new fixed assets, though helpful, will not be as effective as policies which are more lasting or permanently reduce taxes payable on business income. Measures of the latter type include reductions in rates of income tax, a LIFO method of stock valuation and investment allowances in respect of fixed assets.

8.193. In view of the appointment of the special panel and the detailed studies of which it will have the benefit, this Committee makes no recommendations as to steps which might now be taken. It stresses, however, the urgency of the need for action.

VIII. Sundry Costs Of Business Operation

8.194. This section discusses the treatment for taxation purposes of a number of costs in conducting business, all of which involve matters raised in submissions.

Lease Transactions

8.195. Division 4 of Part III of the Act contains special provisions dealing with premiums received in relation to the grant, assignment or surrender of a lease and improvements erected by lessees on leased property. However, the application of these provisions was restricted in 1964 and they are no longer generally available. A number of submissions have sought the reintroduction of provisions similar to Division 4 along lines recommended by the Ligertwood Committee.

8.196. In Section IV the Committee has made recommendations for the allowance of depreciation on buildings, including a tentative proposal in relation to allowances in respect of leasehold improvements carried out at a lessee's expense.

8.197. With the introduction of capital gains tax some changes in the law will be necessary in respect of lease transactions generally. Until such time as the Government's proposals in relation to leases under the capital gains tax legislation are known, it would be inappropriate for this Committee to attempt to make detailed recommendations in this area. Clearly the income tax provisions must be blended with those relating to capital gains tax.

Expenditure on Repairs to Income-producing Property

8.198. Two aspects in relation to repair expenditure have been raised. The first relates to what are generally termed initial repairs, being repairs carried out shortly after the acquisition of property. The second refers to the widely accepted practice by business of treating replacement purchases of plant and small tools, of relatively low value, as repair expenditure rather than as items falling to be dealt with by way of depreciation.

8.199. In the case of repairs carried out shortly after the acquisition of property, usually to buildings and to other structural improvements, the practice has developed, in line with a number of legal decisions, of disallowing a deduction for this expenditure where it is apparent that the repairs were necessary at the time of purchase, the general theory being that this would normally be reflected in the purchase price. This practice has been criticised on the ground that it causes administrative difficulties in the case of minor repairs and some inequity.




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8.200. The Committee believes it would be in the interests of taxpayers and the Revenue if a somewhat more flexible approach could be followed, though it is aware that if its recommendations for building depreciation are adopted, some of the complaints will tend to weaken: at present if an allowance is denied for building repairs no deduction is available. The Committee recommends that deductions be allowed for costs of repairs incurred shortly after acquisition, where the expenditure relates to normal maintenance such as painting and minor building repairs. It agrees that major structural repairs, such as the replacement of roof cladding, carried out in the initial period of ownership should continue to be treated as forming, in effect, part of the cost of the property. This is an area in which the issue of guidelines or public information bulletins would be of assistance to taxpayers and their agents.

8.201. A more flexible approach would also be desirable in relation to purchases of plant and tools of small value. Many large business organisations attempt to lessen clerical costs by writing off, in the year of purchase, minor items of plant and maintenance equipment as it is purchased. It is usual to follow this practice of write-off, subject to a limit of, say, $200 for any one item. By so doing, the need for detailed recording of the asset in depreciation schedules is avoided. The Committee recommends that the Commissioner give favourable consideration to requests of taxpayers to be allowed to deal with minor items of a capital nature in this way, within the statutory authority that it is proposed he be given in paragraph 8.47.

Professional Libraries

8.202. A number of requests have been received, mainly from professional bodies, persons and partnerships, for a more realistic deduction for expenditure incurred in respect of the purchase of textbooks and other publications of a professional nature. While a deduction is normally allowable in respect of a subscription to a journal or to a professional body which sometimes carries with it the right to receive periodical publications, other publications, purchased frequently at considerable cost, are deemed to be assets subject to depreciation at the rate of 5 per cent on a fixed instalment basis or 7½ per cent on the reducing balance method. The submissions on this subject complain that these rates are far too low.

8.203. Textbooks and digests are the necessary ‘tools of trade’ of the professional person. New editions are constantly being published as advances in professional knowledge and methods make existing texts redundant. In the legal profession continual changes in the law brought about by the enactment of statutes and decisions of the Courts have a similar effect. The effective useful life of library texts is therefore limited. In order to cope with these continual changes, modern technical publishing, particularly in the field of law, now often takes the form of loose-leaf services. These are regularly updated by revision sheets which supersede existing parts of the service as they become redundant. The Committee understands that the cost of updating sheets is treated by the Commissioner, in the same way as professional journals, as a revenue expense. This treatment seems reasonable. An ancillary feature of the present provisions for professional library depreciation is the administrative problems of recording depreciation and accounting for disposals and their related balancing adjustments.

8.204. Two methods of simplifying the recoupment of capital expenditure on professional libraries warrant consideration. Texts costing less than, say, $40 could be treated as a revenue expense to be written off in the year of purchase, and the rates of depreciation on other texts might be reviewed in the light of the present limited useful life of publications. Alternatively, the rate of depreciation could be set at a realistic


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level, say 20 per cent per annum, calculated on the reducing balance method for the whole library; additions would be added to the written down value of the library at cost while the sale proceeds, if any, of disposals would be deducted from the written-down balance. Where the sales proceeds in any year exceed the written-down balance plus additions in the year, a balancing charge would need to be made. Otherwise balancing allowances or charges would automatically be added to or deducted from the written-down balance. This effective absorption of balancing adjustments removes the need to maintain continued records of the cost of individual texts. The Committee prefers the second method since it simplifies the clerical task of keeping depreciation records and prevents any abuse of an arbitrary limit for any one text.

Travelling and Entertainment Expenses

8.205. Reference has been made in Chapter 7 to the interpretation given to the general deduction section (section 51) of the Act. It is there recommended that an apportioned amount of an outgoing should be denied deduction where it can be inferred from all the circumstances that the character of the outgoing is in part a payment for a purpose which is not the gaining of income. It is not intended, however, that merely because an outgoing such as travelling and entertainment expenses might be said to be extravagant, some part of it must be denied deduction. The proposition asserted in the authorities that the law does not enable the Commissioner to say how much a taxpayer should spend in the gaining of income will continue to be valid. The Committee would not favour provisions, of the kind included in the Canadian law, which would give the Commissioner power to disallow a deduction if he considers that the expenditure involved is unreasonable.

8.206. It may nonetheless be appropriate for the law to specify particular items of expenditure which are likely to involve substantial elements University private consumption by the proprietors of a business and deny them deduction. Recent amendments to the Act deny, for example, deductions of some expenditure on yachts and expenditure on club subscriptions.

Anti-pollution and Ecological Expenditures

8.207. A number of submissions have been received seeking special deductions in respect of expenditure to reduce pollution and to preserve the ecology. Sometimes the expenditure is incurred to prevent pollution of the atmosphere, on other occasions pollution of the soil, streams and ocean, and in yet others to prevent destruction of the environment by its physical alteration. The expenditure may be incurred to comply with legislation, or solely because of the moral obligation of business to avoid inconvenience to the public. The Committee's attention has been drawn to provisions in the United States which allow expenditure of this type to be recouped over five years, and to a similar allowance available in New Zealand.

8.208. The costs are incurred over the broad spectrum of the manufacturing industry and very often in activities connected with mining and other extractive industries. On occasions the costs by way of special equipment, enlarged chimney stacks and treatment of effluent are substantial. Clearly, expenditure in this area warrants encouragement, and special allowances for costs of this kind might be thought justified. However, as what is sought involves an incentive, the Committee merely draws attention to the fact that a number of submissions have been received seeking concessional treatment in this area.




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IX. Conclusion

8.209. Many of the recommendations made in the chapter are intended to eliminate differences between tax accounting and financial accounting and in general to bring them into closer relationship. None of the recommendations involve concessions to business but merely give tax recognition to the fact that the expenses involved are incurred in earning business income.

8.210. Further differences between net income and financial profit will no doubt arise in the course of time as business operations change. A continuing concern with differences between tax accounting and financial accounting should be one of the main areas of responsibility of the independent standing committee on taxation proposed by the Committee in paragraph 22.63.

8.211. Attention is drawn to the Committee's recommendations in Chapter 18 in relation to the restriction of deductions for certain losses incurred in primary production activities. There it is proposed that a deduction be disallowed for a loss where the activity is not being carried on with a view to profit or where there is no reasonable expectation of a profit being achieved. Consideration should be given to the introduction of a provision along similar lines which would have application to business generally, or at least to a number of specific areas in addition to primary production. Motor racing, fishing and the search for minerals might be examples.

8.212. The Committee has not given special consideration to the peculiar problems of small businesses, whether they be problems of income tax, estate duty or other taxes. Shortly after its appointment it accepted a proposal from the Department of Economics at the University of Newcastle that it provide funds for a special survey of the effect of taxation on small businesses in Australia—a survey forming part of a broader investigation into small businesses. This survey was not completed in time for full consideration by the Committee; it is one of the studies listed at the end of this report which the authors have agreed may be published.

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