I. Problems of Definition

7.2. In the language of the present law, income tax is levied on ‘taxable income’, which is income in the meaning of the law (other than exempt income) derived during a period, normally one year, less (i) expenses in deriving that income and (ii) a number of other deductions reflecting equity considerations and particular social and economic policies. The phrase ‘net income’ is here adopted to refer to income less the first of these deductions, but before the second are subtracted.

The Concept of Income

7.3. The legal meaning of income is drawn very largely from judicial decisions— many of them borrowed from the United Kingdom—extended and refined by specific provisions. The primary characteristic of the tax law's approach has been to express what the word may be taken to mean in ordinary English usage. Some basic notions underlie the meaning. One of these is the idea of gains (in some contexts a receipt, in others a profit) from the carrying on of organised activity—an employment, a business or profession, or a business deal—directed to the making of gains. Another is the idea of gains derived from property which leave the property intact—a fruit of the tree as distinct from the tree itself. A third is the idea of compensation which substitutes for gains that would have been income. A fourth is the idea of gains periodically received. None of the ideas is sharp in its outlines, least of all the third and fourth. Thus compensation which substitutes for gains that would have been income must be distinguished from compensation for an asset that would have produced such gains. Gains periodically received must be distinguished from receipts of a fixed sum by instalments.

7.4. For analysis in terms of economic principles in which theory comes first and practicalities are wrestled with later, economists have sought a primary definition of income in any period that is a measure of the flow of an individual's actual and potential satisfactions. One of the most thorough-going efforts to this end is that associated with the American economist Henry Simons whose Personal Income Taxation, published in 1938, has had great influence in academic debate. That formulation centres upon ‘increases in economic power’ to command satisfactions.

7.5 The economists' definition would in general include in income all of the gains that the law includes: salary and wages; profits from a business or profession or business deal; interest, rent, dividends; compensation for income; and periodical receipts. But it also covers a great many gains that would probably not be reckoned as income in ordinary English usage, and have not been brought in, or have been brought in

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only to a very limited extent, by judicial and legislative extensions and refinements of that usage. The comprehensive tax base would include:

  • (a) capital gains: gains from the realisation of property, when the realisation is not an aspect of the carrying on of a business or a profession, or the carrying out of a business deal;
  • (b) bequests and gifts received;
  • (c) lottery and casual gambling winnings;
  • (d) retirement benefits and compensation for loss of office;
  • (e) compensation for physical injury to person received in a lump sum or for injury to reputation; and
  • (f) non-money income.

Some comment on each of these is called for.

7.6. Except to a limited extent resulting from the provisions of sections 26 (a) and 26AAA of the Income Tax Assessment Act, which define the base to include gains from the sale of property acquired for the purpose of profit-making by sale and gains made within a period of twelve months, capital gains (as defined in paragraph 7.5) are not included in the present base, though the introduction of a tax on such gains has been announced. The Committee's recommendations for the taxing of capital gains are set out in Chapter 23.

7.7 The present base does not include bequests and gifts received except where the receipt is one of a number received periodically, for example an annuity, or where, in the case of a gift, it is included as salary or wages or as a business gain or a gain from a profession. In Chapter 24 the Committee rejects the possible extension of the income tax base to include all bequests and gifts and proposes the continued taxation of property the subject of bequests and gifts on a separate basis.

7.8. Lottery and casual gambling winnings are not infrequently described as ‘windfall gains’, though the phrase has no very precise meaning. It suggests gains that are more or less unexpected. A quality of unexpectedness also belongs to some capital gains, but the Committee takes the view that this is not an argument for freeing capital gains from tax. However, taxing lottery and casual gambling winnings raises awkward problems, some of them administrative, others concerned with the deductions that should be allowed. There would be difficulties of enforcing the law with respect to casual gambling winnings. The problems associated with the allowance of deductions may be illustrated by asking how one would deal with the coins fed into a poker-machine. The Committee has no proposal to extend the tax base to include lottery and casual gambling winnings.

7.9. Retirement benefits and compensation for loss of office which are not periodically received are by an express provision included in the present base only to the extent of 5 per cent of the amounts involved. Were it not for this provision, a retirement benefit would be wholly included as a gain from an employment, while compensation for loss of office received in a lump sum—sometimes called a ‘golden handshake’—would be wholly excluded. Such compensation might be treated as embodying a capital gain if the notion of ‘property’ for the purpose of bringing capital gains to tax were broadened to include an office. Alternatively, it might be regarded as a substitute for salary which would have been earned and thus income. If any change is to be made in the existing law there is much to be said for treating retirement benefits and compensation for loss of office in identical fashion. Moreover,

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the best way of dealing with these receipts depends quite crucially on how the tax law treats superannuation benefits and life insurance proceeds, and the matter is further considered in Chapter 21.

7.10. Compensation for physical injury to person received in a lump sum or for injury to reputation is not at present included in the income base. In theory the compensation could be regarded as embodying a capital gain if the notion of property were made wide enough to extend to human capital. It would, however, be impossible to identify the gain, since the cost of acquiring human capital cannot readily be ascertained. Some of the compensation may be in respect of income already lost and in respect of a loss of capacity to earn income in the future, in which cases it could be regarded as a substitute for the income that would have been earned. To this extent, at least, it might be thought appropriate to include it in the base. If compensation is received in the form of periodical payments, it will be income as received, whether given for lost income or some other aspect of the taxpayer's loss. These matters are further considered in paragraphs 7.34–7.41.

7.11. The major item of non-money income currently omitted from the income base is imputed rent of the owner-occupied home. This omission is discussed later in paragraphs 7.42–7.57. But houses are not the only form of property that may yield flows of satisfaction to which imputed income might be attached. Works of art and consumer durables in general are other obvious examples. Inclusion in the tax base of imputed income from these latter items of property would of course involve great administrative problems, and is not proposed.

7.12. Goods produced for one's own consumption or services performed for oneself are currently excluded from the income base. Whatever the case in economic theory for their taxation, it would be administratively impracticable and the Committee has no proposals to change the present position.

7.13. Other instances of non-money income that would be included in the comprehensive tax base may be found in the fringe benefits an employee receives from his employer. The gain may be in the form of goods received, services received, relief from an obligation that would ordinarily have been incurred or valuable rights.

7.14. The general rule of the income tax law is that a gain must be valued by reference to the amount of money that could be obtained for it. On this principle of valuation, a made-to-measure suit is likely to be valued at the price it would bring as a second-hand suit. A service one receives from another, such as the use of a motor-car or a residence available only to oneself or free holiday travel as an airline employee, has no value. Similarly the relief from the payment of interest enjoyed by a person who has an interest-free loan has no value; nor has a person's right to take up shares in a company, if not assignable, unless there is a way in which he can make the benefit of the right available to somebody else.

7.15. This general rule is, however, qualified in important respects by section 26 (e) of the Act, but only in relation to income gains that are rewards for services rendered. This provision substitutes ‘the value to the taxpayer’ for the test of value under the general rule. The special rule certainly limits the tax-planning possibilities opened up by the general provision, but its operation is not entirely clear. It has not prevented the offering and accepting of fringe benefits in substitution for cash, under employment contracts. Some of these benefits are certainly taxed; but to the extent that they are valued for income tax purposes below what would be paid for them in cash outside the income-producing relationship, the equity of the tax system is seriously affected.

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There may be a form of collusion between employer and employee by their splitting the saving of tax that attends a full deduction to the employer of the cost of providing the benefit and a lesser amount being included in the income of the employee. There is, however, no easy solution to the problem of making adequate provision. In many instances, the fringe benefit is so interwoven with the normal performance of the services for which the fringe benefit is a reward that the element of gain may be very difficult to identify. The commonplace illustration is the use of a motor-car for both employment and personal purposes. The question of the taxation of fringe benefits is explored in Chapter 9.

Deduction of Expenses

Expenses Incurred in Deriving Income

7.16. Besides questions of what should or should not be included in income, a host of problems arise over the identification and measurement of the expenses incurred in deriving income that have to be deducted before a figure for net income is reached. It is common to both the existing tax law and to the theory of a comprehensive tax base that such deductions be made.

7.17. A prime problem here is to achieve a practical application of the distinction between an expense in deriving income (which gives rise to a deduction) and consumption expenditure (which should not unless by some special concessional provision). Some expenses, such as for entertainment and travel discussed in Chapter 9, often involve elements of both. Drawing the distinction becomes very subtle when, for example, equipment is used which, in its luxuriousness, exceeds the commercial needs of business: as, for example, when an expensive car is employed where a more modest vehicle would serve just as well.

7.18. Very important areas of controversy arise over costs of travel to and from work and child-minding expenses. These are not now regarded as expenses of deriving income, though it is often argued that they should be. They are further examined in paragraphs 7.58–7.75. Extended to its logical conclusion, the argument leads to a notion of expense in deriving income that would include almost all personal expenditure, even that on food and clothing, in which event the income tax base would largely disappear.

7.19. Expenses in deriving income include the depreciation or amortisation of investment expenditure on assets that deteriorate through use. Issues that arise in relation to the deduction of this expenditure are considered in Chapter 8.

7.20. Certain expenses that would not usually be thought of as consumption expenditure or investment expenditure on non-deteriorating assets are denied deduction. Examples are the cost of moving business operations or of moving home to a new place of work: the cost does not relate wholly to current income, and there is no obvious asset to which depreciation might be applied. These expenses are considered in Chapters 8 and 9.

Other Deductible Expenses

7.21. From ‘net income’ as the term is used here the tax law authorises a whole series of further deductions before the taxable income is reached to which the prescribed rate scale is applied and liability determined. These are generally known as concessional deductions and for the most part are so called in the Act. They include dependant allowances, medical and education expenses, zone allowances, life

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insurance and superannuation premiums, and gifts to charities. They primarily reflect considerations of equity as well as particular social and economic policies. They are discussed in Chapters 12, 21 and 25.

Exempt Income

7.22. The income base is qualified by a number of express exemptions. Some of these are aspects of the taxation of foreign income and of the income of non-resident taxpayers dealt with in Chapter 17. Others may accord special treatment to particular industries and activities and are discussed in Chapters 19, 20 and 25. Questions of equity are raised by the exemption of child endowment and some scholarships and pensions. The possible inclusion in the tax base of child endowment, scholarships and pensions, where they are grants by government, is considered in Chapters 12 and 13. Receipts of alimony are usually exempt. As a correlative of this there is no deduction for their payment: the equity of this arrangement is discussed in Chapter 10.

Annual Accounting

7.23. The income tax base, like the comprehensive tax base, relates to a selected period. For the income tax base the period of account is normally one year and is referred to as the year of income.

7.24. Where the income is that of an individual and the rate structure is progressive, any unevenness, or bunching, of the amounts of income derived in different years will result in more tax being payable than would be the case if a longer period of account were adopted. The present law has some provisions directed to overcoming the consequences of bunching. Averaging of income is allowed to primary producers and special provisions having a similar effect apply to authors and inventors. These illustrations of averaging are examined in Chapters 14 and 18. There would be administrative and compliance costs in the wider application of averaging: the wider application of averaging is considered in Chapter 14.

7.25. A strict application of annual accounting would work unfairly where a loss has been suffered for a year. Subject to some limitations, the present law allows a loss in one year to be applied to reduce net income of a later year, though not the net income of an earlier year. The treatment of losses is analysed in Chapters 8 and 16.

7.26. Under a system of annual accounting the timing of an income gain or expense in deriving income will affect the amount of net income. The questions, in the language of the law, are when an income gain is ‘derived’ and when an expense is ‘incurred’. Derivation and incurring, in turn, depend on the method of accounting, cash or accruals, held appropriate to the income. Broadly, cash accounting involves actual receipt and actual payment. Accruals accounting involves entitlement to receive and obligation to pay. There are problems as to what is a sufficient right to receive or a sufficient obligation to pay under the accruals method, for example whether a provision for long-service leave in the accounts of a business is an expense. These matters are considered in Chapter 8.

Income of Particular Industries and Activities

7.27. The present law contains a number of special provisions that affect net income arising from the conduct of particular industries and activities or the tax payable in relation to them; and the operation of the general provisions poses special problems in relation to these and other industries and activities. In certain instances, incentives

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are given through exemption of income receipts and favourable treatment of expenses. Various industries and activities, including primary production, mining, superannuation and life insurance, and general insurance, are examined individually in a series of later chapters.

Income Moving Through Intermediaries

7.28. The determination of net income as explained in this chapter is the primary step in ascertaining the amount of income on which tax is levied, whether the income is that of an individual, a trust estate, a partnership or a company.

7.29. A trust estate has income and may be a taxable entity distinct from its beneficiary. Where there is a beneficiary presently entitled to the income, the income is taxed to the beneficiary; though where the beneficiary is a child, the tax may in effect be paid for him by the trustee. Where, however, there is no beneficiary presently entitled, the income is taxed to the trustee as if it were the income of an individual or, in some circumstances, at a special rate of 50 per cent.

7.30. A partnership has income but the income is treated as income of its members in accordance with their interests in the partnership. A partnership is not a taxable entity distinct from its members.

7.31. The taxation of trusts and partnerships is considered in Chapter 15.

7.32. The income of a company is taxed to the company and is taxed again to shareholders when distributed to them. This system is examined in Chapter 16.

International Aspects

7.33. In general, the bases of Australia's jurisdiction to tax income are residence of the taxpayer and source of the income. Foreign-source income of a non-resident is beyond that jurisdiction. International aspects are referred to in a number of chapters, more especially in Chapter 15 in relation to trusts and partnerships, Chapter 16 in relation to companies, and Chapter 17 where issues of general application are considered.