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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.




  ― 82 ―

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


  ― 83 ―
normally be reflected in the true worth of his interest in the total net assets of the partnership, whichever tax basis is being used.

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