IV. The Distinction Between Capital and Income

23.73. If the Committee's recommendations with regard to the introduction of a capital gains tax were to be adopted, the recurrent disputes between the Revenue and the taxpayer attendant upon the realisation of various forms of property would be diminished in number. The present conflict in the rival contentions, on the one hand, that the profit is a taxable income-profit and, on the other, that the profit is a nontaxable capital profit, should be reduced for the reason that the difference in the amount of tax exigible in any transaction will be considerably less than under the ‘all-or-nothing’ approach which must result under the legislation in its present form. The problem of distinguishing between capital and income will continue to exist since, with the presence in the system of a capital gains tax, a capital-profit and an income-profit will be brought to tax in ways producing different monetary consequences. That problem is one which has always defied easy solution because the criteria for distinguishing between the two types of profit can, according to circumstances, encompass such a wide variety of matters which may be relevant to its determination that no universally infallible touchstone is possible. Hence, the fact that the Act does not contain any comprehensive definitions of capital, income, gross income or assessable income should occasion no surprise.

Section 26(a)

23.74. An attempt was made in 1930 to achieve a greater degree of certainty in this area by the enactment of provisions now represented by section 26 (a) which includes as assessable income of the taxpayer:

‘(a) profit arising from the sale by the taxpayer of any property acquired by him for the purpose of profit making by sale, or from the carrying on or carrying out of any profit-making undertaking or scheme.’

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This enactment has proved to be unpredictable in its application and a most potent source of disagreement and litigation between taxpayers and the Commissioner. Until recently its first limb had been thought to involve a subjective test: what was the taxpayer's dominant purpose at the moment of acquiring the asset? The second limb, however, had been thought to involve an objective test as to whether or not the taxpayer was ‘carrying on or carrying out a profit-making undertaking or scheme.’ The second limb thus involved an examination of whether or not the undertaking or scheme was essentially of a business nature, whereas the first limb simply involved an inquiry as to the purpose of the taxpayer at the time of acquisition of the asset. These long-held interpretations of the somewhat differing requirements of the two limbs of the section have now been shown to be incorrect by a recent decision of the High Court. It appears that the first limb as well as the second limb requires that some ‘business purpose’ be shown before the section will have any application. The section is thus considerably narrower in scope than had been thought, and in the Committee's view this narrowing of the section means that it now adds nothing to the determination of income for the purposes of the Act. In other words its operation is merely declaratory, adding no more to the section than section 25 has already provided. Furthermore, the High Court's decision has placed further constraints on the operation of section 26 (a) by requiring that there be a complete identity between the property acquired and the property disposed of. This means that the section may have no operation in cases such as the exercise of an option and subsequent profitable resale. The Committee can see no good reason for retaining the section and recommends that to avoid any further uncertainty it be repealed.

Section 26AAA

23.75. Section 26AAA was inserted into the Act in 1973 and by the introduction of a time-limit seeks to remove some of the difficulties inherent in section 26 (a) by including in the assessable income of the taxpayer any profit arising from the sale of property (other than the taxpayer's home realised as a result of a change in his place of employment or business) within twelve months of its purchase. In the absence of a capital gains tax of the type referred to above, it achieves a measure of certainty in that, in effect, it is a short-term capital gains tax. However, where property is held for more than twelve months after its acquisition, the taxpayer and the Commissioner are then faced with the problems which section 26 (a) creates. In practice a great many land transactions, and probably a number of other property sales, will fall outside the ambit of the section. The section also does not take into account any deductions for losses incurred when property is sold within twelve months; nor does it make any provision for the cases where through some unexpected hardship the taxpayer is forced to realise his property, especially his residence, within the time-limit. The Committee does not favour a short-term capital gains tax by reason of the complexities such a method of taxation involves, in particular in conjunction with the general capital gains tax the Committee has proposed. Having regard to the wider application of the capital gains tax recommended above, the Committee also recommends the repeal of section 26AAA.

Replacement of Sections 26 (a) and 26AAA upon their Repeal

23.76. Firstly, it will be convenient to point out that the Committee's recommended capital gains tax will cover the ground presently marked out by section 26AAA. Secondly, with regard to section 26 (a), it is apparent that no definitions or principles can be framed to provide either a universal or, short of that, a satisfactory solution for the problem of distinguishing between capital and income and between business income

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and non-business receipts. The distinctions between these concepts will of necessity remain areas of difficulty. The Committee is, however, of the opinion that consideration should be given to strengthening the broad sweep of section 25 without in any way detracting from its generality as a substantive enactment. This objective could be attained by giving to the decision-making tribunals directory emphasis of the fact that a business transaction can just as easily be constituted by a single act or operation or by one performed apart from the taxpayer's usual occupation, as a series of repetitive acts. This proposal, expressed as being without restriction of the generality of section 25, would neither add to nor detract from its actual scope and operation and would have an application equally to transactions resulting in a profit as to those in which a loss occurred. The well-known ‘badges of trade’ would still be the major considerations to which recourse would usually be had. However, the effect of the proposal would be that a declaratory warning would be contained in the section that the absence of one of those ‘badges’, which is so often relied upon to deny the business element in an isolated transaction, i.e. the frequency of similar transactions, cannot always be successfully relied upon. The repeal of section 26 (a) would necessitate the repeal of the similar verbiage in the definition of ‘income from personal exertion’ in section 6 (1) and also the repeal of section 52.

23.77. The Budget proposals specifically state that capital gains tax will not apply to transactions caught for income tax under section 25 or under sections 26 (a) or 26AAA upon the assumption that these two latter sections are to be retained against the Committee's recommendation.