Proposed Cash Flow/Tax Value Method of Determining Taxable Income: Structure and Application - [2000] JATax 7; 3(2) Journal of Australian Taxation 82

PROPOSED CASH FLOW/TAX VALUE METHOD OF DETERMINING TAXABLE INCOME: STRUCTURE AND APPLICATION

The proposed cash flow/tax value method of determining taxable income involves a radical departure from the concepts that make up taxable income under the current income tax laws. Under this new method, the measurement of taxable income will involve cash flows and the change in tax values of assets and liabilities. The taxable income formula will also allow for income tax law adjustments (increasing and decreasing adjustments) to reflect tax policy and anti-avoidance measures, and to ensure appropriate private transactions are excluded. This paper examines in detail the elements of taxable income under this method. The opportunity is taken to contrast the outcome under this method with the current taxable income base. To assist understanding, the article provides numerous examples as to how the cash flow/tax value method operates in a range of commercial and non-commercial situations. The paper also provides a discussion as to whether the 1 July 2001 commencement date is achievable and it provides an outline of taxpayers that will be subject to the new method.

1. INTRODUCTION

Now that the Government has given in principle support to the Review of Business Taxation ("RBT") recommendation to introduce the cash flow/tax value method of determining taxable income,^[1] the focus will be on preparing the proposal for practical implementation.^[2] Australia's experience with the Goods and Services Tax ("GST") and the experience with income tax generally suggests that the process of drafting the cash flow/tax value legislation will throw up anomalies and unintended consequences for various taxpayers and industry groups.^[3]

groups seeking to protect their interests against detrimental legislation (intended or unintended) will have to obtain an understanding of the cash flow/tax value concept. They will also have to pay close attention to how the proposal develops over the coming months.

The main purpose of this article is to provide an outline of the structure of the cash flow/tax value method of determining taxable income as currently set out in the three volumes that make up the RBT (See Part 5 below).^[4] This part of the article also identifies areas where the cash flow/tax value tax base may differ from the current income tax base.

Another section of the article (See Part 6 below) provides numerous examples that illustrate the operation of the new method in various commercial and non-commercial situations.^[5] The transactions are clearly labelled for easy identification. To begin with, however, the article sets out the status of the cash flow/tax value method (See Part 2 below), its expected commencement date (See Part 3 below) and taxpayers that will be subject to the new method (See Part 4 below).

2. STATUS OF THE CASH FLOW/TAX VALUE METHOD

Importantly, it is not intended that the cash flow/tax value method will generate a different taxable income figure for taxpayers compared to taxable income under the current income tax. In other words, the cash flow/tax value method is not directed at broadening the current income tax base.^[6]

The following appeared in a Press Release issued by the Treasurer as part of the Government's Stage 2 response to the RBT Report:

The working group/consultative committee established by the Treasurer is chaired by Mr Richard Warburton. After consulting with the Australian Treasury, the Australian Taxation Office, a wide range of business people, industry representatives, tax practitioners and the Business Coalition for tax reform, Mr Warburton released his report to the Treasurer on 6 April 2000.^[8] The report recommended that the government adopt the cash flow/tax value method (Recommendation A). The report also made a number of other recommendations. The key ones are:

The working group chaired by Mr Warburton be retained to enable the development of the cash flow/tax value method by the Treasury, Australian Tax Office etc (Recommendation B).

As will be appreciated later, many of the issues listed are central to the structure and operation of the cash flow/tax value method. Again, it must be stressed that Part 4 of the article is based on the Draft Legislation and material issued by the RBT.

3. COMMENCEMENT DATE

As indicated in the Treasurer's Press Release, it is intended that the cash flow/tax value method will commence on 1 July 2001. Whether this implementation date can be achieved will depend on matters "external" to the cash flow/tax value method as well as matters "internal" to the method.

3.1 External Matters

There are two considerations here - the additional compliance issues and political considerations.

In regard to the additional compliance issues, the question is whether taxpayers are in a position to meet their obligations under the cash flow/tax value method. As will be appreciated later, the calculation of taxable income uses a number of concepts, which are not used in the current calculation of taxable income. A number of information requirements to support the cash flow/tax value, taxable income calculation are not captured/collected by taxpayers as a matter of course for the current taxable income calculation.

The key point is that taxpayers may require time to adjust accounting and/or computer systems so as to be able to capture the new information.

A judgment will have to be made as to whether taxpayers will have sufficient time to make perceived adjustments by 1 July 2001 in light of their compliance obligations flowing from other recent tax reforms. The key reform, of course, is the GST which is scheduled to commence on 1 July 2000. Other reforms such as the unified entity regime^[9] and a move towards effective life depreciation will also provide compliance challenges to taxpayers.^[10]

The second external matter - the political situation - is arguably less problematic. Given the Opposition Party's single-minded focus on the GST, it is unlikely that the cash flow/tax value method will be raised as a political issue by the major political protagonists. However, if the business community, especially small business, raises concerns about the (real or perceived) extra compliance costs associated with the cash flow/tax value method, the Government is unlikely to ignore these concerns.

3.2 Internal Matters

One key point here is the extent to which information required by taxpayers to comply with the cash flow/tax value method differs from information currently captured for tax and/or other purposes (eg financial reports). As will become apparent, a cash flow statement (or information contained therein) and a balance sheet (or information contained therein) will be required under the cash flow/tax value method. It may be that such information is not routinely captured/collected by taxpayers or a significant number of taxpayers at present. The compliance burden will be greater for those taxpayers that are not routinely capturing cash flow and balance sheet data.

The second cause of additional compliance obligations flows from the way in which some assets and liabilities will be valued. While most assets and liabilities will be valued at cost or nominal value, some are expected to have present values attributed.^[11] The determination of present values will mainly occur in the area of financial assets and financial liabilities that are respectively receivable and payable beyond six months.

This aspect of the cash flow/tax value method clearly requires a task (ie discounting of some assets and liabilities) that is not generally required under the present system. Judgments on the level of acceptability of present value taxation might also be influenced by the tax position of affected taxpayers when compared to current treatment (eg deferral of tax for holders of long-term financial assets, acceleration of tax for "holders" of long-term financial liabilities).

The final concern flows from the "state of the legislation" on the scheduled commencement date. Given the different information requirements of the cash flow/tax value method when compared to the current system, it may be far too confusing for taxpayers - perhaps more appropriately, the taxation industry - to have two methods contributing to the calculation of a taxpayer's taxable income for one income year. This concern is only valid if the whole income tax regime cannot be re-written into the cash flow/tax value model by say September 2000. It will however be a major challenge to draft the whole income tax regime to fit the cash flow/tax value method in such a short time period.

legislation, ie the Income Tax Assessment Act 1936 (Cth) ("ITAA36") and the Income Tax Assessment Act 1997 (Cth) ("ITAA97"), it could be asserted that the "core" aspects of the cash flow/tax value method can operate in parallel with the "non-core" aspects of the income tax. This would only require the core provisions to be ready by 1 July 2001.^[12]

It is submitted that the parallel operation of part of the cash flow/tax value method with the current income tax system is quite different to the parallel operation of the two pieces of income tax legislation. Both the ITAA36 and ITAA97 use the same concepts in determining taxable income. This is not the case with the cash flow/tax value method. The concepts used in the cash flow/tax value method, or at least how they are expressed, are quite different from the current taxable income calculation.

If implementation of the cash flow/tax value method by 1 July 2001 is non-negotiable, the next best thing will be to identify transactions or areas where only small numbers of taxpayers are affected. These may be able to be added at a later stage without causing major disruption to affected taxpayers and without delaying the commencement of the cash flow/tax value method more generally.^[13]

4. WHICH TAXPAYERS HAVE TO USE THE CASH FLOW/TAX VALUE METHOD?

The RBT proposes that the cash flow/tax value method "will apply to residents and to non-residents for their Australian sourced income and gains that are not subject to a final withholding tax."^[14] This includes all taxpayers under the Australian income tax, which of course, includes non-residents as well as residents.

As will be appreciated later, the cash flow/tax value method is equivalent to the accruals method of income derivation under the current system. That is, income is recognised/derived at the time the taxpayer completes its side of the bargain which gives rise to a right to demand payment (eg when sale of goods are made or service is completed). In some circumstances, the issue of an invoice might mark the point of derivation.^[15]

There are numerous taxpayers under the current regime that derive income on a cash basis (ie only include amounts in income when payment is received). If the cash flow/tax value method applied to all taxpayers, it would effectively move cash basis taxpayers onto an accruals basis, thus accelerating income.

This concern has been addressed by allowing a modified cash flow/tax value method to apply to individuals and to small businesses that choose the simplified tax system.^[16] This effectively retains the outcome achieved under the current system for these taxpayers. Importantly, the current system is not being retained. Rather, the cash flow/tax value method will have a modified application for these taxpayers.

5. STRUCTURE AND OUTLINE OF CASH FLOW/TAX VALUE METHOD^[17]

Should the cash flow/tax value method ultimately become part of Australia's income tax law, the current method of calculating taxable income (ie assessable income less allowable deductions) will cease to apply. As expected however, the tax period or income year will remain a 12-month period under the cash flow/tax value method.^[18] As per the current income tax, the appropriate tax rate schedule will apply to taxpayers' taxable income.^[19]

Under the cash flow/tax value method, taxable income for an income year will be:^[20]

Net Income

Income Tax Law Adjustment

–

Unused Tax Losses

Receipts

–

Payments

–

Net Change in Tax Value of Assets or Liabilities

Increasing Adjustments

–

Decreasing Adjustments

Before discussing each step of the taxable income formula, some cautionary observations are required.

The current taxable income formula is assessable income less deductions. Under the current income tax regime, a transaction will usually enter assessable income or enter deductions. Very rarely will one transaction raise the application of both elements of the taxable income formula.

The taxable income formula under the cash flow/tax value method has 9 steps. Under this method, a transaction will only rarely affect or impact on one step of the formula. That is, most transactions will impact on 2 steps of the formula. In some cases, 3 steps of the formula will be involved. A couple of examples will illustrate the point.

ABC Pty Ltd pays cash for an item of plant during the year. While this payment reduces taxable income under Step 2 of the formula, the tax value of the plant will be taken into account at year-end under Step 3 of the formula if the plant is on hand. If so, this will increase taxable income thereby largely negating the payment reduction (deduction) under Step 2.

XYZ Ltd sells a block of land surplus to its needs for a cash payment. The receipt, not profit on sale, will be included under Step 1 of the formula thereby increasing taxable income. However, the tax value of the land will no longer be reflected in year-end assets of XYZ Ltd under Step 3 of the formula. This reduces taxable income to offset, at least in part, the inclusion of the cash receipt.

The above emphasises that when analysing a transaction under a step of the taxable income formula, it should be borne in mind that the transaction will usually affect one or more steps in the formula.

5.1 Receipts

This is the starting point (step 1) for calculating a taxpayer's taxable income. In short, every amount received by a taxpayer during the income year will, subject to comments below regarding private and domestic receipts, come within this part of the formula. As per the current income tax law, there is a constructive receipt rule.^[23]

The constructive receipt rule or the ordinary notion of a receipt, should ensure that amounts credited directly to a taxpayer's bank account, etc will come within the notion of a receipt for the purpose of step 1 of the formula. A special rule exists in regard to "money accounts" of a taxpayer. This will be discussed under steps 5 and 6 of the formula (ie liabilities).

2. The relevant concept is "received", not "derived". Derived is the key concept in this area under the current income tax.^[24]

3. The concept is "receipts", not "receipts and/or profits". Thus, the sale proceeds of real estate will enter this part of the formula, not the profit on sale.

4. There is no need for the receipt to have an income character. Receipts of a capital nature will enter this part of the formula.^[25]

5. An amount received will still be a receipt no matter what it represents (eg the sale proceeds of an asset, the release of a liability owed to taxpayer or the receipt of "pre-paid income" ie receipt in advance of services to be provided).

6. It will be irrelevant whether the receipt was obtained while a business or enterprise was being actively carried on or during the wind down phase of the business. Although less likely, it will not matter if the receipt is obtained during the commencement phase of the business.

5.1.1 Private or Domestic Receipts

Under the current income tax, private receipts – or more appropriately, non-income producing receipts – will not enter the tax base (eg a cash gift from a parent). The intent is that the cash flow/tax value method will maintain this position.

The intention is that only individuals can have private or domestic receipts.^[26] Thus, discussions regarding private or domestic transactions will deal with natural person taxpayers only. Private in this context carries a meaning that can be contrasted with "income earning" or "commercial" or "business". Consistent with the meaning of domestic under s 8-1 of ITAA97, domestic refers to transactions related to one's home or place of living.^[27]

Thus, if a receipt is not private or domestic, it will be included under step 1 of the formula. However, it does not automatically follow that if a receipt is private or domestic, it will be excluded. It will depend on such factors as;

1. whether the receipt is for the disposal of an asset that is included in the taxable income formula under step 3;

3. if the answer to 1 and 2 is yes, is the asset or liability a private asset or a private liability.

The starting point is that a receipt, to the extent that it is private or domestic, will not be included under step 1 if the receipt does not result from relinquishment (sale) of an asset or does not generate a liability owed.^[28] The gift of cash from a family member will fall into this category.

If a private or domestic receipt gives rise to a liability (eg a receipt of loan funds from a lender to purchase a lounge suite for the taxpayer's home), the receipt will only be included if the liability is or would be included under step 6 of the formula. A liability will not be included under step 6 if it is a private liability. In turn, a private liability is defined as a liability owed by an individual that is wholly of a private or domestic nature.^[29]

Most liabilities will be financial liabilities (ie obligations to pay money). In the case of a liability constituted by a borrowing, the character of the liability will usually be determined by examining the use of the borrowed funds.^[30] Thus in the example above (borrowing to purchase a lounge suite), the debt owed to the lender is of a private or domestic nature as the borrowed funds were used to purchase an asset that is used for a private purpose. The debt will be a private liability as it is wholly of a private or domestic nature. The liability will not be counted under step 6 and the receipt of the loan funds will not be counted under step 1.

If on the other hand, the lounge suite was to be used say 40% for business purposes, the full amount of the liability would be included as would the full amount of the receipt. The reason is that it cannot be said that the liability was wholly private. There will however be an increasing adjustment under step 7 of the formula (ie increase in taxable income) to recognise the private element or non-taxable use of the lounge suite (asset) which would otherwise attract depreciation reductions.^[31]

A similar approach is taken to receipts that are private in nature and are in return for the sale of an asset. The starting point is that if the asset was a private asset, the asset would not have been included in step 4 of the formula and the receipt will be excluded from step 1.^[32] If the asset is not a private asset, the asset would have been included under step 4 and the receipt will be included under step 1.

The character of a private asset does not mirror the definition of a private liability. This reflects the policy position that gains on some "personal consumption assets" should be brought within the income tax base.

The key is the definition of a private asset in s 12-20. If an asset does not fit within the definition, it will not be a private asset. An asset will be a private asset if it is a depreciating asset (other than collectables) and the taxpayer holds and uses the asset solely for private or domestic purposes.^[33] A depreciating asset is an asset that has a limited useful life.^[34] A collectable refers to such assets as artworks, jewellery and antiques.^[35] This aspect of the definition of a private asset should include most assets found in a domestic residence (eg a refrigerator, furniture, electrical equipment and beds). Thus, the sale of these items giving rise to receipts will not be counted under step 1. On the other hand, a depreciating asset used partly for "taxable income production" will not be a private asset.

Land is specifically dealt with. Subject to the comment below regarding a taxpayer's main residence, land will not be a private asset even when it is not being used to produce rent (eg vacant unimproved land).^[36] Thus, the proceeds from the sale of land will give rise to a receipt under step 1, as the land will or would be taken into account under steps 3 or 4.

There is little doubt that the current treatment of a taxpayer's main residence will be maintained under the cash flow tax/value method. The current treatment is that gains made on the sale of a main residence are exempt from capital gains tax ("CGT").^[37] The technique for achieving this has not yet been developed by the RBT.

All other assets (ie non-depreciating assets and not land) will only be private assets if the taxpayer holds and uses the asset at least partly for private or domestic purposes and the acquisition cost of the asset is $10,000 or less.^[38] A couple of observations can be made. An asset fitting this description with an acquisition cost above $10,000 (including collectables), will not be a private asset.^[39]

In addition to a cost threshold, the other way to exclude an asset from the private asset definition, is for the asset to have no private or domestic use. Thus, a collectable with an acquisition cost of say, $8,000 that is used 60% for private and 40% business purposes will be a private asset. This is puzzling. This would seem to exclude profits or receipts made on such an asset from the tax base, when there is some non-private use (taxable income use) of the item.

An area where the cash flow/tax value method may enlarge or broaden the income tax base is where a receipt falls outside an assessable income inclusion section of the current income tax, yet it is difficult to characterise the receipt as private. The facts and decision in FC of T v Rowe^[40] may provide an example.^[41]

5.2 Payments

This is step 2 of the taxable income formula. The starting point is that every amount paid or constructively paid^[42] by the taxpayer during the income year will enter this part of the formula. Payments out of a taxpayer's bank account will constitute a payment for these purposes. Special rules exist in regard to "money accounts" of a taxpayer. These will be discussed under steps 5 and 6 of the formula.

Five observations, which largely mirror those made above in regard to receipts, can be made:

3. It is irrelevant whether the payment is of a "revenue" nature or "capital" nature.

4. An amount will still be a payment no matter what it represents (eg payment for the acquisition of an asset, the discharge of a liability or a pre-payment for services to be received over say two years).

5. It is irrelevant whether the payment is made prior to the commencement of a business or enterprise, during the active carrying on of the business, or in the wind down phase of the business (ie in selling the business).

5.2.1 Private or Domestic Payments

The same private and domestic definition outlined above under Part 5.1.1 above applies here. If a payment is private or domestic, and the payment does not result in the acquisition of an asset or the reduction of or release from a liability, the payment will be excluded to the extent it is private or domestic.^[44] This will be the case for most private payments as they mainly represent consumption expenditure, which by their nature, do not usually give rise to assets.

If a payment relates to the acquisition of an asset or it effects a reduction in a liability, the treatment of the payment is governed by the treatment of the related asset or liability. In short, the payment will be included in step 2 of the formula if the resulting asset is included or would be included under step 3 of the formula (ie asset on hand at year-end). This in turn depends on whether the asset is a private asset.^[45] See discussion at Part 5.1.1 above for definition of a "private asset".

Similarly, a payment will be included under step 2 only if the liability reduced by the payment was or would be included under step 5 or step 6 of the formula (ie liability owed). This in turn depends on whether the liability is a private liability.^[46] See discussion above for definition of a "private liability".

5.3 Assets

The discussion here deals with steps 3 and 4 of the taxable income formula. Like the current trading stock provisions,^[47] the value of assets on hand at the beginning of the income year is compared with the value on hand at year-end. If the value at the end is greater than at the beginning, the excess makes a positive contribution to taxable income. If the value at the end is less than at the beginning, the shortfall makes a negative contribution to taxable income.

Three issues require attention. First, it must be established whether an "asset" exists. Second, if an asset exists, does the taxpayer "hold" the asset at the end of an income year? If the answer is also yes, a value must be ascribed to the asset for the purpose of the taxable income formula. A negative answer to any of the first two questions will mean that no tax value will be ascribed for the purpose of a taxpayer's taxable income formula.

5.3.1 Asset

An asset is defined as "any thing (tangible or intangible) that embodies future economic benefits."^[48] The definition does not draw on the current CGT definition of an asset.^[49] Rather, the definition seeks to draw on the accounting definition.^[50]

As expected, the definition covers both tangible and intangible things. Tangible things are readily identifiable. Intangible things are more difficult to identify. They will usually comprise rights (eg the right to receive management services over a period from a pre-payment). Rights will usually be identified from transactions entered into in acquiring the rights (eg expenditure on the acquisition of goodwill as part of a business acquisition).

To be an asset, the thing must embody future economic benefits. Economic benefits from an asset will usually come in two forms - the benefit from using the asset (value-in-use) and the benefit from selling it (value-in-exchange).^[51] Most things will embody both types of economic benefit (eg plant that is used to produce goods or services is an example of an economic benefit from value-in use but it may also have value-in-exchange as it can be sold). However, some things may only have value-in-use (eg specialised equipment that only the current owner can operate).^[52] Thus, the notion of an asset can be met even though a thing does not have value-in-exchange.

An asset can exist even though its economic value cannot be precisely measured. Self generated goodwill, trade secrets and know-how may provide examples.^[53] Further, the accounting treatment of an asset (ie balance sheet treatment), will not govern the question as to whether there is an asset for the purpose of the cash flow/tax value method.

A concern for taxpayers is whether the tax base will be enlarged (or taxable income accelerated), as a result of an asset being defined in commercial and economic terms. One area potentially affected is work in progress.

Work in progress of a manufacturer (ie partly manufactured goods) on hand at year-end is counted in arriving at taxable income. To put it another way, costs associated with partly manufactured goods are not deductible until the income year of sale. In contrast, the work in progress of service providers (eg audit services, utilities) is not taken into account at year-end. To put this another way, the costs associated with progressing a partly finished service/job to its year-end position, are deductible in the year of incurrence.^[54]

It is submitted that the definition of an asset in Draft s 6-15 (ie things that embody future economic benefits) is wide enough to include work in progress of service providers. The income tax cases dealing with the "sale" of work in progress supports the notion that it has value-in-exchange and therefore embodies economic benefits.^[55] According to the RBT Report, the accounting treatment of work in progress treats it as an asset.^[56] Further, consumable stores and spare parts would also be assets under the s 6-15 definition.^[57]

Consistent with the treatment of receipts and payments, no distinction is made between assets that are on revenue account and those on capital account under the present income tax regime. It is expected that most items appearing on a standard balance sheet would be an asset for purposes of steps 3 and 4 of the formula.

5.3.2 Private Assets

As noted earlier, the closing tax value of an asset that is a private asset is not taken into account under step 3 (year-end tax value of assets).^[58] This effectively excludes the asset. The notion of a private asset was discussed above at Part 5.1.1. That discussion will not be repeated here.

5.3.3 Asset Held

Before the tax value of an asset can enter the taxable income formula of a taxpayer, it must be held by that taxpayer. Different rules apply depending on the type of asset involved and the form in which the taxpayer enjoys "possessory" rights over the asset.^[59] However, the legal owner of an asset will usually be the holder of the asset for the purpose of the cash flow/tax value method.

There are however special rules dealing with situations such as luxury cars under lease/bailment, assets affixed to leased land where the lessee has a right to remove and depreciating assets hired under contracts of hire purchase. In all these three cases, the lessee/bailee/hirer will be the taxpayer holding the asset.^[60]

Some things that may be assets (eg knowledge, client lists) and that are not capable of being "legally" owned can still be held by a taxpayer. A taxpayer holds such an asset if it is able to use the asset and it has the right to deny other taxpayers use of or access to the asset.^[61]

An interesting issue arises in regard to sale of land contracts where exchange of contracts and settlement straddle year-end (eg an exchange on 10 June and settlement on 18 July). The issue is will the vendor or the purchaser hold the asset on 30 June. The position under the current income tax law is that if the land is trading stock, the vendor will still be the holder.^[62] However, if the land is not trading stock and is purely a CGT asset (ie not a revenue asset), the purchaser will hold the asset for CGT purposes.^[63]

While it can be argued that there should only be one rule under the cash flow/tax value method, there is nothing to prevent the continuation of the current differential treatment as assets that are trading stock do have their own valuation regime.^[64] On the other hand, given the general breaking down of the revenue-capital dichotomy under the cash flow/tax value method, it may be inappropriate to continue with differential treatment. Like the current income tax law, the debate is purely one of timing (ie deferral or acceleration) of gains and losses.

5.3.4 Tax Value

Importantly, for most assets, the tax value will not be the market value or economic value of the asset. This prevents the cash flow/tax value method from being a broad-based accruals income tax.^[65] Rather, the tax value of an asset will be its cost or estimated value (usually cost plus accrued return). In limited circumstances, taxpayers can use market value. Which of these valuations applies depends on the type of asset involved, and in some cases, elections exercised by the holder of the asset.

Assets can be divided conveniently into non-financial assets and financial assets.

5.3.5 Non-Financial Assets

The notion of a financial asset has not yet been determined however it is expected to cover such things as bonds, bills of exchange, options, swaps, shares and rights to receive payments. A non-financial asset will cover tangible items like land, plant and consumable stores. It should also cover non-tangible assets like goodwill, know-how, patents and work in progress.

We shall start with trading stock. Unlike the current income tax system, trading stock will be limited to tangible assets.^[66] Thus, shares and other financial assets will not be trading stock and the following valuation rules will not apply to them. Note that trading stock clearly includes raw materials and partly manufactured goods as well as finished products.

The tax value of an item of trading stock will be the lesser of its cost or net realisable value.^[67] The taxpayer does not have a choice, as is the case under the current system.^[68]

There is also a market selling value election available in regards to a class of items of trading stock.^[69] The market selling value election may only be exercised for the purpose of making it easier for the taxpayer to work out the tax value of trading stock. It must not facilitate the manipulation of tax values and therefore income tax payable.^[70]

The tax value of land will be its cost.^[71] The cost of any asset, including land, may comprise two elements. The first element is the amount paid to become the holder of the asset (ie purchase price).^[72] This will include incidental acquisition costs.

There are special rules where a taxpayer provides a non-cash benefit (eg goods and services) for acquisition of an asset. A different rule applies depending on the nature of the acquired asset. Where a taxpayer provides a non-cash benefit for the acquisition of a non-financial asset, the cost of the acquired asset will be its market value.^[73] However, where a non-cash benefit is provided to acquire a financial asset (eg right to receive payment), the cost of the acquired financial asset will be the market value of the non-cash benefit provided.^[74]

There will be times when a taxpayer acquiring an asset has not paid money for the asset or given a non-cash benefit. Rather, the taxpayer has only incurred an obligation to pay money. In such cases, the cost of acquiring the asset will be the tax value of the liability.^[75]

The second element of the cost of an asset includes amounts that have contributed to bringing the asset to its present condition and location (eg the amount paid to bolt a machine to the factory floor).^[77] The second element should ensure that the absorption costing approach will continue to apply to manufactured trading stock.^[78]

The cost of an asset will not usually include interest on money borrowed to purchase the asset, repairs, insurance and rates. However, in regard to land, the cost will include interest, repairs, insurance, rates and taxes where these payments are private or domestic in nature.^[79]

For an asset that is subject to depreciation or a capital write-off, the written down value of the asset will become its tax value at year-end.^[80] This is the mechanism for granting depreciation relief. Note, while payments made prior to or on commencement of business (income activity) will reduce taxable income under step 2 of the formula, some of these payments will give rise to an asset with a tax value at year-end. Alternatively, the payment may improve an existing asset owned by the taxpayer and therefore add to its tax value. The same may apply to other "blackhole expenditure".^[81]

While consumable stores and spare parts will be an asset held at year-end, they will only be attributed a tax value where their cost exceeds $25,000.^[82] This maintains immediate deduct-ibility for "small stock-piles".

The tax value of goodwill will depend on whether it was purchased or it was self-generated. If it was purchased, the tax value will be its purchase cost. If it was self-generated, its tax value will be nil.^[83] The same approach is taken to know-how.

As noted earlier, work in progress of a service provider will be an asset held at year-end. Non-billable "products" (eg electricity, gas) that are capable of reasonable estimation will have a tax value attributed to them at year-end.^[84] The tax value should be cost, not the realisable value of the product delivered. This measure represents a change to the current law. To overcome a significant (one-off) increase in taxable income and hence tax payable in the first year of the cash flow/tax value method, taxpayers will be able to bring the tax value to account evenly over five years.^[85]

Non-billable work in progress of service providers (eg lawyers, accountants, tradesmen) will not be required to have a tax value where there is a reasonable expectation that the service will be billed within 12-months of the year in which the service was performed.^[86]

5.3.6 Financial Assets^[87]

As noted above, financial assets will probably encompass such things as bonds, bills of exchange, options, swaps, shares and rights to receive payments. We will commence with trade debts.

The tax value of an asset consisting of a right to receive an amount that has become due and payable (ie time for payment has arrived) will be the amount the taxpayer has the right to receive. Similarly, a right to receive payment for supply of goods and services within six months will have a tax value equal to the amount the taxpayer is entitled to receive.^[88] Most accounts receivable will therefore come in at their nominal value. This maintains the current income tax treatment for accruals basis taxpayers.^[89]

In contrast, where a debt is due and payable beyond six months, the return on the asset will be taxed on an accruals basis over the life of the asset.

XYZ Ltd sold trading stock for $94,340 on 31 December 2001. The customer, VBC Pty Ltd, is obliged to pay XYZ Ltd $100,000 in 12-months time (ie 31 December 2002). The tax value on 30 June 2002 of the right to receive payment will be the cost of the asset plus the return on the asset that has accrued at year-end.^[90] The asset was purchased with a non-cash benefit (ie trading stock).^[91] In these circumstances, the cost will be the market value of the non-cash benefit.^[92] The market value of the stock is $94,340.

The tax value of the financial asset as at 30 June 2002 is determined under the following formula in Draft s 45-75, [Last tax value x (1 + Interest %)] – Receipts. The annual compound interest that equates $100,000 in 12-months with $94,340 now is 6%. The last tax value of the asset in this case is its cost, which is $94,340. As the period between the last time the tax value was determined (ie on acquisition of asset) and year-end is less than 365 days, the interest rate is multiplied by the days in the current income year relative to 365 days.^[93] In this case, it will be 181 days over 365 days. Accordingly, the tax value of the asset on 30 June 2002 is $97,146 [$94,340 x (1 + 2.975% (6% x 181/365))].^[94]

There may be cases where the market value of a non-cash benefit is not readily ascertainable (eg a rare item of property) and the purchaser has delayed payment terms. In these cases, the market value of the non-cash benefit provided in acquiring the asset (ie the right to future payments), is determined by reference to the present value of the payments. An appropriate discount rate will be applied to future payments in order to obtain their present value.^[95]

In regard to shares in a company or units in a unit trust, the tax value of the asset will be its cost.^[96] An option will also have cost as its tax value.^[97] This will preserve the current income tax treatment for these items.

The RBT Report recommends that taxpayers be allowed to use market value as the tax value for financial assets and liabilities that are marked-to-market for purposes of the taxpayer's audited profit and loss statement in its financial accounts.^[98] The election could apply to all of a taxpayer's financial assets and liabilities that are marked-to-market for accounting purposes, or those financial assets and liabilities within a recognised asset class that are marked-to-market for accounting purposes. Revenue safeguards have also been recommended (eg once the asset is marked-to-market, it cannot be reclassified out of being marked-to-market).^[99]

As expected, the value of an asset at the end of an income year will become the value for the beginning of the next year.^[100]

5.4 Liabilities

The discussion here deals with steps 5 and 6 of the taxable income formula. Like the asset provisions above, the value of liabilities owed at the beginning of the income year is compared to the value owed at year-end. However, to reflect the different nature of a liability, if the value at the end is greater than at the beginning, the excess makes a negative contribution to taxable income (ie reduces it). If the value at the end is less than at the beginning, the shortfall makes a positive contribution to taxable income (ie increases it).

The issues here are similar to those above in regard to assets. That is, there must first be a "liability". Secondly, that liability must be "owed" by the taxpayer to another person. Thirdly, the tax value of that liability must then be determined.

5.4.1 Liability

A liability is defined as "a present obligation to provide future economic benefits."^[101] An obligation is a requirement to do something (eg pay a debt or provide services over a period). There can be no obligation unless there are two parties involved. The obligation must presently exist. Thus, a contingent "obligation" will not be or become a present obligation until the contingency occurs (eg the "obligation" of an insurance company to pay an amount under a policy becomes a present obligation only when the event insured against occurs).^[102] It appears that provisions for annual leave, long service leave etc will amount to liabilities.^[103]

The liability must be to provide future economic benefits. This will require an obligation to make payment to, or perform services for another taxpayer where a monetary value can be placed on the assets or services. Most liabilities will involve obligations to make payments (ie financial liabilities).

5.4.2 Private Liabilities

The approach here is the same as that for "Private Assets". That is, the closing tax value of a private liability is not taken into account under step 6 (year-end tax value of liabilities).^[104] This effectively excludes private liabilities. What makes a liability a private liability was discussed in Part 5.1.1 above.

Finally, as per the asset definition, no distinction is made between liabilities that would be on revenue account and those on capital account under the current income tax regime.

5.4.3 Liability Owed

There is no specific guidance on when a taxpayer "owes" a liability to another. It is submitted that a liability is owed by a taxpayer in circumstances where it has been incurred but it has not yet been discharged. The notion of "incurred" developed under the general deduction section of the income tax can provide guidance in this area.^[105]

This approach might be viewed as being too narrow or at odds with the approach taken in the liability tax value rules. The tax value provisions contain a rule stating that where a "liability" has not been incurred, its tax value will be nil.^[106] This implies that a taxpayer can owe a liability even though it has not yet been incurred. Provisions for annual leave provide an example. In the end, the concept of "owed" will be wider than the concept of "incurred". The concept of owed will be taken largely from accounting practice and principles.

5.4.4 Tax Value

Like assets, liabilities can be divided into non-financial and financial categories.

5.4.5 Non-Financial Liabilities

This is expected to cover situations where the taxpayer is obliged to provide goods or services over a period (eg "pre-received income" as discussed in Arthur Murray Pty Ltd v FC of T^[107]). Rules for establishing the tax value of non-financial liabilities have not yet been developed.^[108] However, in a pre-received income situation, it is expected that the tax value of the liability to provide future services is likely to be similar to the accounting treatment. That is, the unexpired monetary portion of the pre-received income will be the tax value of the liability at year-end.

5.4.6 Financial Liabilities

The position here largely mirrors the position of financial assets. Thus, liabilities to pay "short-term debts" (ie an amount that is due and payable within six months) will have a tax value equal to the (nominal) amount of the liability.^[109] This should cover not only short-term trade debts, it would also cover the purchase of structural assets with "short credit terms" (eg purchase price of equipment payable within three months of delivery and instalment).

For liabilities due and payable beyond six months, the tax value of the liability is calculated on an accruals basis by reference to the tax value of the identical corresponding asset. That is, in calculating the tax value of the liability, an assumption is made that the taxpayer holds the (notional) corresponding financial asset that is represented by the (real) liability. From there, the notional financial asset's tax value is calculated using the approach discussed above (cost plus return to year-end). The result becomes the tax value of the taxpayer's financial liability.^[110]

Thus, the tax value of the financial liability on 30 June 2002 owed by VBC Pty Ltd in Example 3 will be $97,146.

Consistent with the marked-to-market election referred to in regard to financial assets, some taxpayers will elect to use market value as the tax value of liabilities and assets at year-end.

A liability that has not been incurred will have a nil tax value.^[111] As noted earlier, this would cover provisions for annual leave for employees where the employee has not commenced the leave.

As expected, the value of liabilities at year-end becomes the value for beginning of next year.^[112]

5.5 Money Accounts^[113]

The issue here is whether amounts held or owed by taxpayers in bank accounts or as cash in hand, etc should be included as assets or liabilities under steps 3 to 6 of the formula. The concern appears to be to avoid the potential of double counting for either increases or decreases in taxable income. For example, the receipt of money into a bank account could be included as both a receipt and an increase in an asset, the asset being the right to receive money from bank. Unless corrective measures are taken, double taxation could arise.

The starting point is that when an amount is credited to a taxpayer's money account, the taxpayer is taken to have received the amount.^[114] This gives rise to a receipt under step 1. Further, an amount debited to a taxpayer's money account is taken to have been paid by the taxpayer.^[115] This generates a payment under step 2 of the formula.

A debit balance in a money account of a taxpayer is not taken into account as a liability.^[116] The credit balance in a money account of a taxpayer will not be an asset.^[117]

Thus, if a taxpayer receives payment of say $3,000 by cheque, for the sale of trading stock that had a tax value at the beginning of the year of $2,500, the following appears to be the position under the cash flow/tax value method formula:

Receipt (constructive or on ordinary concepts)	$3,000
Receipt (credit to a money account	$3,000
Less Reduction in tax value of assets (trading stock)	($2,500)

Note that there is no impact on other assets or liabilities. There appears to be an unavoidable double inclusion. The deemed receipt on crediting to a money account does not appear to exclude the actual receipt under Draft s 5-55. If it does displace the actual inclusion, the problem is solved. If it does not, there must be a mechanism for generating a $3,000 payment in order to get back to a $500 taxable income inclusion ($3,000 less $2,500).

This statement appears to provide the solution in that it generates a $3,000 payment for the taxpayer for "transferring" the cheque from himself/herself/itself to their bank account. In effect, this treats the account as an entity separate from the account owner.

The definition of a "money account" may generate some confusion, as a taxpayer must expressly designate an account as a money account. A money account is defined as an account maintained with an authorised deposit-taking institution (eg a bank, building society or credit union) and the taxpayer chooses to treat the account as a money account.^[119] Certain financial assets or liabilities will not be a money account.^[120] A money account is essentially a bank account, a current account or an overdraft.

If the taxpayer fails to nominate an account as a money account, it appears that the balance in the account (credit or debit) is an asset or liability. The balance in an account clearly falls within the definition of asset (ie right to receive payment from the bank of the balance in the account on demand, or on notice). Thus, an addition to an account increases assets, and a reduction will reduce assets. Another variation is that an amount credited to an account will not give rise to a receipt of the taxpayer, as the account is not a money account.^[121]

Thus, the analysis of the transaction outlined above (ie sale of trading stock with a beginning tax value of $2,500 sold for $3,000 in cash (cheque)) may look like this:

Receipt (constructive or on ordinary concepts)	$3,000
Increase in assets (ie amount owed by bank to taxpayer or decrease of amount owing to bank if account in debit)	$3,000
Less Reduction in tax value of assets (trading stock)	($2,500)

Again, there appears to be a double counting that needs to be avoided. Simply excluding money accounts would work in this circumstance. Alternatively, if the account is to be treated as an asset or liability, then payments into it by the taxpayer should be treated as a payment by the taxpayer.

Finally, it should be noted that the definition of "money" means cash in hand, whether or not Australian currency, and a credit balance in a money account.^[122] Rules for converting overseas currency to Australian currency are being developed.

5.6 Increasing Adjustments and Decreasing Adjustments

If the taxable income formula was complete through the measurement of receipts and payments and changing values of assets and liabilities (Steps 1 to 6 above), the income tax base would differ significantly from that currently existing. For example, exempt income would enter the base and losses against exempt income (ie expenses related to exempt income are greater than exempt income) would receive recognition. The payment of (non-private or domestic) income tax would also reduce the tax base, as would the payment of dividends by a company.

The delivery of tax concessions, etc would also be frustrated if the taxable income formula were limited to steps 1 to 6. For example, the 125% immediate deduction for research and development expenditure would largely be defeated.^[123] The inevitable investment allowances provided in economic downturns, in addition to normal depreciation allowances (ie double deduction), would also be defeated. The full operation of anti-avoidance measures may also be frustrated.

Finally, it will be apparent from the outline above that steps 1 to 6 of the cash flow/tax value formula is equivalent to the accrual basis of tax accounting under the current income tax. There will be a need to ensure that individuals and small business proprietors have access to the cash basis of tax accounting as recommended by the RBT.^[124]

It is clear that the taxable income formula requires some mechanism to take account of the above. The mechanism is the so-called "income tax law adjustment". This compares taxpayers' increasing adjustments with decreasing adjustments. In applying these adjustments, one must first appreciate the treatment of the transaction under steps 1 to 6. For example, some receipts, payments, liabilities and assets will have been excluded from the tax base as a result of their private or domestic nature. A further adjustment might lead to inappropriate results.

5.6.1 Increasing Adjustments

Increasing adjustments add to a taxpayer's taxable income. Some examples provided in the RBT Report are:

1. Adjustments equal to the amount of any payment of income tax, but only to the extent the payment of tax was not private. If the payment was private - it will be when made by a natural person - no increasing adjustment is required.

2. Adjustments to reflect the fact that a depreciating asset was used in part for private or domestic purposes (ie non-taxable purpose).

3. Adjustments to reflect the amount of a profit distribution made by a company to shareholders or a trust to beneficiaries.

4. Adjustments will be required to reflect a net capital loss made by a taxpayer under the CGT provisions. This will ensure loss quarantining under the CGT rules occurs.

5.6.2 Decreasing Adjustments

Decreasing adjustments reduce a taxpayer's taxable income. Some examples provided in the RBT Report are:

1. Adjustments to reflect a payment made by way of gift to an institution that qualifies to receive deductible contributions, where the payment is private in nature. Such payments will be private when made by natural persons.

2. Adjustments to give effect to the 125% reduction (deduction) for expenditure on research and development. The amount of the adjustment will depend on whether the expenditure generated an asset at year-end. If so, the decreasing adjustment will be 125% of the expenditure. If not, only the extra 25% is the decreasing adjustment amount.

3. There will be a decreasing adjustment where a portion of a capital gain is to be excluded from the tax base (eg the 50% CGT concession available to individuals, indexation element of gain where natural person taxpayer is using the "old" CGT rules).

5.7 Unused Tax Losses

This part of the formula is fairly much self-explanatory. The rules reflect the current position under the ITAA97. This includes the requirement that companies and trusts satisfy relevant continuity of ownership tests and continuity of business tests. The presence of net exempt income will reduce the amount of a current year loss otherwise determined.^[125] Further, current year net exempt income will also absorb a prior year loss before it can be used to reduce taxable income of a current year (recoupment year).

6. EXAMPLES OF THE CASH FLOW/TAX VALUE METHOD

The following sets out the suggested income tax treatment under the cash flow/tax value method of various standard commercial and non-commercial transactions. The suggested approach is based on the RBT Report, the Draft Legislation accompanying the RBT Report and the Explanatory Notes. For current purposes, the scenarios assume a taxpayer that does not qualify for cash basis accounting treatment or the simplified tax system for small business.

XYZ Ltd purchases trading stock for $2,000 in May. The stock is paid for in June. The stock is on hand on 30 June.

The $2,000 payment will reduce taxable income as a payment under Step 2. The stock is an asset that is held on 30 June. This will increase taxable income. The reduction of taxable income through payment is effectively cancelled by the inclusion of the stock in closing assets (ie the same approach as current income tax law).

If XYZ Ltd had not paid for the stock at year-end, the amount owing (ie $2,000) would have entered year-end liabilities under step 6 at its nominal value. This reduces taxable income in the same way the payment did

ABC Pty Ltd sells trading stock for $4,000 in June. The customer pays for the stock in June. The stock was held at the beginning of the year (ie previous 1 July). The purchase cost to ABC Pty Ltd was $2,500, the stock's year-end tax value last year

The receipt of $4,000 will enter taxable income but the reduction in assets held will reduce taxable income by $2,500. In net terms, $1,500 enters taxable income.

If the customer purchased the stock on 45 day terms, taxable income will have been increased by the $4,000 liability owed to ABC Pty Ltd (ie right to receive payment for stock). This is a (financial) asset to ABC Pty Ltd. Thus, the same outcome arises.

XYZ Ltd pays its employees' wages of $23,000 on 18 June for services during May and June.

If the employees had accrued say $35,000 wages by 30 June (ie time worked during May and June generated these entitlements) that remained unpaid on that date, the $35,000 is included in year-end liabilities of XYZ Ltd. This also reduces XYZ Ltd's taxable income.

In the following year when payment is made, the payment reduces taxable income. There is no double counting (double reduction) however as the liability owed at year-end will be reduced by the $35,000 that was discharged by payment. Thus, year-end liabilities will be $35,000 lower than at the beginning of the year.

ABC Ltd has an $80,000 provision for annual leave of employees in its balance sheet at year-end. None of the employees in respect to which the amount relates have gone on leave as at year-end

While the provision is a liability, it will be given a nil tax value as it has not yet been incurred.

If an employee commenced leave before year-end but had not received their entitlement (ie $2,800), the $2,800 of the $80,000 provision will have been incurred. This would then be the tax value of the liability at year-end.

DEF Ltd has debtors of $400,000 in the balance sheet at year-end, less provision for doubtful debts of $30,000.

The $400,000 will be an asset with a tax value of $400,000. This assumes the payment terms are six months or less. The $30,000 provision will not reduce the asset's tax value.

Further, the $30,000 will not be included in the year-end tax value of liabilities. Even if the provision could be viewed as a liability, it will have a nil tax value as it has not been incurred.

HBA Pty Ltd paid rent of $120,000 during the year for occupancy rights over commercial premises.

Assume that HBA Pty Ltd had failed to pay the June rent by year-end. The reduction in taxable income will be the same as above. Payments will be $110,000 and the tax value of the liability at year-end will be $10,000.

When HBA Pty Ltd pays the $10,000 liability in the following year, the payment will reduce taxable income but this will be offset by an increase in taxable income due to the reduction

ABC Pty Ltd prepays two years worth of maintenance fees for its computers, photocopiers etc commencing on 30 April. The amount paid was $2,400.

The whole payment will reduce taxable income. However, as ABC Pty Ltd will be receiving future economic benefits from the agreement beyond 30 June, ABC Pty Ltd is holding an asset. The tax value of the asset is the unexpired monetary value of the agreement. It will probably be $2,200 (ie 22/24ths of $2,400).

There are no effects on taxable income during the following year under steps 1 or 2 of the formula as there have not been any payments or receipts in regard to the agreement. However, the closing value of the asset will now be $1,000. The opening value of the asset was $2,200. The reduction in taxable income for the year is therefore $1,200.

Receipt of Payment for Services to be Provided in Future (Pre-Received Income)

Let's take the example above regarding prepayment for maintenance of computers, etc. The maintenance firm will have received $2,400 on 30 April in return for providing services over two years.

This whole amount will enter taxable income as a receipt. However, as the firm has an obligation to provide economic benefits (ie services) beyond 30 June, it will owe a liability as at 30 June. That liability will enter year-end liabilities thereby reducing taxable income. The amount of the closing liability will probably be $2,200 (ie 22/24th of $2,400).

XYZ Pty Ltd purchases freehold premises for use as the company's head office for $800,000. The purchase occurs on 25 March. The purchase price is paid immediately. The company did not borrow to purchase the property. The company owns the property on 30 June. The property is not subject to any capital allowances under the ITAA36 and ITAA97 and it is treated as one asset (ie buildings are not a separate asset to the land).

The transaction of purchasing, paying for and retaining ownership of the property will have a nil effect on taxable income. The reason is that while the $800,000 payment does reduce taxable income, the asset's value will be included in assets at year-end. The tax value will be the asset's cost, namely $800,000.

Assume that XYZ Pty Ltd was permitted to pay the purchase price over four months in equal monthly instalments. The first instalment is due on 25 April. Thus, by 30 June, XYZ Pty Ltd has only paid $600,000 of the $800,000 purchase price.

The amount of $600,000 will reduce taxable income. Further, the $200,000 final instalment will be the tax value of the liability owed at year-end. This increases liabilities and therefore reduces taxable income. However, the property will be an asset held at year-end and its tax value will be $800,000. Thus, the effect on taxable income again is nil.

Let us assume that XYZ Pty Ltd borrowed the full amount of the purchase price of the property (ie $800,000). The loan period was 12 years. Interest on the loan was at a fixed rate. Principal and interest payments are due monthly.

The receipt of loan funds by XYZ Pty Ltd will be counted as a receipt. Thus, taxable income is increased by the loan funds. The payment for the property will reduce taxable income. The property on hand at year-end will increase taxable income.

Finally, issues surrounding the loan and associated repayments need to be taken into account. First, the full amount of interest and principal payments will be included in step 2 of the formula (ie payments). As the loan liability is not discharged at year-end, its tax value will enter step 6 of the formula. In short, the tax value of the liability will roughly equal the principal outstanding at year-end.^[126]

XCO Ltd purchases and pays for an item of plant on 31 December. The item cost $50,000 and it has an effective life of five years. It attracts an income tax write-off over five years. The company owns the item on the following 30 June.

The payment will reduce taxable income by $50,000. However, as the plant is an asset held at 30 June the following year, its tax value will increase taxable income. Assuming XCO Ltd uses the straight-line method of depreciation, the tax value of the plant will be $45,000. This provides the appropriate depreciation reduction.

If XCO Ltd continues to use and own the item throughout the next income year, the tax value at beginning will be $45,000 and its value at the end will be $35,000. This provides the appropriate $10,000 reduction in taxable income for that year.

Assume the XCO Ltd example immediately above. XCO Ltd sells the item of plant two years after acquisition for $40,000.

The $40,000 sale receipt will come into taxable income. Taxable income will be reduced by the difference between the opening and closing tax value of the item of plant. The opening value for the sale year will be $35,000 and the closing value will be nil, as the plant is not held at year-end by XCO Ltd. There is no need for any balancing charge calculations. The cash flow/tax value formula does it automatically.

XYZ Ltd sells most of its stock on 21 day terms. However, for one very special customer, terms of 364 days are provided. For example, a sale of stock was made on 31 December for $100,000. However, the customer will be allowed to pay $110,000 in 364 days time. The stock had a tax value of $80,000 on the previous 1 July.

The stock with a tax value of $80,000 at the beginning of the year will not be on hand at year-end. This effects an $80,000 reduction in taxable income by operation of Steps 3 and 4 of the taxable income formula.

XYZ Ltd holds an asset at year-end, namely the right to receive payment of $110,000 within 364 days. This asset is a financial asset. As the consideration provided for acquisition of the financial asset was a non-cash benefit (ie trading stock), the cost of the financial asset will be the market value of the trading stock. This was $100,000.

This is the cost of the financial asset. It will provide the basis for calculating the tax value of the asset at 30 June. In short, the return on the asset, being $10,000, that has accrued to 30 June will be added to the cost and that amount will become the asset's tax value. This will be $104,970 [$100,000 x (1 + 4.97% (10% x 181/364))].

This provides a better outcome for XYZ Ltd compared to that under the present system. Under the present system, $110,000 would have been the assessable income inclusion for the year. There would not have been any discounting of the nominal amount of the debt to reflect delayed payment.

In the following year when the customer pays XYZ Ltd the $110,000, this amount will be included under Step 1 (ie receipts). This is partly offset by the reduced level of assets at year-end compared to the beginning of the year. This reduction will be $104,970.

ABC Pty Ltd purchases trading stock on terms allowing 729 days to pay. The purchase was made on 31 March. Thus, payment is due on 30 March in two years time. The purchase price was $100,000 however given the lengthy terms of credit, ABC Pty Ltd was obliged to pay $121,000 within 729 days. ABC Pty Ltd sold the stock within two months of delivery for $140,000.

The $140,000 sale proceeds received for sale of the stock will be included under Step 1 thereby increasing taxable income.

There are no payments by ABC Pty Ltd during the year in regard to the stock. There is however a liability owed on 30 June in regard to the stock purchase. The liability is a financial liability. It also has a due and payable date beyond six months. Thus, the nominal amount of the liability will not be its tax value at year-end.

The tax value of ABC Pty Ltd's liability to pay its supplier will be determined using the notion of an identical corresponding financial asset. Thus, we assume ABC Pty Ltd holds the asset (ie right to receive payment) represented by the liability and we then determine the tax value of the notional asset as at 30 June. This becomes the tax value of ABC Pty Ltd's liability. In this case, it will equal $102,490 [$100,000 x (1 + 2.49% (10% x 91/365))].

The tax value of ABC Pty Ltd's liability on the next 30 June will be $112,739 (ie [$102,490 x (1 + 10%)]).

Jean pays the local newsagent the regular two-month bill covering March-April. It amounted to $200. Half of the amount covered newspapers read or used for private purposes. The other half was for items of stationery, postage, etc that was used in Jean's business.

The payment is private to the extent of 50%. Thus, only $100 will enter payments under Step 2 of the taxable income formula. No asset resulted from the payment. Thus, there is no issue at year-end.^[127]

XYZ Ltd pays $2,000 for entertaining clients. Note that no employees received entertainment from the expenditure.

The $2,000 will enter payments under Step 2 of the formula. However, in light of the tax policy (which is reflected in s 32-5 of ITAA97) of excluding expenditure with the character of personal consumption, an increasing adjustment will be made under Step 7 of the formula. This reverses the deduction so that no recognition is given for such expenditure.

Depreciable Asset Used Partly for Private Purpose or Wholly for Private Purpose

Jon conducts a consulting business from a renovated garage at home. Jon purchases a computer for $5,000 on 31 December. Jon paid cash for the computer. The computer attracts a two and a half year straight-line write-off under the income tax. The computer is used by Jon and his family 50% of the time for non-business use.

The payment of $5,000 will reduce taxable income under Step 2, as the asset will be included under Step 3. The reason the asset is included is that it is not a private asset. It is not a private asset as it is a depreciable asset and it is not used solely for private purposes.

The asset will be brought into year-end assets. Its tax value at end will be $4,000 ($5,000 less depreciation of $1,000 ($5,000 x 6 months/30 months)).

However, to recognise the private element of use of the computer, an increasing adjustment will be made under Step 7 of the formula. The increasing adjustment will be $500 (50% of $1,000).

If the computer was used wholly for private purposes, the payment for its purchase will not be counted under Step 2 and the tax value of the computer will not be included in assets at year-end.

Continuing with the scenario immediately above (ie Jon's computer), Jon sold the computer one and a half years after purchase (ie 29 June) for $3,000.

The $3,000 receipt will enter taxable income under Step 1 of the formula. As the computer will not be held on 30 June, the decrease in the tax value of assets from the beginning of the year will be $4,000. This reduces taxable income.

7. CONCLUSION

Amongst other things, this article has set out the fundamental structure of the cash flow/tax value method of determining taxable income. It has also provided numerous examples on how the new method will operate in standard commercial and non-commercial situations.

The new method does mark a significant, if not radical, shift under Australia's income tax. New concepts will be used for the basic measurement of a taxpayer's income tax base. Many old concepts will be discarded. Retained concepts will be expressed in a different form or will operate in a different framework. New concepts will be utilised to deliver tax concessions, etc. New concepts will be used to give effect to anti-avoidance measures. Financial information that is not routinely captured by taxpayers will have to be captured or accessed by taxpayers.

However, two adjustments are required to recognise the private element of use. First, an increasing adjustment of $1,000 is made in respect to the decline in value of the computer during the year. To not make this increasing adjustment would effectively have given Jon a deduction for depreciation of a private asset.

Secondly, a decreasing adjustment of $500 is made as a result of the sale to reflect the fact the computer was not purely used for taxable income production.

Time will be spent on clarifying anomalies that will flow from the legislation. There will be extensive debate in particular situations as to whether a change of treatment from the current income tax was intentional or unintentional. For some time after commencement of the new method, tax practitioners will be looking to the Australian Taxation Office (ATO) for guidance on various matters. In turn, the ATO will be looking to accounting principles and practice, and perhaps the courts for guidance on the concepts embodied in the cash flow/tax value method.

The transition alone to the cash flow/tax value method (eg attributing values for assets and liabilities in first year of new method, ensuring there is no double counting of transactions (ie old and new system) will present major challenges. The cash flow/tax value method is arguably the biggest ever reform to Australia's income tax. In light of the above, Australian taxpayers, and perhaps more importantly, Australian tax practitioners will have to undergo a major re-education program.

Dale Boccabella is a Lecturer in Taxation Law in the School of Economics and Finance, University of Western Sydney - Nepean. He is also Visiting Lecturer in Goods and Services Tax Law in the School of Business, University of Sydney. Dale has published numerous articles and conference papers on Australia's tax system including articles in the Australian Law Journal on the GST. One of his articles was cited in the leading High Court case of FC of T v Rowe 97 ATC 4317. Dale is also co-author of Income Tax Analysis: Cases, Questions & Commercial Applications (3rd ed 1999).

^[1] Review of Business Taxation, A Tax System Redesigned (July 1999) ("RBT Report") 155-213.

^[3] The RBT has already drafted some aspects of the legislation required to implement the cash flow/tax value method.

^[4] The RBT Report consists of 3 parts. They are: 1. A Tax System Redesigned - Overview, Recommendations and Estimated Impacts; 2. A Tax System Redesigned; Draft Legislation ("Draft Legislation") - this document contains draft legislation giving effect to some of the recommendations of the RBT (a major part of the draft legislation deals with the cash flow/tax value method); and 3. A Tax System Redesigned; Explanatory Notes ("Explanatory Notes") - this document provides commentary on how the draft legislation would operate.

^[5] The decision to place all the examples in one section of the paper, as opposed to progressively throughout the paper, was forced upon the writer because of the numerous steps in the taxable income formula under the cash flow/tax value method. The reason is that one transaction will usually impact on two or even three steps of the formula. Thus, readers need an appreciation of all the steps in the formula before a transaction can be properly analysed for its impact on taxable income. This is the area where the cash flow/tax value method differs markedly from the current income tax regime.

^[6] RBT Report, 38-39; Explanatory Notes, para 3.14 and paras 6.2 - 6.37. As will be appreciated later, in certain areas the cash flow/tax value method will provide "deductions" which are not available under the current regime. On the other hand, the tax base may be broadened in some areas.

^[8] R Warburton, Initial Report to the Treasurer, the Hon. Peter Costello MP: The Tax Value Method (20 March 2000).

^[9] In short, trusts and their beneficiaries will be taxed in the same way that companies and their shareholders are taxed. This means, the current full imputation system will be extended to trusts.

^[10] Depreciable assets will be written-off in line with their decline in economic value. For some time, Australia's rate of depreciation allowances for plant and equipment have provided for accelerated write-offs.

^[11] This is the technique that introduces accruals taxation for returns and costs on some assets and liabilities. Importantly, accruals taxation here does not refer to the taxation of unrealised gains on appreciating assets.

^[12] The working group/consultative committee, chaired by Mr Richard Warburton, has not recommended a change to the 1 July 2001 commencement date.

^[13] As noted, above n 3, the RBT has already produced the Draft Legislation which covers some of the core provisions that will be required to implement the cash flow/tax value method. Transitional provisions will be required to deal with the changeover from the current system to the cash flow/tax value method (eg tax values attributed to assets and liabilities on commencement of the cash flow/tax value method).

^[15] Bringing assets on hand at year-end into the taxable income formula under the cash flow/tax value method is the thing that places a taxpayer on an accruals basis of income recognition.

^[16] RBT Report, Recommendations 4.4 and 17.2. It is expected that the definition of "small business" for the purpose of the cash flow/tax value method will be a business with an annual turnover of less than $1 million.

^[17] The following provides an outline of the fundamental components of the cash flow/tax value method as currently proposed by the RBT. The outline is not meant to be an exhaustive treatment of the cash flow/tax value method.

^[23] ITAA97, ss 6-5(4) and 6-10(3); ITAA36, s 19 and Draft Legislation, s 5-65.

^[24] It is worth noting that derived means receipt for many taxpayers under the current income tax.

^[25] Note that adjustments may have to be made under another step of the formula (eg step 7) to give effect to certain concessions (eg exclusion of 50% of a net capital gain: ITAA97, ss 115-5 to 115-100). Thus, there will still be a need to identify certain transactions that are on capital account or at least are given capital gains tax treatment.

^[39] This raises the $500 threshold for collectables under the current law to $10,000: see RBT Report, 182-186.

^[41] The taxpayer received a reimbursement of expenditure for which he obtained a deduction in an earlier income year. The reimbursement was held not to constitute assessable income.

^[43] The "incurred" concept largely governs the timing of deductibility of outgoings under the general deduction section at present: ITAA97, s 8-1.

^[51] The comments here draw on the commentary at Explanatory Notes, paras 5.28 - 5.32.

^[53] Note that such assets will usually have a nil tax value. This prevents the cash flow/tax value method operating as an accruals income tax.

^[54] Henderson v FC of T 69 ATC 4049; FC of T v Australian Gas Light Company 83 ATC 4800.

^[55] See Crommelin v DFC of T 98 ATC 4790; Stapleton v FC of T 89 ATC 4818; FC of T v Grant 91 ATC 4608.

^[56] It is the expressed intention of the RBT Report to bring work in progress on hand into the tax base: RBT Report, 174-175.

^[57] While work in progress and consumable stores, etc will be an asset, whether or not the tax treatment of these items differs from the current treatment, will depend on the tax values ascribed to them. This will be dealt with below under "Tax Value".

^[61] Draft Legislation, s 6-15, Item 7 and Explanatory Notes, paras 5.38 - 5.39.

^[65] Accruals income tax here refers to the situation where taxpayers are taxed on the increased value of their assets while continuing to hold/own them. See D Boccabella, "Cash Flow/Tax Value Method: Platform for Accruals Taxation Indelibly Planted" (2000) 34 Taxation in Australia (Blue Edition) 462.

^[74] Draft Legislation, s 45-70(2). The example given this section is a taxpayer that sells a bulldozer worth $75,000 in return for payments of $80,000 to be received over nine months from the customer. The cost of the right to receive payments (ie financial asset) will be $75,000.

^[78] It is arguable that the first element is wide enough to encompass all costs to be absorbed into manufactured trading stock.

^[79] See ss 6-110(4) and 6-115. This ensures the current treatment is maintained: see also ITAA97, ss 108-17, 108-30 and 110-25(4) for current inclusion in the cost base of land.

^[81] The treatment of blackhole expenditure varies between immediate deductibility (ie no tax value), amortisation over a statutory period (eg four years) and capitalisation of the amount (ie included in tax value of an asset).

^[89] This measure (ie including trade debts in closing assets) effectively places cash basis taxpayers onto the accruals basis. As noted earlier, modifications will be made to ensure that taxpayers currently on a cash basis are able to retain that treatment under the cash flow/tax value method.

^[94] Note that this example deals with the situation where amounts receivable under the financial asset were "certain". The formula in Draft Legislation, s 45-80 deals with circumstances where receivables are "not certain".

^[103] Note however that they will have a nil tax value. This effectively maintains the current treatment.

^[105] Cases like FC of T v James Flood Pty Ltd [1953] HCA 65; (1953) 88 CLR 492 and Nilsen Development Laboratories Pty Ltd v FC of T 81 ATC 4031 provide guidance on the incurred concept.

^[113] The treatment of this issue was left to now so that readers have had the chance to appreciate the notion of an asset and a liability, and the operation of the first 6 steps of the taxable income formula.

^[117] There does not appear to be a section stating this in the Draft Legislation. However, it is certainly the intent from a reading of the Explanatory Notes: see paras 3.32 and 3.33. See also the note under Draft Legislation, s 5-60(1).

^[120] Draft Legislation, s 5-60(5). Rules about the definition of financial assets and liabilities are being developed. As noted earlier, it is expected that financial assets will involve such things as bonds, bills of exchange, options, swaps, shares and rights to receive payments.

^[126] The Draft legislation actually requires the application of the (notional) identical corresponding financial asset concept and the application of the formula in Draft Legislation, s 45-75(1). The identical corresponding financial asset is the right to receive payment under the loan. The formula under s 45-75 is [Last tax value x (1 + Interest%)] -; Receipts at test time. It will be appreciated from the above formula that, XYZ Pty Ltd must in fact calculate a new tax value every time the company makes a repayment under the loan. However, as the interest payments are required to be made at least annually, the principal outstanding will roughly be the tax value of the liability at year-end.

Journal of Australian Taxation

1. INTRODUCTION

2. STATUS OF THE CASH FLOW/TAX VALUE METHOD

3. COMMENCEMENT DATE

3.1 External Matters

3.2 Internal Matters

4. WHICH TAXPAYERS HAVE TO USE THE CASH FLOW/TAX VALUE METHOD?

5. STRUCTURE AND OUTLINE OF CASH FLOW/TAX VALUE METHOD^[17]

5.1 Receipts

5.1.1 Private or Domestic Receipts

5.2 Payments

5.2.1 Private or Domestic Payments

5.3 Assets

5.3.1 Asset

5.3.2 Private Assets

5.3.3 Asset Held

5.3.4 Tax Value

5.3.5 Non-Financial Assets

5.3.6 Financial Assets^[87]

5.4 Liabilities

5.4.1 Liability

5.4.2 Private Liabilities

5.4.3 Liability Owed

5.4.4 Tax Value

5.4.5 Non-Financial Liabilities

5.4.6 Financial Liabilities

5.5 Money Accounts^[113]

5.6 Increasing Adjustments and Decreasing Adjustments

5.6.1 Increasing Adjustments

5.6.2 Decreasing Adjustments

5.7 Unused Tax Losses

6. EXAMPLES OF THE CASH FLOW/TAX VALUE METHOD

7. CONCLUSION

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	Journal of Australian Taxation