Capital And Revenue

Lecture Overview



Topic 5 (A) Capital and Revenue (B)Income Statement For Tax Returns







1

INCOME DEFINITION




Income is not defined in the Income Tax Act 2007 (or previous Acts) CIR v Boyton (2001) How to decide what is income? – – –

–

Case Law: Pitney, J. Supreme Court, USA in: Eisner v Macomber (1919) 252 US 189

Economists’ view – capital:





Why do we need to identify the distinction? New Zealand: –

In terms of receipts • • • •

–

Capital is generally non-taxable; Income/revenue; liable for income tax; income generally excludes capital; some capital gains may be taxable -“circulating capital” e.g. capital gains from the sale of land purchased with intention for resale)

In terms of expenditure •

deductions for capital outgoings are generally not deductible

CAPITAL v REVENUE Summary


What is capital? –

• tree; • a reservoir supplied from springs.

– Income is • fruit/crop; • outlet stream to be measured by its flow over time; • not a gain accruing to capital; • not a growth or increment of value;

2

CAPITAL V REVENUE

Implied in the Act Normal usage - e.g.dictionaries Judicial interpretation - ordinary concepts and usages of mankind Recap Topic 4

CAPITAL v REVENUE




Income definition Capital vs. revenue – why important to make the distinction – principles derived from case law Using income as the tax base – economist’s view – accountant’s view – capital gains tax debate Financial vs. tax accounting – why the difference – how different are they

–




An item of wealth or an asset capable of producing wealth e.g. buildings, land, investments.. the “tree” Nature of “fixed capital”

What is income? – –

The “fruits or crop”; rent, interest, dividends…derived from the above are income Nature of “circulating capital”

Case Law CIR v McKenzies NZ Ltd (1988)


Taxpayer making a lump sum payment to lessor in consideration for surrender of lease

Case Law CIR v Inglis (1992)







Court of Appeal held it is capital

Other Tax Cases


CIR v Fraser (1996) 17 NZTC 12,607

INCOME AS A TAX BASE


Most complex and controversial




Impact of economic, accounting and legal principles

-inducement payment -character of receipt important


Shares sold at a loss and claimed a deduction for the loss CIR claimed capital losses not deductible Court decision: share transactions were capital in character BUT is taxed under the Act (s CB 4)- profit on sale of shares; shares held on revenue account i.e. circulating capital

Union Steamship Co of NZ Ltd v CIR (1996) 17 NZTC 12,629 (CA) -surrender of option -agreement not viewed in isolation but in context of other agreements

INCOME: Economist’s View

EXAMPLE At beginning of the year has cash $1,500 but invested $1,000 in shares
Earned salary $15,000
Outside fees $2,000, expenses $400
Dividends received $900
Shares worth $9,800 at end of year
$400 in bank a/c at end of year
$17,600 cash spent on consumption items





Income = increase in economic power




That is net accretion in wealth plus consumption during the period in question

ECONOMIC INCOME Cash

Value at begin $500

Value at end $400

Increase or decrease ($100)

Shares

1,000

9,800

8,800

Increase in net worth

8,700

Consumption exp.

17,600

Economic Income

$26,300

INCOME: Accountant’s view ‘inflows or other enhancements, or savings in outflows, of service potential or future economic benefits in the form of increases in assets or reductions in liabilities of an entity...result in an increase in equity’
GAAP - income measured on basis of completed transactions


ACCOUNTING INCOME S a la ry

$ 1 5 ,0 0 0

F ees

$ 2 ,0 0 0

L ess: ex p en ses

400

DIFFERENCES





1 ,6 0 0 D iv id e n d s

900

A /C In c o m e

$ 1 7 ,5 0 0












ACCOUNTING realisation concept historical cost conservatism objectivity matching expenses with revenue

Capital as a Tax Base

Arguments



ECONOMIC Needs valuation Subjectivity Unrealised gains/losses Includes gifts, inheritances, bequests

New Zealand:

Economist’s approach – – – –

too impractical difficult to apply lack objectivity and accuracy measurement of taxable income; ‘monetary’ v ‘real’ income

– –

–

No specific capital gains tax; Tax Review 2001: current income tax base includes a wide range of changes in value of assets and liabilities; Capital gains tax, as used overseas, is a transactional tax on disposal of assets: encourage tying up of assets unproductively to avoid tax.

Capital as a Tax Base


Arguments for:

Capital as a Tax Base


Arguments against: – Administration problems such as:

– Equity i.e.

• the erratic nature of such gains; • difficulty in assessing -rate of tax to be applied? difficulties with adjustment in changes in money values; will the public accept a capital gains tax?

• Profits in the form of income taxable so should profits of capital nature; • Increase in taxable capacity (vertical equity); • It would prevent a common means of tax avoidance; • Avoids excessive concentrations of economic power in a few hands.

– Political • likely to incur bad feeling particularly as proportion of NZers own their own homes, shares, etc.

– Economic

–

• Absence – tendency to over invest in assets subject to capital gain and under invest in productive assets; • Stabilisation effective? In times of inflation and excess demands the tax yield would increase.

Income Statement: Accounting v. Tax


Introduction:

–

Standard income year => “tax year” Tax year – 31 March Alignment of corresponding income year to a tax year Non-standard income year (early or late) and accounting balance dates Profit v net / taxable income:

–

Income returned in ‘prescribed forms’

– – – –

•

–

– Impact on farmers

Financial v Tax Accounting


– –




Purposes of Taxation: – – –




Principles of taxation: – – – –




To raise revenue for public goods and services; To encourage certain economic behaviours; Redistribute wealth.

Equity; Certainty; Convenience/simplicity; Economy of collection.

Accurate assessment of tax liability

Why are they different? How are they different?

Purpose of Financial Accounting: –

Accounting is the “the process of identifying, measuring and communicating information to permit informed judgments and decisions by users of that information” (Bazley & Hancock, 110.100)

–

Statements of Concepts for financial reporting imposed for specific business/economic purposes

–

Concerned with ‘true and fair view’.

Financial v Tax Accounting





Basic questions:

Financial v tax accounting

Financial v Tax Accounting

• Possible reduction in tax yield Economic; possibly interfere with society’s choice in the patterns of production and consumption Grounds of equity; is the tax to be on real wealth or illusory increase?

Tax accounting methods: – When income is derived and expenditure incurred? – Cash method • •

–

Based on income received Deemed to be derived if amount is credited in account, etc. (s BD 3)

Accruals method • • •

Based on income earned Adopt a method that best discloses taxpayer’s true income Generally considered the appropriate method for accounting for business

Financial v Tax Accounting


Permanent & timing differences for deferred tax purposes




Permanent differences result from:

Financial v Tax Accounting


Timing/taxable temporary differences are: –

•

•

Items of income/gains realised for financial accounting purposes but not recognized for tax; and Items of expense/loss matched against financial accounting revenue but not deductible against gross (tax) income.

INCOME TAX LIABILITY Annual Gross Income
Less: Annual Allowable Deductions
Net Income
Less: Available Losses (brought forward)
Taxable Income
Multiply by tax rates
TAX LIABILITY


–

Difference between financial (profit) & taxable incomes arising strictly from taxpayer’s method of accounting Same item of income/gains or expense/loss is taken into account in different year(s) for accounting v tax purposes