Week 4: income from property Sadiq chapter 9
Receipts such as interest, rent, royalties and dividends that flow from the passive ownership of capital investments will be ordinary income under s 6-5 of the ITAA 1997 – these receipts are generated from capital without the capital being diminished in any way.
Property income is a class of ordinary income, but certain forms of property income may also be specifically deemed assessable as statutory income. if a receipt is both ordinary and
statutory income under the act, section 6-25 states that it is included in assessable income only once and will normally be taxed under the statutory provision rather than as ordinary income unless the statute states it only applies if it is not ordinary income.
The main areas of property income are: - Interest
- Dividends
- Rental and lease income - Royalties
- Annuities Interest
Most ordinary people understand interest to be the cost of borrowed funds or the return from fixed-term investments – in this form, receipts of interest are clearly income from property and are assessable as ordinary income under s 6-5. However, ‘interest’ is not defined in the legislation and therefore we look to case authority.
- Riches v Westminster: Interest is described as ‘a payment which becomes due because the creditor has not had his money at the due date’.
- Therefore, interest is the return that flow from the lending of money and is the compensation for the loss of use of that money.
Taxation in its normal form is ordinary income, but there are some statutory provisions which impact on the taxation of interest.
Discounts and premiums:
- A discounted loan is one where the amount provided to the borrower is less than the amount of the loan.
- A loan premium is one where the borrower has to repay more than the amount advanced by the lend
- For a loan discount, interest is levied on the principal cost, but on a loan premium interest is only charged on the money advanced
- These arrangements have been introduced to alter the timing of assessable income and as an attempt to characterise the discount on premium as capital rather than ordinary income (Lomax v Peter Dixon & Sons Ltd)
Lomax v Peter Dixon & Sons:
- English taxpayer lent money to an associated Finnish company just before WW2. Taxpayer was not in the business of lending money and determined that there was a high level of risk associated with the loan and as a result, the taxpayer required a much higher rate of return than would normally be accepted. This was not achieved
by charging a higher interest rate but instead by requiring the borrower to pay both a premium and a discount on the debt.
- The house of lords accepted the argument by the taxpayer that the benefits received as a result of the discount and premium were capital in nature and not interest.
- The court appears to have taken into account in this decision the facts that a
commercial rate of interest was charged and that the taxpayer was not in the business of lending money
- This case shows that there is a distinction between interest which is ordinary income and a capital return that results from an allowance for risk.
- This case also shows the principle that if the discount is simply a replacement for interest, then it will be ordinary income (same as first strand of myer case) FCT v Hurley Holdings (NSW) pty ltd:
- Taxpayer’s main business was investing in hotels. The company realised some of its investments so as to be more liquidated until the MD’s son took control of the company. As part of this process, the taxpayer purchased a discounted bill for $442 200 with a face value of $500 000 and a maturity date of just over a year. No actual interest was paid but on maturity the value of the investment had increased by $57800 which is a notional return of 13% on the original investment. The commissioner assessed the $57800 as ordinary income, but the taxpayer argued it was capital - Federal court held that the gain made on the realisation of the investment was
ordinary income.
- Gummow J distinguished the current facts to that of Lomax. The basis of this distinction was because Hurley did not receive interest and the discount was more akin to a substitute for interest and not simply an increase in capital value (same conclusion through first strand of myer case)
Courts these days are generally more inclined to view premiums and discounts as ordinary income but Lomax is still good law as it is conceivable that a genuine discount or premium could be held to be capital if:
- The interest was payable on the loan;
- The interest and the terms of the loan were commercial justifiable - The discount took into account the risk of non-repayment
Timing of interest receipts:
- Even though discounts or premiums will generally be ordinary income, deferring the receipt of gain to when the debt is redeemed may delay the time when the gain is assessable as interest is normally derived and assessable on a cash basis – i.e. if interest is paid on an annual basis, the interest will be derived and assessable under s 6-5(2) in that year.
- To the extent that the fain is realised via a discount or premium at the end of the loan, it will not be derived and assessable under s 6-5(2) until that later dater (FCT v AGC) - Deferral of the taxation of interest earned by wat of a discount/premium may cause an
imbalance in the taxation system. This happens if the borrower can claim a deduction on a yearly basis, but the lender only has assessable income when the loan is repaid. A range of legislation was introduced to counter the possible deferral of tax through discount and premium arrangements.
o Division 16E of the ITAA 1936 deals with the timing of assessable income and deductions relating to discount and deferred interest payments on ‘qualifying securities’ - this only affects the timing and does not determine whether they are assessable.
§ Effect is that the gains made on these securities are included as assessable income of the lender annually over the life of the loan o Sections 26BB and 70B of the ITAA 1936 apply to ‘traditional securities’
acquired after 10 May 1989. These provisions deem premiums and discounts to be assessable income to the recipient and deductible for the payer, even when they are capital in nature
o Difference between qualifying and traditional securities is based on the amount of the premium/discount. Traditional securities have a return equal to or less than 1.5% pa and qualifying securities have a return of greater than 1.5% pa, or where the return cannot be determined at the time of issue. - Decision 230 of ITAA 1997 was introduced to cater for some of the more complex
and new financial arrangements. This applies to financial instruments acquired on or after 1 July 2010, but a taxpayer may also elect to apply these rules from 1 July 2009 the main aim was to tackle the issue of effects of inflation
Interest and compensation:
- Interest may also be paid on damages and compensation payments to compensate for the time lag between the loss and the receipt of the compensation. For example, a person injured in a car accident who receives $100 000 but has to wait a year for the final decisions and receipt of payment may be entitled to interest on the money because of the delay.
- If the compensation itself is ordinary income, then any interest paid on the compensation will also be ordinary income. however, if the compensation is not ordinary income, there is question around the tax treatment of the interest component of the compensation payments. These may be
o Ordinary income
o Capital because it cannot be separated from compensation of a capital nature o Capital for other reasons, such as being pre-judgment interest on personal
injury payments
o Specifically exempt by ITAA 1997
- Case law shows there may be different approaches for compensation for the loss of property and compensation for personal injury
Federal Wharf Co Ltd v DCT: loss of property
- Taxpayer’s property was compulsorily acquired under legislation and the relevant act allowed for interest at the rate of 4% pa to be paid on the amount owing from the time of acquisition to the time the compensation was paid. Compensation for lost property was clearly capital but Federal wharf argued that the 4% formed part of compensation for resumption of land and thus was also capital
- The HC held that the interest was ordinary income because it was paid to account for the fact the taxpayer had been deprived of the use of the funds that it was due. Rich J made the point that if the funds were received immediately, they would have been invested and any interest would be ordinary income.
Whitaker v FCT: personal injury
- Taxpayer was awarded compensation of about $808 000 following surgery that left her blind. The sum awarded included a pre-judgement interest of $65 000. The
Taxpayer also received approximately $288 000 in post-judgment interest because the compensation remained unpaid for over two years due to the case being appealed. The commissioner included both the post and pre-judgment interest in the assessable income
- On appeal to the FFC, it was held the pre-judgement interest was capital in nature and not ordinary income, but the post-judgement interest was ordinary income and
therefore assessable.
- The court found it easy to claim the post-judgement payment was ordinary income because it was paid to compensate delay in payment of compensation and had nothing to do with the damages awarded for injury. However, the pre-judgment interest was seen as part of the compensation awarded for the injury suffered and therefore was capital in nature.
Section 51-57: exemption of post-judgment interest on personal injury compensation: the decision in Whitaker generated considerable media interest and political debate about fairness/equity. Consequently, respective legislation was introduced effective from the 1992-93 tax year, to exempt post-judgment interest from assessable income.
Interest compensation and CGT
- Compensation of a capital nature may be subject to CGT provided it is not exempted by s 118-37 of ITAA 1997.
Section 15-35: interest on over-payment and early payment of tax Interest portion of instalment payments
- Interest may also be imputed into periodic payments for capital items. These arrangements are commonly known as ‘term sale’ or ‘vendor financing’ and may occur where purchasers cannot obtain their own finance.
- If this type of arrangement states a specific interest rate to be charged on the
outstanding balance, then that interest will clearly be ordinary income. However, if no explicit interest rate is included in the agreement, the issue arises as to whether there is an implied interest included in periodic payment
- Australian courts have generally been reluctant to impute an interest component into periodic payments and are more inclined to treat the total amount as capital if there is no identifiable amount of interest (Californian Oil Products Ltd (in liq) v FCT) Dividends
Dividends are paid to company shareholders as their share of company profits. Therefore, dividends flow from ownership of shares and are ordinary income under s 6-5. However, dividends are also specifically made assessable as statutory income under s 44 of ITAA 1936 and because of s 6-25 of ITAA 1997, the statutory provision has precedence over the general provision of s 6-5.
Section 6(1) of ITAA 1936 defines dividend as including:
- Any distribution in the form of money or property that a company makes to its shareholders; and
- Any amount credited by the company to any of its shareholders as shareholders Over the years, the rules of dividends have been complicated due to attempts to alter the tax effect of benefits paid to shareholders. Of specific concern is whether the payments by a company are dividends paid to the holder of shares (equity) or interest paid on debt. The main differences between investments in debt and equity are:
- The different level of risk borne by the investor, in that lenders are exposed to less risk than shareholders; and
Rental and lease income Rent:
- Rent is payment by one party in exchange for the exclusive possession of the other party’s property for an agreed amount of time
- The receipt of rent by a lessor clearly constitutes ordinary income as it is income rom property
- Under the flow concept, rent flows from an investment in property - Can still constitute ordinary income when it is paid as a lump sum City-bank:
Lease premiums:
- A lease premium is a payment by a potential lessee to induce a lessor to enter a lease agreement with the lessee
- Normally treated as capital because it is regarded as a receipt for realising an interest in an asset (usually assessable under CGT). However, lease premiums will constitute ordinary income in either of the two following situations:
o Where the taxpayer is in the business of receiving lease premiums (Kosciusko Thredbo Pty Ltd v FCT)
o Where the lease premium is in reality a substitute for rent (Dickenson v FCT) Kosciusko Thredbo Pty Ltd v FCT:
- The taxpayer, in its capacity as a tenant, entered into a 45-year lease of a state park. The taxpayer proceeded to develop the land, building facilities and apartments. The taxpayer subsequently sublet apartments and other facilities to various tenants and received lease premiums upon granting some of these leases
- The court held that the lease premiums were ordinary income as they were part of the normal proceeds of the taxpayer’s business. This was because the receipt of the premiums was repetitive and an essential ingredient of the taxpayer’s business. Section 15-25: amount received for lease obligations to repair
- This section states that amounts received by a lessor from a lessee due to the lessee failing to comply with a lease obligation to repair the premises are assessable income. this section will only apply where:
o The lessee has used the premises for producing assessable income’ and o The payment is not ordinary income
Royalties:
- A royalty is a payment that is calculated based on the usage of intellectual property or the quantity/value of a substance taken, such as coal taken from a mine.
- McCauley v FCT: taxpayer was a dairy farmer who owned land with trees on it. Taxpayer entered into an agreement with Laver, where Laver would cut and take the trees from the taxpayer’s land. The agreement stated that Laver would pay the taxpayer an amount based on the quantity of timber that had been cut and removed from the land. The HC held by 2:1 that the payment was a royalty as it was payment made in relation to the amount of timber removed
- Section 15-20 deems royalties to be assessable as statutory income. However, this section does not apply to royalties that are ordinary income under s 6-5.
- Royalties that are the product of exploiting intellectual property will constitute ordinary income.
- Taxpayer was a farmer who granted a sawmiller the right to come on to his land and remove timber in exchange for a predetermined sum to be paid quarterly. This agreement also prescribed a maximum amount of timber that could be removed and gave a proportionate reduction of the payment if less than this maximum was removed.
- HC held that the payments were not royalties but were capital in nature.
Consequently, the payment was not assessable as it was not ordinary income and s 15-20’s predecessor did not apply as the payment was not a royalty.
- Court said: taxpayer’s receipt was not a royalty because the agreement expressed the payment as a predetermined amount despite there being a link between amount taken and amount paid. Therefore, the court appeared to define royalty in its form rather than its substance.
- If this case was decided today, it is likely the court would still find it was not a royalty payment. However, it is likely the court would find the payment to be ordinary
income under other grounds. Barret’s case:
- Sandstone moved by mining company Moneymen Pty Ltd v FCT:
- ?
Nethersole v Withers?
- Partial realisation of capital - Capital sum
- Once-and-for-all Murray’s case:
- Copyright Annuities:
- An annuity is a stream of payments that occur at regular intervals, maybe for a fixed time or for life. Where the annuity is purchased, it is known as a ‘purchased annuity’, which occurs where the taxpayer pays an entity, such as an insurance company, a lump sum in exchange for that entity paying the taxpayer a regular income stream. The main two types are fixed-term and life annuities.
o A fixed-term annuity is where the payments are made by the annuity provider for a predetermined amount of time
o A life annuity occurs when the terms of the annuity contract state that annuity payments are to be made for the rest of the recipient’s life. At the end of the annuity period, the original purchase price of the annuity will usually have been totally consumed and the recipient will not be entitled to any final capital payments. In effect the provider of the annuity has repaid over the life of the annuit the purchase price plus any interest earned during the annuity period. In some limited cases, the taxpayer will be entitled to receive part of the purchase price of the annuity at the end of the annuity period, but this ultimately
depends on the term of the annuity period
- Under case law, the full amount of the regular annuity payment is regarded as
ordinary income (Egerton-Warburton v DCT). This is an unjust outcome because only part of the annuity payment is a real gain, whereas the rest is a return of the taxpayer’s purchase price, which is capital
- As a result, the government enacted s 27H of ITAA 1936, which makes the return of the annuity’s capital component tax free. Section 27H only applies to
non-superannuation annuities as non-superannuation annuities are subject to other legislative provisions.
- ANZ bank case:
