Private ruling: Income Tax – Assessable Income – Cash vs Accruals
Date of advice: 26 September 2017
Published: February 2018
Ruling period: 1 July 2016 – 30 June 2019
Date scheme commenced: 1 July 2016

Ruling: Q1: Is it appropriate for the taxpayer to change from accrual/earnings to cash/receipts accounting method for the purposes of Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No. The taxpayer should continue to use the existing earnings/accrual method to determine its taxable income.

Relevant facts and circumstances: The taxpayer is a labour hire company ( the Company) specialising in placing skilled labour (the Contractors) with its clients in a particular industry. The Contractors are provided to clients for either short-term or long-term positions, and they are not employees of the clients. The Company pays all the Contractors’ wages and entitlements. The Company pays the Contractors weekly, but gets paid by the clients once every two months. Wages paid to the Contractors are approximately 72 – 74% of the turnover. Direct staffing costs (wages, superannuation and payroll tax) comprise approximately 84% of the turnover. The Company currently accounts for tax using the accruals/earnings method. Debtor days average 30 days. The Company is registered as an Australian Proprietary Company. The Company’s sole director has been in the position since early 200X. The Company falls into the market segment of $2 to $10 million turnover small business entity. The Company employs the following staff: ● X permanent full time employees ● X part-time employees The Contractors are all casual workers. There is no obligation for any Contractors to accept any shift offered to them. Each engagement is a temporary one.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subsections 6-5(1), 6-5(2), 6-5(3) and 6-5(4).

Reasons for decision: Detailed Reasoning - Question 1: Is it appropriate for the taxpayer to change from accrual/earnings to cash/receipts accounting method for income tax purposes? | Summary: The Company derives income from the hire of skilled labour (the Contractors) to other entities. The Company employs X full time employees and X part time employees to carry on the business, and does not provide personal services. The main variable expense of the business (the Contractors’ wages) has a direct relationship to its income producing activity. The Company extends credit, with debtor days averaging 30 days. Therefore, the earnings/accrual method is the most appropriate method of reporting income in your case. | Detailed Reasoning - Detailed reasoning: Subsection 6-5(4) of the Income Tax Assessment Act 1997 (ITAA 1997) states: (4) In working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct. The adoption of an appropriate method to determine when the income is derived under Sections 6-5 of ITAA 1997 in a relevant year of income is an issue of practical concern to taxpayers. The two commonly used methods of determining when income is derived are the receipts/cash method and the earnings/accrual method. Taxation Ruling TR 98/1: Income tax: determination of income; receipts versus earnings (TR 98/1) provides guidance on choosing an accounting method. According to TR 98/1, the sole test for determining which accounting method should be used is its “appropriateness”. Paragraph 18 of TR 98/1 provides that the receipts/cash method of accounting is likely to be appropriate to determine: ● income derived by an employee ● non-business income derived from the provision of knowledge or the exercise of skill possessed by the taxpayer ● business income where the income is derived from the provision of knowledge or the service of skill possessed by the taxpayer in the provision of services Paragraph 39 of TR 98/1 lists the factors that weigh against the receipts method and in favour of the earnings method: ● the commercial and accounting principles and practices governing accounts kept by companies generally require the accruals (earnings) method of bookkeeping; and ● a company generally relies upon employees; it is not able to provide personal services. In this case, the taxpayer is incorporated as a company, with a sole Managing Director. The Company employs various other permanent full time staff, and X part-time staff. The operations of the Company resemble that of a “business”. It relies on its employees and the existing business structure for generating its income. The Company is not providing personal services. Paragraph 45 of TR 98/1 provides further guidance for determining whether the income generated by a business is personal services income. The presence of any factors listed under Paragraph 45 to a significant degree would indicate that the earnings method may be more appropriate: (a) the taxpayer's income producing activities involve the sale of trading stock; (b) the outgoings incurred by the taxpayer, in the day to day conduct of the business, have a direct relationship to income derived; (c) the taxpayer relies on circulating capital or consumables to produce income; or (d) the taxpayer relies on staff or equipment to produce income. According to the information provided by you, the Company’s most significant expenses are the wages and the employment-related expenses paid to the Contractors (84% of the total turnover). As the provision of casual labour is the main service the Company provides to its clients, the Contractors’ wages have a direct relationship to the income derived. Therefore, the Company’s situation matches the circumstances described in subparagraphs 45 (b) (the outgoings have a direct relationship to income) and 45 (d) (the taxpayer relies on staff to produce income) of TR 98/1. Another factor in favour of using earnings/accruals method is the use of formal procedure for extending credit or collecting debit by a taxpayer . According to Paragraph 57 of TR 98/1, where a taxpayer has formal procedures for extending credit and collecting debts, the earnings basis is likely to be the more appropriate accounting method. The facts of your case state that the Company’s debtor days average 30 days. No other information has been provided regarding the Company’s credit and collection policy, however. However, the Company does extend credit, therefore, accruals is a more appropriate accounting method in this case. In support of your argument for using receipts/cash method, you have quoted paragraph 39 of TR 98/1, stating that a substantially correct reflux of a company’s business would be given by the earning method except where that method was an ‘artificial, unreal and unreasonably burdensome method of arriving at the income derived’. TR 98/1 includes Example 6 (paragraphs 77 – 81), which serves as a good example of the case where the use of the accruals method would be “artificial” and “unreasonably burdensome”: Example 6 77. Roger is the sole shareholder, director, and employee of a company. Roger's company owns and hires out a backhoe. The business rents the backhoe out at a fixed rate per hour. The rate is for the backhoe and Roger's labour. The business never rents the backhoe out separately. For the purposes of taxation, the company has always returned the income from its business on the basis of cash received. 78. The company derives income through the efforts of its employee; it is also considered that it relies to a significant extent on a capital asset, the backhoe, to derive income. 79. In industry terms, Roger's business has a small annual turnover and he has no related service entities. Roger's business does use some circulating capital and consumables, such as tyres, petrol and registration. However, unlike trading stock that directly produces assessable income, expenses of this type, while necessary for the income producing activity carried on, do not directly produce income. 80. The business does not usually extend credit and requests payment on completion of a job. The company maintains simple books of account, recording income when received. Also for purposes other than taxation (e.g., under the Corporations Law) the business records income on a receipts basis, although the business accounts do record debtors and creditors. 81. The answer in this example is not straightforward because of the reliance on a significant capital asset and the existence of a corporate structure that usually suggests the earnings method is the more appropriate method of accounting. However, having regard to all of the circumstances relevant to the company management and ownership and the way it conducts its income earning activities it is considered that, on balance, for the purposes of taxation the earnings method is an artificial, unreal and unreasonably burdensome method of arriving at the income derived. Accordingly, the receipts method is the more appropriate method for the company to determine its business income. In your case, the business falls into the small business market segment. The Company does not provide personal services to its clients, but rather relies on the skills and knowledge of various employees. The main variable expense of the business (the contractors’ wages) has a direct relationship to its income producing activity. The Company extends credit, with debtor days averaging 30 days. Therefore, on the balance of all the above factors, the earnings/accrual method is the most appropriate method of reporting income in your case.