Chapter 4 – Assessable Income
4.1 OVERVIEW
(ITA Part C, Subparts BC, YA & ss BD 1, BD 3)
Not every gain received by you or your business is taxable. The Income Tax Act only imposes tax on taxable income.
4.1.1 - Which income is taxable?
4.2.1 - When is Income Derived?
4.2.2 - Business Income (sCB 1)
4.2.2.1 - How Wide is Your Business Activity?
4.2.2.2 - Common Types of Business Profits
4.2.2.3 - Market Salary – warning
4.2.3 - Employment Income (s CE 1)
4.2.4 - Income from Personal Property Sales (s CB 3-5)
4.2.5 - Revenues from Land (s CC 1)
4.2.6 - Capital Gains
4.3.1 - When Do I Recognise My Income for Tax Purposes?
4.3.2 - Adequate Documentation
4.3.3 - Sale of a Business
4.1.1 - Which income is taxable?
Taxable income does not usually include:
capital gains (related party capital gains and property transactions may be taxable in some situations)
windfall gains such as prizes, gambling wins
gift and estate receipts
modest receipts from a hobby activity
sales of second-hand personal property, for example proceeds of a garage sale or sale of a private vehicle for which no depreciation had been claimed.
Part C of the Act and ordinary concepts established in the Courts determine whether receipts and gains are assessable. Taxable income generally includes:
business profits and profits from commercial activities
income from investments (interest, dividends)
employment income, allowances, bonuses, some annuities and pensions
income from certain property transactions
revenues from land (rental, lease)
service-related payments
For tax purposes, income also includes a range of perhaps less obvious receipts and gains:
Accident Compensation Corporation payments of earnings related compensation
New Zealand Superannuation, income tested benefits and veterans pensions
attributed foreign income from foreign companies or foreign investments in which you may hold an interest
royalties
benefits from money advanced
income subject to the accrual rules (see Chapter 10 on “Financial Arrangements”)
debts owed by you which have been forgiven
most gains on foreign exchange transactions
bad debts recovered
depreciation recovered on the sale of a capital asset
The Income Tax Act (ITA) also provides for a “catch-all” provision, which can bring into the tax net other receipts/ items.
While assessable income includes a comprehensive range of gains and receipts, it does not capture all gains (see discussion below).
4.2 - Application
(ITA Part C & Subpart YA)
4.2.1 - When is Income Derived?
Income tax is payable for the income year in which income is derived or earned. In most circumstances, income is derived at the time the taxpayer obtains a legally enforceable right to receive the income. Often this will occur before the date of actual cash receipt. For example, if a business sells an item of trading stock on credit, the income on sale will be derived for tax purposes at the date of sale.
4.2.2 - Business Income
(sCB 1)
The Income Tax Act states that all profits or gains from a business or commercial activity are assessable. This appears to be relatively straightforward. A retailer selling trading stock generates assessable income. Businesses in the service industry generate assessable income when they perform services. However, not all gains and receipts derived by businesses are assessable. Capital gains derived by a business are generally not assessable. Refer to the discussion on capital gains to follow.
4.2.2.1 - How Wide is Your Business Activity?
You may operate a business and wonder if all of your transactions are business transactions.
Example
A sole trader has a business that owns a motor vehicle, employs a few people and carries out car repairs. In their private capacity, the owner of the business owns a couple of vintage cars and often spends Sunday afternoons doing up the vintage cars. Let’s say that one of the vintage cars is sold. The vintage car is an asset held outside the business. The sale of the vintage car is not a business transaction. This activity is a hobby and the receipt is not taxable. However, if the person concerned had an established pattern of doing up and selling vintage cars, the gains may be taxable as assessable gains from an additional commercial activity.
4.2.2.2 - Common Types of Business Profits
Common types of business profit include:
all sales of trading stock by wholesalers and retailers
all sales of manufactured goods by manufacturers
profits earned by service providers when providing services
personal property sales when the property was acquired for the purpose of resale. For example, all gains made on shares acquired for resale will be assessable
4.2.2.3 - Market Salary – warning
The IRD has been on the trail of taxpayers who use companies to limit their salaries and avoid paying the top marginal tax rate. Market rate salaries have been imposed using the tax avoidance provisions.
NOTE
Penny and Hooper: In a landmark case, the IRD won a Supreme Court appeal against two Christchurch surgeons who had each set up companies to buy their individual practice. They then employed themselves in the 2002, 2003 and 2004 tax years at salaries the IRD considered were not market-related, being artificially low. The IRD took the view that this was tax avoidance.
The court found that the surgeons should not be allowed to structure their pay with a “more than merely incidental purpose of obtaining a tax advantage, unless that advantage was in the contemplation of Parliament.”
Since then, the IRD has recovered millions of dollars pursuing others who restructured their affairs artificially with a “more than incidental purpose” of saving tax.
If this affects you, discuss it with your tax advisor.
4.2.3 - Employment Income
(s CE 1)
If you are an employee and receive cash remuneration in respect of your employment it is almost certain that your receipts are assessable income.
The following receipts made in relation to an employee’s position are assessable income:
salary and wages, including commissions and paid overtime
employment related allowances (See Chapter 26)
bonuses and gratuities
compensation for loss of employment
any other benefit in money (in relation to services)
inducement and restraint of trade payments. See Chapter 26 on “Employment Responsibilities”.
In practical terms, nearly all payments made by an employer to an employee will be assessable income.
A major exclusion from employment income is the payment of non-taxable reimbursements and non-taxable reimbursing allowances to employees. See Chapter 26 “Employment Responsibilities” for further details on these payments.
4.2.4 - Income from Personal Property Sales
(s CB 3-5)
Gains on the sale of personal property, e.g. shares, motor vehicles, boats and collectibles will normally be taxable if you acquired the property with an intention or purpose of resale, are in the business of dealing in such property, or the sale is part of a profit making undertaking or scheme. If the assets have been acquired to be used in your business as a fixed asset then the gain on sale may be a capital gain (non-taxable) but there may be depreciation recovered (taxable - See 6.2.10.1).
Real Estate Transactions
These are subject to specific taxation rules and are covered in detail in Chapter 9 “Real Estate Transactions”.
4.2.5 - Revenues from Land
(s CC 1)
Rental returns received from leasing out land and buildings are assessable. Other assessable receipts derived by a person with an interest in land include:
all fines
all premiums
all other revenue (including site goodwill, benefit from any statutory licence or privilege)
For example a landowner may receive key money in return for granting a lease to a tenant. This receipt would be assessable to the landowner.
4.2.6 - Capital Gains
Not all receipts and gains are taxable. How can you tell a taxable gain from a non-taxable gain?
Example
A long-term share investor invests for dividend return. After a period of say five years, the investor decides to sell the entire share portfolio. This transaction turns out to be very profitable, earning a gain on sale of $50,000. As you would expect, the dividends earned over the year are taxable. But what about the gain on sale of shares? Is the gain an assessable or non-assessable gain?
An old tax case, Eisner v Macomber provides a useful guideline for distinguishing between assessable income and non-assessable capital gains. The judge referred to an apple tree laden with fruit. Assessable income is like the fruit or the produce of the tree. The capital is the actual tree itself.
Applying this analogy to our share investor, we conclude that the dividends (the fruit of the tree) are assessable and the gain on sale of shares (sale of the tree) is a non-taxable capital gain. Capital gains have some other identifying features. These include:
capital gains are usually generated from the sale of fixed assets or other substantial assets used in the running of the business or generating income
capital gains are derived from transactions that occur infrequently. This can be compared to trading stock transactions that are regular and frequent and generate assessable income
capital gain transactions are often derived from the sale of assets that have been held for longer-term purposes
The distinction between capital gains and assessable income can be further clarified by considering the following examples:Let’s look at the tax consequences for the long-term share investor in the example above. While the dividends are clearly assessable, gains made on the occasional sale of shares are likely to be non- assessable capital gains. This is because the shares were not purchased with the intention of resale and the sale and purchase activity is confined to an occasional and infrequent rationalisation of the share portfolio.
Compare this to someone who frequently buys and sells (trades in) shares. This activity earns both dividend income and profits on sale of shares. The dividend is clearly assessable, but what about the gain on sale of shares? Because the shares are purchased as part of a trading operation, and for that matter, purchased with an intention of resale, the gains are assessable.
4.3 - Practical Hints
4.3.1 - When Do I Recognise My Income for Tax Purposes?
This is an important taxation issue for business.
Example
On 30 March (one day prior to balance date) you sell goods to the value of $5,000 on 1 month’s interest free credit. You actually collect payment on this sale in April (i.e. the next financial year). Should your income on sale be recognised in the year ended 31 March when the sale took place or in the subsequent year? Clearly, this has an effect on tax payments due.
As a rule of thumb:
Income is deemed to be derived when the income earning process has been completed
When you sell goods or services for cash, income is deemed to be derived at the date of sale
When you sell goods and services on credit, income is usually derived at the date of sale (notwithstanding that cash may be collected some time after). The Tax Authorities will generally review this matter closely in a tax audit. In our example above the $5,000 sale will be assessable in the earlier financial year when the sale took place.
Where your business receives payment now for goods and services to be provided over a future period, it may be possible to argue that your income is not earned until the goods are supplied or the services performed in that period. A “classic tax case” involved a dance teacher who received advanced “payments for the next 10 lessons” At year end, the teacher had received payment but had not provided lessons. It was held that the income had not been earned until the lessons were provided. Significantly, the dance teacher had occasionally refunded fees where lessons were not taken. However, there was no obligation to do this.
If your business earns income from long-term construction contracts, it may also be possible to defer your income on a percentage of completion basis or in some cases until the contract has been completed
Barristers and doctors are the only professionals who are able to recognise income on the basis of cash received rather than services billed
If you believe that you have received payment in advance of goods or services being provided, then seek specialist advice on the appropriate income recognition policy to adopt.
4.3.2 - Adequate Documentation
The question of whether a gain on sale is an assessable or a non-assessable gain is often resolved by considering relevant facts. The Department will often dispute a taxpayer’s assertion that gains are tax-free capital gains. The taxpayer must always be in a position to disprove the Department’s assertions. It is essential that your transaction documentation supports the tax treatment adopted.
Example
If you acquire a residential property for long-term rental purposes, your correspondence with solicitors, banks and real estate agents should reflect this fact. If some years later, for some unforeseen reason, you are required to sell this property and you derive a gain, your initial purchase documentation will support your treatment of the gain as a capital receipt.
4.3.3 - Sale of a Business
When selling your business, important capital gains issues arise. If a company conducts your business, the sale of shares in that company to the purchaser is likely to generate a capital gain for you, the vendor. The purchaser is most unlikely to obtain a deduction for any part of the purchase price.
If you do not own a company and are selling your business or are selling the business assets of the business, careful tax planning is required.
Example
The purchaser may pay an amount for goodwill relating to the business. This receipt is likely to be a capital gain to you, the vendor. In contrast, amounts paid by the purchaser for trading stock and other revenue items may create assessable income to you, the vendor. Amounts paid by the purchaser for fixed assets of the business may create taxable depreciation recoveries for the vendor. It is important that both vendors and purchasers seek professional assistance prior to entering into a sale and purchase contract.