Lecture Overview

Income definition

Capital vs. revenue
Topic 5 – why important to make the distinction
– principles derived from case law
(A) Capital and Revenue
Using income as the tax base
(B)Income Statement For Tax – economist’s view
Returns – accountant’s view
– capital gains tax debate

Financial vs. tax accounting
– why the difference
1 – how different are they 2

INCOME DEFINITION CAPITAL V REVENUE

Income is not defined in the Income Tax Act
Why do we need to identify the distinction?
2007 (or previous Acts)
New Zealand:

CIR v Boyton (2001) – In terms of receipts
• Capital is generally non-taxable;

How to decide what is income? • Income/revenue; liable for income tax;
– Implied in the Act • income generally excludes capital;
• some capital gains may be taxable -“circulating capital”
– Normal usage - e.g.dictionaries e.g. capital gains from the sale of land purchased with
– Judicial interpretation - ordinary concepts and intention for resale)
usages of mankind – In terms of expenditure
– Recap Topic 4 • deductions for capital outgoings are generally not
deductible

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

Economists’ view
What is capital?

– capital: – An item of wealth or an asset capable of
• tree; producing wealth e.g. buildings, land,
• a reservoir supplied from springs. investments.. the “tree”
– Income is – Nature of “fixed capital”
• fruit/crop;
What is income?
• outlet stream to be measured by its flow over – The “fruits or crop”; rent, interest,
time;
dividends…derived from the above are income
• not a gain accruing to capital;
– Nature of “circulating capital”
• not a growth or increment of value;
Case Law
CIR v McKenzies NZ Ltd (1988)

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

Court of Appeal held it is capital
Other Tax Cases

CIR v Fraser (1996) 17 NZTC 12,607
-inducement payment
-character of receipt important

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

Income = increase in economic power

That is net accretion in wealth plus
consumption during the period in
question
Case Law
CIR v Inglis (1992)

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
INCOME AS A TAX BASE

Most complex and controversial

Impact of economic, accounting and
legal principles
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
ECONOMIC INCOME INCOME: Accountant’s view
Value at Value at Increase or
begin end decrease
Cash $500 $400 ($100)
‘inflows or other enhancements, or
savings in outflows, of service potential
Shares 1,000 9,800 8,800
or future economic benefits in the form
Increase in 8,700 of increases in assets or reductions in
net worth
liabilities of an entity...result in an
Consumption 17,600
exp. increase in equity’
Economic $26,300
GAAP - income measured on basis of
Income
completed transactions

ACCOUNTING INCOME DIFFERENCES

S a la ry $ 1 5 ,0 0 0
ECONOMIC
ACCOUNTING

Needs valuation
realisation concept
F ees $ 2 ,0 0 0

Subjectivity
historical cost
L ess: 400

Unrealised
conservatism
ex p en ses
1 ,6 0 0 gains/losses
objectivity

Includes gifts,
matching expenses
D iv id e n d s 900
inheritances, with revenue
A /C $ 1 7 ,5 0 0 bequests
In c o m e

Arguments Capital as a Tax Base

New Zealand:

Economist’s approach
– too impractical – No specific capital gains tax;
– difficult to apply – Tax Review 2001: current income tax base
– lack objectivity and accuracy includes a wide range of changes in value of
assets and liabilities;
– measurement of taxable income;
– Capital gains tax, as used overseas, is a
‘monetary’ v ‘real’ income
transactional tax on disposal of assets:
encourage tying up of assets unproductively
to avoid tax.
Capital as a Tax Base

Arguments for:
– Equity i.e.
• 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.
– 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.
Capital as a Tax Base

Arguments against:
– Administration problems such as:
• 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?
– Political
• likely to incur bad feeling particularly as proportion of NZers
own their own homes, shares, etc.
• 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?
– Impact on farmers

Income Statement: Accounting v.

Financial v Tax Accounting
Tax

Introduction:
Basic questions:
– Standard income year => “tax year” – Why are they different?
– How are they different?
– Tax year – 31 March

Purpose of Financial Accounting:
– Alignment of corresponding income year to
– Accounting is the “the process of identifying,
a tax year measuring and communicating information to
– Non-standard income year (early or late) permit informed judgments and decisions by users
and accounting balance dates of that information” (Bazley & Hancock, 110.100)
– Profit v net / taxable income:
• Financial v tax accounting – Statements of Concepts for financial reporting
imposed for specific business/economic purposes
– Income returned in ‘prescribed forms’
– Concerned with ‘true and fair view’.

Financial v Tax Accounting Financial v Tax Accounting

Tax accounting methods:
– When income is derived and expenditure

Purposes of Taxation: incurred?
– To raise revenue for public goods and services;
– Cash method
– To encourage certain economic behaviours; • Based on income received
– Redistribute wealth. • Deemed to be derived if amount is credited in account,
etc. (s BD 3)

Principles of taxation: – Accruals method

– Equity; • Based on income earned
– Certainty; • Adopt a method that best discloses taxpayer’s true
income
– Convenience/simplicity;
• Generally considered the appropriate method for
– Economy of collection. accounting for business

Accurate assessment of tax liability
Financial v Tax Accounting

Permanent & timing differences for deferred
tax purposes

Permanent differences result from:
• 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.
Financial v Tax Accounting

Timing/taxable temporary differences
are:
– 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

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