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The Income Tax Assessment Act 1936 (the ITAA 1936) and the Income Tax Assessment 1997 (the ITAA 1997) are the main income tax laws in Australia. The ITAA 1936 was regarded to be complex and unwieldy and be rewritten and reconstructed into the ITAA 1997 by the Tax Law Improvement Project (TLIP). However this rewritten process does not end.
This essay analyses several rules of the ITAA 1936 and the ITAA 1997 which covers income tax for the employee, the company and its directors and shareholders.
Firstly, this essay identifies four kinds of taxpayers. Secondly, after clarifying the several key concepts, such as the assessable income, the ordinary income and so on, and stating their relationships with each other, this essay analyses the case and calculates the assessable income for each taxpayer according to the relevant rules of the Income Tax Assessment Act. Finally, this essay makes some suggestions about how to better plan the family's income taxes.
Who the taxpayers are
According to Section 4.1 of the ITAA 1997, every individual, company and some other entities, which are stipulated in the Division 9, should pay income tax.
Snow White Cleaning Pty Ltd. (the Snow White) is a taxpayer because it is a company and received income by offering the cleaning service according to Section 6.5 of the ITAA 1997.
Mary is a taxpayer because she received income by being the employee of the company and getting salaries for her cleaning service according to Section 6.5 of the ITAA 1997. Besides, under Section 12.35 of the Pay As You Go withholding system (The PAYG withholding system) in SchÂ 1 to TAA, salary and wages are assessable.
Mary and her husband Rory are taxpayers because of two reasons. Firstly, they received income by being the directors of the Snow White. Secondly, they are the shareholders of the Snow White, should pay tax for their dividends according to Section 44(1) of the ITAA 1977.
Assessable Income of each identified taxpayer
According to Section 4.10(2) of the ITAA 1997, multiplying the taxable income and the relevant rate and minus the tax offsets equals the income tax. According to Section 4.15(1), the assessable income minus the deductions equals the taxable income. So calculating the assessable income is an important step when calculating the final income tax. So before ascertaining and calculating the assessable income of each identified taxpayer, we should firstly find out what the concept "income" means.
In Scott v FCT, the judge held the concept of income should be defined within the usages of the ordinary people, although the statute could stipulated some exceptions or special rules  . So the Section 6.1(5) of the ITAA 1997 distinguishes two types of the income: the ordinary income and the statutory income.
The Section 6.1(5) of the ITAA 1997 also applies another classification which divides the income into three types: the assessable income, the exempt income and the non-assessable non-exempt income. Both the ordinary income and the statutory income could be one of the three types discussed above, but could not be two or three of these three types at the same time.
According to Section 6.5(2) of the ITAA 1997, when the taxpayer is an Australian resident, the taxpayer's assessable income includes the ordinary income no matter where the income comes from and how the income comes from. Also there are several statutory income should be assessable according to Section 6.10 of the ITAA 1997 with a list of these statutory income in Section 10.5 of the ITAA 1997.
Mary as the employee
Mary received a salary of $75,000 from the Snow White. The Section 6.5 of the ITTA 1997 provides that ordinary income is included when calculating the assessable income. Mary is an Australian resident, and should pay taxes for her ordinary income no matter where the income has been derived from. Obviously, the salary the employee received should be regarded as ordinary income and assessable.
Besides, the Snow White was not any particular entity such as charity, public educational institution and so on in Section 11(5). It was the salary which was not interest on infrastructure borrowings and so on in Section 11(10). The salary was not any scholarship or educational allowance in Section 11(15). So the salary was not any type of exempt income stipulated in Section 11(5), 11(10), and 11(15). The assessable income was $75,000.
Mary and Rory as the directors
Mary and Rory each received the directors' fees of $10,000. The directors' fee was just another example of ordinary income and was assessable. The assessable income was $10,000 each.
Mary and Rory as the shareholders
Mary and Rory each received a fully franked dividend of $10,000. The ITAA 1997 stipulates the concept of dividend in Section 44(1) and the frankable distributions and some exceptions in Section 202.40(2).
In MacFarlane v FCT  , and in FCT v Condell  , the judges both regarded when judging the dividend was whether assessable or not, it was critical to find where the company's fund came from. In this case, the company's revenue came from Manningham Secondary College, which means the dividend comes from Australia, so the dividend was assessable.
According to Section 207.20(1), when calculating the shareholder's assessable income, the cash distribution and the franking credits should both be considered. In this case, the imputation credit is $4,286 (fully franked dividend $10,000* company tax rate 30%/70%). The imputation amount is $4,286.
For Mary, the taxable income is $89,286 ($4,286+ salary $75,000+ director's fee$10,000).
For Rory, the taxable income is $14,286 ($4,286+ director's fee$10,000).
Snow White Cleaning Pty Ltd
There is another question about the differences between the income and the capital gains when deciding the character of some receipts. In FCT v Dixon, the judge held receipts received regularly or periodically will be more likely to be ascertained to be assessable income  . However, the judge in Prendergast v Cameron held a different view holding that the income might be paid at a time and the capital gains might be paid by way of installment  . In this case, the Snow White received the receipts for providing cleaning service rather than selling assets such as land, buildings and so on. More importantly, the Snow White received the receipts periodically, which is $120,000 a year over 3 years, meaning the Snow White should continue providing cleaning service for the consecutive three years. Besides, there were also other small contracts. Considering the above three points, the receipts are more appropriate to be decided as the income.
According to Section 6.5 of the ITAA 1997, the revenue the Snow White received from providing services was ordinary income and should be assessable. So the Snow White's assessable income was $152,000 ($120,000+2*$16,000).
More effective tax planning
There are several means to help Mary rearrange her affairs and lower her, her husband's and her company's taxes.
However, tax planning will be risky because the border between the tax planning and the tax evasion is not absolutely clear. Sometimes the taxpayer's intention could be considered. In Fletcher v FCT, the judge gave weight to the taxpayers' intention when deciding whether an anti-avoidance provision applies  . So when applying following tax planning techniques, it is suggested to obtain legal advice form counsel, just like in Tip Top Dry Cleaners Pty Ltd v Mackintosh  .
Choice of entity: Partnerships rather than company or limited partnerships
Mary could choose partnerships rather than company to run her cleaning business. The advantages of partnerships are as follows.
The two owners of the Snow White are all in one family. If the family runs the cleaning business through partnerships, they pay individual income taxes. This year the revenue of the Snow White was $152,000. Mary and Rory each received $76ï¼Œ000 ($152,000/2) and the assessable income was $76,000 which was less than $89,286. So, the partnerships could save more taxes from the partnerships view.
If the partnerships get losses, the individual partners could offset losses against their other income. Company or limited partnerships could only offset losses against the future income of the company (sometimes including the parent company in a consolidated group) or the limited partnerships, and the shareholders of the company or the individual partners of the limited partnerships could not enjoy the offset. As the Snow White was founded after 2008, which means it is vulnerable to losses. So the partnerships will be more appropriate for Mary.
Besides, if the Snow White disposes of assets of partnerships, the partners that are Mary and her husband could enjoy 50% CGT (Capital gains tax) discount under some conditions according to Part 3.1 of the ITAA 1997.
However, if the couple chooses the partnerships, Mary will not be the employee of the Snow White. Because in Ellis v Joseph Ellis & Co, the judge regarded one could not be both the employer and the employee at the same time  .
Choice of tax system: small business entity rather than standard tax system
According to Subdivision 328(c) of the ITAA 1997 and Section 328.110(1), (4), if the "aggregated turnover" of an entity was less than $2 million last year, was likely to be less than $2 million at the beginning of this year, and turned out to be less than $2 million at the end of this year, the entity was a small business entity. In this case, the "aggregated turnover" of the Snow White was obviously less than $2 million in the recent two years.
If the Snow White chooses to apply the small business system, the Snow White will enjoy a wide range of tax concessions, such as the CGT small business concession which stipulated in the Division 152 of the ITAA 1997.
Other tax planning
There are other means to help Mary and her family to plan their taxes. For example, one of them is maximize and accelerate deductions. However, when using this technique, the taxpayers should keep the relevant written evidence about deductible expenses according to Division 900 and Division 28 of the ITAA 1997. Otherwise these expenses will not be deducted.
The ITAA 1997 stipulates different tax regimes for different entities and different income. How to choose the most appropriate tax plan is various from one entity to another.
As to this case, this essay regarded it is more appropriate for the family cleaning business to choose partnerships instead of company or limited partnerships because of three main reasons. Firstly, the partnerships could operate like an income splitting device and secondly, transfer the loss from the partnerships to the individual partners. Thirdly, the family may possibly receive 50% CGT discount when disposing of assets of partnerships.
However, there are disadvantages about the partnerships. One of them is the partner and the employee could not be the same person at the same time.
In addition to partnerships, this essay suggests to apply the small business regime, rather than standard tax system, and maximize and accelerate deductions. When applying these tax planning techniques, the tax payers should be careful because there are vague areas between tax planning and tax evasion. The best way to defense the tax planning risk is to obtain legal advice form counsel.