Introduction

[12.1] The distinction between two regimes of tax accounting, the first identified as receipts and outgoings accounting and the second as specific profit or loss accounting, was drawn in [11.7]ff. above. Specific profit or loss accounting is different from the financial accounting that might be called overall profit or loss accounting. Overall profit or loss financial accounting is the process of determining the positive or negative balance of the profit or loss account for an accounting period. The parallel in tax accounting is the process by which allowable deductions (which may be outgoings or specific losses) are subtracted from assessable income (which may be receipts or specific profits) to bring out a figure of taxable income for the tax accounting period identified as a year of income.

[12.2] Receipts and outgoings tax accounting is the generally appropriate method of accounting where the taxpayer is engaged in a continuing business. Some transactions of a continuing business will however call for specific profit or loss accounting. It is explained in [11.7]-[11.11] above that the cost of a non-wasting revenue asset is not an outgoing, and the item of gain or loss that may be assessable income or an allowable loss is the positive or negative balance of proceeds of realisation of the asset over that cost. At least this is so where the Assessment Act has not provided that the cost is an outgoing and the proceeds are income. It has done so in regard to trading stock of a business, though with some confusion of analysis. There is an express provision in s. 51(2) intended to allow the deduction under s. 51(1) of the cost of trading stock and it is an appropriate inference that proceeds of realisation are income in the whole of their amount. The effect of the trading stock provisions is to force accounting for trading stock into a special framework of receipts and outgoings accounting, which brings about tax consequences which generally accord with specific profit or loss accounting, though there are important differences. Those differences are mentioned at appropriate points in the present discussion of specific profit or loss accounting, and are developed in more detail later in Chapter 14 below.

[12.3] Not all revenue assets of a continuing business are trading stock, and in regard to assets that are not trading stock specific profit or loss accounting is the appropriate regime. Thus, for example, the regime applies in accounting for the transactions in securities of a taxpayer engaged in a continuing business of the kind found by Gibbs J. to exist in London Australia Investment Co. Ltd (1977) 138 C.L.R. 106; for the transactions in securities of a bank or life insurance company; and for the transactions in loans of money entered into by a money lender. And the regime applies to exchange gains and losses on revenue account experienced by a taxpayer. In this instance, the regime extends both to revenue assets and to liabilities on revenue account.

[12.4] Where the taxpayer enters upon an isolated business venture—in the sense of those words when used to identify an aspect of the ordinary usage meaning of income—specific profit or loss accounting will be the appropriate regime. The line that separates a continuing business from an isolated business venture is not definitively drawn. Some want of definitiveness is inescapable. St Hubert’s Island Pty Ltd (1978) 138 C.L.R. 210 may be seen as holding that the taxpayer company was engaged in a continuing business of land development and sale. At least in the implications of the matters treated as common ground by the parties in Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355, the taxpayer company in that case was engaged in an isolated business venture. Yet the line of distinction between the facts of the cases is not very evident.

[12.5] Specific profit or loss accounting is the appropriate regime where a transaction or venture is entered into that may give rise to a profit or loss under either limb of s. 25A(1) (formerly s. 26(a)) or under s. 26AAA. In these instances the accounting will reflect the specific statutory provisions, and the interpretations given to those provisions by the courts.

[12.6] The notion of an isolated business venture suggests a venture which has no affinity with any other ventures in which the taxpayer is currently engaged, in which he has engaged in the past, or in which he will engage in the future. If there is such affinity, ventures each of which would be a distinct business venture if it stood alone, may become aspects of a continuing business to which the generally applicable regime is receipts and outgoings. An illustration may be afforded by the activities of a building contractor. The consequence will be that some expenses will be deductible currently, as buildings are being completed. But the possibility is not excluded that profit or loss accounting may be applicable to each building venture.

[12.7] The assumption in previous paragraphs has been that receipts and outgoings accounting is appropriate only to a continuing business, and that it is not appropriate to an isolated business venture. There will be occasions when receipts and outgoings accounting may offer a more correct reflex of the income of an isolated business venture than profit or loss accounting. The application of receipts and outgoings in these circumstances may be justified as giving the better reflex, in the same way as a choice between accruals and cash accounting, within receipts and outgoings, may be justified. In the circumstances of New Zealand Flax Investments Ltd (1938) 61 C.L.R. 179 receipts and outgoings accounting, tempered in relation to receipts by the principle in Arthur Murray (N.S.W.) Pty Ltd (1965) 114 C.L.R. 314, may give a more correct reflex of income than would be afforded by profit or loss accounting, which would, presumably, have deferred any recognition of income until the completion of the development stage in the farming of the flax.

Specific profit accounting within receipts and outgoings accounting of a continuing business

[12.8] Generally, specific profit accounting within a continuing business will relate to revenue assets that are not trading stock. The costs of acquiring such assets, if they are not wasting, are not outgoings. They are mere outlays, and not deductible under s. 51(1). The costs, none the less, enter the calculation of a profit derived that is income, or of a loss that is deductible. There is a question of what outlays are to be treated as such costs. There will be a derivation of the profit that is income or an incurring of the loss that is deductible at the moment or moments when the specific profit or loss is to be struck. There is a question as to the identification of that moment or those moments.

[12.9] The question of what outlays are to be treated as costs is parallel with the question of what deemed outgoings in respect of trading stock—the deeming arises from s. 51(2)—are to be treated as costs of trading stock. Unless the taxpayer has elected another basis of valuation of the relevant items of stock, the deduction of costs of trading stock that are on hand at year end will be deferred until the year of income in which the stock is disposed of, so that there is, in effect, an accounting for profit. It will be seen in Chapter 14 below that the costs of trading stock of a manufacturer include not only direct costs but also a share of on-costs—the overheads of a business. There are problems, though less acute, in determining the costs of the trading stock of a merchant. The treatment of costs of storage of trading stock may pose such a problem.

[12.10] Revenue assets that are not trading stock will generally be choses in action, for example the investments in the circumstances of London Australia Investment Co. Ltd (1977) 138 C.L.R. 106, and one might expect outlays that are to be treated as costs to be limited to direct costs.

[12.11] The matter of identifying the moment or moments when a profit must be struck is not so easily resolved. In the case of trading stock, what is in effect a profit is struck at one moment—when the item of stock is realised, and there is an amount receivable that is ascertained and is not subject to any contingency (J. Rowe & Son Pty Ltd (1971) 124 C.L.R. 421). At least this is so when the taxpayer is on an accruals basis in relation to business gains, and there may be room for an argument that the trading stock provisions are confined to a taxpayer on an accruals basis. The striking of a profit in relation to an item that is a revenue asset but is not trading stock may depend on realisation and cash receipts. And Thorogood (1927) 40 C.L.R. 454, decided at a time when it was assumed that the trading stock provisions did not apply to land, may support a view that there may be several moments of striking of a profit where cash receipts in respect of an item extend over a period of time. An approach, called a “profit emerging” approach, in one usage of that phrase, may be taken so that there is a derivation of a profit, potentially in an amount receivable, as that amount receivable is received in cash. There is thus a derivation of profit as each receipt of cash occurs in circumstances where the receivable is actually received over a period of time. Alternatively, the profit is derived when the amount actually received comes to exceed cost, and thereafter as each further receipt of the amount of the receivable occurs. It is sometimes said that this approach requires the application of a cash basis in the determination of a specific profit. It will be apparent that cash basis in these circumstances is different from cash basis when the accounting regime applicable is receipts and outgoings.

[12.12] If the striking of a profit depends on a cash receipt it may be asked whether it also depends on all outlays having been made in cash. It would be surprising if the taxpayer could defer the striking of a profit that is income by omitting to pay his debts. At the same time, it might be thought that the receipt of proceeds of realisation of an asset should not be a moment of striking a profit that is income if there is a contingent liability resting on the taxpayer in respect of the revenue asset realised, or the amount of a liability resting on him is not yet ascertained. In circumstances such as in London Australia Investment Co. Ltd (1977) 138 C.L.R. 106 the commission payable to a broker in relation to the acquisition of securities may be the subject of dispute. The commission may not be regarded as a cost of the securities: it may be treated as an outgoing deductible as incurred. But if it is seen as a cost, the striking of a profit would be indefinitely delayed. In these circumstances, the striking of an estimated profit may be proper, the estimate being open to correction by an amended assessment under s. 170(9), though only at the initiative of the Commissioner. The taxpayer, where a correction would favour him, should be given power to compel the Commissioner to amend.

[12.13] The observations so far made in relation to the striking of a profit bear equally on the striking of a loss. Where the trading stock provisions are applicable, what is in effect a loss will arise where the proceeds of realisation are less than the deemed deductible outlays.

[12.14] Where the item is a revenue asset that is not trading stock, a loss will arise and be deductible under s. 51(1) if it can be said to be incurred in “gaining or producing income”. The deductibility of a loss under s. 51(1) was the subject of comment in [5.14]-[5.22] and [10.65]ff. above.

[12.15] The class of revenue assets to which specific profit or loss accounting may be applicable is not confined to assets that are acquired and disposed of in the conduct of business operations. A revenue asset includes a receivable that may be the subject of an exchange gain or loss or a bad debt loss, and there may be a liability on revenue account that can give rise to an exchange gain or loss, or a gain that arises from a relief from the liability. Specific profit accounting in the circumstances is considered in [12.185]ff. below.

[12.16] The discussion so far has been concerned with non-wasting revenue assets. Specific profit accounting may be appropriate to wasting revenue assets. Comment was made in [11.10]-[11.11] above that an outlay on a wasting revenue asset should be treated as an outgoing only to the extent that the advantage that is acquired by the outlay is absorbed during the year of income in the business of the taxpayer. The view thus adopted expresses a general principle that an outlay, though otherwise presently incurred, becomes a deductible outgoing only as it is consumed. If there is a realisation of the asset before the advantage that it gives is totally absorbed, specific profit or loss accounting becomes appropriate. The determination of the amount of the profit or loss will give effect to s. 82, so that an outlay which has already been allowed as a deduction will not thereafter be brought into the resolution of costs and proceeds which is reflected in a specific profit or loss.

[12.17] The effect of the principles thus asserted may be illustrated in relation to spare parts acquired by a business to be used in the repair of assets used in the business—the situation in Guinea Airways Ltd (1950) 83 C.L.R. 584. An outlay on spare parts is not a presently deductible outgoing. There is as yet no using up of the advantage that the spare parts afford. For this reason it would be argued that the view expressed by Latham C.J. in Guinea Airways, that an outlay on spare parts is deductible when incurred, should be rejected. If a spare part is used in effecting a repair, there will be a deduction of the outlay as an expense of the repair. The outlay at this time becomes an outgoing consumed. If the spare part is realised in a business disposition, there will be a profit that is income to the extent that proceeds exceed costs, or a loss that is deductible if the proceeds are less than cost. If the taxpayer is deprived of the spare parts by an event that is relevant to the business operations, as in Guinea Airways, there is a realisation which will give rise to a profit or loss that is income or deductible. If a receipt is generated by the event—for example, an insurance receipt—that receipt will enter the calculation of the profit or loss. If there is no receipt, there will be a loss in the amount of the cost of the spare parts. This, it would be claimed, is a preferable analysis to what may appear to have been suggested by Kitto J. in Guinea Airways, an analysis that would regard the deprivation as involving a “gross loss” which, it is said, is the “loss” to which s. 51(1) refers. “Gross loss” would describe the value of the item of which the taxpayer has been deprived. To give the taxpayer in a Guinea Airways situation a deduction of this amount would be to confound principle, unless an item of income were first recognised in the amount of the excess of the value of the spare parts at the time of deprivation over their cost. It is not clear that Kitto J. did intend such an analysis. Other observations in his judgment are consistent with the view taken in this Volume that the “loss” referred to in s. 51(1) is the failure of an asset to realise its cost.

[12.18] Specific profit accounting within a continuing business will be appropriate where a taxpayer engages in ventures which are repetitive and in their totality are of a sufficient scale and sufficient system to amount to a continuing business of engaging in such ventures. The fact that any one of several ventures, if it stood alone, would not be an isolated business venture, a profit from which would be income by ordinary usage, does not preclude a conclusion that the totality of ventures amounts to a business and a specific profit arising from each venture is income. Where a taxpayer is held to have engaged in a business of gambling, he will derive income in the form of specific profits on gambling transactions and be allowed deductions for losses. An isolated gambling venture would not be an isolated business venture that could produce a profit that is income or a loss that is deductible.

[12.19] The fact that a venture is an aspect of a continuing business does not require that receipts and outgoings accounting must be applied to the exclusion of specific profit accounting. Which is not to say that it may not be appropriate to apply receipts and outgoings in a particular case, because it will give a better reflex of income. Whether specific profit accounting, or receipts and outgoings accounting already applicable in other respects, is appropriate to the contracts of a builder will depend on the nature of the individual contract, and it may be proper to apply specific profit accounting to some contracts, while others are governed by the generally applicable receipts and outgoings accounting. In this area specific profit accounting is not dictated. The outlays are not costs of non-wasting revenue assets.

[12.20] It will be seen in [12.37]ff. below that where a specific profit accounting is applied to an isolated business venture, no distinction is drawn between costs that are currently deductible as outgoings, and costs that enter the determination of the specific profit. All costs enter the determination of the specific profit. Where specific profit accounting is applied to a venture within a continuing business there will be outlays that are outgoings and currently deductible. In the result there will be a need to distinguish costs that are to be treated as costs of a venture, and costs that are currently allowable outgoings. Drawing the distinction raises questions of the kind already considered in relation to a continuing business that acquires and disposes of revenue assets.

​Accounting for a loss

[12.21] Accounting for a loss where a revenue asset of a continuing business is realised depends on the answers to questions of principle of a fundamental kind. In [10.273] above it was said that an acceptable rule might assert that where there is a continuing business a loss is deductible in circumstances where a profit would have been assessable income. The rule assumes that the realisation of the revenue asset was an act done in carrying on the continuing business. Where the realisation is not in the carrying on of the continuing business, it is arguable that there is an abortion of the business purpose in relation to the asset realised and there can be no profit that is income or loss that is deductible arising from the realisation. There is some authority that where revenue assets are sold in a disposition of the business, or in a sale that is made in immediately putting an end to the business, no profit that is income or loss that is deductible can result (C. of T. (W.A.) v. Newman (1921) 29 C.L.R. 484), but there is no authority that would support the argument in its widest application.

​Accounting on a disposition not in the ordinary course of business

[12.22] Section 36 has been included in the trading stock provisions to ensure that an amount, being the market value of the asset, is included in assessable income in circumstances where there is an abortion of business purpose by a disposition of trading stock otherwise than in the ordinary course of carrying on the business. Section 36 is demanded by the trading stock provisions which allow a deduction of the cost of an item of trading stock, in effect at the time when the item ceases to be “on hand”. The notion “on hand” does not require any element of carrying on business in the event by which the taxpayer ceases to own the item.

[12.23] In the present context of the realisation of revenue assets that are not trading stock, the law could tolerate a view that would treat a realisation other than in carrying on the business as not productive of a profit that is income or a loss that is deductible. But the virtue of such law may be doubted. Sharkey v. Wernher [1956] A.C. 58 is a United Kingdom authority which could appropriately be adopted. The case concerned what may be seen as only a notional realisation—the taking of a revenue asset from a business and the use of it for private purposes. The principle requires that the realisation be treated as a realisation at market value. In subsequent United Kingdom decisions the principle of the case has been applied to an actual realisation not in the ordinary course of carrying on the business. At the same time it has suffered a restriction by the decision in Mason v. Hammond Innes [1967] 2 W.L.R. 479, so that the principle does not apply to a taxpayer who accounts on a cash basis. And, presumably, it does not apply to a realisation in putting an end to business operations.

[12.24] If a Sharkey v. Wernher principle is not adopted as part of the Australian law there will be distortions, which may not be destructive of the integrity of the income tax, but may none the less be considered unacceptable. The extent of the distortion will depend on how much of outlays that relate to revenue assets have been denied deduction. The point was made in [12.8]–[12.10] above that the scope of outgoings that are to be seen as costs of revenue assets and not deductible, may be wider or narrower dependent on whether a direct cost or an on-cost approach is taken. If an on-cost approach has been taken the extent of distortion is at a minimum. If a direct cost approach has been taken and deductions have been allowed of costs that relate to revenue assets, the failure to deem the realisation to have been made at market value will produce a distortion: deductions will have been allowed that are not matched by an item of gain that is income. In theory it might be possible to adopt a principle which would in effect reverse the allowance of the deductions by bringing in as income an amount equal to those deductions. But there are obvious difficulties in identifying those deductions.

[12.25] The Sharkey v. Wernher principle should be adopted and extended to all realisations of property not in the ordinary course of business, whether they are occasional realisations or are realisations in the disposition of the business, or in the disposition of assets in an act of bringing the business to an end. Authorities dealing with dispositions in putting an end to the business should not be followed. The limitation of the principle imposed in Mason v. Hammond Innes should not be adopted. The limitation defeats the function of the principle for no apparent reason. The reason given by Lord Denning for rejecting the principle—that it would extend to a professional artist who paints a picture of his mother and makes a gift of the picture to her—is not persuasive. If he paints the picture in the course of his business it is a revenue asset, whoever sits for the picture, and the Sharkey v. Wernher principle should apply to whomsoever he makes the gift. If he does not paint the picture in the course of his business—if he paints it in filial devotion—the Sharkey v. Wernher principle will not apply, whether he in fact gives it to his mother or to some other person. If he sells the item, there will not be a profit that is income unless the item can be said to have been taken into his business. In which event a deemed cost of the value of the item at the time it was taken in will be a cost in computing the profit. None of the costs of painting the picture should have been allowed as deductions or will be treated as costs of the picture.

[12.26] The operation of a Sharkey v. Wernher principle depends on there having been a withdrawal of the revenue asset from the process of income derivation in which it was held. The taking for a private purpose of a revenue asset of a business, as in Sharkey v. Wernher itself, is one illustration of circumstances to which the principle applies. Another illustration would be the taking of the revenue asset from a business and the holding of it thereafter in a different business of the same taxpayer, or in another process of income derivation, including a s. 25A(1) process. All other illustrations will involve some disposition otherwise than in the ordinary course of carrying on the business. All circumstances to which the principle would apply could be described as partial abortions of a process of income derivation.

[12.27] Section 36 in relation to trading stock has no application to the taking of an item for a private purpose, or the taking of an item from a business into another process of income derivation. In this respect the section may be thought to be deficient. The matter is more closely considered in Chapter 14 below.

[12.28] The notion of a disposition which is not in the course of carrying on a business is a creature of a principle of tax accounting, though it has its parallel in the s. 36 notion of a disposition “not in the ordinary course of carrying on [the] business”, a creature of the words of the Assessment Act. The tax accounting notion has its expression in a number of United Kingdom cases, most important being Skinner v. Berry Head Lands Ltd [1970] 1 W.L.R. 1441 and Petrotim Securities Ltd v. Ayres [1964] 1 W.L.R. 190. In Skinner v. Berry Head Lands an inference that the transaction was not in the course of business was drawn from the “enormous disparity” between the price at which the revenue asset was sold and its market value, and the fact that the sale was made to the taxpayer’s parent company. In Petrotim Securities a like inference had been drawn in respect of a sale at a “gross under-value” by a company to its parent company.

[12.29] Australian authority is concerned with the operation of s. 36. In Pastoral & Development Pty Ltd (1971) 124 C.L.R. 453 at 464, Walsh J. held that a sale of trading stock was at a price “that was an arbitrary one and was so low as to take the transaction outside the category of an ordinary business transaction”. At the same time he observed (at 463):

The United Kingdom cases in the paragraph and the Australian case are concerned with transactions in the course of profit-shifting between associated companies. In Australia, at least, where grouping was not until recently allowed so as to apply the losses of one company against the profits of an associated company, it may have been appropriate to treat profit-shifting between associated companies as action in the course of carrying on a business. Where however a disposition is made not to an associated company engaged in business but to some associated person who will acquire the property for a private purpose, a conclusion that the sale is not in the course of business should be more readily drawn from the circumstances that the sale is for an amount less than the market value of the asset sold. Where the sale is in the course of profit-shifting and it is held to be in the course of business of the seller, the buyer will take the asset with a cost of the price at which the item was sold to him. At least that is the assumption in the United Kingdom cases. And the assumption draws support from the decision of Plowman J. in Jacgilden (Weston Hall) Ltd v. Castle [1969] 3 W.L.R. 839, though there remains room for an argument that so far as there is an element of gift in a sale at an undervalue, that element of gift should be brought to account as a cost in determining the profit of the buyer that will be his income. The matter is more closely examined in [12.78]–[12.88] below. The general principle of tax accounting must be that property that is not received in carrying on or carrying out a process of income derivation, but may be said to have been brought into that process, must be give a cost equal to its market value at the time it is brought in to the process. Where property is purchased in a transaction that reflects an element of gift by the seller, and that element of gift is not received in the process of income derivation, the part of the property that may be said to have been given must be given a cost of the market value of that part. In effect the cost of the whole property to the buyer must be increased to its market value. If the general principle is held applicable to the situation of the buyer, the appropriateness of treating the sale as a realisation at market value by the seller becomes more compelling.

[12.30] The notion of disposition other than in the course of carrying on a business needs to be applied not only in relation to revenue assets, whose disposition is at all times expected in the carrying on of the business, but also to revenue assets that are expected to be consumed in the carrying on of the business—wasting revenue assets—or are expected to be realised by the receipt of payment—receivables on revenue account. A taxpayer who holds import licences which may be expected to be consumed in the carrying on of his business may sell those licences to another. Whether the disposition is in the course of business will be determined by considerations already examined in regard to assets held for disposition. A taxpayer may factor his receivables on revenue account and none the less act in the course of business, though his general practice is to await payment of his receivables. Again the considerations already examined in regard to assets held for disposition will be relevant.

[12.31] The disposition of a wasting revenue asset may give rise to a profit that is income or a loss that is deductible, if it is made in the course of business. The calculation of the profit or loss will be made having regard to s. 82. If the disposition is not in the course of business, there is need of an extended Sharkey v. Wernher principle if there is to be a profit that is income or a loss that is deductible. The Sharkey v. Wernher principle in United Kingdom authority may not go so far. The limitation imposed on the principle by Mason v. Hammond Innes [1967] 2 W.L.R. 479 confines it to situations where the asset in question was held for disposition. The reasoning in the latter case in fact shifts between a limitation in terms of a requirement that a cash basis of accounting is applicable to the taxpayer’s business, and a limitation in terms that the assets must be trading stock.

[12.32] The discussion in previous paragraphs has been concerned with the tax consequences of a disposition of property by way of gift or for an amount less than its market value. There are distinct but parallel issues that arise where there has been a disposition for an amount greater than market value. The disposition may be an aspect of a plan to shift profit from one associated entity to another, so that the profit arises in the entity disposing of property rather than in the entity taking the disposition. Or it may be that the fixing of the consideration at an amount greater than market value is an aspect of a gift intended by the person taking the disposition.

[12.33] One view would be that the disposition at greater than market value indicates that the disposition is not in the course of business, so that there has been a partial abortion of the business operation. The consequence would be that there is no income derived unless some provision prevents the abortion. Section 36 is such a provision, though it might be thought surprising that the section should operate to deem a disposal to have been made for an amount less than the actual consideration. The operation of the section would deny the person acquiring a cost of the actual amount paid: his cost would be limited to the value at which the seller is taken to have disposed. If a Sharkey v. Wernher principle is held to be part of the law and to apply, it would have the same effect.

[12.34] Another view would say that an element of gift by the buyer in a receipt by a seller is not to be regarded as proceeds of sale that should enter the determination of the seller’s profit that is income. The income quality of the element of gift will need to be judged for itself—it may be that it is a product of services preformed by the seller and income in his hands on that ground. The treatment of the price paid to the seller would raise similar issues. A payment for property which reflects a gift made by the buyer may be seen as only in part a cost of the property. Its characterisation in other respects must be determined by the purpose of the payment, and the tax consequences for the buyer will depend on that purpose.

[12.35] This exploration of possible lines of analysis leads back to some of the most intractible areas of income tax law—the effect of McLaurin (1961) 104 C.L.R. 381, and Allsop (1965) 113 C.L.R. 341 in regard to the dissection or apportionment of a receipt and the effect of Europa Oil (N.Z.) Ltd v. C.I.R. (N.Z.) (No. 2) (1976) 76 A.T.C. 6001 and South Australian Battery Makers Pty Ltd (1978) 140 C.L.R. 645 in relation to identifying distinct purposes in a payment and consequent apportionment of an outgoing. An appropriate response would be to say that those cases are concerned with receipts and outgoings accounting, and the present concern is with specific profit accounting in relation to which considerable flexibility is allowed. It is true that receipts and outgoings accounting does apply where trading stock is involved, but in that area s. 36 is available to achieve the same result as profit accounting should allow.

[12.36] It is evident that the operation of the tax system would not tolerate an examination of every transaction in search of a disparity between the price of property and the market value of property. Jacgilden v. Castle [1969] 3 W.L.R. 839, in rejecting the application of the Sharkey v. Wernher principle where there has been a sale and acquisition by an “honest bargain”, sets the limit on the room for examination.

Specific Profit Accounting in its Application to an Isolated Business Venture

[12.37] It is only since Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355, at least in modern experience, that it has been clearly recognised that a gain from carrying out an isolated business venture will be income. There may continue to be doubt whether a loss from carrying out such a venture is deductible. When, in 1930, the equivalent of s. 25A(1) was added to the 1922 Act, it would not have been doubted that the principles established in the United Kingdom expressing the notion of “adventure in the nature of trade” belonged to the ordinary usage meaning of income and were part of the meaning of income for purposes of the Assessment Act. However, the attention given to the former equivalent (s. 26(a)) of s. 25A(1) by the Commissioner’s assessments, and by the courts in their decisions, rather suggested that the provision was to be regarded as a code fixing the meaning of income in isolated venture situations, to the exclusion of that aspect of the ordinary usage meaning concerned with isolated ventures. The principal significance of the decision in Whitfords Beach is a rejection of the suggestion that s. 25A(1) is a code displacing some of the ordinary usage meaning of income. Indeed Gibbs C.J. and Mason J. would relegate s. 25A(1) to a role in determining the meaning of income for the purposes of the Assessment Act which would deny that it applies to any of the field that is covered by the ordinary usage meaning. To some extent their view is dictated by a parallel provisions and two meanings analysis of the structure of the Assessment Act, which in the view of this Volume is an incorrect analysis. But their view can equally be accommodated to a single meaning and central provision analysis. Denying that s. 25A(1) applies to any of the field that is covered by the ordinary usage meaning asserts a conclusion that s. 52 has an operation limited in the same way.

[12.38] The tax accounting appropriate to the determination of a specific profit from an isolated business venture has not been the subject of any detailed judicial examination. In Whitfords Beach the parties agreed that the trading stock provisions were inapplicable, presumably because they did not see the facts as giving rise to a continuing business. The suggestion has already been made that the conclusion in St Hubert’s Island Pty Ltd (1978) 138 C.L.R. 210 that the trading stock provisions were applicable was a conclusion that there was a continuing business. If the trading stock provisions had been treated as applicable in Whitfords Beach, accounting for specific profit would have had no place.

[12.39] The other aspect of the agreement between the parties in Whitfords Beach was that the taxpayer, in determining the amounts of any specific profits arising from the isolated business venture, was entitled to treat the value of the property at the time the venture commenced as a cost. The matter of when the venture had commenced was referred back to the Federal Court and a decision made by that court: Whitfords Beach Pty Ltd (1983) 83 A.T.C. 4277.

[12.40] The inference from the assessments that had been made by the Commissioner in Whitfords Beach (1982) 150 C.L.R. 355, which are referred to in the High Court judgment, is that he did not allow any outgoing deductions. The assumption is that an isolated business venture to which specific profit accounting applies does not have any currently deductible outgoings. All outlays are costs of assets that will be realised and have tax consequences only in the determination of specific profits. It would follow that the expenses of administering the land development were not currently deductible. And interest payments on money borrowed to meet development costs were not currently deductible. The specific provisions of the Assessment Act allowing deductions against assessable income, including the depreciation provisions, may offer some guidance as to what are subtractable costs, but they are not definitive. And provisions specifying the manner of a deduction are not definitive. Thus s. 51(3), requiring payment before a long service leave expense is deductible, does not preclude the subtraction of a provision for such an expense in determining a specific profit.

[12.41] In Whitfords Beach, as land was sold, the tax accounting in Thorogood (1927) 40 C.L.R. 454 became applicable. That accounting brings in profits as parcels of land that result from the development are disposed of. A profit in respect of any parcel will involve a surplus of proceeds over costs applicable to the parcel. The costs applicable will reflect a spreading of costs over all the land involved in the development. There will be questions as to how the spreading is to be done. Observations by Windeyer J. in Elsey (1969) 121 C.L.R. 99 at 110-111, made in relation to a development subject to the second limb of s. 26(a) (now s. 25A(1)), suggest that an average cost is inappropriate save where each parcel is of a relatively uniform kind. Profits will be income as they “emerge”, which in this context may mean as proceeds of realisation are received in excess of costs, or in the proportion that proceeds received bear to proceeds receivable. In the latter situation a calculation must be made of potential profit from a realisation, reflecting the excess of the sale price over costs, and that potential profit will be income in the proportion that receipts bear to the sale price.

[12.42] A number of more detailed aspects are unresolved. The fact that a cost has not yet been the subject of an actual payment should not preclude the striking of a profit. Presumably the liability is none the less to be regarded as a liability on revenue account, that may give rise to a deductible loss, or a profit that is income when it is discharged. There may be an exchange loss or profit, or a profit that is income arising in the circumstances of British Mexican Petroleum Co. Ltd v. I.R.C. (1932) 16 T.C. 570, and despite the decision to the contrary in that case.

[12.43] There may be a liability that is contingent, or the liability may be of an amount not yet ascertained. The point was made in connection with accounting on the realisation of revenue assets of a continuing business ([12.12] above) that the striking of a profit cannot be made to wait until the contingency has occurred or cannot now occur, or until the amount of the liability is ascertained. In these circumstances it was suggested that an estimate must be made of this part of the cost, and a profit struck. The Commissioner will have power, in effect, to correct the estimate by an amended assessment under s. 170(9). The taxpayer, where a correction would favour him, should be given power to compel the Commissioner to amend.

[12.44] Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355 is illustrative of a specific profit from an isolated business venture that concerns the realisation of property of the taxpayer. There may be an isolated business venture where profit is to be made otherwise than by a realisation of property. A building or construction project on the land of another is the obvious illustration. The tax accounting applicable in these circumstances is examined in [12.64]ff. below.

[12.45] Whitfords Beach was concerned with the profits that may arise from an isolated business venture which, it may be assumed, will be carried out to completion. There is thus a notion of a realisation in the course of carrying-out the isolated business venture which corresponds with a notion of realisation in the course of carrying on a continuing business. If a loss arises on such a realisation it will be deductible under s. 51(1). There may however be a particular realisation which is not in the course of carrying out the venture. In which event the question is raised whether the realisation should be treated as a partial abortion of the venture that cannot give rise to profit that is income or loss that is deductible. The principle in Sharkey v. Wernher [1956] A.C. 58 will need a substantial extension of its scope beyond any allowed to it by Mason v. Hammond Innes [1967] 2 W.L.R. 479 if it is to operate. Its operation would be to treat the realisation as having been made for market value, and to treat any resulting profit or loss as income or deductible. However to accept that there has been a partial abortion is the easier in this context than in the context of a continuing business where some deductions of current expenses relating to the item realised may have been allowed.

[12.46] A Sharkey v. Wernher principle could be imagined that would extend to a general abortion of an isolated venture. The assumption of St Hubert’s Island (1978) 138 C.L.R. 210 is that there is no such principle. The importance to the Commissioner of a conclusion that there was a continuing business to which the trading stock provisions were applicable lay in the resulting availability of s. 36. There was no suggestion in the case that the Commissioner might have succeeded in any event by the operation of a Sharkey v. Wernher principle. Indeed the view expressed in dissent by Stephen J. (following Mahoney J. at first instance)—that the land was not yet in such a state that it was trading stock so that the Commissioner could not succeed—impliedly rejects Sharkey v. Wernher where there is a realisation of revenue assets in disposing of a business, or in a disposition that brings the business to an end. Section 36 thus appears as a special provision with a narrow field of operation: it is not backed by a general principle drawn from ordinary usage principles.

[12.47] If there is no Sharkey v. Wernher principle to be applied in circumstances of a general abortion of an isolated venture, there will not be a realisation of profits in a Whitfords Beach situation, if, after some carrying out of development, there has been a liquidation of the company and the taking of the developed land by the shareholders in satisfaction of their rights as shareholders. Nor will there be a realisation of profits in a Whitfords Beach situation if, the market for land having become depressed, the company decides to build houses on the land and hold it as an investment for rental returns. This is to assume that those circumstances would involve a general abortion. It may be arguable that there is no abortion that could involve the present operation of a Sharkey v. Wernher principle. If the land market improves, the company may then decide to sell, and it is arguable that the isolated venture has experienced no more than a suspension. Whether or not there has been an abortion must depend on the definition of the venture. The more particularity there is in that definition, the easier is a conclusion that the circumstances have involved an abortion. The matter is the subject of some comment in relation to the second limb of s. 25A(1) in [3.73] above and is approached again in that connection in [12.49]-[12.50] below.

Specific Profit Accounting in its Application to Section 25A(1) and Section 26AAA Situations

[12.48] Some attention has been given in Chapter 3 above to the tax accounting appropriate to a transaction within s. 25A(1). There is an observation by Kitto J. in Becker (1952) 87 C.L.R. 456 at 467 which suggests a liberality in regard to tax accounting, justified by the word “profit”, which contrasts with the rigidities of interpretation of other words of s. 25A(1). He said:

The tax accounting thus envisaged would be generally consistent with the accounting suggested in [12.37]-[12.47] above, applicable to an isolated business venture. But there may be some differences. The reference to “ultimate sum received” indicates that a profit that is income arises only on actual receipt. It may also indicate a view that there is no profit to be struck until all of the amount receivable has been received, which would preclude the kind of profit emerging approach referred to in [12.41] above. It may not however be appropriate to take the case as deciding that such a profit emerging approach is precluded. The liberality proposed would leave room for choice of an approach that will best reflect income. Yet there are problems associated with a derivation of profit that is income in advance of receipt of the total proceeds of realisation. If a profit is treated as emerging and being derived in the proportion cash received is of cash receivable, there is a question of the effect of a failure of cash receipt in respect of the remaining cash receivable. The receivable is not readily seen as a revenue asset in respect of which a bad debt loss under s. 51(1) may be experienced. In any case, to allow a deduction on the failure of the receivable to realise its remaining amount, would be to produce a distortion in tax accounting. More appropriate would be a reopening under s. 170(9), of the earlier assessments, but that reopening is not a matter of any right in the taxpayer. The initiative is with the Commissioner. Most appropriate would be to allow a deduction of the amount by which the profit that has been treated as already emerged and included in income, exceeds the total profit that has in fact emerged, having regard to the failure of the receivable.

[12.49] The drafting of s. 25A(1) raises special issues in regard to the consequences of an abortion. It would be generally assumed that the profit making process under the first limb cannot be aborted save by a disposition that does not amount to a sale. If there is an acquisition with the relevant purpose, a change of purpose cannot in itself bring about an abortion. The taxpayer may change his purpose to one of holding for investment. When eventually he does sell, there will be an operation of the section if there is a surplus of receipts over cost. Implicit in this analysis would be a surprising consequence. If it be assumed that he gave notice under s. 52(1) after acquisition, he would be entitled to a loss deduction if he sold for a price that is less than cost, even though the sale price had been chosen in a transaction between associated persons so as to bring about a loss. Such a consequence is now, however, precluded by subs. (5)(a) added to s. 52 in 1984.

[12.50] An approach that would recognise that there can be an abortion even though there has been a sale would focus on the word “profit” in s. 25A(1) and the word “loss” in s. 52(1) and assert that there is no profit or loss realised on sale unless the property has been sold in a transaction which does not involve an element of donation given or received. Such an approach would reinforce s. 52(5)(a) in regard to a deduction for a loss. But it would involve the consequence that a taxpayer might resist the inclusion in his income of an excess of proceeds over cost by insisting that he had sold at more or less than market value, in order that he might receive from or make a gift to the buyer. An alternative approach that would avoid such a consequence, would assert that there is no abortion, but the transaction should be seen as the receipt of proceeds to the extent of the market value of the property and the making of a gift by the taxpayer, or a receipt of proceeds to the extent of market value, and the receipt of a gift. Such an approach would achieve for purposes of s. 25A(1) first limb what is achieved for purposes of s. 26AAA by s. 26AAA(4). It will be noted that s. 26AAA(4) in the determination of a profit extends to both a sale at more than market value, and a sale at less than market value.

[12.51] Other aspects of tax accounting in relation to a s. 25A(1) first limb profit, involving the new provisions in subss (2)-(12) of s. 25A, are examined in Chapter 3 above.

[12.52] There are some special issues in relation to tax accounting for a s. 26AAA profit. It would be readily accepted, more especially since Bernard Elsey Pty Ltd (1969) 121 C.L.R. 119 and Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355, that the cost of property in a s. 25A(1) second limb transaction must be the market value of that property at the time it is taken into the scheme, if it was not acquired in the carrying out of the scheme. And, perhaps less readily, it would be accepted that any element of donation by the person from whom property is acquired in a transaction of acquiring property for the purpose of profit-making by sale must be valued and treated as a cost of that property for purposes of the first limb of s. 25A(1). But it may not be accepted that an element of donation by the vendor in a “purchase” for purposes of s. 26AAA should be treated as a cost of the property purchased. There is perhaps room for an argument that s. 26AAA(4) expressly provides in a way that does make the element of donation a cost to the purchaser where that section has operated so as to deem the vendor to have sold at market value. In having provided expressly in this way, the argument would run, the section precludes any operation of a general principle that would treat the value of the element of the donation as a cost. The fact remains that s. 26AAA is concerned with “profit” arising from sale. A taxpayer who acquires property by gift and sells it, might be said to profit by the receipt of the gift but he does not profit by the sale except to the extent that the sale price exceeds the value of the property at the time of the acquisition by gift.

[12.53] A too literal reading of s. 26AAA may give it an operation that will make it incoherent. Section 26AAA(1)(f) provides that the receipt of property on transfer from another without consideration is a deemed purchase. It is said that the transfer of property to a shareholder in the liquidation of a company, or, indeed, in the payment of a dividend in specie, or the transfer of property to a beneficiary by a personal representative in the administration of a deceased estate, is a transfer “without consideration”. When this view is combined with a view that the value of the element of donation in a transfer of property is not to be seen as a cost of the transferee’s acquisition, the shareholder or beneficiary who sells within 12 months of the transfer to him will derive income to the extent of the gross proceeds of sale. The view that the transfer is “without consideration” might be countered by reliance on the reasoning in Howie (Archibald) Pty Ltd v. Commissioner of Stamp Duties (N.S.W.) (1948) 77 C.L.R. 143. Whether or not it can be countered successfully, there is a distinct issue whether a conclusion that the transfer is without consideration carries the consequence that the transferee does not have a cost for the purposes of determining the profit which is his income arising on sale of the property.

[12.54] Section 26AAA(4) has a function which has its parallel in s. 36 or in the principle in Sharkey v. Wernher [1956] A.C. 58. Section 36 and a Sharkey v. Wernher principle preclude the abortion of a process of income derivation by deeming a disposal which is outside the process to be a disposal at market value, a deeming which it is assumed in each instance will bring the disposal within the process. Section 26AAA(4), in combination with s. 26AAA(1)(f), deems there to be a sale at market value where property is transferred from one person to another and those persons in the opinion of the Commissioner were not dealing with each other at arm’s length, and any consideration for the transfer, in the opinion of the Commissioner, is less than the value of the property. It has been seen that there may be doubts about the operation of a Sharkey v. Wernher principle, at least in relation to an isolated business venture, and it presumably has no application to transactions within s. 25A(1). There are in the result significant areas where there can be an abortion of a process of income derivation which will leave the process without any tax consequences if s. 26AAA, in particular s. 26AAA(4), does not operate. The scope of the operation of s. 26AAA is then of major importance. Section 26AAA may operate as a reserve force for the Commissioner where there has been an abortion of a process of income derivation within s. 25A(1). Section 26AAA (5)(a) provides that the principal operative provision of the section, in s. 26AAA(2), “does not apply in relation to a sale by a taxpayer of property if the property was included in the assets of a business carried on by the taxpayer and, as a result of the sale, an amount will be included in the assessable income of the taxpayer of the year of income under a provision of this Act other than this section”. Section 26AAA may therefore operate as a reserve force to bring about tax consequences where abortion has defeated the operation of a process of income derivation involving the carrying on of a business. In the result the relationship between the operation of s. 26AAA and principles expressed in the ordinary usage meaning of income is very different from the relationship between the operation of s. 25A(1) and those principles, at least as the latter relationship is seen by Gibbs C.J. and Mason J. in Whitfords Beach. The operation of s. 26AAA as a reserve force is of course limited by the time span within which a transaction must be completed if the section is to operate.

Receipts and Outgoings Accounting in its Application to an Isolated Business Venture

[12.55] Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355 is a landmark in the history of the income tax in the recognition—it is true only in the agreement between the parties—that specific profit accounting is applicable in relation to events that give rise to income within the ordinary usage meaning of the word. There are occasions still when the assertion is made that tax accounting for purposes of s. 25(1) is distinct from tax accounting for purposes of s. 25A(1). Section 25(1), it is said, is concerned only with the bringing in of receipts—“gross income”. Section 25A(1), it is said, is concerned with a distinct notion of income, one that involves a balance of proceeds over costs. The assertion has been associated with a parallel provisions analysis, and a two, or perhaps multiple, meanings analysis, of the structure of the Assessment Act, analyses that have been rejected in this Volume. The demise of the assertion may in turn bring on the demise of those analyses ([1.31]ff. above).

[12.56] An exclusively receipts and outgoings accounting is possible only when there are no outlays on non-wasting assets, or where the trading stock provisions are applicable to all non-wasting assets. An exclusively specific profit accounting is possible, in theory, in all situations. The law will determine which of possible methods of accounting is appropriate. An exclusively specific profit accounting would presumably never be appropriate to a continuing business. On the other hand, receipts and outgoings accounting, exclusive as far as it can be, may be appropriate to an isolated venture. Receipts and outgoings accounting was adopted in New Zealand Flax Investments Ltd (1938) 61 C.L.R. 179, though the process of income derivation, at least in the period until regular harvesting would have begun, could be seen as an isolated business venture.

[12.57] Specific profit accounting for an isolated venture, if applied in New Zealand Flax would have delayed the derivation of income by the company until the work of establishing the flax plantation and bringing it to the productive stage was complete. At least this would have been so, unless the kind of profit-emerging accounting that may be appropriate to a building contract could have been applied. Profit emerging accounting of this kind is considered in [12.64]ff. below. It may involve the emergence of a profit that would as yet be said to be unrealised.

[12.58] The receipts and outgoings accounting in fact adopted by the High Court in New Zealand Flax lacked the principles now associated with the decision in Arthur Murray (N.S.W.) Pty Ltd (1965) 114 C.L.R. 314. With the principle in Arthur Murray receipts and outgoings accounting might be thought more appropriate to the facts of New Zealand Flax than specific profit accounting.

Profit or Loss “Realised”, and a Profit or Loss “Arising” or “Emerging”

[12.59] There is a financial accounting convention that would assert that a profit should not be recognised until it is “realised”. There is another convention that an impending loss should be “anticipated”. Both conventions reflect a principle of conservatism in accounting—that the profit stated for a period should not mislead investors and creditors by being overstated.

[12.60] The convention that a profit should not be recognised until it is “realised” is reflected in a principle of receipts and outgoings tax accounting that, even though accruals is the basis of accounting, an item is not derived until it is of an ascertained or ascertainable amount, and there is no element of contingency about the right to receive it. The convention that a loss should be anticipated is reflected in receipts and outgoings tax accounting applicable to trading stock: s. 31 allows a taxpayer to value closing stock at market selling value, so that he may by his valuation anticipate a loss in circumstances where market selling value has fallen below cost. It is true that s. 31, contrary to financial accounting convention, also allows the taxpayer to anticipate a profit where market selling value is above cost. It does not, of course, compel an anticipation, and the taxpayer may be expected to make use of the election to value at market selling value if this is above cost only in exceptional circumstances: he may wish to anticipate income so that it might be absorbed by an ordinary loss carried forward that will otherwise be defeated by lapse of time.

[12.61] The principle in J. Rowe & Son Pty Ltd (1971) 124 C.L.R. 421, which would bring in the amount receivable on the sale of trading stock even though that amount is not presently receivable, may be thought to require the anticipation of a profit. In J. Rowe & Son Pty Ltd the taxpayer sought to avoid this consequence by arguing for what was called a “profit-emerging” method of accounting in relation to the receivable: the amount receivable would be brought to account only as it became presently receivable. The High Court rejected this method of accounting principally because of the difficulties which arise from the rigidities of trading stock accounting. If the taxpayer sells on credit terms, present receivability and, more so, cash receipt is likely to occur (at least in some degree) subsequent to the year of income in which trading stock ceases to be on hand. It would follow that a deduction of the value of the stock would not be accurately matched with the derivation of income in the form of proceeds of sale. If an item of trading stock is sold in the year in which it is acquired there would be like distortion arising from the allowance of the whole cost as a deduction and the bringing in of only part of the proceeds. The New Zealand High Court decision in Farmers’ Trading Co. Ltd v. C.I.R. (N.Z.) (1980) 80 A.T.C. 6022 raised the possibility, under a trading stock regime similar to the Australian regime, of bringing in immediately as income an amount of the receivable equal to the value of the item of trading stock shown as an item of opening stock—the value at which the item had been brought to account in the closing stock of the previous year of income—or an amount equal to the amount of its cost if it is sold in the year of acquisition. The balance of the receivable could then be brought to account as income when received on a basis akin to one of the profit-emerging bases referred to in [12.41] above. However the New Zealand Court of Appeal (C.I.R. v. Farmers’ Trading Co. Ltd (1982) 82 A.T.C. 6001) rejected “profit emerging” of these kinds and adopted the Australian decision in Rowe.

[12.62] Another possibility would have been to bring in the present value of a receivable when it becomes receivable and to bring in further amounts, in the same or subsequent years, reflecting the excess of an actual receipt over the amount of the receivable already brought to account. Where provision has been made for a rate of interest to be charged on the receivable, such a present value approach becomes at least awkward. In any case a present value approach raises a question of the treatment of costs. If a present value approach is applied to proceeds, there seems to be equal justification for its application to costs.

[12.63] A view that specific profit accounting does not recognise a profit until it is realised has so far been assumed in this Volume. “Profit-emerging” as the applicable method of accounting, on one approach, requires cash receipts of proceeds of sale that exceeds costs. On another approach, profit-emerging will bring in the profit that inheres in a receivable—the excess of the receivable over costs—in the proportion that actual cash receipts bear to the total amount receivable. The latter approach is, in fact, a less than perfect expression of the principle that profit should not be anticipated. The balance of the receivable may never be received, but this is a characteristic of accruals tax accounting that is accepted as consistent with the realisation principle.

[12.64] There is however some suggestion in the case law of a kind of profit-emerging accounting applicable to a specific profit that would require the bringing in of an unrealised profit. The suggestion was made by the Revenue in the New Zealand case H. W. Coyle v. C.I.R. (N.Z.) (1980) 80 A.T.C. 6012, though the detail of the Revenue’s submission does not appear from the report. The case concerned a single venture by a partnership under a contract to roof a power station and clad its walls. The partnership had maintained accounts which reflected what was called a percentage of completion method of ascertaining the profit emerging from the venture. Presumably this method involved an estimate of total expenses that had been and would be incurred in carrying out the contract, and the determination of an estimated profit, being the total of the amounts receivable at any time under the contract, less the estimated expenses. This profit was to be treated as emerging over the years the contract was being carried out in proportion to the amount of the work completed in any year. The amount of the work completed in any year was, presumably, to be determined by reference to the fraction expenses of that year bore to the total estimated expenses. The Revenue’s submission was that profit thus emerging in any year should be taxed as income of that year. The partnership accounts did not show the actual monthly progress payments received by the partnership. The method of accounting adopted made them irrelevant. The taxpayer’s submission was that the partnership accounts did not express an appropriate method of specific profit tax accounting. The appropriate method was completion of contract, a method which, it was said, the New Zealand Revenue had accepted in the past. Such a method would have brought in a profit that was income when all the work required by the contract had been completed, if it then appeared that total costs were less than the total of amounts received and receivable. It was not argued that cash receipt of all amounts was necessary. The judgment of Holland J. does not resolve the question of which method of specific profit tax accounting was appropriate. In effect he rejected any method of specific profit accounting and directed that receipts and outgoings accounting should be applied, so that the profit subject to tax in any year would be determined by the deduction of costs incurred in that year and the bringing in of progress payments received in that year. Some statements in his judgment would indicate that specific profit accounting has no place in New Zealand tax law. He drew attention to the New Zealand section corresponding with s. 51(1) of the Australian Assessment Act by which an outgoing is deductible in the year in which it is incurred, with the inference that it cannot enter the computation of a profit that is income in a later year. At the same time be observed (at 6018–9):

[12.65] The difficulty in accepting the percentage of completion method of determining profit-emerging is that its operation may contradict a principle that would confine a profit that is income to a realised profit. The concession made by the Revenue avoids the contradiction in the circumstances of one payment receivable on completion. In the context of progress payments, profit-emerging confined to realised profit would bring in the surplus of a progress receipt over the expenses in bringing the work to the stage of completion to which the payment relates. At least it would do this if the amount of the receipt does not involve any withholding so that the amount is a fraction of total receipts exactly reflecting the stage of completion. To the extent that there is an element of withholding, the profit treated as emerging is distorted. In the circumstances of progress payments, the receipts and outgoings approach in fact directed by Holland J. brings about additional distortion. The additional distortion is in the failure of matching in the allowance of the deduction of expenses which relate to receipts yet to be derived. Receipts and outgoings accounts will be consistent with a principle requiring realisation only when receipts constantly run ahead of outgoings, and the principle in, Arthur Murray (N.S.W.) Pty Ltd (1965) 114 C.L.R. 314 is applied to the receipts. An illustration is the accounting suggested in [12.56]–[12.58] above as appropriate to the circumstances of New Zealand Flax Investments (1938) 61 C.L.R. 179.

[12.66] Where there is an element of withholding in progress payments, a profit-emerging that is consistent with a principle requiring realisation and gives a true reflection of income, will need to adjust the costs that enter the calculation of the profit. There is thus a corresponding deferral of costs.

[12.67] Receipts and outgoings accounting does not expressly provide for the anticipation of a loss, save in the election given to the taxpayer by the trading stock provisions referred to in [12.60] above. Receipts and outgoings accounting may have the effect of anticipating a loss where outgoings have been incurred in advance of receipts and no principle of the kind proposed in [11.116]–[11.121] is recognised by which the incurring of an outgoing may be deferred so that there is an incurring of the outgoing as the outgoing is consumed. But this is a fortuitous operation. The loss thus recognised need not to be a loss actual or prospective. It simply reflects the imperfect expression of a matching principle in receipts and outgoings tax accounting.

[12.68] Specific profit tax accounting could offer greater scope for anticipating a loss. Thus the percentage of completion profit-emerging accounting proposed in H. W. Coyle Ltd v. C.I.R. (N.Z.) (1980) 80 A.T.C. 6012, could anticipate a loss. There is however no suggestion in the authorities that specific profit accounting will allow or require the anticipation of a loss. It would be assumed that if the market price of land had fallen in Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355 between the inception of the scheme and the sale of any of the developed land, the taxpayer would not have been entitled to any deduction for anticipated loss. A realised loss on the sale of any parcel of land would have been deductible but the loss would have been confined to the loss on that sale.

[12.69] The principle that a profit should not be brought to account until it is realised has been considered so far in this discussion as a principle requiring that there be proceeds received or presently receivable in which the profit is to be found. The principle, in another understanding of it, requires that there be proceeds received or presently receivable, and a realisation, in what is another sense of that word, of property that is the occasion of proceeds becoming received or presently receivable. On this understanding of the principle a number of questions call for some consideration:

• (i) Where cash or receivable is the proceeds of realisation of property, is the passing of title in the property necessary if there is to be a realisation?
• (ii) Is there a realisation of property when property is exchanged for other property?
• (iii) Is there a realisation of property if property is consumed in the acquisition of other property?

[12.70] Generally, there will not be proceeds in cash or present receivable unless property has passed. But the passing of property, more especially where the property is land, may be delayed until there has been actual receipt of the whole proceeds of disposition. Delaying the passing of property ought not to prevent the realisation of a profit where there is a contract and there are proceeds in cash or present receivable. At least some equitable interest will have passed and income tax law ought not lightly be made to depend on a distinction between the passing of a legal and the passing of an equitable interest. It will follow that a transaction by which land is sold on deferred payment terms, with the passing of property delayed until all payments have been received, is not to be distinguished from a sale with an immediate passing of property, the payments to be made being secured by a mortgage back to the seller. There will of course be a question whether there has been a receipt by the seller of the whole of the proceeds of sale and a loan back to the buyer, so that profit fully emerges immediately. A construction of a transaction as a receipt and a loan back is open, but there is need to look to the realities of the matter if Permanent Trustee Co. of N.S.W. (1940) 6 A.T.D. 5 is to be followed ([11.129] above). The realities do not show a receipt where it does not appear that the taxpayer could have had a payment from the buyer of money the taxpayer might have retained.

[12.71] The question whether there has been a realisation of property where property is exchanged for other assets may be seen as answered by the observations in Smith (1932) 48 C.L.R. 178 that an exchange of assets for other assets is a sale. The issue in the case was whether a dividend could be said to have been paid from a profit from the sale of an asset when there had been a compulsory resumption of property. The conclusion that it had been so paid proceeded on a view that a compulsory resumption is a sale, and in this connection it was said that an exchange of an asset for another asset is a sale. There was no suggestion that the compulsory resumption was not, or that an exchange of assets would not be an occasion of a realisation of a profit. In the case of an exchange of assets, the profit emerges, presumably, when there is a receipt of the asset in exchange, and the amount of the profit will reflect the money value, at the time of receipt, of the asset received in exchange. Section 21 assists this conclusion though it does not fix expressly the time at which the money value is to be determined. Where the asset received is shares whose value is volatile, the time of valuation becomes especially significant.

[12.72] The third question is whether there is a realisation of property if property, for example options, is consumed in the acquisition of other property. The reference to property consumed in the acquisition of other property is intended to identify a transaction distinct from the exchange of an asset for another asset. Varty v. British South Africa Co. [1966] A.C. 381 is authority that the exercise of an option is not an occasion of realisation of a profit. There is a distinction to be drawn between the exercise of an option on the one hand, and, on the other, the disposition of the option for cash or in exchange for another asset. There will be a realisation of a profit, that may have been inchoate in the options, on the eventual disposition of the asset acquired in exercise of the options. The circumstances in which the option was held may be such that a sale of the option would have given rise to a profit that was income. The transaction involving the acquisition of property in the exercise of the option may not, however, be such that a profit on the disposition of the property an element that is attributable to the option. is ignored. It is possible, perhaps, to find in the profit on the disposition of the property an element that reflects the profit inchoate in the option at the time it was exercised, or it may be possible to find in the profit on the disposition of the property an element that is attributable to the option. In conditions of rising values the latter would be a greater amount than the former. The difficulties envisaged may suggest that the conclusion in Varty v. British South Africa Co. that the exercise of an option is not an occasion of realisation of a profit is not to be followed. Section 21 would assist the calculation of a profit on the exercise of the option. It is, however, assumed that Varty v. British South Africa Co. is Australian law.

The Determination of Profit or Loss on each of Successive Transactions where the Proceeds of an Earlier Transaction is an Item other than Cash

[12.73] Miranda (1976) 76 A.T.C. 4180, is authority that rights or options issued by a company to its shareholders are property distinct from the shares in relation to which they are issued. It was not suggested in the case that the rights or options are proceeds of the transaction in which the shares were acquired. If they are seen as proceeds, there is the prospect of finding a realisation of profit in the receipt of the rights or options. In Miranda such a profit could not have been held to be income because the case concerned s. 26(a) (now s. 25A(1)) and that section is confined to a profit realised by sale. In other circumstances, however, a profit, if held to be realised, may be income. The determination of the amount of the profit that is realised will pose difficulty though not insuperable difficulty. The fall in the market value of the shares resulting from the rights or option issue will measure the part of the shares that is realised. If the rights or options are seen as involving realisation of profit that is income the value at which they are brought to account in computing the profit must be treated as a cost in any new transaction involving the rights or options. There will otherwise be a prospect of two impositions of tax on the one gain.

[12.74] An item of property other than cash may be income as a receipt. It may be a reward in kind for services, or it may be income derived from property—rent received in kind. In this situation also the value at which the item is brought to account in the earlier transaction must be allowed as a cost in any new transaction in which a profit may be realised.

[12.75] In Curran (1974) 131 C.L.R. 409 the issue of bonus shares to a share trader might have been seen, on general principle, as involving a partial realisation of a profit arising from the shares in respect of which they were issued. In which event, there would have been a question whether s. 44(2) precluded such a view being taken. And there would have been other questions, involving the application of the trading stock provisions which, it was assumed, applied generally to the share trading activities of the taxpayer. If a profit that was income had been held to be derived the value at which the bonus shares were brought to account in computing that profit would have had to be allowed as a cost in relation to later dealing with those shares. In fact in Curran the matter was approached only in terms that the bonus shares might be income derived from property. Barwick C.J. thought that they were, and that they had been made exempt income by s. 44(2). It followed that the value at which the bonus shares were brought to account as exempt income had to be allowed as a deduction under the trading stock provision as a cost of those shares. The consequence would not be doubted, though the finding that the bonus shares from a capital profit were exempt income by force of s. 44(2) is a reversion by Barwick C.J. to the majority view of the interpretation of s. 44(2) in W. E. Fuller Pty Ltd (1959) 101 C.L.R. 403, a view which had been later rejected in Gibb (1966) 118 C.L.R. 628. As s. 44(2) was interpreted by Dixon C.J., in dissent, in Fuller and by the High Court in Gibb in overruling Fuller, a bonus issue from a capital profit is not exempt income. It is not income and thus cannot be exempt income. There is, therefore, no exemption to be protected by allowing deduction of a cost.

[12.76] The judgment of Stephen J. in dissent in Curran rejected the principle adopted by Barwick C.J. Stephen J. was conscious of a consequence of the rejection: if the bonus issue is made from a revenue profit there will be two taxes on the same gain—the one on the value of the bonus shares and the other on that value reflected in the proceeds of sale of the bonus shares. That such a consequence will follow from the rejection is a demonstration of the correctness of the principle adopted by Barwick C.J. With respect, the error in the judgment of Barwick C.J. is in the reversion to an interpretation of s. 44(2) that had been rejected by the High Court in Gibb by overruling its own previous decision.

[12.77] The principle that requires the allowing of a cost to prevent two impositions of tax on the same gain, or to protect an exemption given to income, is distinct from the principle explained in [12.78]–[12.88] above that where an item of property is “taken into” a process of income derivation, a cost must be allowed of the value of the item at the time it is taken into the process. It is this latter principle that was applied by Gibbs J. in Curran. He saw the bonus shares as a gift by the company to the shareholder, to be treated in the same way as a gift made, for example, by father to son of property which the son then takes into a business of trading in property of that kind. With respect, the principle was misapplied. The bonus shares came to the taxpayer as a consequence of his holding of shares. They arose out of that holding. That they might in some sense of the word be regarded as a “gift” is not to the point. There is no affinity between the receipt of the bonus shares and the act of a taxpayer in taking property, until now held privately, into a business so that it becomes a revenue asset of that business. Nor is there any affinity between the receipt of the bonus shares, and the receipt of property by a taxpayer from another person who, as a private expression of goodwill towards the taxpayer, makes a gift to him of property or sells property to him at less than its value.

The Identification of Cost where Property is Held before a Process of Income Derivation is Entered on, or Property is Acquired Wholly or Partly by way of Gift, or where an Excessive payment is made for Property

[12.78] Discussion in previous paragraphs has adverted to the question of identifying cost where property is already held by the taxpayer when it is taken into a process that may yield a profit that is income. In Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355 it was agreed by the parties that in determining the profits realised on disposition of the land, a cost had to be allowed of the value of the land at the time the isolated business venture commenced. The land had previously not been held in any process of income derivation. The principle that is reflected in the agreement in Whitfords Beach has been accepted in relation to the second limb of the predecessor of s. 25A(1) (s. 26(a)) in Official Receiver in Bankruptcy (Fox’s case) (1956) 96 C.L.R. 370 and Bernard Elsey Pty Ltd (1969) 121 C.L.R. 119. The cost is the market value of the property at the time the item is taken into the business venture or profit-making scheme. The principle would also be accepted when the item is taken into the trading stock of a continuing business carried on by the taxpayer. A view against acceptance of the principle in these circumstances was taken by Barwick C.J. in McClelland (1969) 118 C.L.R. 353 at 371 but that view was withdrawn by him in N. F. Williams (1972) 127 C.L.R. 226 at 241. In the case of trading stock, there will be an immediate deduction of the value as the cost of trading stock. The principle should also be accepted when the item is taken into a continuing business and becomes a revenue asset though not trading stock of that business.

[12.79] The principle reflected in the agreement in Whitfords Beach should have an application where property held as a structural asset is taken into a process that may yield a profit that is income as in the New Zealand case Rank Xerox (N.Z.) Ltd v. I.R.C. (N.Z.) (1982) 14 A.T.R. 821. In this instance there are other issues raised if the structural asset was one to which the depreciation provisions were applicable, involving the operation of s. 59. The principle should also apply when an asset is transferred from one business or scheme in which it may have yielded a profit that was income to another business or scheme in which it may yield a profit that is income. Issues raised in such circumstances are considered in [12.99]ff. below.

[12.80] The principle reflected in the agreement in Whitfords Beach, a principle for which, save on some strict view of precedent, the case may be said to stand, should have an application where property is physically taken from other property held by a taxpayer.

[12.81] A number of references have been made to the taking and disposal, or the simple disposal in the carrying on of a business of timber, sand, gravel and the like which, until the event, had been part of real property owned by the taxpayer. The references are in [11.271]–[11.272], [2.313]ff., [7.19]ff. above. Some of the cases would suggest that, generally, the value in situ of the property physically taken from the land is not a cost to be brought to account in determining the income from the business. Those cases sit most awkwardly with Whitfords Beach. Clearly there are problems in putting a value on the property in situ and in fixing the time at which this valuation is to be made. Where the taxpayer enters on a business operation—a continuing business or an isolated business venture—in the disposal of property physically taken from his land, the cost will be the value in situ at the time the property was committed to that business. The Federal Court was asked by the High Court to determine the time of commitment in Whitfords Beach (1983) 83 A.T.C. 4277. The question of value was left to be settled between Commissioner and taxpayer. Valuation is of course the easier where the whole of the land is to be valued but the greater difficulty where a physical part of the land is to be valued does not justify the abandonment of a principle. The task of valuation is no different from the task of allocating some of the cost of land to a physical part of it when the land is acquired in order that the physical part might be disposed of in the course of business operations.

[12.82] There is a specific provision in s. 124J applicable to growing timber acquired and subsequently physically separated from the taxpayer’s land. The operation of the provision is the subject of some comment in [11.271]–[11.272] and earlier paragraphs. Where the land was not acquired in contemplation of the disposition of the timber in carrying on a business, the allowance of a deduction of some part of the price paid for the land is obviously inappropriate unless the timber itself is seen as income derived from property (cf. [11.272] above). The deduction should be of the value in situ at the time the land becomes committed to the business. The section provides for the allowance of a deduction of some part of the price paid for land carrying standing timber where “timber is felled in pursuance of a right to fell timber granted by the taxpayer to another person in consideration of payment to be made to the taxpayer as or by way of royalty”. The special significance of the section is in thus allowing a deduction against royalty receipts. The function of s. 124J in this respect has some parallel with the function of s. 27H allowing a deduction of the purchase price of an annuity against receipts under the annuity. A principle asserted in Chapter 2 above (Proposition 4) that an essential element in the notion of income is gain is supported by s. 124J and s. 27H. In other contexts where the item of income is not a specific profit but an item that will be ordinary usage income as a gain derived from property, the principle that an essential element in the notion of income is gain may not be supported. The principle in Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355 may not extend beyond specific profit tax accounting. A taxpayer who adopts the form of the transaction in Stanton (1955) 92 C.L.R. 630 may not derive income in the receipt of the proceeds of the transaction. There may not be a business in the disposing of the property separated from his land. But if there is a business, he will be entitled under the Whitfords Beach principle to a cost of the value of the property in situ at the time it became committed to the business. A taxpayer who adopts the form of the transaction in McCauley (1944) 69 C.L.R. 235, will derive income, as royalties—receipts for the use of his property by another in the taking of the property separated from his land—and, without the aid of the Whitfords Beach principle, he will be taxed on what is not a gain, save so far as the circumstances attract the operation of s. 124J, and that section gives appropriate relief.

[12.83] If the Whitfords Beach principle is to be extended to circumstances where there is no business, but the taxpayer’s receipts are income derived from property—royalties arising from the use of his land by another—there will be a problem of identifying the time when a value that will be a cost of what is taken from his land is to be determined. The Whitfords Beach principle would suggest that it is the time when the agreement under which another will take the property is entered into. The operation of the Whitfords Beach principle in a McCauley situation will go most of the way to assimilating the consequences in a McCauley situation to those in a Stanton situation, which will, at least, be a sensible outcome.

[12.84] Property may be acquired wholly or partly by way of gift, and, in being acquired, become subject to a process that may yield a profit that is income. Where the element of gift involves a derivation of income by the receiver, for example as a reward for services, the principle considered in [12.74] above, will require that the value of the element of gift be treated as a cost of the property. A person may sell land to a taxpayer at less than its market value in order to reward him for some service, and the taxpayer may acquire with a purpose that attracts the first limb of s. 25A(1). The element of gift will be an income item derived at the time of the acquisition. The element of gift must be treated as a cost of the land in computing a profit on sale of the land by the taxpayer in order that there should not be two taxes on the same gain.

[12.85] There is another reason why the element of gift must be treated as a cost. The gift may be a pure gift, which is not income. That gift may, in the very transaction in which it is acquired, be committed by the donee to a process of income derivation. Treating the value of the gift as a cost is necessary to prevent it being taxed in the taxing of the proceeds later arising in the income derivation. The circumstances of Curran (1974) 131 C.L.R. 409 were different, and the principle now expressed is no basis for the conclusion reached by Gibbs J. in that case. The bonus shares were not acquired and then immediately committed by the receiver to a process of income derivation. They arose out of the process of income derivation. The receipt of them was not as yet a derivation of a gain: s. 44(2) precluded such a conclusion. But sale of the bonus shares would realise a gain. In the calculation of that gain a subtraction of some part of the cost of the original shares that were the subject of the bonus issue would be appropriate. Section 6BA merely states what sound principle requires in any event.

[12.86] The second reason why the element of gift must be treated as a cost is an expression of the principle in Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355. The element of gift is treated as a cost in treating the value of the property at the time of receipt as the cost of the property acquired. Clearly an inquiry as to the existence of an element of gift in a transaction by which property is acquired should not be too lightly undertaken. Jacgilden (Weston Hall) Ltd v. Castle [1969] 3 W.L.R. 839 is authority that the consideration given in an “honest bargain” will determine the taxpayer’s cost even though there is some basis for a view that the consideration was less than the prevailing market value of what was acquired.

[12.87] It is a corollary of the Whitfords Beach principle that where the price paid for a revenue asset includes an element of donation by the taxpayer who is the buyer, that element of donation should not be treated as a cost. However, the corollary runs against authorities that have been characterised in this Volume as adopting a “form and blinkers” approach to the interpretation of s. 51(1). Those authorities are considered in [9.17]ff. above. Clearly they are relevant where the specific profit accounting is that required by the trading stock provisions, of which s. 51(2) is a part. Cecil Bros Pty Ltd (1964) 111 C.L.R. 430, and the Privy Council decision in Europa Oil (N.Z.) Ltd v. C.I.R. (N.Z.) (No. 2) (1976) 76 A.T.C. 6001 (on appeal from New Zealand) involved the acquisition of trading stock. The authorities may not be directly relevant when cost is not a deductible outgoing, but is brought to account in determining the amount of a profit that is income. At least there is a basis for distinguishing them. But until Cecil and South Australian Battery Makers Pty Ltd (1978) 140 C.L.R. 645 are overruled, they are likely to be extended to the determination of the amount of a cost brought to account in computing a profit that is income. The view of this Volume is that they should be overruled, and an outgoing should not be wholly deductible where its function is in part simply to confer a benefit on another. An inference of such a function may be drawn where the parties are not at arm’s length, and there is a clear disparity between the market price and the consideration given.

[12.88] A number of provisions of the Assessment Act are directed to overcoming the operation of Cecil and South Australian Battery Makers in particular contexts. They are considered in [10.290]–[10.365] above. Section 65 is concerned with any “payment made or liability incurred” that would have been “an allowable deduction”. It cannot have any application to a cost that is not an allowable deduction but enters the calculation of a profit that is income or a loss that is deductible. Sections 82KJ and 82KL are directed to denying the deduction of a “loss or outgoing”. The significance of the reference to “loss” in those sections is not apparent. None the less, it is clear that the sections can have no application to a cost that is not itself deductible, though it enters the determination of a specific profit that is income or a specific loss that is deductible. Part IVA could apply to deny a tax benefit that would otherwise arise by way of the minimising of a specific profit that is income, or the increasing of a specific loss that is deductible, if a cost that includes an element of gift were to be taken into account in determining the profit or loss.

Profit or Loss on a Disposition Wholly or Partly by way of Gift

[12.89] The consequences of a disposition of property wholly or partly by way of gift have been explored in the general treatment of specific profit accounting in [12.1]–[12.47] above. Where trading stock provisions are applicable there is a prospect of the operation of s. 36 which may, in effect, bring out a profit or a loss determined by the positive or negative balance of the deemed proceeds of the disposition—the market value of the property—over the cost of the property. Where the item of property is a revenue asset of a continuing business but is not trading stock, the principle in Sharkey v. Wernher [1956] A.C. 58 may be attracted to bring about the same consequences. But the authority of Sharkey v. Wernher in Australia is not settled. Where the item is property that is the subject of an isolated business venture the reconstruction of the proceeds of disposition and the bringing in of a profit or loss on the basis of the reconstructed profit, must in any event depend on the recognition of an extended Sharkey v. Wernher principle. The alternative is that the venture in relation to property disposed of is simply aborted. Where the item is an asset subject to the first limb of s. 25A(1) the gift will abort the transaction, so that no profit or loss that is income or deductible can arise, unless the gift is in a transaction which can be characterised as a sale. There is no express provision of the kind included in s. 36, nor is there any judicially established principle of the Sharkey v. Wernher kind that would reconstruct the sale proceeds where the sale is partly by way of gift. Any reconstruction will need to rely on the words “profit arising” in s. 25A(1). Where the item is an asset subject to the second limb of s. 25A(1), a sale is not necessary to attract the operation of the provision. But again there is no express statutory provision or judicially established principle that would reconstruct the proceeds of disposition, and any reconstruction will need to rely on the words “profit arising”. In regard to both limbs the disposition wholly or partly by way of gift is likely to be seen as a simple abortion, so that no tax consequences involving a profit that is income or a loss that is deductible will follow. Section 26AAA contains an express provision in s. 26AAA(4) such that where property is disposed of by a taxpayer to another person with whom he does not deal at arm’s length—which will cover most occasions of a disposition wholly or partly by way of gift—there is a deemed disposition by the taxpayer for the value of the property.

Disposition in Closing down a Business

[12.90] Section 36 clearly extends to a disposition of revenue assets in the closing down of a business by a taxpayer, whether a disposition of assets in the transfer of the business to another or a disposition in putting an end to the business. C. of T. (W.A.) v. Newman (1921) 29 C.L.R. 484 treated such dispositions as aborting business operations. Section 36 corrects the consequences of that case where the items of property are trading stock, or property of one of the other kinds to which the section applies. There is no judicial decision that would extend the principle in Newman to other dispositions which are not made in the carrying on of a business. Other dispositions may attract the operation of the principle in Sharkey v. Wernher or an extension of that principle. An extension of the Sharkey v. Wernher principle should displace Newman. Newman, it is considered, should not be followed.

The Consequences of Death of the Taxpayer

[12.91] Section 37 of the Assessment Act contains a provision which has an operation in relation to trading stock in the case of the death of a taxpayer, parallel with the operation of s. 36 in the case of a disposition of trading stock not in the ordinary course of carrying on a business. The rigidities of the trading stock provisions explain the need for s. 36. The need for s. 37 is not so evident. In the absence of the section the trading stock would have been shown as still on hand in the deceased’s return to the date of death, so that s. 28 would not have operated to allow what is in effect a deduction of the cost of the trading stock. Indeed, it is arguable that s. 37 does not require that the trading stock be treated as not being on hand at the date of death—in which case there would be deemed proceeds to be included in assessable income with no allowance for cost. Escape from such a conclusion will depend on a construction being given to the concluding words of s. 37(1) so that they carry an inference that the taxpayer must be taken to have disposed of the trading stock at the moment of his death.

[12.92] Section 37 prevents an abortion of the business operations by the death of the taxpayer. Its operation may be modified by an election under s. 37(2) made unanimously by the trustee of the estate of the deceased and the beneficiaries who are liable to be assessed in respect of the business. If there is an election, the value to be included in the assessable income of the deceased is the value at which the property would have been taken into account at the date of death of the deceased person if he had not died but an assessment had been made in respect of the income derived by him up to that date. There is no express provision which would confine the availability of the election to circumstances where the property becomes an asset of a business carried on by the trustee of the deceased estate. There is such provision in s. 36A(2), applicable to an election where a change has occurred in the ownership of or in the interests of persons in trading stock as a result of the death of a partner.

[12.93] Another aspect of s. 37 will prevent an abortion of business operations on the death of a taxpayer where he carried on a business whose revenue assets included standing or growing crops, crop-stools, or trees which had been planted and tended for the purpose of sale. The operation of this aspect may also be modified by an election under s. 37(2). The manner of operation of s. 37 is to include the value of the property in the assessable income, not the profit that may result from a deemed disposition of the property at that value. The assumption, presumably, is that all costs will have been the subject of allowable deductions. But they may not have been, and in that event they would need to be subtracted from the value at death in order to fix a profit. In this respect s. 37 is defective. The taxpayer may himself have acquired as a result of the death of the previous owner, and s. 37(1) will deem the taxpayer to have purchased the property at the value to which s. 37 refers. This deemed cost would not be immediately deductible, though it would be deductible as part of the cost of trading stock if the property is severed by the taxpayer and sold, or if the property is severed by the buyer under the sale. If the taxpayer sells the property unsevered as part of the land, s. 36 will operate and he should be entitled to subtract from the proceeds the cost of acquiring the property. That cost will not have been an allowable deduction: s. 37 in deeming the taxpayer to have purchased the property at its value from the deceased, does not in its terms allow a deduction of that value. In including the value of the property in the assessable income of a person who disposes of it otherwise than in the ordinary course of business, s. 36 suffers from the same deficiency as s. 37.

[12.94] Section 37, in deeming the person who acquires from the taxpayer to have purchased at the value given to the property for purposes of the section, does no more than make more specific the operation of the general principle discussed in [12.78]–[12.88] above, by which property taken into a business operation as revenue assets of that operation has a deemed cost of its value at the time it is taken in.

[12.95] There is no section of the Assessment Act that provides generally for a deemed realisation of revenue assets of a business on the death of a taxpayer who conducts that business. And there does not appear to be any judicially created principle. It would be assumed that the principle in Sharkey v. Wernher [1956] A.C. 58 could not be extended to this situation. It follows that death simply aborts the business operations.

[12.96] The same observations would be appropriate in relation to an isolated business venture, and to transactions otherwise within the first and second limb of s. 25A(1).

[12.97] A sale for purposes of s. 26AAA includes the transfer of property from one person to another without consideration (s. 26AAA(1)(f)). A transfer on death may not be included. The inference to be drawn from s. 26AAA(4), by which the Commissioner may treat the transfer as having been made for the amount that in his opinion was the value of the property, is that the notion of sale does not include a transfer on death. It is not a possible description of a transfer on death that the deceased and his estate “were not dealing with each other at arm’s length”. It follows that a transaction that might otherwise have been within s. 26AAA is aborted by the death of the taxpayer.

[12.98] [11.150]ff. above include a discussion of the operation of s. 101A where property is disposed of by the estate of a deceased taxpayer after the death of the taxpayer and a disposition made during his life would have given rise to a profit that was income. The view there taken is that, despite the wide operation given to s. 101A by the High Court in Single (1964) 110 C.L.R. 177, the section would not give an income character to any part of the receipt by the estate on the sale by it of the property. The transaction entered into by the deceased is left aborted by his death. The disposition of the property by his estate may be the conclusion of a distinct transaction by the estate that may give rise to a profit that is income. But the disposition is not the conclusion of a transaction commenced by the deceased and concluded by the estate, by which a profit inchoate in the value of the property at death is realised as income. This interpretation of s. 101A is supported by Spence (1967) 121 C.L.R. 273.

The Consequences of Cessation of a Business, or the Taking of Assets out of a Business, or the Transfer of an Asset from one Business to Another

[12.99] In [12.89]–[12.90] above the question has been raised whether a disposition of property in putting an end to a continuing business, or a disposition of property in disposing of the business, or a disposition not made in carrying on the business, involves a total or a partial abortion of business operations, so that, in the absence of express provisions of the Assessment Act, no tax consequences attend the disposition. The possible application of an extended Sharkey v. Wernher principle was considered, a principle that will treat the disposition as a disposition at market value in carrying on the business. Parallel questions are raised in [12.45]–[12.47] above in regard to an isolated business venture and in [12.48]ff. above in regard to s. 25A(1).

[12.100] The question now raised is whether the cessation of a continuing business or of an isolated business venture, generally or in relation to some of the assets of that business, but without any disposition of assets, involves a total or partial abortion of business operations.

[12.101] Sections 36 and 37, applicable to trading stock and to some other revenue assets of a business, were noted in [12.89]–[12.98] above. Section 36 requires for its operation that there should have been a “disposal” not in the ordinary course of carrying on the business. If “disposal” is taken to mean disposition, the section has no operation on the occasion of a cessation of business when assets of the business come to be held as private assets, or come to be held as assets of another business or in some other income producing process. The facts of Sharkey v. Wernher [1956] A.C. 58 afford an illustration: the horse was taken from the taxpayer’s breeding stable conducted as a business, and thereafter was held in the taxpayer’s racing stable which was conducted not as a business but as a hobby. The facts involved only a partial cessation of the breeding business. Other facts might be imagined that would involve a total cessation. Another illustration involving partial cessation would be the taking by a dealer of a motor car from his trading stock so that it might be used by him for private purposes. Yet another illustration would be the action of a farmer, who takes an item of livestock as food for himself and his family.

[12.102] Murphy (1961) 106 C.L.R. 146, though not directly concerned with the issue is consistent only with an interpretation of the word “disposal” that will equate it with disposition, in a sense of disposition which would involve the passing of property at law or, presumably, in equity.

[12.103] Section 36 has therefore no operation on the occasion of a simple cessation of business in relation to an asset. However, on the interpretation of the section in Murphy, it will have an operation on the subsequent disposition of the asset, at a time when it may be held privately, or be held as an asset of another business, or held in some other process of income derivation. The fact that disposition may not occur until many years after the cessation of the business in which the item was trading stock, does not prevent the operation of the section—a conclusion that is summed up in a phrase “once trading stock, always trading stock”.

[12.104] In the result, s. 36 is a barrier to the adoption in Australian law of the Sharkey v. Wernher principle in its application to an occasion which does not involve the disposition of property. And, in any case, s. 36 must come into collision with principles that seek to determine the consequences of disposition of an asset by reference to the circumstances of its holding at the time of the disposition. At the time of its disposition, the asset that was trading stock in the old business, may have come to be held in a new business, or in an isolated business venture, or in a transaction that involves the operation of s. 25A(1). When taken into the new business or business venture, or into the s. 25A(1) transaction, the asset must be given a cost of its value. If it is trading stock of the new business, the cost will be deductible though in effect deferred until the item is disposed of—when it becomes an item no longer “on hand”. The proceeds of disposition will be income. If the item is not trading stock of the new business but is a revenue asset of that business, or is an item now subject to an isolated business venture, the cost will be subtractable in determining the profit that is income on the realisation of the item. The cost will be subtractable in determining the profit that is income in the s. 25A(1) transaction. But the hanging fire of the operation of s. 36 in relation to the asset because it was trading stock of the old business must in some way be accommodated. As interpreted in Murphy, s. 36 requires that the value of the item on the occasion of its disposition in the new business, business venture or transaction, must be brought to account as assessable income. A disposition in the new activity could not be in the ordinary course of the old business. There will, presumably, at this time be an operation of s. 28 in relation to the old business, so that the cost of the item in that business now becomes deductible. A conclusion that s. 28 operates in this way was assumed in Murphy, though it is curious that an item must be regarded as still “on hand” in the old business, though that business ceased a number of years previously. The correlation of the operation of s. 36 and s. 28 in the old business, with the operation of the trading stock provisions in the new business or specific profit accounting in the new business, business venture or s. 25A(1) transaction, can only be on some arbitrary basis that would select one regime and reject the other.

[12.105] The tax consequences of the action of the farmer who takes an item of livestock as food for himself and his family are, it seems, fixed by the Commissioner on a basis that assumes s. 36 is not applicable. The practice is to bring in an amount in respect of the item being the value at which the item was shown as stock on hand at the beginning of the year of income, or its cost of purchase if it was purchased during the year. The effect is to offset the allowance of a deduction in respect of the item which is no longer “on hand”, though it has not been and now can never be “disposed of” so as to attract the operation of s. 36. The practice recognises an abortion of the process of income derivation in relation to the stock. It leaves the farmer, however, with those deductions, already effectively allowed, which relate to the stock but would not have entered the determination of the value of the stock on hand. Where the item of livestock is natural increase, its cost price is fixed by regulation at an arbitrary low figure, so that the deductions relating to the item that are effectively allowed will be substantial. The consequence is a special subsidy to production for one’s own consumption.

[12.106] The case for adopting the principle of Sharkey v. Wernher [1956] A.C. 58, at least in an application to cessation of business and to ceasing to hold assets in a business, is compelling. A conclusion that there is a “disposal” in these circumstances for purposes of s. 36 is not expressly rejected in Murphy (1961) 106 C.L.R. 146. The question was not raised. If the conclusion were to be accepted, s. 36 would cease to be a barrier to the adoption of the principle. But it would be no more than a partial confirmation of it. The principle should be adopted with as wide an operation as possible. And it should have no less operation in regard to isolated business ventures and s. 25A(1) second limb transactions, than it may be allowed in regard to continuing business situations.

[12.107] The adoption of the principle will, it is true, raise issues as to when a business or business venture or profit-making scheme may be said to cease, and as to when an asset may be said no longer to be an asset held in a business, business venture or scheme. Ferguson (1979) 79 A.T.C. 4261 is the subject of some comment in [2.440] above. The views expressed in the Federal Court in that case would draw a distinction between a preliminary business of building up a herd of cattle under arrangements for breeding and agistment, and a later business of being a grazier. The proposed Sharkey v. Wernher principle would operate on the change from the one business to the other.

[12.108] There is good reason to extend a Sharkey v. Wernher principle not only to the cessation of business and the movement of an asset out of a business, but also to the movement of an asset within a business from a holding where it has the character of a revenue asset to a holding where it has the character of a structural asset. If a taxpayer who deals in motor vehicles takes a vehicle from his stock and uses it as a demonstrator, s. 36 or Sharkey v. Wernher should operate to bring about a deemed realisation at market value. The cost for purposes of depreciation on the demonstration vehicle will be that value.

The Determination of Profit or Loss on Successive Transactions in Shares and Rights to Shares

[12.109] A consideration of the determination of profit or loss on transactions in shares and rights to shares may assist an understanding of the variations in tax accounting that will arise depending on what set of principles or specific statutory provisions apply to a transaction. It will also serve to introduce some aspects of trading stock accounting: a share, or a right to or option over a share, may be held in a way that makes it trading stock of a business and the accounting provided for in ss 28ff. becomes applicable. In its effect, trading stock accounting is accounting for profit or loss, though the consequences of its operation may differ in a degree from the consequences of the operation of other principles or specific provisions by which a profit or loss in a transaction in shares may be determined.

Where there is no rights or bonus issue in respect of shares held by the taxpayer

[12.110] For the purposes of the following discussion, this example will be considered: the sale of land by a company that is a dealer in land to a company that is engaged in land development. Part of the consideration is a number of options over shares in the development company. The remainder of the consideration is cash. The exercise price under the options is the market value of the shares at the time of sale of the land. The market value of the shares increases steadily over a period of time during which the land dealing company sells some of the options, exercises the remaining options and disposes of the shares thus acquired. It disposes of the shares acquired in the exercise of the options in response to a share exchange takeover bid. It is assumed that the land dealing company—the taxpayer—has not engaged in any other transaction involving shares.

[12.111] There is an immediate question of the accounting applicable to the sale of the land. The possibility is explored in [12.69]ff. above that the time of realisation of the land, at which a profit will normally be determined, is the time of the contract of sale, and not the time of completion of the contract by conveyance. The proceeds of sale that will be income under the trading stock provisions, will include the amount of cash receivable under the contract. Trading stock accounting, in this context an aspect of accruals accounting, is clearly applicable to the taxpayer as a dealer in land. J. Rowe & Sons Pty Ltd (1971) 124 C.L.R. 421 requires that an amount receivable in cash even though it is not immediately receivable will be treated as income derived at the moment of realisation of the asset.

[12.112] The options may be differently treated. The view was expressed in [11.57]ff. and [11.148] above that, where consideration is property other than cash, derivation will not occur until all steps have been taken, having regard to the nature of the property, to vest it in the taxpayer. This, it would be asserted, is the test of derivation irrespective of whether the taxpayer is on accruals or cash in relation to the transaction, and irrespective of whether or not the item is trading stock. It would follow that there is no derivation of the options until there is an issue of options to the taxpayer by the purchasing company. In determining the amount that is to be brought to account as assessable income of the taxpayer, the options will be given a value, not at the time of the contract, but at the time of issue of the options. There is thus some prospect that the policy sought to be achieved in J. Rowe & Son Pty Ltd (1971) 124 C.L.R. 421—that there should be a derivation of all the consideration on the sale of trading stock at the time the stock ceases to be on hand—will be defeated. The issue of the options may be delayed until a year of income subsequent to the year in which the land was sold.

[12.113] The value of the options will reflect the exercise price, the period during which the options are exercisable and the anticipated movement in the value of the shares during that period. The value of the options on the facts assumed may be small since the exercise price is the value of the shares in the development company at the time of the contract of sale, though valuation will need to take into account the period of time within which the options are exercisable. The value that will be brought to account will not, it seems, be affected by an inside knowledge of the affairs of the land development company which the taxpayer might have. Section 21 and general principles require that the market value be brought to account, not the “value to the taxpayer” which might be greater or might be less. Section 26(e), which would bring in the value to the taxpayer, has no application because the options are not a reward for services rendered by the taxpayer (Cooke and Sherden (1980) 80 A.T.C. 4140).

[12.114] Accounting in relation to any transaction involving the sale of the options, or the exercise of the options and the sale of the shares, will depend on the character that the options assume in the hands of the taxpayer. The options will have the character of trading stock if they are seen as land, held in another form, but indistinguishable in principle from the other land in which the taxpayer deals. They will equally have the character of trading stock if they are seen as the first stock acquired of a business of dealing in options and shares. The first possibility is the more likely. If the options have the character of trading stock there will be a deduction of their cost, which in these circumstances is the amount at which they are brought to account as income on the sale of the land. The taxpayer must be taken to have sold the land for an amount that includes the value of the options, and to have outlaid the amount of the value of the options in acquiring the options. This amount will be a deduction in the year of acquisition of the options, and will be included in the value of closing stock at the end of the year, if the options have not been dealt with before the end of the year, and no election has been made to value the options otherwise than at cost. Trading stock accounting is more closely explained in Chapter 14 below. The options may not have the character of trading stock but may, none the less, be revenue assets. This may be the more appropriate characterisation of the options when their acquisition is incidental to the carrying on of a business. In Jennings Industries Ltd (1984) 84 A.T.C. 4288 shares were acquired by the taxpayer in a company that would let a building contract to the taxpayer, a contract from which the taxpayer might profit. A sale of the shares thereafter by the taxpayer was contemplated, but was not a definitive intention. The Federal Court held that the “profit” from a sale of the shares was income. The events were seen as an extension of the taxpayer’s business activity of acquiring land, its development by erecting buildings, and the sale of the land.

[12.115] There is some basis for a conclusion that the options will be revenue assets if it was not commercially open to the taxpayer to receive the value of the options in cash from the land development company. The matter is discussed in [12.188] below. In these circumstances the options will have the same character as a right to receive payment in cash as proceeds of sale of trading stock would have. They will have an attributed cost equal to the amount of the notional cash receivable. There will be no deduction of an attributed cost of the options and there will be no present tax accounting. But the attributed cost will be brought to account, on the realisation of the options, in determining the amount that is a profit that is income, or a loss that is deductible.

[12.116] There are other possible characterisations of the options. They could conceivably be assets acquired in an isolated business venture, being the acquisition of the options, their exercise and the sale of the shares. The judgment of Jacobs J. in Macmine Pty Ltd (1979) 53 A.L.J.R. 362, in treating the exercise of options and the sale of shares as no more than an advantageous realisation of the options, does not dictate a conclusion that an operation that includes the acquisition of the options with a purpose to exercise them and sell the shares is not an isolated business venture. If the operation is treated as an isolated business venture, there will be a prospect of tax accounting on completion of the venture but no present accounting. The cost of the options, for this purpose, will be an amount equal to the amount at which they were brought to account as proceeds of the sale of the land.

[12.117] If the options are none of trading stock, revenue assets or assets held in an isolated business venture, they may yet be assets to which the first limb of s. 25A(1) applies. On the authority of the statements made by Gibbs C.J. and Mason J. in Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355, a characterisation as a s. 25A(1) assets is only open if none of the other characterisations is appropriate: s. 25A(1) is applicable only when the asset is not held in circumstances that may yield income by ordinary usage. If s. 25A(1) applies there will be a prospect of tax accounting on a sale occurring but no present tax accounting. Again the cost of the options will be the amount at which they were brought to account on sale of the land.

[12.118] The options may be assets to which the second limb of s. 25A(1) applies. They cannot be such is they are trading stock, revenue assets or assets held in an isolated business venture. The statements of Gibbs C.J. and Mason J. are again relevant. If the second limb applies, there will be a prospect of tax accounting on the arising of a profit in carrying out the undertaking or scheme, but no present tax accounting. Cost will be determined as in the first limb transaction.

[12.119] The options may not be assets to which s. 26AAA could be applicable. They cannot be such if they are trading stock, revenue assets or assets held in an isolated business venture (s. 26AAA(5)). The applicability of s. 25A(1) does not however preclude the operation of s. 26AAA, though distinct and cumulative amounts cannot be included in income by the operations of both s. 25A(1) and s. 26AAA. However, s. 26AAA seems not to be applicable to the options. The inference to be drawn from paras (d) and (e) of s. 26AAA(1) is that giving value for the creation of a right is not a purchase of that right for purposes of s. 26AAA(2).

[12.120] The taxpayer may sell the options. If the options are trading stock, the proceeds of sale will be income, and the value of the options as opening stock of the year of sale, if they were acquired in a previous year, will in effect become deductible. The options will not be any longer on hand. If they are revenue assets, a profit determined by the excess of the proceeds of sale over the attributed cost of the options will be income. A loss would be deductible, but the assumption of a steady increase in the value of the shares would in fact exclude the possibility of a loss. If the options are assets to which the first limb of s. 25A(1) applies, a profit determined in the same way as for a revenue asset will be income.

[12.121] Instead of selling the options the taxpayer may exercise them and acquire shares. The question now raised is whether the exercise of an option is the realisation of that option, so that there may be an item of income or loss deduction then arising. British South Africa Co. v. Varty [1966] A.C. 381 is authority that the exercise of an option is not a realisation. It will follow that there are no proceeds that will be income on the exercise of options that are trading stock. It does not necessarily follow that the options remain “on hand” so that the cost or other value of them must continue to be deferred by the operation of s. 28. Yet it would distort the operation of the trading stock provisions to hold that the options are no longer on hand. A rational view of the operation of the provisions would treat the options as still on hand in the form of the shares into which they have been converted, and the shares as having a cost which includes the attributed cost of the options. The shares are treated as having been acquired in a two step transaction.

[12.122] The exercise of the options would not be a realisation of a revenue asset, or a realisation that will require the striking of a profit if there is an isolated business venture. And, presumably, the exercise of the options would not be an event on which a profit arises for purposes of the second limb of s. 25A(1). If the exercise of the options is not a realisation of them, it is, a fortiori, not a “sale” of them within the meaning of that word in s. 25A(1). There will not therefore be any accounting on the exercise of the options if they are s. 25A(1) first limb assets.

[12.123] The questions now raised concern the character of the shares acquired in the exercise of the options. The shares will presumably be trading stock if the options are trading stock. Alternatively, the shares may be revenue assets as assets acquired in what is, as yet, the incomplete process of realising the options that are revenue assets.

[12.124] If the shares are trading stock or revenue assets, they will not be assets subject to the operation of s. 25A(1) (Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355). And they will not be assets subject to the operation of s. 26AAA (s. 26AAA(5)). If they are not trading stock or revenue assets, they may be s. 25A(1) first limb assets. If they are s. 25A(1) first limb assets, their cost for purposes of the calculation of the profit that is income on the sale of the shares will depend on the analysis of the s. 25A(1) transaction. On one analysis the exercise of the options was an abortion of a transaction which involved the acquisition of the options for the purpose of profit-making by sale. It will follow that the exercise of the options is the first and only step in the acquisition of the shares for profit-making by sale, so that the cost of the shares must include both the amount paid on exercise of the options and the value of the options at the time of their exercise (Executor Trustee & Agency Co. of S.A. Ltd (Bristowe’s case) (1962) 36 A.L.J.R. 271. Another analysis will involve a lower cost. This analysis would treat the acquisition of the options and their exercise as steps in the acquisition of the shares for resale at a profit. It will follow that the cost of the shares is the value of the options at the time they were acquired, and the amount subscribed in the exercise of the options. The possible distinction between a one step acquisition and a two step acquisition is drawn by all members of the High Court in Steinberg (1975) 134 C.L.R. 640.

[12.125] There is yet another analysis that would exclude the operation of the first limb of s. 25A(1) by treating the acquisition of the shares, albeit for resale at a profit, as a step in the advantageous realisation of the options. This would follow the analysis adopted by Jacobs J. in Macmine Pty Ltd (1979) 53 A.L.J.R. 362 which is the subject of comment in [3.68] above.

[12.126] There will remain the possibility of the application of the second limb of s. 25A(1), or of s. 26AAA. The operation of the second limb of s. 25A(1) requires that the acquisition of the options and the exercise of the options be treated as steps in the carrying out of a profit-making undertaking or scheme. Treating the acquisition of the options and their exercise in this way will have to reject a view that any scheme was aborted by the exercise of the options, the scheme being a scheme to acquire the options and sell them. The view of Barwick C.J. in Steinberg (1975) 134 C.L.R. 640 that all details of a scheme must be formulated at the time of acquisition would exclude a view that there was simply a variation within a more general scheme to profit, and such an adjustment did not give rise to an abortion. If there is a scheme within the second limb of s. 25A(1), the costs of the shares that will enter the calculation of any profit that arises will be the value of the options at the time of their acquisition, and the amount paid on their exercise.

[12.127] The operation of s. 26AAA must begin with the acquisition of the shares. The acquisition of the options, it has already been noted, is not a purchase of them: the circumstances are not within the deemed purchase situations in paras (d) and (e) of s. 26AAA(1), and the express provisions made in those paragraphs would be treated as excluding the possibility of treating the giving of value for the issue of options as a purchase of those options. The acquisition of the shares by subscription, in exercise of the options, is a purchase (s. 26AAA(1)(b)). The cost of the shares will be the value of the options at the time of exercise and the amount paid on the exercise of the options. The amount of profit that is income if s. 26AAA applies will thus be less than the profit that may arise under the second limb of s. 25A(1).

[12.128] The final event in the assumed series of events is the disposition of the shares in response to a share exchange takeover bid. If the shares are trading stock there is presumably a realisation. British South Africa Co. v. Varty [1966] A.C. 381 would support such a conclusion. The value of the shares received in exchange would be proceeds of realisation. Questions of the precise time of the realisation, considered above in relation to the realisation of the land, will arise. The amount of proceeds may be different if the amount is to be determined at the time of issue of the shares received in the takeover, and not at the time of the acceptance of the takeover offer. The time of issue of the shares is the appropriate time.

[12.129] If the shares are revenue assets or assets of an isolated business venture, like questions will arise as to the fact of realisation and the moment when realisation occurs. If the first limb of s. 25A(1) is applicable, the issue is whether the share exchange is a sale. There are observations in Smith (1932) 48 C.L.R. 178 that would support a view that the exchange is a sale.

[12.130] The share exchange will be a sale for purposes of s. 26AAA (s. 26AAA(1)(f)), and if s. 26AAA is otherwise applicable there will be an operation of the section. The exercise of the options, involving a subscription of capital, is a purchase (s. 26AAA(1)(d)). The profit will be calculated by subtracting the value of the options at the time of their exercise and the amount paid on their exercise. The profit will then be less than the profit in the s. 25A(1) two stage acquisition situation.

[12.131] The complexity of the analysis required in relation to a relatively simple fact situation is the consequence of general principle and specific statutory provisions tending to converge. In some circumstances a moment of realisation will attract more than one basis on which a profit is income. Where it does, there are not several profits all subject to tax. But the Commissioner is presumably entitled to treat as income the highest profit that any applicable basis will yield.

​Where there is a rights or bonus issue in relation to shares held by the taxpayer

[12.132] The fact situation considered in previous paragraphs does not involve a rights or bonus issue. The tax accounting, if there is such an issue as an aspect of a transaction in shares, requires separate consideration. The tax accounting applicable to transactions in shares when there is a rights or bonus issue in relation to the shares will depend on the manner of the holding of the shares: whether they are held in circumstances which attract the operation of s. 25A(1) or s. 26AAA or of the ordinary usage concept of income. Within the ordinary usage concept they may be held as trading stock of a continuing business as in Investment & Merchant Finance (1971) 125 C.L.R. 249, or they may be held as revenue assets though not trading stock, of a continuing business. Illustrations of the latter are afforded by the view of the facts taken by Gibbs J. in London Australia Investment Co. (1977) 138 C.L.R. 106 and by the banking and life insurance cases ([2.455]ff. above).

[12.133] In the following account of the applicable tax accounting ss 25A(1) and 26AAA situations are dealt with first, in order that contrasts might be drawn when dealing with the operation of ordinary usage principles. It is assumed, however, that where there is a continuing business, s. 25A(1) will have no application: this is to adopt the view of Gibbs C.J. and Mason J. in Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355. It is also assumed that where there is a continuing business, s. 26AAA has in general no application: s. 26AAA(5)(a) excludes the operation of s. 26AAA where the property sold was “included in the assets of a business carried on by the taxpayer and, as a result of the sale, an amount will be included in the assessable income of the taxpayer of the year of income under a provision of [the] Act other than [s. 26AAA]”. It is also assumed that a rights issue (which would include an options issue) and a bonus share issue, made in relation to a taxpayer’s shares, are not income of the taxpayer as dividends under s. 44(1), or within an ordinary usage notion of a dividend. The discussion in [2.247] above is relevant. And it is assumed that a rights or bonus issue is not proceeds of realisation of the shares held by the taxpayer in relation to which the issue is made. The discussion in [12.73] and [12.75] above is relevant.

[12.134] There is, at least in theory, a possibility that, because of the operation of the principle in Curran (1974) 131 C.L.R. 409 to a rights issue in a continuing business situation, involving revenue assets that are not trading stock, ordinary usage business income principles may give rise to a loss and for this reason s. 26AAA(5)(a) will not operate to exclude the operation of s. 26AAA. The situation envisaged would involve the exercise of rights and the sale of shares. The simple sale of the rights acquired in a rights issue will not attract the operation of s. 26AAA since there is no purchase. But a sale of shares acquired in the exercise of rights in a continuing business situation may prima facie attract the operation of s. 26AAA to bring in a profit and may give rise to a loss on ordinary usage principles, at least as those principles are understood by Gibbs J. in Curran. Since there is no profit on ordinary usage principles, the possibility of the operation of s. 26AAA to give rise to a profit that is income is raised. The possibility would depend on the amount of cost attributable to the rights that are exercised in the deemed purchase of the shares sold within 12 months. That cost is presumably the value of the rights at the time of their exercise, which may be different from the cost attributable to the rights in the operation of the ordinary usage business principles which is their value at the time of issue. The competition between a loss deduction under ordinary usage principles and a profit under s. 26AAA would, presumably, be resolved in favour of bringing in the latter.

[12.135] The applicability of ordinary usage principles will almost invariably exclude s. 26AAA if the shares and rights are trading stock. In that event, save where the shares or rights are valueless, there will be an amount to be included in assessable income on sale: the trading stock provisions of the Assessment Act include in assessable income the whole of the proceeds of sale.

[12.136] There is nothing in s. 26AAA(5) that will exclude the operation of s. 25A(1). Where s. 25A(1) will give rise to an amount of assessable income, the Commissioner may include that amount notwithstanding that s. 26AAA would yield a lesser amount. And the Commissioner may include an amount under s. 26AAA, even though it is greater than the amount that would be included under s. 25A(1).

[12.137] Subsections (2)–(12) of s. 25A(1) include a number of provisions which extend the operation of s. 25A(1). One of these, s. 25A(4), deems bonus shares and rights, the issue of which is attendant on shares that were acquired for profit-making by sale, to have themselves been acquired for profit-making by sale, thus overcoming Miranda (1976) 76 A.T.C. 4180. Another provision, s. 25A(5), will deem the transferee of property where the property was acquired by the transferor for profit-making by sale, himself to have acquired for profit-making by sale, if, for example, the property was transferred to him by way of a gift or for less than an arm’s length price. Some reference is made to these provisions in the discussion of tax accounting that follows. The tax accounting implications of these provisions are considered more closely in Chapter 3 above. It is assumed that all the provisions of s. 25A(2)-(12), like those of s. 25A(1), are applicable only when the ordinary usage principles in relation to business income are not attracted. Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355 is taken to be authority.

[12.138] The model facts assumed in the following discussion are an acquisition of shares—“the original shares” and:

• (1) a sale of some original shares;
• (2) the issue of rights attendant upon some of the original shares, and the sale of those rights;
• (3) the issue of rights attendant upon some of the original shares, the exercise of those rights and the sale of the new shares;
• (4) the issue of bonus shares attendant upon some of the original shares and the sale of those bonus shares;
• (5) the disposal of original, new and bonus shares in response to a share exchange offer; and
• (6) the disposal of original, new and bonus shares in response to a share exchange offer and the sale of shares received in exchange for original, new and bonus shares.

​The operation of section 25A

[12.139] A sale of original shares will attract the operation of s. 25A(1) where they were acquired for profit-making by sale. There is a question of the cost of the original shares so sold where they are sold subsequent to a bonus issue or a rights issue attendant upon those shares. The Commissioner is empowered by s. 25A(10)(e) and by s. 6BA(3) to apportion the cost of the original shares between those shares and the bonus shares. The apportionment is made as the Commissioner considers appropriate in the circumstances. The effect of the exercise of the power is that the cost of the original shares will be less, and the profit that is income on the sale of the shares will be greater or the loss that is deductible under s. 52(1) will be less. There will presumably be no room for the operation of s. 52A, so as to empower the Commissioner to decline to take into account some part of the cost of the original shares in determining the profit or loss on their sale. Section 52A is applicable only where shares are acquired as trading stock or in the carrying on or carrying out of any profit-making undertaking or scheme, or are treated or used as assets of a business or in the carrying out of a profit-making undertaking or scheme. It is assumed that none of those circumstances exist in relation to the original shares.

[12.140] The Commissioner has no power under s. 25A(10)(e) and s. 6BA to apportion the cost of the original shares between those shares and the rights that have been issued attendant upon those original shares. For reasons explained in the last paragraph, the Commissioner has no power under s. 52A to decline to take into account some part of the cost of the original shares in determining the profit or loss on sale of the original shares. In the result the profit on the original shares that is assessable income will be limited or the loss deduction inflated by the making of a rights issue.

[12.141] Rights issued attendant upon the original shares will be brought within the operation of s. 25A(1) by s. 25A(4). The rights will be deemed to have been acquired for the purpose of profit-making by sale and to have been acquired at no cost (s. 25A(10)(d)). In the result the whole amount for which the rights are sold will be assessable income. There does not appear to be any function for the Commissioner to perform under s. 25A(9), which gives him power to determine the amount of the proceeds of sale that is deemed to be the profit arising from the sale of the rights. The provisions of s. 25A(10)(d) are mandatory. There is no transfer of any part of the cost of the original shares to the rights, and in this respect the treatment of rights received by the taxpayer in a rights issue and sold by him differs from the treatment of bonus shares received and sold. It is appropriate that s. 52A has no application in relation to the cost of the original shares: a reduction by the Commissioner of the cost of the original shares under s. 52A, if it did apply, would produce an unfair outcome.

[12.142] If the rights are not sold, but are exercised so that shares are acquired and those shares are sold, s. 25A(1) may be attracted by an actual acquisition of the shares for profit-making by sale. But there will not be a deemed acquisition for profit-making by sale. The deeming by s. 25A(4) is confined to the rights and does not extend to shares acquired in exercise of the rights.

[12.143] The taxpayer will carry the onus of showing that the shares were not acquired for profit-making by sale, but that onus might be discharged. And the conclusion may be drawn, in line with the judgment of Jacobs J. in Macmine Pty Ltd (1979) 53 A.L.J.R. 362, that an acquisition and sale of the shares is not within the first limb of s. 25A(1), because it is simply an advantageous realisation of the rights. If the first limb of s. 25A(1) is applicable in relation to the acquisition of the shares by exercise of the rights, there will be a question whether s. 25A(10)(d) applies to limit the cost of the shares to the amount paid in subscribing for the shares. That paragraph in its terms deems the rights to have been acquired at no cost, but this deeming is only for the purpose of determining the profit on the sale of property deemed to have been acquired by the taxpayer for profit-making by sale. It would be argued that s. 25A(10)(d) does not exclude the giving of a value to the rights which will be part of the cost of the shares, following the analysis in Executor, Trustee & Agency Co. of S.A. Ltd (Bristowe’s case) (1962) 36 A.L.J.R. 271.

[12.144] There is a possibility that subs. (6) of s. 25A will apply so that the sale of the shares acquired in exercise of the rights is deemed to be a sale of property acquired for the purpose of profit-making by sale, as property in which rights deemed to have been acquired for profit-making by sale have merged. The Commissioner would then, by the operation of subs. (9), have a power to fix a profit that is income. In the exercise of his function he is required by subs. (10)(c) to have regard to the extent to which the shares consist of or are attributable to the rights. The application of s. 25A(6) is doubtful. It was inserted to deal with merger of interest situations such as in McClelland (1970) 120 C.L.R. 487 and A. L. Hamblin Equipment Pty Ltd (1974) 131 C.L.R. 570. The exercise of rights is not easily described as a merger of the rights in the resulting shares. In any case there is nothing in subs. (6) that would require that the value of the rights at the time of the exercise should not be treated as a cost of the shares. It is true that s. 25A(10)(d), on a sale of the rights, requires that the rights be treated as having no cost. But there is no provision of s. 25A that makes the sale of shares a sale of rights exercised in acquiring the shares. In the result there would appear to be some advantage to be gained by the exercise of rights and sale of the resulting shares, rather than selling the rights.

[12.145] Where bonus shares attendant upon the original shares are issued they will be deemed by s. 25A(4) to have been acquired for profit-making by sale and s. 6BA is expressly attracted by s. 25A(10)(e). Section 6BA will have the effect of transferring some of the cost of the original shares to the bonus shares and of denying that any part of the moneys paid up on the bonus shares in the process of their issue is a cost to the taxpayer of the bonus shares, save where the bonus shares are assessable income and the taxpayer is not a company (s. 6BA(2) and (4)). The denying of cost by s. 6BA(2) will operate save where the moneys paid up have been or will be included in the assessable income of the taxpayer and the taxpayer is not a resident company (s. 6BA(4)). Section 25A(10)(e) taken with s. 6BA, is directed to overcoming the principle in Curran (1974) 131 C.L.R. 409 in its possible application to bonus shares deemed to have been acquired for profit-making by sale. The bonus shares may be sold in a transaction not at arm’s length for an amount that is less than their value, so as to bring about a loss. The loss will not, however, be deductible. Deductibility is excluded by s. 52: it is not expressly allowed by s. 52(2), and is denied generally by s. 52(5)(a).

[12.146] The taxpayer may dispose of some of the original shares or bonus shares in response to a share exchange takeover bid. Two questions arise: the first is whether a share exchange involves a sale and the second concerns the amount of the proceeds of such a sale that will enter the determination of the profit arising. The answer to the first question may be found in the judgment of Rich J. in Smith (1932) 48 C.L.R. 178 at 186: “Sale is not a word of precise technical import. In many contexts the essential idea it conveys is an agreement to transfer property for a valuable consideration”. The essential idea would embrace a transfer of shares in response to a share exchange takeover bid. The answer to the second question is presumably afforded by s. 21: the money value of the shares received in exchange is deemed to have been received by the taxpayer.

[12.147] On the sale of the shares acquired in exchange for the original or bonus shares, there will be an operation of s. 25A only if the acquisition was an acquisition with an actual purpose of profit-making by sale. There is no deeming arising from these circumstances. The shares acquired will have a cost equal to their value at the time of acquisition—the value brought to account in determining the profit on the transfer of propery in the original or bonus shares. The original or bonus shares must be taken to have been sold for an amount equal to the value of the shares taken in exchange and the shares taken in exchange to have been acquired for an amount equal to that value.

​The operation of s. 26AAA

[12.148] A sale of original shares will attract the operation of s. 26AAA where they were purchased within 12 months of the sale. “Purchase” and “sale” have extended meanings attributed to them by s. 26AAA(1). The amount of any profit will be income but a loss will not be deductible. Where the profit is greater than the profit that is income under s. 25A(1) and that section is applicable, the Commissioner is entitled to insist on the inclusion of the greater amount. The profit that is income under s. 26AAA may be greater because of the operation of s. 26AAA(4) which will attribute proceeds of sale equal to the price that would have been received in an arm’s length transaction. The amount of s. 25A(1) income may be less than the amount of s. 26AAA income because the former is calculated by reference to the actual sale price which, it is here assumed, is less than the arm’s length price. There will however be the prospect under s. 25A(5) of a further derivation of assessable income by the transferee of the original shares when he sells.

[12.149] Section 25A(5) deems the transferee to have acquired for profit-making by sale, where he acquired from a person who had acquired the property for profit-making by sale, and acquired it in a transfer not at arm’s length by way of gift or for a consideration less than the amount considered by the Commissioner to be the value of the property immediately before the transfer. When the transferee sells the Commissioner is empowered by s. 25A(9) to determine the amount of the profit then derived by the transferee. In determining that profit the Commissioner is required to have regard to the matters specified in subs. (10). Any expenditure by the transferee in acquiring the property is to be disregarded. The transferee takes the transferor’s costs and is entitled in effect to a further cost of the amount of any profit included in the income of the transferor in respect of the transfer of the propery. Profit, for this purpose, would presumably include profit that is income of the transferor under s. 26AAA. In the result double tax of the amount by which the transferor’s profit under s. 26AAA exceeds his s. 25A(1) profit is avoided.

[12.150] There is a question of the cost of the original shares for purposes of s. 26AAA where they are sold subsequent to a bonus issue or a rights issue attendant upon those shares. The question will be answered in the same manner as the like question considered in [12.139]–[12.140] above in relation to the operation of s. 25A(1). Again, there will be no room for the operation of s. 52A so as to empower the Commissioner to decline to take into account some part of the cost of the original shares in determining the profit on their sale.

[12.151] Section 25A(1) and s. 52(1) in the circumstances of the sale of the original shares may give rise to a loss that is deductible. Section 26AAA cannot give rise to a deductible loss.

[12.152] Where there has been a rights issue attendant upon the original shares and the rights are sold, the sale will not attract the operation of s. 26AAA. There has not been a purchase within the meaning of that word in s. 26AAA. The deeming by s. 25A(4) is not relevant to s. 26AAA.

[12.153] If the rights are not sold, but are exercised so that shares are acquired and those shares are sold, s. 26AAA may be attracted. There will be a purchase of the shares in the subscription for the shares (s. 26AAA(1)(d)) and the cost should include both the amount paid by way of subscription and the value of the rights at the time of the subscription. Section 26AAA cannot give rise to a loss. Where both s. 25A(1) and s. 26AAA operate to produce a profit that is income, the Commissioner may include the greater amount in the taxpayer’s income.

[12.154] Where bonus shares attendant upon the original shares are issued there may be a deemed purchase under s. 26AAA(7). The provision is primarily directed at determining the time of purchase of the bonus shares. But it seems also to deem the acquisition of the bonus shares to be a purchase of them. The cost of the bonus shares for purposes of determining the profit that is income will be the amount of cost transferred from the original shares by the Commissioner acting under s. 6BA. Section 6BA precludes any imputation of a cost that might have resulted from the operation of the principle in Curran (1974) 131 C.L.R. 409 unless the bonus shares are assessable income and the taxpayer is not a company (s. 6BA(2) and (4)). There cannot in any case be a deductible loss under s. 26AAA.

[12.155] The taxpayer may dispose of some of the original shares or the bonus shares in response to a share exchange takeover bid. The share exchange is a sale for purposes of s. 26AAA: it is made so by s. 26AAA(1)(f). The value of the shares received in exchange will be the proceeds of the sale. The cost of the original shares and of the bonus shares will be affected by the operation of s. 6BA. Section 26AAA cannot give rise to a loss.

[12.156] Shares acquired in exchange will be deemed to have been purchased (s. 26AAA(1)(f)). They will have a cost equal to their value at the time they were taken in exchange. Section 26AAA cannot give rise to a loss.

​The operation of ordinary usage principles in relation to business income

[12.157] The original shares may be held as trading stock of a continuing business of dealing, or as revenue assets, though not trading stock, of a continuing business. The shares may be sold after a bonus or rights issue attendant upon the shares has been made. In the circumstances the Commissioner may have power to adjust the cost of the shares. Where there has been a bonus issue and the original shares are trading stock, the Commissioner’s power will rest on s. 6BA and may also rest on s. 52A. The adjustment in the case of s. 6BA will be made under s. 6BA(3)(a). An adjustment in the case of s. 52A would be made under s. 52A(1) and (2). Where the adjustment is under s. 52A there is simply an adjustment to the cost of the original shares so as to deny some of the cost, and no transfer of the cost denied to the bonus shares. Presumably it would not be open to the Commissioner to rely on s. 52A and refuse the operation of the more specific provisions of s. 6BA which require a transfer of cost.

[12.158] Where there has been a bonus issue and the original shares are revenue assets but not trading stock the Commissioner’s power will rest on s. 6BA(3)(b). There will be no power to adjust cost under s. 52A.

[12.159] The Commissioner has no power under s. 6BA to transfer any part of the cost of the original shares to rights that have been issued attendant upon those original shares. Nor has he any power under s. 52A to deny any part of the cost of the original shares save where the original shares are trading stock. An adjustment under s. 52A does not involve any transfer of cost from the original shares to the rights issued attendant upon those shares.

[12.160] If rights issued attendant upon the original shares are sold they will have a cost determined by the principle in Curran (1974) 131 C.L.R. 409. The allowance of such a cost gives a rogue operation to the law, save where the Commissioner has disallowed under s. 52A some part of the cost of the original shares, the Commissioner having power to disallow because the original shares are trading stock. Section 25A(10)(d) has no operation to exclude the principle in Curran. Section 25A, it is assumed on the basis of the judgments of Gibbs C.J. and Mason J. in Whitfords Beach (1982) 150 C.L.R. 355, has no operation in an ordinary usage business situation.

[12.161] If the rights are exercised and the shares subscribed for are sold, the cost of the shares will include the value of the rights at the time of issue and the subscription amount: Executor Trustee & Agency Co. of S.A. Ltd (Bristowe’s case) (1962) 36 A.L.J.R. 271. Section 6BA will have no application to deny the Curran cost.

[12.162] Where the bonus shares are sold they will have as a cost the amount of any cost of the original shares transferred in accordance with s. 6BA(3). But they will not have a Curran cost unless the bonus shares are assessable income and the taxpayer is not a company (s. 6BA(2) and (4)).

[12.163] If the original shares or the bonus shares are disposed of in response to a share exchange takeover bid the value of the shares received in exchange will be proceeds that will be assessable income where the shares are trading stock, or will enter the determination of a profit that is income where they are revenue assets of a continuing business. In this instance the question whether the share exchange is a sale is not raised. The exchange is a realisation which is the occasion of a derivation of proceeds or of an element of profit in the proceeds.

[12.164] When the shares taken in exchange are sold they will have a cost equal to their value at the time of the share exchange—the amount brought to account in determining the assessable income, or the profit that is income on the disposal of the original or bonus shares.

​Where section 26AAC applies

[12.165] Tax accounting in relation to transactions in shares and rights to shares in circumstances which do not involve bonus issues or rights issues presents some difficulties. There are further difficulties when a bonus or a rights issue is involved. The difficulties are extreme when the transactions attract the operation of s. 26AAC.

[12.166] Section 26AAC is at least primarily concerned with the acquisition of shares or rights to acquire shares under a scheme for the acquisition of shares by employees, though subs. (1) would appear to make the section applicable in circumstances where the taxpayer is not an employee if the acquisition of shares or rights was “in respect of, or for or in relation directly or indirectly to … services rendered by the taxpayer or a relative of the taxpayer”. Some comment on the operation of s. 26AAC is made in [2.25]ff., [2.35], [4.20], [4.82]–[4.83], [4.85], [4.134]–[4.137] above. The present concern is with the problems of tax accounting to which the section may give rise.

[12.167] It will be assumed in what follows that a taxpayer who is a director of a company takes up an offer of options over the company’s shares, the offer having been made to him because he is a director, and pays a nominal amount for the options. The options are exercisable between specified dates. The exercise price is the market value of the shares at the time of the offer of the options. The taxpayer exercises the options, and thereafter sells the shares. There has been at all relevant times a steady and continuing increase in the market value of the company’s shares.

[12.168] If s. 26AAC does not apply, the tax accounting will follow general principles, supplemented by s. 26(e). There will be a derivation of income at the time the taxpayer takes up the offer of options (Abbott v. Philbin [1961] A.C. 352 and Donaldson (1974) 74 A.T.C. 4192). The amount of income will be the “value to the taxpayer” of the options less the amount paid by him in accepting the offer of options. The effect, in the determination of this value, of the fact that the options are not immediately exercisable, and the bearing of any inside information about the company’s affairs that the taxpayer may have, are discussed in [2.15]ff. above. The possible operation of s. 25A(1) or of s. 26AAA if the taxpayer subsequently exercises the options and thereafter sells the shares thus acquired, is considered in [2.18]ff. above.

[12.169] If s. 26AAC is applicable, the offer and acceptance of the options will not give rise to a derivation of income. General principles of derivation of income by ordinary usage are, it is assumed, excluded to this extent, though subs. (10) might have been more appropriately drafted. The assumption is made in the anticipation of legislative action to correct the consequence, explained in [1.39], [2.223] and [2.369] above, of the words added to s. 25(1) in 1984. Those words direct an inescapable inference that s. 26AAC cannot be treated as a code displacing ordinary usage principles. There may be a derivation of income by the taxpayer if he disposes of his options to a person who is not his associate. “Associate” is defined in s. 26AAC(14). There will be a derivation of income in the “amount received by the taxpayer as consideration for the right less the amount paid or payable by him as consideration for the right” (s. 26AAC(8)). It follows that a gift of the options to a person who is not an associate will preclude a derivation of income. There will be no derivation of income under s. 25A(1) first limb on the gift of the options even if it can be said that the options were acquired with the relevant purpose, since there is no sale, though there is the prospect that the donee will acquire with a deemed purpose of profit-making by sale under s. 25A(5). There will be no derivation of income under the second limb of s. 25A(1) if it be assumed that the simple acquisition and disposition of property is not a scheme. In any case the gift will, it seems, abort the scheme. There will be no derivation of income under s. 26AAA, though the gift is made within 12 months, because there has been no purchase. The inference to be drawn from paras (d) and (e) of s. 26AAA(1) is that the acquisition of rights that arise at the moment of acquisition is not a purchase of those rights.

[12.170] The sale of the options to a person who is not an associate could involve a derivation of income under s. 25A(1), as well as under s. 26AAC. Subsection (11) seeks to prevent double taxation by providing that the amount that would be income as a result of the operation of s. 26AAC(8) shall be reduced by so much of that amount as does not exceed the amount that would be included in the income of the taxpayer by virtue of another section of the Act. It might be asked whether subs. (11) in this aspect of its operation is necessary. An amount derived that is income on two grounds could not be income twice over.

[12.171] A disposition of the options by the taxpayer to an associate is not an occasion of the operation of s. 26AAC(8). There may, however, be an operation of s. 26AAC(7) if the associate, or another associate who has acquired from an associate, disposes of the options to a person who is neither an associate nor the taxpayer himself. In these circumstances the income of the taxpayer includes the amount, if any, received by the associate who disposes to a person who is not an associate, as consideration for the options, less the amount, if any, paid or payable by the taxpayer as consideration for the options. Each of the dispositions that will have occurred could have generated a derivation of income either under s. 25A(1) or, in the cases of all dispositions other than the first, under s. 26AAA. And if the associate is a dealer in options and shares there could have been a derivation by him in the operation of the trading stock provisions. Subsection (11) has a necessary operation to prevent what might be seen as double taxation in these circumstances. The amount of income derived by the taxpayer is reduced by the amount or amounts of income derived by the taxpayer or an associate, in the first disposition to an associate and in subsequent dispositions by associates or by the taxpayer. In one instance the operation of subs. (11) may defeat the intention of s. 26AAC. A company that is a share trader and an associate of the taxpayer might buy the options and sell them to the taxpayer or another associate at a time immediately before the sale by the taxpayer, or an associate, to a person who is not an associate. The associated company share dealer, if the purchase and sale by it are at market value, will derive little, if any, profit, but it will derive “assessable income” in the amount of the proceeds of sale. This assessable income will in general generate a tax liability for the associated company, only to the extent that it exceeds the price paid by the company for the options. Yet subs. (11) will allow an abatement of the amount that would otherwise be income derived by the taxpayer under subs. (7) to the full extent of the amount that was included in the assessable income of the company.

[12.172] If the taxpayer exercise the options, there will be a derivation of income by him under s. 26AAC(5), unless the taxpayer’s right to dispose of the shares he has acquired in the exercise of the options is restricted, or the taxpayer is liable to be divested of his ownership of the shares so acquired. The amount of income derived will be the value of the shares at the time they were acquired by the taxpayer, less the amount paid by him on the exercise of the options and the amount paid by him when he took up the offer of the options. The value of shares will be the market value and not the value to the taxpayer. If value to the taxpayer were applicable, inside knowledge of the affairs of the company might have had a bearing on value.

[12.173] When the taxpayer disposes of the shares acquired in exercise of the options there may be a derivation of income. Derivation will not depend on any provision of s. 26AAC, though the amount of income treated as derived may be reduced by the operation of s. 26AAC(12). That subsection requires that the amount derived by the taxpayer on the disposition of the shares be reduced by so much of that amount as does not exceed the amount included in his income under s. 26AAC(5). The reduction is intended to prevent double taxation. It is at least arguable that double taxation is in any case prevented by a general principle which would assert that where an item is an income receipt, or is a receipt that will enter the calculation of a profit that is income, it must, for purposes of determining income derived on any further transaction involving the realisation of that item, be treated as having a cost equivalent to the amount at which it was brought to account as income or at which it was brought to account in calculating a profit that is income. It would follow that for purposes of calculating a s. 25A(1) profit or a s. 26AAA profit in relation to the acquisition and realisation of the shares, the shares must be given a cost in the amount of their value for purposes of the earlier operation of s. 26AAC(5). The function of subs. (12) of s. 26AAC is thus obscure. Clearly it would be an absurd outcome if the taxpayer could have the value of the shares as a cost for purposes of s. 25A(1) or s. 26AAA and at the same time enjoy the reduction provided for in subs. (12).

[12.174] The options might have been disposed of by the taxpayer to an associate who in turn exercised the options. Section 26AAC(6) will make the acquisition of shares by the associate an acquisition by the taxpayer, and there will be a derivation of income by the taxpayer under s. 26AAC(5). The calculation of the amount of this income would involve the value of the shares, less the amount paid by the taxpayer in accepting the offer of the options and the amount paid by the associate in exercising the options. The associate may subsequently dispose of the shares he acquired in the exercise of the options. In which case s. 26AAC(12) is directed to avoiding an assumed double taxation arising from the inclusion of what is seen as the same profit in the income of the taxpayer and of the associate. The income derived by the associate is reduced by so much of the amount of that income as does not exceed the amount included in the income of the taxpayer. Where the associate has acquired the options from the taxpayer, he will presumably have paid an amount that reflects the increase in value of the options between the time of their acquisition by the taxpayer and the time of their acquisition from the taxpayer by the associate. The income derived by the taxpayer, which will reflect the increase in the value of the options from the time of his acquisition to the time of exercise, will thus cover a profit which in part would not come to be included in the profit derived by the associate. To reduce the associate’s income by the whole of the amount that is income of the taxpayer is, in effect, to allow some profit to go untaxed to anyone.

[12.175] Options may have been disposed of by the taxpayer to an associate who may in turn have disposed of the options to another associate who exercises the options. Indeed there might have been a reacquisition of the options by the taxpayer from the associate and a disposition of them to another associate who then exercises the options. The operation of s. 26AAC(5) on this exercise could involve the taxing of a profit which has in effect been already taxed in part to an associate or to the taxpayer. Subsection (12) does not appear to deal with such a double tax situation. It is confined to a situation of first disposition after the acquisition of the shares.

[12.176] The shares acquired by the taxpayer in the exercise of the options may be subject to restrictions on rights to dispose or may be liable to be divested. In this event the operation of s. 26AAC(5) is deferred until one of two events occurs: either the shares cease to be subject to the restriction or the liability to be divested, or the shares are disposed of by the taxpayer. For purposes of s. 26AAC(5), the shares are deemed to have been acquired by the taxpayer at the time when the shares ceased to be subject to the restriction or the liability to be divested, or the time immediately before the taxpayer disposed of the shares, whichever event first occurs. Where the acquisition is deemed to be at the moment immediately before the shares are disposed of, the shares will be valued at that time for purposes of the operation of s. 26AAC(5). They will be given a value that reflects the restrictions on disposition or the liability to be divested. A gift to an associate will presumably be a disposition for purposes of s. 26AAC(15), and such a gift may bring about some defeat of the policy of s. 26AAC.

[12.177] The operation of s. 26AAC(12) in circumstances where the operation of s. 26AAC(5) has resulted from a disposition of the shares is perplexing. The gift of the shares referred to in the last paragraph above may generate a profit that is income under subss (2) and (4) of s. 26AAA, the gift being treated as a sale at market value. Paragraph (b) of subs. (12) refers to the “first disposition” of the shares after an acquisition that will bring about a derivation of income under s. 26AAC(5). The gift by virtue of s. 26AAC(15) brings about an acquisition, for purposes of s. 26AAC(5), that is deemed to occur immediately before the disposition constituted by the gift. An analysis is thus possible which would treat s. 26AAC(12) as applicable, so that the s. 26AAA profit will be reduced by the amount that is income under s. 26AAC(5). The profit and this amount will be the same. If s. 26AAC(12) is not applicable, the taxpayer must assert a principle that an amount which is income on more than one basis is not several amounts of income. The fact that there are two amounts derived separated only by the deeming that one is immediately before the other, should not affect the operation of the principle.

[12.178] Shares may, in fact, have been acquired by the taxpayer, but that acquisition may not yet have generated the operation of s. 26AAC(5) because the shares are subject to restrictions on disposition, or the taxpayer is liable to be divested of his ownership of them. There is as yet no acquisition for purposes of s. 26AAC(5). A bonus issue of shares in respect of those shares is made, the bonus issue shares being subject to the same restrictions or liability. There is an initial question whether the bonus shares are shares acquired “under a scheme for the acquisition of shares by employees” as those words are defined in s. 26AAC(1). It is at least arguable that they are acquired “in respect of or for or in relation directly or indirectly to … services rendered” by the taxpayer. Indeed it is arguable that they are acquired under a scheme even if the original shares are not subject to restrictions, or there is no liability on the taxpayer to be divested, so that s. 26AAC(5) has already operated in respect of them, and there are no restrictions or liability applicable to the bonus shares. At least in those circumstances there will be some apparent conflict between s. 26AAC(5) and s. 44(2). The apparent conflict may be resolved by drawing attention to the fact that Gibb (1966) 118 C.L.R. 628, overruling W. E. Fuller Pty Ltd (1959) 101 C.L.R. 403, held that s. 44(2) does no more than avoid an operation of s. 44 that would give an income quality to the amount notionally distributed in a bonus issue. It does not preclude any general principle or other specific provision giving an income character to some aspect of a bonus share issue.

[12.179] If the bonus shares are to be regarded as acquired under a scheme, the operation of s. 6BA is excluded (s. 6BA(1)). The question then raised is whether the operation of s. 26AAC(5) in relation to the bonus shares will allow as a cost the amount notionally paid up on the shares that are the subject of the bonus issue. The view taken in this Volume would reject as incorrect the law in the judgments of Barwick C.J. and Gibbs J. in Curran (1974) 131 C.L.R. 409, and would ask for a reconsideration of that decision by the High Court. While Curran remains an authority, it is arguable that the amount paid up in the bonus issue is to be treated as an “amount paid” by the taxpayer for the bonus shares, as those words are used in s. 26AAC(5). There may not be “expenditure”, but the definition of amount paid in s. 26AAC(17) is not an exclusive definition. Some support might be gained from the express provision in s. 6BA(8) which, when s. 6BA operates, requires that the amount paid up on bonus shares should not be treated “as being an amount paid … in respect of the bonus shares”. If the amount paid up is an amount paid as consideration for the bonus shares, a bonus issue on shares that are subject to a scheme for the acquisition of shares within s. 26AAC becomes a means of tax planning, offering like tax advantage as those held to be available generally in Curran, and now denied by s. 6BA. The planning would ensure that the bonus shares and the original shares are affected by a restriction or liability that will defer the operation of s. 26AAC(5).

[12.180] The amount paid up on the bonus shares will “not be treated as being an amount paid or payable by the taxpayer in respect of the bonus shares or as in any way constituting any part of the cost to the taxpayer of the bonus shares” if a profit on realisation of the bonus shares falls to be taxed under s. 26AAA (s. 6BA(2)). Section 6BA(2) would equally apply in determining a s. 25A(1) profit. Section 25A(4) will make the operation of s. 25A(1) possible where bonus shares are involved: it overcomes Miranda (1976) 76 A.T.C. 4180. The profit under s. 26AAA may exceed the amount that is income under s. 26AAC(5). It is true that s. 26AAC(12) will reduce the amount that is income under s. 26AAA by the amount that is income under s. 26AAC(5), but the advantage of having the amount paid up on the bonus shares treated as a cost is defeated. Where s. 26AAC(5) operates at the moment before a disposition of shares that are subject to restriction or liability to be divested, any profit that is income under s. 26AAA arising on the disposition can be reduced by s. 26AAC(12) only to the extent of the amount of the s. 26AAC(5) income. There is a qualification that should be made to these statements. When the s. 26AAA profit is calculated, s. 6BA(3) will allow a deduction of some part of the cost of the original shares and for this reason the s. 26AAA profit in respect of the bonus shares might be less than the s. 26AAC(5) profit. But a s. 26AAA profit in respect of the original shares will be increased by the operation of s. 6BA(3), since the cost of those shares will be reduced by the amount of the cost that is now attributed to the bonus shares. The s. 26AAA profit in respect of the original shares will thus exceed the s. 26AAA(5) profit, which would suggest that a disposition that will bring on the operation of s. 26AAA and s. 26AAC(5) should be made only of the bonus shares. There is advantage in delaying the disposition of the original shares so that more than one year has elapsed since acquisition. Acquisition for this purpose will be the time of exercise of the options. In the case of the bonus shares the time of acquisition is also the time of the exercise of the options. This is the effect of s. 26AAA(7). That subsection might also settle a question whether there is a purchase of bonus shares for purposes of s. 26AAA when bonus shares are issued. The discussion above has proceeded on the assumption that there is. Section 26AAA(1)(d) operates to deem a purchase. In which case, s. 26AAA(7) will merely shift the time of purchase to the time when the taxpayer exercised the options and acquired the shares. Section 26AAA(7) may do more. It may supply a deemed purchase as well as fixing the time of purchase. There is a question of the meaning of the words “shall be deemed, for purposes of this section, to have purchased the bonus shares at the time when he purchased the shares in respect of which the dividend was payable”.

Accounting for Debts

[12.181] Attention was given in [6.310]ff. above to the notion of a revenue asset as it applies to a debt. A profit or loss on realisation of a debt that is a revenue asset may be income by ordinary usage or deductible under s. 51(1). A profit or loss on the realisation of a debt receivable that would not be described as a revenue asset may none the less be income or deductible where tax accounting has required that it be brought to account in determining the profit that is income or the loss that is deductible in a transaction that is an isolated venture. A profit or loss on realisation of a debt that is neither a revenue asset nor a debt thus brought to account may be income or deductible under s. 25A(1) and s. 52, and a profit may be income under s. 26AAA.

[12.182] Attention was given in [6.322]ff. above to the notion of a liability on revenue account, and the matter is raised again in regard to accounting for exchange gains and losses in [12.192]-[12.211] below. A profit or loss on the discharge of a liability on revenue account may be income by ordinary usage or deductible under s. 51(1). A profit or loss on the discharge of a debt payable may be income or deductible if the debt payable has been brought to account in determining the profit that is income or the loss that is deductible in a transaction that is an isolated venture.

Accounting for profit or loss in regard to a debt receivable

[12.183] Accounting for a profit or loss in regard to a debt receivable must distinguish circumstances to which s. 63 is applicable, a section that may allow the anticipation of a loss deduction, and circumstances where there is a derivation of a profit that is income, or a loss that is deductible under s. 51(1) or s. 52. The circumstances in which s. 63 is applicable are considered in [10.50]ff. above. The accounting contemplated by s. 63(3) involves the prospect of an adjustment if, in a year subsequent to the write-off, there is an amount recovered in respect of the debt that wholly or partly recoups the loss that was the subject of the write-off. The realisation of the debt may thus have tax consequences when there would otherwise have been no tax consequences because there has been a cessation of the business of which the debt was a revenue asset and that cessation preceded the realisation. Save where the debt was trading stock, the realisation of a debt after cessation will not, it seems, generate a profit that is income or a deductible loss. A.G.C. (Advances) Ltd (1975) 132 C.L.R. 175, though grudgingly, recognises a principle that the realisation of a debt that was a revenue asset of a business, the realisation being after the cessation of the business, cannot give rise to a loss deductible under s. 51(1). It must follow that the realisation cannot give rise to a profit that is income. The special situation of trading stock is considered in [12.103] above and [14.64]ff. below.

[12.184] There can be no profit that is income, or loss that is deductible under s. 51(1), until the realisation of the debt. Realisation of the debt will occur when the debt is disposed of, when it is released, when there is a receipt by the creditor that will discharge the debt or when the debt becomes commercially irrecoverable. Accounting for the gain or loss requires a balancing of the cost of the debt, normally its amount, and any amount received on the disposition of the debt, the release of the debt or its discharge. Where an amount receivable as a result of realisation is not yet the subject of an actual receipt of the whole amount, issues as to the manner of accounting for a profit or loss considered in [12.8]ff. above are raised. Where actual receipts have come to exceed the cost of a revenue asset, there will be at least a partial emergence of a profit that will be regarded as derived, and later receipts will involve a further emergence. Where actual receipts do not exceed cost, a deductible loss should not be recognised unless all of the amount that may be judged commercially recoverable has been recovered. This may be seen as the necessary corollary of a profit emerging approach applied to the derivation of a profit.

Accounting for profit or loss in relation to a debt payable

[12.185] The recognition of a profit that is income or a deductible loss arising on the discharge of a liability on revenue account, has been principally in the field of exchange gains and losses. The recognition of a gain in International Nickel Aust. Ltd (1977) 137 C.L.R. 347, provoked some consideration of a need to recognise gains in other circumstances, and to explain the failure to recognise a gain in the House of Lords decision in British Mexican Petroleum Co. Ltd V. I.R.C. (1932) 16 T.C. 570, where a taxpayer obtained release from a liability on revenue account by payment of an amount less than the amount of the liability. Reference was made in [6.328] above to the suggestion by Mason J. in International Nickel that British Mexican is to be explained on the ground that the discharge of the liability was not done in the ordinary course of the taxpayer’s business. This would be to acknowledge a principle in regard to gain or loss in the discharge of liabilities parallel with a principle that would seem to be established in regard to gain or loss in the realisation of revenue assets. The adoption of the principle in Sharkey v Wernher [1956] A.C. 58 in respect to a revenue asset disposed of otherwise than in the ordinary course of business would require the adoption of a like principle in respect to a liability: the liability would be deemed to have been discharged for its value and any resulting gain or loss treated as income or deductible. The amount paid in securing an actual discharge would be evidence of value.

[12.186] The striking of a profit or loss on the discharge of a liability on revenue account will require a balancing of the amount of the liability and any amount outlaid to discharge the liability. Where the amount actually outlaid, which may include penalty interest, is more than the amount of the liability, there will be a deductible loss. There will be a gain that is income where the amount outlaid to discharge the liability is less than the amount of the liability: Mutual Acceptance Ltd (1984) 84 A.T.C. 4831. If the amount of the liability ceases to be payable as a matter of law or commercial probability, there will be a profit that is income from the discharge of the liability.

Accounting where an item other than cash is taken in satisfaction or given in discharge

[12.187] Some consideration was given in [6.319] and [6.322] above to the meaning of realisation of a debt that may give rise to a profit that is income or a deductible loss, and to the meaning of discharge of a liability on revenue account that may give rise to profit that is income or a deductible loss. What is received in a realisation or what is given in discharge may be some item other than cash. In particular, it may be another receivable or another liability. The receivable or the liability must be valued in determining the proceeds of realisation or the cost of discharge.

[12.188] A taxpayer entitled to be paid by a company for goods supplied or services rendered may accept a debenture issued by the company. There will be an immediate question whether he has taken the debenture by way of security or by way of satisfaction of the debt he is owed. In the first case there is no realisation, though there may be a realisation if he exercises his power of sale of the security. If there is no realisation the debt subsists. It may be the subject of a write-off under s. 63 and, on subsequent realisation, there will be a loss deduction or derivation of income. The determination of profit or loss on the subsequent realisation will reflect the amount allowed as a deduction on the s. 63 write-off. If the debenture is taken in satisfaction, there will be a realisation, and a moment for striking a profit that is income or a loss that is deductible. For this purpose the debenture must be valued. The debenture does not necessarily succeed to the character of revenue asset that attached to the original debt. The creditor may have been content to make an investment by lending to the debtor the amount he was owed. The character of the debenture as a revenue asset will then depend on other principles. Thus, the debenture may be an addition to the taxpayer’s trading stock, or be a revenue asset of a business of the kind Gibbs J. found to exist in London Australia Investment Co. Ltd (1977) 138 C.L.R. 106.

[12.189] But the possibility that the debenture takes on the character of the original debt should not be excluded. There is room for a principle that a taxpayer who takes a debenture in satisfaction of a debt in circumstances where no other way of obtaining payment is commercially open to him, acquires an asset that has the character as a revenue asset that attached to the original debt. Receiving payment of a business debt is an aspect of carrying on a business. The acquisition of the debenture is thus an acquisition in the course of carrying on the business, and should be treated as a revenue asset. The fact that the debenture is evidence of a debt and that the revenue asset realised was a debt, is not significant. A block of land taken by a taxpayer in satisfaction of a debt that is a revenue asset may equally succeed to the character of the debt, if taking the land is commercially necessary to obtain payment of the debt.

[12.190] The decision of Hunt J. in Commercial Banking Company of Sydney Ltd (1983) 83 A.T.C. 4208 is in some conflict with views expressed in this Volume. Some debts owed to the bank as interest presently payable by customers had not been brought to account in earlier years as assessable income of the bank. The interest had become presently receivable before the New Zealand decision in National Bank of N.Z. v. C.I.R. (1977) 77 A.T.C. 6001 at 6034, and at a time when it was assumed that at least that part of an interest receivable whose recovery was doubtful did not have to be brought to account when it became receivable. The Commissioner did not attempt an amendment of earlier assessments so as to bring in as income the interest in question. The taxpayer purported to write-off the debts for interest under s. 63. Hunt J. was not prepared to allow a deduction on this ground, though on this point he was overruled by the Federal Court (sub nom. National Commercial Banking Corp. of Aust. Ltd (1983) 83 A.T.C. 4715). He did, however allow a deduction under s. 51(1). Some consideration should have been given to the question whether the debts had been realised. In failing to consider this issue, the judgment of Hunt J. perpetuates the idea, now given some statutory support in s. 63A of the Assessment Act, that the event which will generate a deduction under s. 51(1) for a loss in respect of a debt is the writing-off of the debt. The matter is discussed in [6.318] above. The allowing of a deduction, notwithstanding that the debts for interest had not been brought to account as assessable income, can be justified on reasoning of a kind adopted by Kitto J. in Country Magazine Pty Ltd (1968) 117 C.L.R. 162. On a true view of the law the debts were derived as assessable income, and were thus revenue assets. The fact that they had not been the subject of an assessment did not affect the matter.

[12.191] Another aspect of Commercial Banking Company of Sydney Ltd calls for comment. Hunt J. considered it important that the debts for interest had been added to the principal sum, so that they now themselves bore interest. Only in these circumstances did he think they could attract a s. 51(1) loss deduction. In this aspect, his judgment is in conflict with the view taken in this Volume, and it is suggested, with the law underlying the exchange gains and losses cases. If a debt for goods supplied or for services rendered is a revenue asset immediately it arises, a debt for interest or rent, as debts for allowing the use of money or land, are revenue assets immediately they arise. It is true that establishing a cost for a receivable depends on an analysis that is not easily expressed: an attempt is made in [6.311], [6.325]-[6.326]. The cost of a receivable is the accommodation granted. But to insist that there must have been a further event in relation to the receivable—sometimes referred to as a “capitalisation”—before it may be regarded as a receivable that has a cost, seems at odds with established authority, in particular the exchange gains and losses cases. And it raises the question—suggested perhaps by the use of the word “capitalised” in the common description of the event—whether the receivable may not have already been the subject of payment followed by a new transaction by which the amount of the payment has been lent to the debtor. The debt on this lending would not necessarily be a revenue asset.

Accounting for Exchange Gains or Losses

[12.192] The tax law as to when an exchange gain or loss in relation to a debt is income or a deductible outgoing is a particular expression of general principles in relation to gains and losses in respect of debts. It is an exchange gain and loss case, AVCO Financial Services Ltd (1982) 150 C.L.R. 510 that has given us what law we may have on the character of a liability as a liability on revenue account, where a debt for money borrowed is involved. The law has been discussed in [6.328]-[6.330] above.

[12.193] To describe a gain or loss as an exchange gain or loss is no more than to give a reason why a gain or loss in relation to a debt has occurred. The possibility of treating an exchange loss on the discharge of a liability as an additional interest expense is raised by an observation in the judgment of Rogers J. in Hunter Douglas Ltd (1982) 82 A.T.C. 4550 at 4559. Such a treatment would not be consistent with the reasoning in AVCO Financial Services where the focus is on the revenue character of the liability. An approach in terms of an additional payment of interest would need to focus on the character of the borrowing as a borrowing of money used to produce income, which is a different character. The matter is the subject of some observations in [6.329] above. An exchange gain could hardly be treated as some kind of reverse interest, and coherence in the treatment of exchange gains and losses is abandoned if a loss is treated as additional interest.

[12.194] An exchange gain or loss will most often arise in the receipt of payment of a debt, or in the making of payment of a debt. It may, however, arise in other ways. Thus a taxpayer may be owed a debt in a foreign currency and that debt is a revenue asset. If he sells the debt for an amount in the same currency he may experience a loss, not only because the amount he receives reflects some doubt about the financial responsibility of his debtor, but also because a change in exchange rate has given rise to the consequence that what he receives in the foreign currency has a value in Australian currency less than its value at the time the debt arose.

[12.195] In some sense of “bad”, an exchange loss in relation to a receivable may be seen as a bad debt loss. The taxpayer receives less in Australian currency in payment of his receivable than the amount expressed in Australian currency at which it was brought to account as income, or the amount of the loan expressed in Australian currency at the time of lending where it is a debt on a loan. The reason he receives less is that the exchange rate has moved unfavourably, but one would think that there is no reason to distinguish his situation from that of a taxpayer who receives less because his debtor is not able to pay him in full. Reasoning of this kind might suggest that s. 63 should be available to a taxpayer so that he might have a deduction in anticipation of an exchange loss that is impending. It would be assumed, however, that s. 63 will be interpreted so that the notion of “bad debt” is confined to circumstances where the debtor is unable to pay the full amount.

[12.196] The common situations in which an exchange gain that is income or an exchange loss that is deductible may arise are:

• (1) a taxpayer buys goods or services and agrees to pay for them in a foreign currency;
• (2) a taxpayer sells goods or services and is entitled to receive payment in a foreign currency;
• (3) a taxpayer borrows money in a foreign currency repayable in that currency; and
• (4) a taxpayer lends money in a foreign currency and is entitled to repayment in that currency.

An income gain, or a loss that is deductible, will generally arise when the liability is on revenue account, and it has been discharged by payment, or the right to receive payment is on revenue account and the taxpayer has received payment. It is assumed that what is a payment and what is a receipt of payment for these purposes is determined by principles examined in [11.122]–[11.149] and [11.174]–[11.187] above, which determine what is a receipt and what is an outgoing by a taxpayer on a cash basis in relation to the item. Notions of constructive receipt and constructive payment will have their applications.

[12.197] There may be a profit or loss emerging. Where receipts come to exceed the cost of a receivable there will be a profit emerging. Further receipts will give rise to the derivation of further profits. Where receipts are as yet less than the cost there will be a loss emerging only when there is no commercial prospect of further receipts. Should the commercial prospect prove wrong, and there are further receipts, there will be profit emerging which will in effect adjust the amount of the loss.

[12.198] The judicial decisions are concentrated in the area of profit or loss on discharge of liabilities arising in respect of goods or services received or the borrowing of money. There are no cases which concern a gain or loss on the receipt of a receivable.

[12.199] Three decisions of the High Court emphasise discharge as the occasion when a profit or loss will be struck in relation to a liability. There is a possible distinction between a change in the nature of a liability, and a discharge of a liability that might be immediately replaced by a new liability. The decisions in Texas Co. (Australasia) Ltd (1940) 63 C.L.R. 382, and Armco (Australia) Pty Ltd (1948) 76 C.L.R. 584 might be taken to reject a view that a profit or loss should be struck when a liability changes its character from a liability on revenue account to a liability on capital account, or to a liability that may be described as a private liability. Attention was given in [12.104] above to a view of the law that would treat a change in the character of a revenue asset, as in Sharkey v. Wernher [1956] A.C. 58, as an occasion of realisation of that asset at its market value. It would be an appropriate extension of such law to treat a change in the character of a liability on revenue account as a discharge of that liability at the arm’s length amount that would need to be paid to effect the discharge. Murphy (1961) 106 C.L.R. 146, in holding that a revenue asset that is once trading stock cannot change its character so as to avoid the operation of s. 36, may have established a principle applicable to other revenue assets. In Murphy the business in which the assets were trading stock had itself come to an end. An argument that the assets had in effect become private assets, and could not generate an income gain on realisation was rejected. Murphy does not sit with Sharkey v. Wernher. Sharkey v. Wernher would have required a finding of a deemed realisation at the time the business ceased. Murphy preserves the character of the item so as to allow an operation of s. 36 on actual realisation. The case is at odds with A.G.C. (Advances) Ltd (1975) 132 C.L.R. 175 so far as that case supports a view that a debt that was a revenue asset but is disposed of after the business has ceased cannot generate a loss that is deductible. There may yet be room for a submission that in both Murphy and A.G.C. (Advances) the wrong issue was raised. The issue should have been whether the undoubted change in character that resulted from the cessation of the business was not a deemed realisation. The applicability of Sharkey v. Wernher would then have been raised. And the applicability of a similar principle in relation to liabilities might have been left open for decision. But Sharkey v. Wernher has been subject to qualification in the United Kingdom in Mason v. Innes [1967] 2 W.L.R. 479, and Texas Co. (Australasia) Pty Ltd and Armco (Australia) Pty Ltd would appear to reject the decision in its possible application to accounting for debts where an exchange gain or loss is involved.

[12.200] The third case emphasising discharge as the occasion when a profit or loss will be struck is Caltex Ltd (1960) 106 C.L.R. 205. In that case there was an attempted discharge of a debt in a foreign currency using moneys borrowed in the same currency from a related company. The majority of the High Court took a view of the matter that looked to “reality” and “substance”, in holding that there had not been a discharge so as to generate a deductible exchange loss. There is a parallel between this conclusion and that reached by Rich J. in The Permanent Trustee Co (Executors of Estate of F. H. Prior, dec’d) (1940) 6 A.T.D. 5 discussed in [11.127] above, in relation to the receipt of payment of moneys owing to the taxpayer for interest on a debt.

[12.201] It could hardly be denied that in Caltex a new liability had taken the place of the liability that it had been sought to discharge, and the case leaves a question whether that new liability has the revenue character of the initial liability, so that it could generate an exchange gain or loss on its discharge. It will be seen that a borrowing specifically to provide funds to discharge a liability on revenue account may itself be regarded as giving rise to a liability on revenue account. The authorities are Thiess Toyota Pty Ltd (1978) 78 A.T.C. 4463 and Cadbury-Fry Pascall (Aust.) Ltd (1979) 79 A.T.C. 4346. The new liability in Caltex, it would be argued, was a liability on revenue account.

[12.202] In Caltex the attempt to discharge the debt to the parent company in U.S. dollars was made with U.S. dollars. Which may suggest that a discharge that may give rise to an exchange gain or loss must involve the conversion of Australian dollars into the foreign currency in which the debt is owed. The judgments in the case do not suggest any such rule. It follows that an Australian resident taxpayer engaged in branch operations abroad may make an exchange gain or loss on every payment received for goods or services supplied, or on every payment made for goods or services received, if there is a movement in the rate of exchange of Australian currency for the currency in which the branch operations are conducted. The conclusion may be surprising, but it is inescapable. A transaction under which foreign currency is acquired may have tax consequences which are distinct from the consequences of the discharge of a liability by payment in a foreign currency. A taxpayer may enter into a transaction by which he is entitled to buy foreign currency in the future at a specified price in Australian dollars, his object being to “hedge” against his possible loss on another transaction under which he will be liable to make a payment in the foreign currency. The first transaction may be seen as incidental to the business activity out of which the latter transaction arose. If the value of the foreign currency has increased in relation to the Australian dollar, the taxpayer may make a gain that is income on the surrender of his rights under the contract in the first transaction; or he may make a gain by the exercise of his rights under that contract to obtain the foreign currency, and the application of foreign currency in discharging the liability in the second transaction. There is a realisation of the foreign currency obtained in the first transaction for the amount in Australian currency required to discharge the liability in the second transaction. The gain that is income in the first transaction will be off-set by the loss that is deductible in the second. A like analysis is appropriate in explaining the consequences of a so-called currency “swap” transaction associated with the discharge of a liability on revenue account. By selling an amount of foreign currency for delivery in the future, a taxpayer may “hedge” against a possible loss on a transaction under which he will be entitled to receive on revenue account an amount in the foreign currency in the future. The contract may be seen as incidental to the carrying on of the business out of which the receivable on revenue account arose. A gain or loss that will be income or deductible arising from the contract to sell the foreign currency will be realised when foreign currency is acquired and delivered under the contract of sale, or when the taxpayer receives an amount in Australian currency or pays an amount in Australian currency, to grant a release or to obtain a release from the contract. A currency “straddle” involving a contract to sell in the future, and a matching contract to buy in the future may give rise to a potential loss on one contract and a potential gain on another. A taxpayer who realises his loss on one contract before year end and takes his gain on the other after year end, may achieve a deferral of income. Matching contracts may be used in the same way where they relate to commodities, so that a commodity straddle is established. The arising of losses and gains that are deductible or income, will turn on the contracts being revenue assets of a business carried on by the taxpayer. A contract is unlikely to be regarded as an isolated business venture or a s. 25A(1) second limb transaction. The contract may be a revenue asset of a business if making contracts of these kinds is incidental to the business operations of the taxpayer. The taxpayer may be “hedging” against a change in the value of foreign currency which he may have contracted to pay, or to receive in the course of his business, though there may be some reason to doubt that he is hedging when his rights to payment and his obligations to pay in the future in the foreign currency match one another. It is not easy to see how the taxpayer could be said to make matching contracts as a business in itself. A profit purpose is lacking in the view of this Volume, as it was lacking in Investment & Merchant Finance Corp. Ltd. The taxpayer may be in business of making profits by speculations in the futures market but the making of matching contracts is not an aspect of that business.

[12.203] A taxpayer may be subject to a number of liabilities to the same creditor, some of them on revenue account and some not. There may be a question as to which liability has been discharged by a payment. Texas Co. (Australasia) Pty Ltd (1940) 63 C.L.R. 382 may support a view that liabilities must be taken to be discharged in the order in which the debtor became subject to them. There does not appear however to be any reason to deny the application of the general law of appropriation, by which the identity of the debt discharged will be determined by the debtor’s appropriation, or, in the absence of action by the debtor, then by the appropriation of the creditor.

[12.204] Texas Co. (Australasia) Pty Ltd (1940) 63 C.L.R. 382, Armco (Australia) Pty Ltd (1948) 76 C.L.R. 584 and Caltex Ltd (1960) 106 C.L.R. 205 all involved a claim for a loss in the discharge of a liability. Where a loss would be deductible, a gain will be income. International Nickel Aust. Ltd (1977) 137 C.L.R. 347 is authority. The integrity of the law clearly requires such a conclusion. The High Court was impressed by the novelty of a notion of a gain from the discharge of a liability. A loss can be rationalised as a further outgoing, but a rationalisation of a gain as a further receipt is simply not open. International Nickel, indeed, is a frank admission by the High Court that, in some circumstances, specific profit accounting is applicable, and displaces receipts and outgoings accounting.

[12.205] There is, however, an observation by Mason J. in International Nickel which maintains some place for receipts and outgoings accounting in relation to the discharge of a liability. He suggested that if a debt for trading stock is both incurred and discharged in the same year of income, the cost of the trading stock will be treated as the amount in Australian currency paid to discharge the debt. At the same time he recognised that a payment in the following year would be dealt with in terms of profit and loss accounting, and that the cost of the trading stock would remain the amount of the debt incurred expressed in Australian currency. The letting in of receipts and outgoings where the debt is discharged in the year in which it is incurred may be justified by simplicity in administration and compliance. But it is an abandonment of principle. A taxpayer may buy trading stock for $100, the amount of Australian currency at the time the debt in a foreign currency is incurred, and discharge that liability before the end of the year of income for $120 Australian currency. On the approach suggested by Mason J., he will be denied a present deduction for the $20 exchange loss. If one assumes that the trading stock is still on hand at year end, Mason J. would allow a deduction of $120 but treat this as the cost that will be deferred by the operation of s. 28. The effect is that the $20 loss will be deferred until the year in which the trading stock is sold. These consequences may be compared with the consequences if the debt is discharged for $120 in the next following year of income and the goods remain on hand at the end of that year. The discharge will generate a loss deduction in the year of discharge and there will be no deferral to the year of realisation of the stock. The cost of the trading stock will be $100 and this is the cost deferred to the year of realisation by the operation of s. 28.

[12.206] A good deal of attention has been given in judicial decision to exchange gains and losses arising from the discharge of a liability on a borrowing. While the issue is in all cases whether the liability is on revenue account, the notion of a borrowing on revenue account is ill-defined. The matter is discussed in [6.329] above. In AVCO Financial Services Ltd (1982) 150 C.L.R. 510, the High Court rejected the suggestion of Gibbs J. in Commercial & General Acceptance Ltd (1977) 137 C.L.R. 373 that a liability on a borrowing will never be on revenue account. A borrowing made specifically to discharge a liability on revenue account will itself be a liability on revenue account. Thiess Toyota Pty Ltd (1978) 78 A.T.C. 4463 and Cadbury-Fry Pascall (Aust.) (1979) 79 A.T.C. 4346 have not been questioned. Presumably it is the objective purpose or function of the borrowing that is relevant, and tracing of the money borrowed into the money paid to discharge the liability on revenue account is unnecessary. AVCO iself would appear to establish that a borrowing whose function is to finance the acquisition of trading stock, is a borrowing on revenue account. It would be assumed that a borrowing to finance the acquisition of other revenue assets, for example the investments in London Australia Investment Co. Ltd (1977) 138 C.L.R. 106 would be treated in the same way as a borrowing to finance the acquisition of trading stock. And a borrowing to finance loans made by a taxpayer whose business is to lend—the actual circumstances of AVCO—will be a borrowing on revenue account. Though some of the language used in Commercial & General Acceptance Ltd and in AVCO may suggest that an actual tracing of the money borrowed into outgoings on trading stock or other revenue assets, or the lending on revenue account, is necessary, it would appear that an actual movement of funds in this way is no more than an indication of the function of the borrowing. Put in another way, any tracing required is a tracing through purposes—the notion suggested in [6.86]ff. above in relation to a determination that a borrowing has been used in a process of derivation of income.

[12.207] A borrowing whose function is to finance the acquisition of assets that are structural assets of a business or to finance the acquisition of pure investments, will not be a borrowing on revenue account (Commercial & General Acceptance). There is thus a vital distinction, already emphasised in this Volume on a number of occasions, between the deductibility of interest on a borrowing and the deductibility of an exchange or other loss in relation to that borrowing. Interest will be deductible where the money borrowed has been used in a process of income derivation by being outlaid in the acquisition of structural assets of a business, or in investment whence income is derived.

[12.208] The Federal Court in Hunter Douglas Ltd (1983) 83 A.T.C. 4562 would appear to have established that a function in borrowing which is to meet regular business outgoings, other than for the acquisition of trading stock or other revenue assets, or to lend on revenue account, will not give the borrowing the character of a liability on revenue account. A function of the borrowing to provide working capital to be used in the running expenses of a business, expenses that will be consumed and will generally be deductible outgoings, will not give the borrowing the character of a liability on revenue account. The justification for a distinction between a borrowing to acquire trading stock and a borrowing to meet expenses that will be consumed in the running of a business is not evident. If the distinction is to be drawn, the principle for which Thiess Toyota Pty Ltd (1978) 78 A.T.C. 4463 and Cadbury-Fry Pascall (Aust.) Ltd (1979) 79 A.T.C. 4346 appear to stand would need reconsideration. It is true that in both cases the borrowing was to meet the cost of trading stock. There is, however, no suggestion in the cases that the exchange loss would have been differently treated if the borrowing had been made to meet the costs of shipping the trading stock.

[12.209] The difficulties of analysis that have resulted from an approach that focuses on the function of the borrowing in determining the character of the borrowing, may suggest that a different approach concerned with the nature of the borrowing itself is appropriate. The different approach assumes that a distinction can be drawn between the function of a borrowing and the nature of the borrowing itself. The “nature of the borrowing” may be seen as involving a broader characterisation, which may be assisted by an identification of the function of the borrowing but is not determined by it. The characterisation of the borrowing as a revenue liability will require a conclusion that the borrowing was made in carrying on the business of the taxpayer, which will exclude any borrowing where there is no business. The borrowing may be directly in the carrying on of the taxpayer’s business operations, as it will be where it is a borrowing by a bank to lend in the course of its business. It may be a borrowing incidental to the carrying on of the taxpayer’s business—a short term borrowing to finance the acquisition of trading stock as in Thiess Toyota and Cadbury-Fry Pascall. Or it may be a borrowing that reflects system and organisation directed to minimising the cost of borrowing. In the last instance, the borrowing will most often be short term. The longer the period of borrowing the less will be the regularity of borrowing and the less will be the system and organisation that it reflects. In this instance, the notion of a borrowing on revenue account will correspond with the particular notion of a revenue asset reflected in the judgment of Gibbs J. in London Australia Investment Co. Ltd (1977) 138 C.L.R. 106. His judgment recognises a business activity of investing where the investing reflects system and organisation directed to maximising the income that may be derived from the investment. The notion of a borrowing on revenue account will recognise a business activity of borrowing where the borrowing reflects system and organisation directed to minimising the costs of borrowing.

[12.210] An approach concerned with the nature of the borrowing itself, function being only an indication of that nature, will resolve the apparent conflict between AVCO Financial Services Ltd (1982) 150 C.L.R. 510 and Hunter Douglas (1983) 83 A.T.C. 4562. AVCO will be explained in terms of a direct business activity of a finance company in borrowing money, and not in terms of the function of the borrowing to finance revenue assets—loans to customers—seen as akin to trading stock. In Hunter Douglas a function of the borrowing to acquire trading stock would have made no difference to the outcome. Function can do no more than indicate that the borrowing was incidental to the carrying on of business. In Thiess Toyota Pty Ltd (1978) 78 A.T.C. 4463 a borrowing resulting from a transaction effected by a commercial letter of credit was incidental to the carrying on of business. The borrowing from the parent company in the circumstances of Cadbury-Fry Pascall (Aust.) Ltd (1979) 79 A.T.C. 4346 might be seen as incidental to the carrying on of business, and the decision explained in that way, but only where the borrowing is no more than a convenient way of discharging the liability to the supplier, and is not a continuing provision of funds by a parent to its subsidiary.

[12.211] It is generally assumed that the liability of a purchaser of goods or services to pay for those goods or services is a liability on revenue account where the liability is deductible as an outgoing by a taxpayer on an accruals basis of accounting. Where, however, the goods or services have been provided under an agreement by which a long term has been allowed for payment, there is room to argue that the character of the liability should be judged in the same way as that directed by the approach suggested in the last paragraph to the determination of the character of a borrowing—an approach that looks to the nature of the borrowing itself. This would be to revive the Commissioner’s argument in Texas Co. (Australasia) Ltd (1940) 63 C.L.R. 382 and Armco (Australia) Pty Ltd (1948) 76 C.L.R. 584, an argument that may appear to have been rejected in those cases. It is true that these two cases can be explained on the basis that a change in the initial character of a liability does not have any tax consequences. That however is not a view of the law that should be supported. A principle that is parallel with the principle in Sharkey v. Wernher [1956] A.C. 58 applicable to assets should be recognised so that there is a deemed discharge of a liability for the amount of its value on the occasion of the change in character. If an approach in terms of the nature of the liability itself is to be taken, in relation to borrowings or other liabilities, in determining whether the liability is on revenue account or capital account, it will not be possible to preserve all principles that the cases may be thought to support. Some of those principles are, in any event, strange bedfellows.

Accounting for Premiums on the Repayment of Loans, and Discounts allowed on the Undertaking of Liabilities to Repay Loans

[12.212] Attention has been given in [11.252]–[11.267] above to the characterisation of premiums on the repayment of loans, and discounts allowed on the undertaking of liabilities to repay loans. The emphasis was on the possibilities of treating the premium or discount as income in the nature of income derived from property by the original lender, or by an assignee of the lender, and of treating the premium or discount as an outgoing incurred by the borrower in paying for the use of the money borrowed. Original issue discount or premium may, it seems, be treated as income derived from property by the original lender, though the time of derivation is likely to be regarded as the moment when the debt becomes repayable, in the case of an accruals basis taxpayer, or the moment of actual or constructive receipt by a cash basis taxpayer. And the moment of incurring of an outgoing by the borrower is likely to be regarded as the moment when the debt becomes repayable, in the case of an accruals basis taxpayer, or the moment of actual or constructive payment in the case of a cash basis taxpayer.

[12.213] Where the premium or discount is not treated as a gain derived from property or a deductible outgoing, the possibility that it will give rise to a profit that is income or a loss that is deductible must be considered. Such a possibility depends on the character of the lending as an asset of the lender, and the character of the borrowing as a liability of the borrower. Income derivation will require that the asset be held by the taxpayer as a revenue asset, or that it be an asset that will be realised in the carrying out of an isolated business venture or a transaction within s. 25A(1) or s. 26AAA. The deductibility of a loss will require that the liability be a liability on revenue account. The circumstances in which a debt for money lent will be a revenue asset, and a liability to repay money lent will be a liability on revenue account, have been explored in relation to accounting for debts ([12.181]–[12.191] above) and accounting for exchange gains and losses ([12.192]–[12.211] above). An asset held as a pure investment will not generate a profit that is income on its realisation unless s. 26AAA applies, though it may be the source of a receipt that is income as a gain derived from property. A liability that is not held on revenue account cannot generate a loss that is deductible, but a payment for the use of the money acquired in exchange for the undertaking of a liability may be deductible, even though the liability is not on revenue account, if the money acquired has been used in a process of income generation.

[12.214] The vital difference between circumstances when receipts and outgoings accounting is appropriate, and the circumstances where profit or loss accounting is appropriate becomes evident. That vital difference is at the heart of the debate as to the appropriate treatment of the greater amount a taxpayer may receive on the sale or redemption of a bond over the amount that he paid for it. The assumption of s. 23J of the Assessment Act is that the greater amount is income as a gain derived from property. The section is, it seems, intended to have an operation so as to give an exemption, limited to acquisitions at a discount prior to 30 June 1982, in circumstances other than those which could give rise to a profit that is income. Subsections (2) and (3) of s. 23J, the exclusion provisions, extend to all circumstances in which a profit might be income, save an isolated business venture. It would not seem that the purchase and sale of a bond or the purchase and redemption of a bond could be an isolated business venture. The section will thus have no operation, or an operation in only a rare event, if the greater amount is not income as a gain derived from property.

[12.215] The discussion in [2.285]ff. above would indicate that it may be possible to treat the greater amount as income as a gain derived from property in the circumstances of Lomax v. Peter Dixon & Co. Ltd [1943] K.B. 671, where there is a repayment of the moneys lent and the payment is made to the original lender. And it may be possible to treat the greater amount as income derived from property wherever the bond is held by the taxpayer until redemption. The possibility that the greater amount will be income derived from property where it is the surplus on sale of a bond over its purchase price seems indeed remote.

[12.216] Where a discount or premium is income as a profit derived, or is deductible as a loss on the discharge of a liability, the accounting appropriate will be specific profit or loss accounting, and will follow the general principles explored in [12.8]ff. above. The moment for striking a profit or loss will be an actual or constructive payment. Profit emerging will apply so that profit is derived as receipts come to exceed cost—the money lent, or the cost of the debt for money lent—and loss is incurred as payments come to exceed the loan moneys that were received.

The Treatment of Discounts on the Negotiation of Bills of Exchange

[12.217] The possibility that a discount on the negotiation of a bill of exchange will be income as a gain derived from property, or deductible as an outgoing incurred for the use of money, was explored in [11.264]–[11.267] above. The more likely possibility is that the discount is income as a profit or deductible as a loss, though this possibility involves different principles. Those principles were not discussed in Willingale v. International Commercial Bank Ltd [1978] A.C. 834 where the taxpayer was a bank and the bill of exchange was held in the ordinary course of carrying on its business. Conceivably a taxpayer may invest in a bill of exchange though the very nature of the security suggests that it will be held in the carrying on of a business. Where it is held as an investment the inference that a s. 25A transaction is involved will be strong, and s. 26AAA may apply. Neither s. 25A nor s. 26AAA will apply where the bill is held to maturity. There is no sale for the purposes of either section, despite, in the case of s. 26AAA, the widened meaning given to that word by s. 26AAA(1)(f).

[12.218] Deductibility of a loss incurred by a party to the bill in paying it depends on a conclusion that his liability on the bill was on revenue account. The principles by which a liability will be characterised as a liability on revenue account remains confused. The decision of the High Court in AVCO Financial Services Ltd (1982) 150 C.L.R. 510 has not dispelled the confusion. The matter is considered in relation to exchange gains and losses in [12.192]–[12.211] above. Where the liability is that of an indorser of a bill of exchange, it will most often be on revenue account for the same reason that the bill whose endorsement gave rise to the liability was a revenue asset of the indorser. In other circumstances, a study of AVCO and Hunter Douglas Ltd (1983) 83 A.T.C. 4562 is inescapable.

[12.219] The accounting that will be applicable will follow profit and loss accounting in relation to loans. Where a taxpayer has endorsed a bill on its sale to another, and is called on to pay the bill, there will be a loss to the extent that what he pays in discharge of his liability on the bill exceeds what he will recover from other parties to the bill. There will be a question whether the striking of the loss will proceed on the basis of bringing in the amount he is entitled to recover from other parties. If it does, there may be no loss, save where his rights to recover from others do not realise their amount. This question is an aspect of a more general question of accounting for profit or loss considered in [12.12] above. The suggestion there is that there is a loss that emerges only when actual recoveries are less than the amount paid to discharge the liability and further recoveries are commercially unlikely. Further recoveries after the striking of the loss will be items of income.

Accounting where the Circumstances Reflect Multiple Bases of Income Character, Embracing Several Derivations of Income

[12.220] A single item derived may have an income character because of the operation of more than one of the principles that make up the ordinary usage notion of income, or the operation of one or more of those principles and a specific statutory provision. Thus, a fee charged by a taxpayer practising a profession will have an income character for the reasons that it is a gain from carrying on a business, and a reward for services, or for these reasons and the operation of s. 26(e). Such an item is income in its amount once only. It is not to be regarded as being as many items of income as there are reasons for concluding that it has an income character. So too, a single outgoing may be deductible under s. 51(1) and under some specific provisions, such as s. 53, relating to repairs. It is deductible in its amount once only.

[12.221] Circumstances in which there is a single item derived which has multiple bases of income character are, however, to be distinguished from circumstances which reflect multiple bases of income character and embrace several derivations of income. The more likely illustrations involve the disposition of property or the provision of services by a taxpayer for a consideration that is an annuity, or for a consideration that is an assignment to the taxpayer of rights to future receipts.

Disposition of goods or the provision of services in exchange for an annuity

[12.222] In Just (1949) 23 A.L.J. 47, discussed in [2.220] above, the taxpayer disposed of land for a consideration that involved the payment to him over a number of years of a percentage of the gross rents of a block of shops owned by the buyer. The receipts by the taxpayer were held to be income as an annuity. There was no suggestion that the land disposed of was held by the taxpayer as trading stock of a business of dealing in land or as a revenue asset of any business carried on by him, or was held in carrying out an isolated business venture or in circumstances that attracted the operation of the equivalent to s. 25A(1), or would now attract the operation of s. 26AAA. The annuity receipts were income as such. There was then only one basis of income character reflected in the transaction. On the analysis explained in [2.220] the taxpayer should have been treated as having purchased the annuity by the outlay of the land. The value of the land at the time of the transaction should have been treated as undeducted purchase price of the annuity and substractions under s. 26AA, now s. 27H, made from each of the annuity receipts.

[12.223] A different analysis would however have been appropriate, if the land had been trading stock of a business of dealing in land carried on by the taxpayer, or had been held in such circumstances that a profit on realisation would be income. There would then have been two derivations, each of an income character, reflected in the proceeds of the disposition of the land—a gain in carrying on a business, or carrying out a business venture or transaction in which a profit is income—and annuity receipts. Identifying the two derivations requires a break-up of the circumstances into two elements: a disposition for a consideration being the promise to make the annuity payments, and the receipt of annuity payments under that promise. In this way a realised profit on the disposition of the asset will be brought to tax, and the annuity receipts will be brought to tax with a purchase price, for purposes of s. 27H, of the value of the promise brought to account in the determination of the profit that is income. The accounting thus required reflects the principle that where an item of an income character, or one that must be brought to account in determining a profit that is income, is derived and that item is a cost in a further derivation of income, it must be treated as a cost in the amount at which it was brought to account. It is true that the law has not adopted a general approach of treating the present value of a series of future receipts as the proceeds of a transaction of sale of property or services by a taxpayer. But the approach has not been rejected and should not be rejected in the context now being considered, where the receipts are income on a basis of characterisation that has no concern with the origin of the obligation to make the payments. The approach would, indeed, be appropriate where the taxpayer is on a cash basis in regard to the disposition of the property. The present value of the annuity must be taken to have been received. The circumstances bring s. 21 into operation: consideration has been given otherwise than in cash. The promise to pay the annuity is a chose in action that is to be distinguished from a simple promise to pay money, which would involve a derivation by a cash basis taxpayer entitled to receive payment, only on actual receipt. The promise to pay should be treated in the same way as the promise to issue shares involved in the issue of options in Abbott v. Philbin [1961] A.C. 352 and Donaldson (1974) 74 A.T.C. 4192.

[12.224] The cost of the annuity will be the amount of its value brought to account in determining the income arising from the sale of the property. That cost will be applied under s. 27H over the period of the annuity, against the annuity receipts. The principle of tax accounting dictates the construction of “purchase price” for purposes of s. 27H.

Disposition of goods or the provision of services in exchange for a right to future receipts

[12.225] The tax consequences of an assignment of rights to future receipts is the subject of discussion in Chapter 13 below. The view is there taken that an assignment of the right to future receipts, effective by the general law, may shift liability to tax on those receipts from the assignor to the assignee. The emphasis in that statement of view is on the word “right” in the phrase “right to future receipts”. A transfer of an expectancy of future receipts, though effective as far as it can be by the general law—which would require that consideration be furnished by the transferee—cannot shift liability in this way, unless the property on which the expectancy is attendant is itself assigned. Thus, an effective assignment of the right to future receipts in a Shepherd (1965) 113 C.L.R. 385, situation—involving future receipts under a licence given to use patent rights—will pass tax liability on those receipts from assignor to assignee. An assignment of an expectancy of future receipts in a Norman (1963) 109 C.L.R. 9 situation—interest receipts that will fail to arise if the debt is repaid by the borrower—will be effective when made for value, but it will not pass tax liability on those receipts unless the assignment accompanies an assignment of the debt on which the future receipts are expectant.

[12.226] An employer, contractually bound to reward his employee in this way for services the latter has performed, may transfer his claim to future receipts of interest under debentures. If his claim is a right—as in the circumstances of Shepherd—there will be a derivation by the employee of income in the amount of the value of the right at the time of the transfer. There will be further derivations of income by the employee as actual receipts of interest arise. Those receipts will not be income of the employer. The receipts are income of the employee as gains derived from the right to future receipts. The receipts will be income, notwithstanding that the debt on which the interest receipts are attendant has not itself been transferred. In these circumstances, the scope of the principle of tax accounting referred to in [12.223] above is tested. The principle has so far been identified as a principle that the item that is income must be treated as being a cost equal to the amount of that income in determining any profit that is income on the realisation of the item. In the case of the annuity considered in [12.222]ff. above, the annuity receipts were regarded as proceeds of realisation of the annuity. In so regarding them, there may be a widening of the principle of tax accounting so as to make it applicable in the circumstances of receipts under a right to future receipts. If the principle does so apply, receipts by the assignee who has derived income in the assignment to him of the right to the receipts will be income only as a profit emerges, presumably when the receipts come to exceed the deemed cost of the right to those receipts. In this context, the principle of tax accounting merges into another principle which has been argued for in a number of places in this Volume: where there are receipts that are income derived from property and the property is consumed in part in generating each receipt, the value of the property, as it is consumed, should be substracted from the receipts in determining the amount of each of them that is income.

[12.227] If the employer’s claim is not a right to future receipts but an expectancy of future receipts, there will be a derivation of income by the employer in the amount of each receipt as it arises. Each receipt will arise as it becomes receivable and subject to a trust in the hands of the employer in favour of the employee. Each receipt is income of the employee as a reward for services: the item of receipts is the equity in the receivable which vests in the employee. The receivable is not at any time income of the trust of which the employer is trustee. It is corpus of that trust ([13.9] below). There is a derivation by the employee in the receipt of the equity in that corpus. Derivation is confirmed by s. 21, which provides that where consideration is given otherwise than in cash, the money value of the consideration shall be deemed to have been given.

[12.228] The employee’s equity in the receivable will have a cost equal to its value. That cost will be significant if the employee disposes of his equity in circumstances that may generate a profit that is income, or a loss that is deductible. But the cost will not otherwise be significant. An actual receipt by the employer trustee for the employee will not be income of the trust. There is only a receipt in realisation of an item that has been received as corpus of the trust. There is no gain derived from property of the trust. And there can be no derivation of income by the employee beneficiary of that trust. These propositions are stated summarily: they are more closely explained in the chapter that follows.