Chapter 15
[15.1] Proposition 4 ([2.38]ff. above) describing an aspect of the ordinary usage concept of income assumes that income involves a gain to the taxpayer. Some qualifications on that proposition were noted, the most important arising from the fact that income tax law, save for a brief period covering the 1977, 1978 and 1979 years of income, makes the assumption that the value of money does not change.
[15.2] In the determining of the amount of a profit that is income or a loss that is deductible, costs will be expressed as the number of dollars outlaid if the taxpayer is on a cash basis of accounting, or the amount in dollars of a monetary liability at the time the liability arose if he is on an accruals basis. And the proceeds of realisation will be expressed in terms of the number of dollars received or receivable at the time of realisation. There will not be any adjustment of the cost to reflect the circumstance that the dollars of cost were more valuable dollars than the dollars received or receivable at the time a profit was derived or a loss incurred.
[15.3] Amortisation of the cost of an asset, whether under the depreciation provisions or other provisions having a like function will be allowed by reference to historical cost—the number of dollars outlaid or deemed outlaid at the time the cost subject to amortisation was incurred—notwithstanding that those dollars were of greater value than the value of the like number of dollars at the time of the allowance of amortisation.
[15.4] The amount that is income as a gain derived from a monetary asset—generally interest on money lent—will reflect the number of dollars derived notwithstanding that some of those dollars might be seen as simply a receipt by the taxpayer of an amount that reflects the fall in the value of the monetary asset whence income is derived.
[15.5] In the last instance given, there is however some recognition that the value of money does change in the principle discussed in [2.285]ff. above: a discount or premium received in relation to the lending of money may be treated as being for the undertaking “of the capital risk” involved in the lending of money. One justification for treating the discount or premium as being for the capital risk is that it compensates the lender for the fall in the value of his monetary asset: the dollars of his loan returned to him will be of less value than the dollars that he lent, if there has been a fall in the value of money.
[15.6] It may be thought that the distortions that flow, in conditions of inflation, from the assumption of the income tax that dollars have immutable value can be easily cured. Wherever the amount of a cost enters the calculation of a profit that is income or loss that is deductible, its amount should be determined not by reference to its value in dollars at the time the cost was incurred, but by reference to its value in dollars at the time the profit or loss is struck. Whenever the amortisation of a cost is allowed, it should be allowed by reference to the amount of the cost expressed not in dollars of the time the cost was incurred but in dollars of the time the amortisation deduction is allowed. Whenever the amount of income gained from a monetary asset falls to be determined, the gain should be adjusted to take account of the fall in value of the monetary asset reflected in the less value of the dollars that would now be receivable or received in satisfaction of the monetary asset.
[15.7] But the distortions are not so easily cured. They may be cured in this way if the taxpayer has not borrowed or otherwise received accommodation from a creditor. If he has received accommodation and used that accommodation to meet a cost that enters the calculation of a profit or loss that is income or deductible, or to meet a cost that is amortisable, or in making an investment in a monetary asset which yields income in the form of a gain derived from property, the gain that may arise on the discharge of the liability that arose from the receipt of accommodation must be brought to account.
[15.8] The notion of gain arising from the discharge of a liability is no longer a novel idea in income tax law. It was recognised by the High Court in International Nickel Australia Ltd (1977) 137 C.L.R. 347, a case concerned with exchange gains, discussed in [12.192]ff. above. International Nickel was a decision that marked the recognition of a new analysis of the nature of income and deductible loss as aspects of the ordinary usage concept of income.
[15.9] The recognition of gains and losses that are income or deductible where there are exchange gains and losses, provides an important framework of analysis to support the recognition of gains and losses as a means to correct the distortions that arise in the operation of the income tax in conditions of inflation. But the recognition in the field of exchange gains and losses stops short of the recognition that is necessary if inflation distortions are to be corrected. The law in relation to exchange gains and losses extends only to gain or loss on a receipt in satisfaction of a receivable on revenue account, or on the discharge of a liability on revenue account, arising from a lending or borrowing, or from accommodation otherwise given or received. In one respect that law might have gone further so as to recognise that an exchange gain or loss that is income or deductible might arise in relation to accommodation given from which interest may be derived and in relation to accommodation received where interest on that accommodation is deductible. Certainly the recognition of an inflation adjustment gain or loss as income or deductible is necessary in relation to any monetary asset whence income from property—interest or receipts in the nature of interest—may be derived, and any monetary liability where the cost of servicing is a deductible outgoing.
[15.10] At this point in any development of theory about inflation adjustments, some of the most intractable problems of identification that beset the income tax arise. A good deal of attention was devoted in [6.86]ff. above to the matter of identification of a borrowing that is outlaid for the purpose of producing assessable income, an identification which goes to the deductibility of interest on that borrowing. Such an identification will be necessary if an inflation gain on discharge of the borrowing is to be brought to account. And clearly it must be, if inflation losses arising from the investment of the borrowing, or from the acquisition of revenue assets with the money borrowed, are to be brought to account. The lesser task of identifying a borrowing on revenue account which is an aspect of the law of exchange gains and losses, does not take analysis far enough where the issue is the bringing in of an inflation gain that will balance an inflation loss.
[15.11] Against this background it may be helpful to survey the Australian discussion of inflation tax accounting; the recommendations that have emerged; the action that has been attempted and abandoned; and the inadequacies of that action.
[15.12] Tax accounting in conditions of inflation was the subject of some comment in the Report of the Asprey Committee (Taxation Review Committee, Full Report, A.G.P.S., Canberra, 1975), and was the subject of detailed study in the Report of the Mathews Committee (Report of the Committee of Inquiry into Inflation & Taxation, A.G.P.S., Canberra, 1975).
[15.13] The Asprey Committee in para. 8.183 of its Report left the matter of adjustments for inflation in determining the taxable income of a business to the consideration of the Mathews Committee. It was one of the matters specially committed to the Mathews Committee. The Asprey Committee did however risk an observation that the bringing in of a gain arising from the discharge of accommodation received, where money has fallen in value, may not be thought appropriate if one’s approach concentrates on the need of a business entity to maintain a level of funds sufficient to be able to meet the higher costs in dollar terms of replacing stock and depreciable assets. Such an approach is basic to that kind of financial accounting that is referred to as current cost accounting. On the other hand, if an approach is taken in terms of gains that reflect accretions to the value of the interests of the proprietors of a business, which will include the holders of equity capital in a company, the bringing in of some gains arising from the discharge of accommodation received is essential to ensure that adjustments for inflation are thorough going in removing distortions that affect the equity of the income tax.
[15.14] The Asprey Committee also gave consideration to the need to adjust the interest gains that may be derived from monetary assets, so that there is excluded from income that part of any receipt that is in effect a repayment of a lending, because it is no more than equivalent to the fall in value of the dollars of the monetary asset. The Committee proposed an ad hoc arrangement that would allow a deduction, in computing taxable income, of a fixed amount of net interest—interest received less interest that is deductible as interest on money borrowed and outlaid for the purpose of earning income from business or property. The adjustment was intended to correct some of the distortion that arises from inflation, but did not express any developed theory of inflation adjustments.
[15.15] The Mathews Committee was specially charged with the function of making recommendations as to adjustments that should be made in determining the taxable income of a taxpayer conducting a business, so as to remove distortions arising from inflation. The most significant aspect of those recommendations is the absence of any proposal to bring in gains arising from the discharge of accommodaton received. The absence of any such proposal reflects the accounting theory that underlies the recommendations made by the Committee. That theory is current cost accounting. An aspect of that theory is the maintenance of the business entity. In conditions of inflation, it is said, a business entity does not gain by discharging accommodation though the payments are, in terms of their value, less than the value of the accommodation received. It does not gain because it will need new accommodation, of a greater amount than the amount of the dollars paid, if it is to maintain the same level of operations as it conducted before the payment. The theory is beyond doubting, but there is a question of its relevance to an income tax that is concerned with equity between taxpayers. The theory, in its relevance to an income tax, is an argument for abandoning equity by giving special treatment to taxpayers engaged in business in order to preserve business entities.
[15.16] The recommendations of the Mathews Committee in regard to adjusting costs to take inflation into account equally reflect current cost accounting theory. Accounting—sometimes called current purchasing power accounting—that is concerned only to adjust costs for inflation by expressing the value of those costs in dollars of the time a profit is to be struck, or at the time a cost is an allowable deduction, will simply apply a general index of purchasing power to those costs. The value of dollars is seen in terms of their general purchasing power, not their purchasing power in relation to particular goods or services. Current value accounting and the Mathews recommendations would adjust costs in determining profits by reference to the actual current costs of goods of the same kind as those that have been sold. Such an adjustment reflects the theory that so much of the proceeds of realisation of goods as will need to be applied in acquiring other goods of the like kind to be held for sale, should not be diminished by tax if the operating capacity of the business is to be preserved. The recommendation of the Mathews Committee was that a “cost of sales valuation adjustment” should be allowed as a deduction, being the difference between the cost of stock held at the beginning of a year of income “at actual” prices, and the same stock at the same prices as closing stock, using actual price lists as the basis of calculation. The recommendation translates theory into a workable formula.
[15.17] Current cost accounting theory also underlies the Mathews Committee recommendation in regard to adjustments to the cost of capital assets that are depreciable, in determining the amount that is an appropriate deduction in a year of income. The recommendation was that depreciation deductions should be indexed by way of a “depreciation value adjustment” using replacement cost of assets, the replacement costs being derived from a published index of replacement costs prepared by the Commissioner on the advice of the Australian Bureau of Statistics.
[15.18] Another aspect of the Mathews recommendations that reflects their origin in current cost accounting theory, and not in an attempt to remove distortions affecting the equity of the income tax, is the proposal that when stock levels fall or the ownership of a business changes hands the cost of sales valuation adjustment should be reversed by the bringing in of a corresponding amount as income. With some want of consistency the Mathews Committee proposed that the depreciation value adjustment should be treated as bringing about a permanent deferral of tax.
[15.19] There is also a want of consistency in the Mathews Committee recommendation that the stock valuation adjustment should not apply to livestock, nor to land, shares and other securities, and a want of consistency in the absence of any proposal that an allowance having the same function as the stock valuation adjustment should apply to the cost of work in progress that is not represented by physical stock, for example a solicitor’s work in progress, or is not represented by physical stock that would appear as opening stock in a tax account, for example the cost to a farmer of planting a crop of wheat or the costs of building and construction work in progress.
[15.20] The recommendations of the Mathews Committee led to limited legislative action, first operating in the 1977 year of income. The legislative action hovers between adjustments reflecting current cost accounting theory and adjustments reflecting a theory of inflation accounting that would seek to remove distortions that defeat the equity of the income tax.
[15.21] The limited legislative response relates only to the Mathews Committee recommendation of a cost of sales valuation adjustment. The response was in provisions allowing a “trading stock valuation adjustment” increasing the cost of opening stock by the application of one half the percentage increase in the “goods” element of the consumer price index over the relevant year of income. The figure of one half, rather than the whole, was justified in terms of Government budgetary limitations. The provisions made up Subdiv. BA of Div. 3 of Pt III of the Assessment Act. The use of the consumer price index was generally at odds with current cost accounting theory, though there is some compromise in the reference only to the goods element. The consumer price index covers only consumer goods, and it may be thought a singularly inappropriate index in current cost accounting theory in some circumstances, though clearly appropriate if the concern is with the equity of the income tax.
[15.22] The scope of Subdiv. BA of Div. 3 of Pt III was somewhat wider than the recommendations of the Mathews Committee. The cost of livestock was made subject to adjustment. One important difference from the Mathews recommendations was the absence of any provision to recover the amount of the accumulated adjustment in respect of the cost of stock, where stock levels were permanently reduced or the business was disposed of. Provision was, however, made so that the adjustment would apply to the cost of closing stock where there had been a permanent fall in the level of stock during a year of income. A reconstruction provision, in s. 31C, was added so as to control the giving of an artificial cost to stock by acquiring it in transactions with associated taxpayers. That provision remains in the Assessment Act as a control on transfer pricing, though its operation is now lifted in international transfer pricing situations when Div. 13 of Pt III is applied.
[15.23] The trading stock valuation adjustment provisions were repealed with effect from the end of the 1979 year of income. Events leading up to that repeal included an attempt by the Australian Accounting Standards Committee to persuade company directors to follow a provisional accounting standard issued in 1976 expressing current cost accounting. That standard required adjustments to financial accounts much like those proposed by Mathews for tax accounts. The level of compliance with the standard was minimal. An accounting standard that would depress companies’ profits was not welcome, though tax accounting under the trading stock valuation adjustment provisions, which would depress companies’ taxable incomes, had been welcomed by company management.
[15.24] The trading stock valuation adjustment provisions had attracted criticism on a number of fronts. They were discriminatory in applying only to stock within a narrow definition of trading stock. And they were wanting in equity in not providing for the bringing in of gains that would arise on the discharge of monetary liabilities associated with the acquisition of the stock. The latter criticism puts equity ahead of a policy of protecting the operating capacity of a business entity. In abolishing the trading stock valuation adjustment Government drew attention to this want of equity, and pointed to the fact that business itself was not anxious to demonstrate in its financial accounts that it had suffered a loss of operating capacity: it had not embraced current cost accounting.
[15.25] Meanwhile the Accounting Standards Committee had, in 1978, followed up the provisional standard for current cost accounting with an exposure draft on “Recognition of Gains and Losses on Holding Monetary Items in the Context of Current Cost Accounting”. The exposure draft provided for the recognition of losses and gains arising from the holding of monetary assets, and monetary liabilities other than loan capital, in the determination of entity net profit. Loan capital is defined as “borrowings for financing the operating capabilities of an entity”. It thus brought current cost accounting nearer to principles of tax accounting that would remove the equity distortions in the operation of the income tax in conditions of inflation. The exposure draft held to the view that a gain from the repayment of loan capital should not be brought to account in determining entity net profit. It did however concede that such a gain should be recognised for the purposes of determining profits attributable to shareholders, and, presumably, the proprietors of a business. In this there is an acceptance that if equity between taxpayers is the objective, gains on the repayment of loan capital may need to be brought to account.
[15.26] In 1983 the Accounting Standards Committee consolidated the provisional current cost accounting standard and the exposure draft into a Statement of Accounting Practice—something less, it seems, than an accounting standard. Business remains generally unwilling to accept any standard, or follow any stated practice. The level of compliance with the Statement of Accounting Practice is low.
[15.27] A coherent system of tax accounting for inflation must recognise gains on the discharge of liabilities. But its feasibility may be doubted. The monetary liabilities whose discharge should be held to give rise to a gain that arises from inflation may be identified. They are monetary liabilities that relate to the financing of a cost of a revenue asset, or a cost that attracts amortisation deductions, principally under the depreciation provisions; monetary liabilities that relate to monetary assets that may generate income from property; and other monetary liabilities whose costs of servicing would be deductible. There are two principles involved. The first is that an inflation gain in respect of a liability should be recognised in all circumstances where that liability may be said to have financed a cost that itself attracts an inflation adjustment; or to have financed the acquisition of a monetary asset that attracts an inflation adjustment. The second principle is that the deductible costs of servicing a liability are unreal to the extent that there is a countervailing gain on the discharge of the liability.
[15.28] The identification of a liability that finances the cost of an asset employed in a process of derivation of income, or a liability that finances other costs of deriving income is discussed at length in [6.86]ff. above in relation to the deduction of interest. Those problems may not be insurmountable where the taxpayer is a company and there will, presumably, not be any borrowing for a private purpose. Where the taxpayer is an individual, the problems are acute. If tests in terms of tracing of money borrowed are to be applied, the taxpayer will seek to steer borrowed moneys away from an income producing purpose, wherever he has borrowed at a rate of interest less than the rate of inflation. He will assert that the borrowing was for consumption or to invest in an asset that is not an asset held in any process of income derivation.
[15.29] The assumptions in the preceding paragraphs are that an inflation adjustment will be applied to a monetary asset whether or not that asset generates income from property—interest, or a receipt in the nature of interest—and that an adjustment will be applied to a monetary liability, whether or not that liability does in fact have servicing costs. It is unlikely that a principle would be accepted that a taxpayer should be entitled to an inflation loss deduction in respect of the holding of a monetary asset where that holding does not in fact give rise to income from property. A taxpayer would enjoy a loss deduction by lending money interest-free. Indeed it would be good sense to hold that a taxpayer should be limited in determining his loss deduction arising from the holding of a monetary asset by the amount of income in fact derived from the monetary asset.
[15.30] It may be more difficult to justify a principle that an adjustment that will produce a gain should be applied to a monetary liability only when that liability does in fact have deductible servicing costs and, where it does have deductible servicing costs, should be limited to the amount of those costs. But it might be argued that the element of gift that is involved in the receipt of an interest-free or low-interest borrowing should not be taxed.
[15.31] Out of this discussion there will have emerged a further need to identify a borrowing beyond an identification that it relates to an income producing process. There is need to identify a borrowing as one that relates only to investment in monetary assets from which income from property may be derived. The burdens of identification press the prospect of achievement of a coherent system of inflation adjustments near to extinction.