As the amount of income tax you have to pay is determined on an annual basis it is important to ensure items of income are allocated correctly to a particular year. Although common sense will get the right answer in most situations, being aware of some of the concepts around this topic could help you to identify amounts that should be deferred. Deferring income will have the effect of decreasing the amount of income tax payable in the current year, thereby providing a cash flow advantage.
Income needs to be “derived” in a particular year for it to be taxed in that year. However, the point at which income is derived is not specifically defined in the Income Tax Act; therefore its meaning must be determined by case law.
Various cases in New Zealand and Australia, such as FCT v Arthur Murray (NSW) Pty Ltd  and CIR v Farmers Trading Co Ltd , have developed a number of principles to assist in determining when income is derived.
Broadly speaking, there are three important factors that have consistently been referred to by the courts:
- How is the income treated under ordinary accounting principles and accounting practice?
- Has an enforceable debt been created?
- Has the income earning process been completed?
Accounting principles and commercial practice
Although not always determinative, the courts have given significant weight to a person’s accounting treatment and commercial practices when determining their taxable income. The accounting method used by a person should give a fair view of their annual income and produce a substantially true picture of the real profits of the person. Simply because a sale has been made and an invoice has been issued does not necessarily mean that an amount of income has been derived, particularly if a service is to be provided in a future period. For example, it is common for a person in the construction industry to determine their taxable income by following accounting principles, under which income is determined based on a project’s stage of completion.
Entitlement to bill / enforceable debt
Whether or not there is an entitlement to bill or an enforceable debt is often quoted as a determining factor for the question of whether income has been derived. Although this factor is relevant and should be taken into account, the broader circumstances should still be considered.
Completion of earning process
A fundamental element of income derivation is that the income earning process must be complete before income can be said to be “derived”. To ascertain whether the income earning process is complete it is important to consider the agreement under which the entity performs its obligations. For example, does the agreement stipulate ownership on the receipt of payment, or does a service occur progressively over a period?
An amount is likely to be income when the obligations arising as a result of the receipt have been discharged.
When reviewing your income for the year, ask yourself, have I done everything I need to do to say that income is mine? If not, it could be worth having a closer look to potentially defer income to a future year.
All information in this newsletter is to the best of the authors’ knowledge true and accurate. No liability is assumed by the authors, or publishers, for any losses suffered by any person relying directly or indirectly upon this newsletter. It is recommended that clients should consult a senior representative of the firm before acting upon this information.