Assessable income : drawings of partnership 'salary' to a partner

Is the taxpayer, a partner in a partnership assessable under subsection 92(1) of the Income Tax Assessment Act 1936 (ITAA 1936), or section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997), on drawings of partnership 'salary' taken from the partnership, when there are insufficient partnership profits to cover the drawings and the partner must repay the excess drawings?

No. The taxpayer is not assessable on the drawings of partnership 'salary' in excess of available partnership profits under subsection 92(1) of the ITAA 1936 or section 6-5 of the ITAA 1997 as the partnership agreement required that the partner repay the excess drawings back to the partnership and the partner did so.

The taxpayer is an Australian resident carrying on a business in partnership as a partner for income tax purposes.

There is a partnership agreement in place. The partnership agreement allows the partners to draw a salary. However, the partnership agreement also requires the partners to repay any drawings in excess of their entitlement or interest in the profits of the partnership, as determined at the end of the income year.

Prior to the end of the income year, the partners orally agreed that the taxpayer be paid a salary for performing various duties in relation to the partnership business.

However, during the income year the expenditure incurred by the partnership exceeded any income produced. Therefore, it was determined at the end of the income year that the partnership made a net loss before accounting for the partnership 'salary'. As a result, the taxpayer became liable to repay the funds drawn as 'salary' in accordance with the partnership agreement. The obligation of the partner to repay the drawings was shown in the partnership accounts.

Section 6-5 of the ITAA 1997 provides that an Australian resident is assessable on ordinary income derived directly or indirectly from all sources, whether in or out of Australia during the income year.

Subsection 92(1) of the ITAA 1936 provides that the individual interest of a resident partner in the net income of the partnership for an income year, is included in their assessable income.

Generally, income derived from a partnership is not assessed to the partners under the ordinary income provisions, such as section 6-5 of the ITAA 1997, but is instead assessable under subsection 92(1) of the ITAA 1936.

An agreement that a partner may draw a 'salary' against the partnership business does not create the relation of employer and employee but rather operates as an agreement to vary the sharing of partnership profits between the partners ( Ellis v. Joseph Ellis & Co . [1905] 1 KB 324). The 'salary' payments received by the partner during the year before partnership accounts are taken and the partnership profit (or loss) ascertained, are merely advances or drawings and not real salary ( Watson v. Haggitt [1928] AC 127; MacKinlay v. Arthur Young & Co [1990] 2 AC 239 (refer ATO ID 2003/1125).

The effect of such an agreement is that where available partnership profits are sufficient to cover the drawings, the 'salary' forms part of that partner's share in the net income of the partnership, and is assessable to the partner under subsection 92(1) of the ITAA 1936.

However, in this case the partnership agreement provides that the right to retain the drawings is contingent on there being sufficient partnership profits. This means that if available partnership profits are insufficient to cover the 'salary' drawn, the partner has an obligation to repay the drawings to the extent of the insufficiency. The part of the drawings that the partner has an obligation to repay is not assessable under subsection 92(1) of the ITAA 1936 or section 6-5 of the ITAA 1997 as it constitutes a repayable advance.

Therefore, as it was ascertained at the end of the income year that there were insufficient partnership profits to cover any of the 'salary' drawings taken by the taxpayer during the income year and the taxpayer is liable to repay the drawings (as recognised in the partnership accounts) the 'salary' is not assessable to the taxpayer under subsection 92(1) of the ITAA 1936 or section 6-5 of the ITAA 1997.