Discharge of debt arising from the provision of services - changing from cash to accruals accounting

Where the method of accounting changes from cash to accruals basis in an income year, does section 118-20 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to reduce any capital gain made when a debt that arose from the provision of services in the previous income year is discharged?

No. Section 118-20 of the ITAA 1997 does not apply to reduce any capital gain made when CGT event C2 happens on the discharge of the debt. Section 118-20 will not apply to reduce the capital gain because no amount of the debt that was taken into account in working out the capital gain was included in assessable or exempt income under a provision of the ITAA 1997 (apart from Part 3-1) or the Income Tax Assessment Act 1936 (ITAA 1936).

The taxpayer carries on a business of providing services to clients.

The taxpayer had previously accounted for the income of the business on a cash basis.

Due to the nature and growth of the taxpayer's business, the taxpayer decides it is more appropriate for the business to convert to an accruals basis of accounting and render its income tax return on that basis.

Accordingly, the taxpayer lodges a return on an accruals basis in the current income year.

There are outstanding debts owing to the taxpayer in relation to services rendered in the previous income year. The taxpayer receives these amounts in the current income year. These amounts were not included in the taxpayer's assessable income in the previous income year because of the chosen method of accounting.

A debt owed to the taxpayer is a CGT asset under section 108-5 of the ITAA 1997.

Under subsection 104-25(1) of the ITAA 1997, CGT event C2 happens when the ownership of an intangible asset ends by the asset being satisfied or discharged. The time of the event is when the contract is entered into, or if there is no contract, when the asset ends (subsection 104-25(2) of the ITAA 1997).

The taxpayer makes a capital gain if the capital proceeds from the ending of the asset are more than the asset's cost base. On the other hand, the taxpayer makes a capital loss if the capital proceeds are less than the reduced cost base of the asset (subsection 104-25(3) of the ITAA 1997).

In this situation, the capital proceeds from discharging the debt are the amounts paid to the taxpayer by its debtors (subsection 116-20(1) of the ITAA 1997).

Under subsections 110-25(2) and 110-55(2) of the ITAA 1997, the first element of the cost base and reduced cost base of the debt is nil as the provision of services is not money paid, or other property given, to acquire the debt. Further, the market value substitution rule in section 112-20 of the ITAA 1997 will not apply to treat the debt as having been acquired for its market value (refer to ATO ID 2005/211).

Accordingly, the taxpayer makes a capital gain and the amount of the capital gain is the sum received in respect of the outstanding debt.

The anti-overlap provisions in section 118-20 of the ITAA 1997 apply to reduce a capital gain to the extent that because of a CGT event an amount is otherwise included in assessable income or exempt income under another provision of the ITAA 1997 or the ITAA 1936.

In this case, the taxpayer had not included the outstanding debt in assessable income in the year in which the services were provided to its client because the taxpayer had accounted for its income in that year on a cash basis.

In accordance with Henderson v. Federal Commissioner of Taxation (1970) 119 CLR 612; (1970) 44 ALJR 115; (1970) 1 ATR 596; (1970) 70 ATC 4016 (Henderson Case), a change in the basis of accounting should be strictly adhered to, and the income calculated should be arrived at by the proper and regular application of the elected method of accounting. The Henderson Case concerned an entity changing its method of accounting from cash to accruals basis. The full High Court found that the earnings arising from the provision of services supplied in the previous income year were not ordinary income in the current year, only the earnings of the current year could be included in the computation.

Applying the decision in the Henderson Case, the debt payment was not ordinary income derived in the current year, thus, no amount would be included in the taxpayer's assessable income under section 6-5 of the ITAA 1997.

Consequently, the capital gain made when CGT event C2 happens on discharge of the debt is not reduced under section 118-20 of the ITAA 1997.

The resulting capital gain is taken into account in working out the taxpayer's net capital gain or capital loss for the current income year (section 102-5 of the ITAA 1997).

Date of Amendment Part Comment 20 November 2015 Reasons for Decision Replace 'that' with 'than'.

Date of Amendment | Part | Comment

20 November 2015 | Reasons for Decision | Replace 'that' with 'than'.