Income tax: notional averaging of net capital gains or of abnormal income to calculate the rate of tax payable on taxable income

This Ruling explains the method for calculating the rate of tax on taxable income which includes a net capital gain or abnormal income or both. It also explains how the calculation applies to primary producers whose income is subject to the averaging provisions and to minors.

The method of calculation explained in this Ruling is provided by Schedule 7 and Schedule 11 (minors) of the Income Tax Rates Act 1986 (ITRA). It only applies to individual taxpayers (i.e. it does not apply to calculate the rate of tax payable on capital gains included in the income of companies or trusts). The method applies to both residents of Australia and non-residents.

The method involves the notional averaging of net capital gains or abnormal income (or both) to calculate the rate of tax. Notional averaging alleviates the effect of including in a taxpayer's assessable income of a particular year income which may be attributable to previous years.

This Ruling does not apply to taxpayers who receive notional income in terms of sections 59AB and 86 of the Income Tax Assessment Act 1936 (ITAA), which is subject to tax at the rate prescribed in Schedule 9 of the ITRA.

Some of the terms used in this Ruling are defined in paragraph 11.

Unless paragraph 4 applies, the rate of tax payable by taxpayers (other than certain minors) whose taxable income includes a net capital gain or an amount of abnormal income is calculated by following the steps outlined in Attachment A to this Ruling.

Division 6AA of Part III of the ITAA applies to certain minors, i.e. children under the age of 18 who receive eligible taxable income during the year and who satisfy the other requirements of section 102AC. Eligible taxable income is defined in section 102AD. Broadly speaking, it is unearned income of minors which is taxed at special rates of tax. The rate of tax payable by Division 6AA minors whose taxable income includes a net capital gain or an amount of abnormal income is calculated by following the steps outlined in Attachment B to this Ruling.

Notional averaging of net capital gains and abnormal income received by a taxpayer whose income is subject to the averaging provisions is based on average income rather than taxable income. In broad terms, Division 16 applies to primary producers carrying on a business in a year of income who have at least two average years and have not withdrawn from the averaging system. Average income is used whenever Division 16 of Part III of the ITAA applies to the taxpayer, even if there is a primary production loss for the year.

The rate of tax calculated by the methods outlined in the attachments to this Ruling is applied to the whole of the taxpayer's taxable income to determine the amount of tax payable (excluding Medicare levy). The total amount of tax payable is calculated by adding the Medicare levy to this amount, and subtracting any rebates or credits. Primary producers also need to add any complementary tax payable under section 156 of the ITAA.

This Ruling sets out the current practice of the Australian Taxation Office and is not concerned with a change in interpretation. Consequently, it applies (subject to any limitations imposed by statute) for years of income commencing both before and after the date on which it is issued.

Terms used in this Ruling have the following meanings: Abnormal income This is the abnormal income amount defined in subsection 3(1) of the ITRA by reference to section 158L of the ITAA. Broadly, it is income of an eligible person (i.e. an artist, composer, inventor, performer, production associate, sportsperson or writer) which exceeds the person's average income over previous years. Division 16A of the ITAA deals with abnormal income generally. Eligible taxable This is defined in Division 6AA of Part III of income the ITAA (section 102AD). Broadly speaking, it is unearned income of minors (although there are some exceptions). 'If the amount of ETI does not exceed $416, it is treated as ordinary taxable income and would be liable to be taxed at ordinary rates. If the amount of ETI exceeds $416 but does not exceed $1,445, it is taxed in accordance with subsection 13(1) of the ITRA as modified by subsection 13(2). If the amount of the ETI exceeds $1,445 then the top marginal rate (currently 47%) will apply.' Net capital gain The amount of capital gain on the disposal of an asset (or assets) which is included in assessable income as a net capital gain under subsection 160ZO(1) of the ITAA. Notional income Income derived by either: (i) a person who has successfully applied to the Commissioner of Taxation for a notional income determination under section 59AB of the ITAA because of disposal, loss or destruction of business assets; or (ii) a person who has received a premium for a lease and has a notional income by virtue of section 86 of the ITAA. The rate of tax applicable to a taxpayer who receives notional income is governed by Schedule 9 of the ITAA. Ordinary rates The rates of tax applicable under the income of tax tax law (Schedule 7 of the ITRA) to the taxable income of a taxpayer who is not a minor. The rates vary according to whether the taxpayer is a resident of Australia (Part I of Schedule 7) or a non-resident (Part II of Schedule 7). Reduced taxable This is defined in subsection 3(1) of the income (RTI) ITRA as: Taxable income minus SIC . Special income This is also defined in subsection 3(1) of the component (SIC) ITRA. It is either: (a) net capital gain or abnormal income or the sum of both; or (b) taxable income (if taxable income is less than or equal to the amount calculated in (a) above).

The definition of SIC in section 3 of the ITRA provides that if the net capital gain or abnormal income (or the sum of both) is greater than taxable income for the income year, SIC equals taxable income. For example, that would be the case if the taxpayer has incurred a revenue loss during the income year. In that case, as SIC and taxable income are the same, RTI is nil. In other words, the lowest figure RTI can be is zero.

Division 16 of Part III of the ITAA generally provides for the averaging of income from primary production. It applies if a taxpayer is a primary producer (section 157) who is actively carrying on a business (section 152) and who has had at least two average years (section 158). Division 16 applies even when the taxpayer has made an overall primary production loss for the year of income. For example, section 153 specifically provides that any year in which a taxpayer was carrying on business but had no taxable income is capable of being an average year. Thus, Division 16 applies to the taxpayer's income unless the person has specifically elected under section 158A that the Division is not to apply. The effect of such an election is that the Division does not apply to the year of income in which the election is made and all subsequent years of income.

Under section 149A, net capital gains and abnormal income are excluded from the taxpayer's assessable income and taxable income in calculating the taxpayer's rebate or complementary (extra) tax payable under section 156. However, net capital gains are included in the taxpayer's assessable income and taxable income for the general purposes of the ITAA (section 160ZO).

Clause 3 of Part 1 of Schedule 7 of the ITRA provides a method for calculating the rate of tax payable if: (a) the taxable income of a resident taxpayer consists of or includes a special income component; and (b) the averaging provisions apply to the income of the taxpayer. In the case of a primary producer with an overall primary production loss and a net capital gain, the taxpayer's taxable income (as defined in subsection 6(1) of the ITAA) includes a special income component (the net capital gain). As stated in paragraph 13, the averaging provisions apply if the taxpayer is actively carrying on a primary production business, has at least two average years and has not opted out of the averaging system. Therefore the calculation method in Schedule 7 of the ITRA applies to such a taxpayer.

The fact that, under Schedule 7 of the ITRA, tax on net capital gains and abnormal income of primary producers is calculated by reference to the taxpayer's average income (rather than taxable income) means that the taxpayer pays more or less tax on that income in any one year, depending on whether average income is more or less than taxable income.

This outcome is due to a fundamental change in the averaging provisions that has applied since 1 July 1983. That change altered the averaging system from one where primary producers paid no greater tax in any year to one which ensured that primary producers pay no greater tax over time than other taxpayers.

There may be cases in which a primary producer would derive no long-term benefit from the averaging rules applying to his or her net capital gains and abnormal income. In that case, it may be appropriate to withdraw from the averaging system (refer section 158A of the ITAA). For example, that may be the case if the primary producer is selling assets while withdrawing from primary production activities.

The following examples illustrate the method outlined in Attachments A and B to calculate the rate of tax on taxable income which includes a net capital gain or abnormal income. The rates of tax used are those applicable to residents of Australia. Example 1: net salary and net capital gain Anna's taxable income for the 1991/92 financial year was $70,000. It consisted of: Salary: $20,000 Net capital gain: $50,000 The rate of tax Anna will pay on her taxable income is calculated as follows: Step 1 Anna's SIC is the amount of her net capital gain, i.e. $50,000 Step 2 Anna's RTI is her taxable income minus SIC , i.e. $70,000 - $50,000 = $20,000 Step 3 Component A is the amount of tax payable on Anna's RTI ($20,000) at ordinary rates, i.e. $2,920 Step 4 Anna is not a primary producer, therefore she will work out Component B like this: (a) Tax payable on ($20,000 + 20% of $50,000) at ordinary rates is $6,594 (b) Component B = 5 x ($6,594 - $2,920), i.e. $18,370 Step 5 The rate of tax Anna will pay on each dollar of her taxable income is: ($2,920 + $18,370)/$70,000 = 30.41428 cents Example 2: net capital gain only Ellen's taxable income for the 1991/92 financial year was $50,000. This consisted solely of a net capital gain. The rate of tax Ellen will pay on her taxable income is calculated as follows: Step 1 Ellen's SIC is the amount of her taxable income (which is also the amount of her net capital gain), i.e. $50,000 Step 2 Ellen's RTI is her taxable income minus SIC , i.e. zero Step 3 Component A is the amount of tax payable on Ellen's RTI at ordinary rates. Because Ellen's RTI is zero, Component A is also zero. Step 4 Ellen is not a primary producer, therefore she will work out Component B like this: (a) Tax payable on (0 + 20% of $50,000) at ordinary rates is $920 (b) Component B = 5 x ($920 - 0), i.e. $4,600 Step 5 The rate of tax Ellen will pay on each dollar of her taxable income is: (0 + $4,600)/$50,000 = 9.2 cents Example 3: business loss and net capital gain Cynthia runs her own business (as a sole trader) which made a loss in the 1991/92 financial year of $5,000. During the year she also received a net capital gain of $20,000. Thus Cynthia's taxable income was $15,000, comprising: Net capital gain: $20,000 Business loss: ($5,000) The rate of tax Cynthia will pay on her taxable income is calculated as follows: Step 1 Cynthia's SIC is the amount of her taxable income, i.e. $15,000 Step 2 Cynthia's RTI is her taxable income minus SIC , i.e. zero Step 3 Component A is the amount of tax payable on Cynthia's RTI at ordinary rates. Because Cynthia's RTI is zero, Component A is also zero. Step 4 Cynthia is not a primary producer, therefore she will work out Component B like this: (a) Tax payable on (0 + 20% of $15,000) at ordinary rates is zero because it is below the tax-free threshold (b) Component B is also zero Step 5 Because Component A and Component B are both zero, Cynthia will not pay any tax on her taxable income. Example 4: minor with net capital gain and other income Frank is 16 years old and has a part-time job at a supermarket from which he earned $8,000 during the 1991/92 financial year. He also received a net capital gain of $20,000 from the share portfolio which had been given to him by his parents. This capital gain is eligible taxable income. Thus Frank's taxable income for the year was $28,000, comprising: Wages $8,000 Eligible taxable income $20,000 The rate of tax Frank will pay on his taxable income is calculated as follows: Step 1 Frank's SIC is the amount of his net capital gain, i.e. $20,000 Step 2 Frank's RTI is his taxable income minus SIC , i.e. $28,000 - $20,000 = $8,000 Step 3 Component A is the amount of tax a minor would pay on Frank's RTI ($8,000). Because this is employment income it is taxed at ordinary rates. Therefore Component A is $520. Step 4 Frank will work out Component B like this: (a) Tax payable on ($8,000 + zero) at ordinary rates is $520 (b) Tax payable on RTI at ordinary rates is $520 (c) Component B = 5 x ($520 - $520), i.e. zero Step 5 Component C is 47% x $20,000, i.e. $9,400 Step 6 The rate of tax Frank will pay on each dollar of his taxable income is: ($520 + zero + $9,400)/$28,000 = 35.42857 cents 'Example 4A (variation of Example 4) The same facts as in Example 4 except that Frank's net capital gain is $1,000 instead of $20,000 resulting in a taxable income of $9,000 consisting of: Wages $8,000 Eligible taxable income $1,000 The rate of tax Frank will pay on his taxable income under subsection 13(1) as modified by 13(2) and Part I of Schedule 11 of the ITRA is calculated as follows: Step 1 Frank's SIC is the amount of his net capital gain, i.e., $1,000 Step 2 Frank's RTI is his taxable income minus SIC , i.e., $9,000 - $1,000 = $8,000 Step 3 Component A is the amount of tax Frank would pay on his RTI ($8,000). Because this is employment income it is taxed at ordinary rates. Therefore, Component A is $520. Step 4 Frank will work out Component B like this: (a) tax payable on ($8,000 + zero) at ordinary rates is $520 (b) tax payable on RTI at ordinary rates is $520 (c) Component B = 5 x ($520 - $520), i.e., zero. Step 5 As the ETI of $1,000 exceeds $416 but does not exceed $1,445, subsection 13(2) of the ITRA must be applied to calculate Component C . The amount of tax payable on the ETI must not exceed the greater of two calculations required under paragraphs 13(2)(a) and 13(2)(b) of the ITRA. (i) paragraph 13(2)(a) calculation: ( ETI - $416) x 0.66 = ($1,000 - $416) x 0.66 = $584 x 0.66 = $385.44 (ii) paragraph 13(2)(b) calculation: tax on the taxable income of $9,000 at ordinary rates ($720) minus tax on the taxable income reduced by the ETI ($9,000 - $1,000 = $8,000), at ordinary rates ($520), = $200. It follows that Component C as calculated under subsection 13(2) will be $385.44. Step 6 The rate of tax Frank will pay on each dollar of his taxable in come is: ($520 + zero + $385.44)/$9,000 = 10.06044 cents' Example 5: minor with net capital gain only Frances is 14 years old and is a full-time student. During the 1991/92 financial year she received a net capital gain of $2,000 from the sale of shares. This capital gain is eligible taxable income (unearned income). She received no other income during the year. Thus her taxable income for the year was $2,000. The rate of tax Frances will pay on her taxable income is calculated as follows: Step 1 Frances' SIC is the amount of her net capital gain, i.e. $2,000 Step 2 Frances' RTI is her taxable income minus SIC , i.e. zero Step 3 Component A is the amount of tax a minor would pay on Frances' RTI . Because Frances' RTI is zero, Component A is also zero. Step 4 Frances will work out Component B like this: (a) Tax payable on RTI (zero) + 20% of SIC which is not eligible taxable income (zero) is zero (b) Tax payable on RTI at ordinary rates is zero (c) Component B = 5 x (zero - zero), i.e. zero Step 5 Component C is 47% x $2,000, i.e. $940 Step 6 The rate of tax Frances will pay on each dollar of her taxable income is: (zero + zero + $940)/$2,000 = 47 cents 'Example 5A (variation of Example 5) The same facts as in Example 5 except that Frances' net capital gain is $1,000 instead of $2,000. Step 1 Frances' SIC is the amount of her net capital gain, i.e., $1,000. Step 2 Frances' RTI is her taxable income minus SIC , i.e., zero. Step 3 Component A is the amount of tax a minor would pay on Frances' RTI . Because Frances' RTI is zero, Component A is also zero. Step 4 Frances will work out Component B like this: (a) tax payable on RTI (zero) + 20% of SIC which is not eligible taxable income (zero) is zero (b) tax payable on RTI at ordinary rates is zero (c) Component B = 5 x (zero - zero), i.e., zero. Step 5 As the ETI of $1,000 exceeds $416 but does not exceed $1,445, subsection 13(2) of the ITRA must be applied to calculate Component C . The amount of tax payable on the ETI must not exceed the greater of two calculations required under paragraphs 13(2)(a) and 13(2)(b) of the ITRA. (i) paragraph 13(2)(a) calculation: ( ETI - $416) x 0.66 = ($1,000 - $416) x 0.66 = $584 x 0.66 = $385.44 (ii) paragraph 13(2)(b) calculation: tax on taxable income of $1,000 at ordinary rates (i.e., zero) minus tax on taxable income reduced by ETI ($1,000 minus $1,000) at ordinary rates (i.e., also zero). The difference is therefore zero. In accordance with subsection 13(2) the tax on the ETI is therefore $385.44. Step 6 The rate of tax Frances will pay on each dollar of her taxable income is: (zero + zero + $385.44) / $1,000 = 38.544 cents' Example 6: primary producer (whose income is subject to the averaging provisions) with a net capital gain (i) Net primary production profit Boris is a primary producer whose taxable income for the 1991/92 financial year was $40,000. This consisted of: Primary production income: $30,000 Net capital gain: $10,000 Boris' primary production income was higher than in previous years. His average income is $25,000. The rate of tax Boris will pay on his taxable income is calculated as follows: Step 1 Boris' SIC is the amount of his net capital gain, i.e. $10,000 Step 2 Boris' RTI is his taxable income minus SIC , i.e. $40,000 - $10,000 = $30,000 Step 3 Component A is the amount of tax payable on Boris' RTI ($30,000) at ordinary rates, i.e. $6,594 Step 4 (a) Tax payable on ($25,000 + 20% of $10,000) at ordinary rates is $5,454 ( Amount Y ) (b) Tax payable on $25,000 at ordinary rates is $4,694 ( Amount Z ) (c) Component B = 5 x ($5,454 - $4,694), i.e. $3,800 Step 5 The rate of tax Boris will pay on each dollar of his taxable income is: ($6,594 + $3,800)/$40,000 = 25.985 cents (ii) Net primary production loss Dolores is a primary producer. In 1991/92, she incurred a primary production loss and her taxable income for that financial year was $8,000. This consisted of: Primary production loss: ($2,000) Net capital gain: $10,000 Her average income was $25,000. The rate of tax Dolores will now pay on her taxable income is calculated as follows: Step 1 Dolores' SIC is the amount of her taxable income, i.e. $8,000 Step 2 Dolores' RTI is her taxable income minus SIC , i.e. zero Step 3 Component A is the amount of tax payable on Dolores' RTI at ordinary rates. Because Dolores' RTI is zero, Component A is also zero. Step 4 Assuming that Dolores does not withdraw from the averaging system, Component B is calculated like this: (a) Tax payable on ($25,000 + 20% of $8,000) at ordinary rates is $5,302 (b) Tax payable on $25,000 at ordinary rates is $4,694 (c) Component B = 5 x ($5,302 - $4,694), i.e. $3,040 Step 5 The rate of tax Dolores will pay on each dollar of her taxable income is: (0 + $3,040)/$8,000 = 38 cents Example 7: abnormal income (i) Abnormal income only Daniel is an author whose taxable income for the 1991/92 financial year, derived from writing, was $30,000. Daniel's average income is $10,000, therefore the remaining $20,000 is abnormal income. The rate of tax Daniel will pay on his taxable income is calculated as follows: Step 1 Daniel's SIC is the amount of his abnormal income, i.e. $20,000 Step 2 Daniel's RTI is his taxable income minus SIC , i.e. $30,000 - $20,000 = $10,000 Step 3 Component A is the amount of tax payable on Daniel's RTI ($10,000) at ordinary rates, i.e. $920 Step 4 Daniel is not a primary producer, therefore he will work out Component B like this: (a) Tax payable on ($10,000 + 20% of $20,000) at ordinary rates is $1,720 (b) Component B = 5 x ($1,720 - $920), i.e. $4,000 Step 5 The rate of tax Daniel will pay on each dollar of his taxable income is: ($920 + $4,000)/$30,000 = 16.4 cents (ii) Abnormal income and net capital gain Assume Daniel also received a net capital gain of $5,000. His taxable income is $35,000, comprising: Average income: $10,000 Abnormal income: $20,000 Net capital gain: $5,000 The rate of tax Daniel will now pay on his taxable income is calculated as follows: Step 1 Daniel's SIC is the amount of his net capital gain plus abnormal income, i.e. $25,000 Step 2 Daniel's RTI is his taxable income minus SIC , i.e. $35,000 - $25,000 = $10,000 Step 3 Component A is the amount of tax payable on Daniel's RTI ($10,000) at ordinary rates, i.e. $920 Step 4 Component B is calculated like this: (a) Tax payable on ($10,000 + 20% of $25,000) at ordinary rates is $1,920 (b) Component B = 5 x ($1,920 - $920), i.e. $5,000 Step 5 The rate of tax Daniel will pay on each dollar of his taxable income is: ($920 + $5,000)/$35,000 = 16.91428 cents