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Incurred Tax and Letter of Advice to Client on Taxpayers Advantage

TAXA 5001



Essay Topic – Do both Parts A and B

Part A (1,000 words)

Discuss the meaning of the word “incurred”.  Using relevant legislation and cases, explain the relevance of this word in the calculation of taxable income.

This section must be referenced in accordance with the Australian Guide to Legal Citation (AGLC).  A summary of this document has been provided on Blackboard.

Part B (500 words)

Prepare a letter of advice to a client explaining what you have discussed in Part A ins such a way that a person who has no tax knowledge would understand the importance of this word and how it can be used to a taxpayer’s advantage.

For this section it is not necessary to use referencing.

Answer

PART A

According to the Cambridge dictionary, the word ‘incur’ means ‘to experience something, usually something unpleasant, as a result of actions you have taken’, e.g. the monthly detail of all the costs/expenses incurred by you. However, the term has a different meaning when it comes to business.

As per Income Tax Assessment Act 1997 (ITAA), Section 8-1, the word ‘incurred’ has the same meaning for taxpayers who return their income on a receipts basis as it does for those taxpayers who generally return their income on an earnings basis. As of now, there is no concrete definition of “incurred” as per the legislation. Broadly, the term ‘incurred’ is used at times when an individual or a company promise to pay a present loss/ expense in future. [Income Tax Assessment Act 1997 (ITAA)]

The legislation has been hesitant to endeavor a thorough definition of the term 'incurred'. After taking the recommendations the legislation decided to offer assistance to define the scope of the word “incurred” while calculate the taxable income of an individual taxpayer. The following common rules, settled by the law, help in most cases in characterizing whether and when a loss or expense has been incurred: 

  1. a taxpayer doesn’t require to pay any cash to have incurred an expense, if the expense is definitively paid by the taxpayer within the year of revenue generated. In a similar manner, a loss/ expense may be brought about inside segment 8-1 indeed in spite of the fact that it remains unpaid, given the tax-payer is 'completely subjected' to the loss/ expense. Subject to the standards set out underneath, it isn't adequate in the event that the obligation is contingent or no more than pending, undermined or anticipated, no matter how certain it is in the year of income that the loss or expense will be incurred in the future, it must be a directly existing obligation that can be paid in a monetary sum; 

Case I: ABC Ltd. bought raw materials worth $3000 in year 2017, out of which $2000 was in credit and $1000 was paid in cash. Even though the cash paid in the financial period was $1000 only. The expenses incurred in 2017 will be recorded as $3000 and will be deducted from the revenue to determine the taxable income.

  1. a citizen may have a currently existing obligation, in spite of the fact that the risk may be forfeited by others; 

Case II: ABC Ltd. has taken up insurance for damage of raw materials, if any material gets damaged it is a cost/ loss for ABC Ltd. at that time and will be deducted from the revenue to determine the taxable income. Later it might be covered by the insurance company.

  1. a citizen may have a directly existing obligation, indeed in spite of the fact that the sum of the risk cannot be accurately found out, given it is competent of sensible estimation (based on probabilities); 

Case III: As per the accounting rules, all probable future loss and expenses should be taken in account while calculating the taxable income, on the basis of appropriate estimates.

  1. In the case of a payment made in absence of a currently existing liability (where the amount is not from the taxpayer’s fund) the cost is said to be “incurred” when the cash is paid.

Case IV: From Case I, suppose that outstanding amount of $2000 is paid in the following period i.e., year 2018. Even though the cash is paid out in 2018, the cost will not be recorded as “incurred” in that year and it will not affect the taxable income of 2018.

As per section 8-1, in some cases it is not sufficient that a loss/ expense has been incurred. The expense must also be adequately committed to the year of income in which the deduction is recorded [Coles Myer (1993)]. The basis of an individual’s accounting system is not based on the period in which it was paid rather it is based on the period in which it was incurred. 

The principles set out above relating to the interpretation of the word 'incurred' derive from cases where taxpayers operated on an earnings basis. However, the cases have not generally sought to limit the meaning of the word 'incurred' by reference to the nature of a taxpayer's accounting system.

Case V: ABC ltd. incurred transportation expense of $200 and paid immediately in cash.

Note: As per ATO guidelines, there might be cases when there can be difference in accounting methods and amounts when the meaning of 'incurred' for taxpayers is when cash is paid out for expenses. They are generally small firms who follow cash based accounting system and are not required to maintain a detailed books of account. In these circumstances, the taxpayers are able to claim relevant expenditure prior to the when those expenses are actually been paid. 

In simpler terms, the company or individual who uses a cash basis of accounting system might not necessarily have paid an expense or borne a loss order for that loss or expense to have been 'incurred'.

Most of the organizations follow accrual basis of accounting in order to prepare their financial statements and calculate the taxable income. This system eliminates the risk of double entry, i.e. there will not be overlapping or doubling up of expenses or incomes. A company cannot claim an unpaid expense in one year on the basis that it has been incurred, and then claim again in a subsequent year when it is paid.

Note: If taxpayers wish to claim tax deductions on losses or expenses which are incurred but not claimed in a previous year, they can request for amendment or re-assessment, but this re-assessment is subject to the four years only. This limitation set by subsection 170(3) Income Tax Assessment Act 1936 (refer Taxation Ruling IT 2613). The Addendum to this rule was issued on 23 July 1997, which applies in relation to the 1997-98 or a later income year.



PART B

Name of the Student

Address of the Student


09/25/2018

Mr. XXXX 

Address of the client


To Mr. XXXX,

This letter is regarding your query that you wanted me to address. You had some doubts regarding the terminology “incurred” as per the law and taxation rules and I will try to make this letter as simple and elaborate for you to understand the concept properly.

The term “incurred” holds a very strong relevance in accounting rules and taxation laws. It also impacts the taxable income of a taxpayer. The term ‘incurred’ means a happening, an experience or an event; mostly negative; which occurs as a result of an action done by you. As per the accounting and taxation rules, incurred in used in regard to losses or expenses of a business. The word ‘incurred’ is used to identify and emphasize the period in which such expense or loss occurred and therefore, in which accounting period it should be recorded. 

The expenses incurred or losses borne can be incurred in a period and paid in another, e.g. expenses paid prior to the period when they were due, i.e. prepaid expenses or expenses not paid immediately when they were due and paid late on, i.e. outstanding expenses. 

A company might follow any of the following accounting system to record its transactions-

  1. Cash basis
  2. Accrual basis

Whatever system of accounting company follows has a direct impact on its taxable income. If a company is following cash basis of accounting then all the transactions and expenses are recorded in the books when there is a cash flow for that or whenever cash is paid for such expenses. Hence, it will directly affect the total expenses which will in turn affect the taxable income of the company or individual. This system of book-keeping is generally followed by small sized companies with limited number of transactions, and which doesn’t need to maintain an elaborate books of accounts.

If the company is following accrual basis of accounting, then all the transactions and expenses are recorded in the books in whatever period they are incurred irrespective of the is a cash flow for that or whenever cash is paid for such expenses. This means that expenses are said to be incurred in the period in which the company is generating simultaneous revenue through it. This will also affect the total expenses which will in turn affect the taxable income of the company or individual. This system of book-keeping is generally followed by majority of the companies and is prescribed as per the Income Tax Assessment Act 1997 (ITAA), Section 8-1 as well. 

This will not only help the company maintain an accurate books of accounts with accurate profits but it will comply with the tax laws and there won’t be any difference between the taxable amount calculated as per the company and as per the tax authority. Whereas, in case of cash basis of accounting, the company fails to record the correct profit, fail to abide by the taxation laws and there will always be some difference in the tax payable amount as per the company and the tax authority.

I hope you are able to get a broad perspective on how important it is to understand the implications of the term ‘incurred’ as per the taxation laws in calculating taxable income. 

Thank You!

Yours Sincerely,

Name of the student

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