What is Income?
Put simply, an individuals income includes receipts from:
• salaries and wages
• business and self-employment income
• unemployment benefits
• rental income
• profit from selling capital assets
• New Zealand resident overseas income
However, there is much more to it. What we refer to as income is referred to as an individual’s assessable income in tax terms.
As the Income Tax Act 2007 imposes tax on income, it is essential for taxpayers to understand what constitutes as income and its relevance in tax calculations.
In the Income Tax Act 2007:
• Section BB1 states tax is imposed on taxable income.
• Section BC5 states taxable income for a tax year is determined by subtracting any available tax loss that the person has from their net income.
• BC4 (1) states that Net income = Annual gross income - annual gross deduction
• BC2 - A person's annual gross income for a tax year is the total of their assessable income that is allocated to the corresponding income year.
The most important portion of assessable income is income under ordinary concepts.
Section CA1 states:
1. An amount is income of a person if it is their income under a provision in this Part.
2. An amount is also income of a person if it is their income under ordinary concepts.
Income Tax Act 2007 defines “assessable income” in tax terms. So, to understand income, we must first look into assessable income.
Section BD1 (5) Assessable income consist of 2 limbs; negative and positive.
Assessable income is an amount of income of a person in the calculation of their annual gross income (positive limb), if it is not income of any of the following kinds (negative limb):
(a) exempt income:
(b) excluded income:
(c) non-residents' foreign-sourced income.
The legislation does not define income and it has been purposely left open to capture all types of transactions. In response to this, the courts have made the definition simple and in ordinary language.
In Reid v Commissioner of Inland Revenue (1983) 6 NZTC 61,624 (HC) the concept of income was described to have these key features:
- Income is something which comes in
Income comes into your pocket, not what saves your pocket e.g., discounts of frequent flyer points.
- Income is money or moneys’ worth
Income is convertible into money or moneys worth
- If paid in gold bars, this can be converted into money
- If you have been taken out to lunch, although you have saved money, the lunch is not convertible into money or money worth and Is therefore not income
- Certain quality in the hands of the recipient
We must think what the receipt represents in the hands of the recipient. If it is something on which we regularly rely and depend on, it is likely an income.
- Periodicity, recurrence or regularity
There is the quality of regularity or reoccurrence upon which the recipient depends on.
- Holiday package offered to an employee by the employer is not his income. However, it would be subject to fringe benefit tax.
- A one off gift where love & affection is involved is not income in the hands of the recipient.
- Winning lottery tickets or money from tab cannot be regarded as income (unless one is in the business of doing so)
- Tips received by the hotel staff would be income since it is regular or periodic in nature. Because the income they received it is in lieu of services they provide. But if an accountant received $200 gift from their client which is not in lieu of his service, will not be an income of the accountant.
The important thing is motive, what was the motive behind the whole transaction. Courts have determined that you must stand in the taxpayer shoes.
- It is the produce or property of labour
It is incurred through labour or e.g., renting/leasing property.
The is often an argument between the taxpayer and the IRD in defining capital receipts. Receipts which are capital in nature do not constitute as income and are therefore treated differently. Capital receipts are not taxed and therefore no deductions can be claimed against them either.
An analogy commonly applied to understand and distinguish capital vs income receipts is the Tree vs Fruit. Capital is the tree and income is fruit of that tree.
- Think from rental house perspective, the house is a capital and rent is an income.
- Water reservoir is capital and water outlet is income
Generally employers place a few conditions surrounding an employees exit from the company. These may include:
- Geographic location clause
- Time clause
- Customers can not approach them
- Trade secrets cannot be revealed
Section CE 9 states that if it your profession to do something and you are paid to not do that for a period, then it is a replacement of income and should be treated as income.
Income from selling personal property
Section CB 3 states that an amount that a person derives from carrying on or carrying out an undertaking or scheme entered into or devised for the purpose of making a profit is income of the person.
- It is important to look at the taxpayers dominant purpose. If the dominant purpose for which the property was bought was for a profit making undertaking/scheme, then CB 3 will apply.
- The profit may be derived in an unintended way, as long as the scheme has been carried out
- The onus of proof is on the taxpayer to prove the purpose.
What is undertaking or scheme?
An undertaking/scheme is some sort of plan or formulation in relation with making a profit.
- CB3 will not trigger if you are just merely selling off the asset, this will just be realisation.
For example, you sold your car on trade me, if you make some money out of it, this will not be your income as it is not regular in nature, it is merely realisation of an asset.
In order to define business income, we must first understand what a business is.
- Business is something which is more than a hobby and intention to make profit exists
- A Business requires planning, budget preparation, set number of hours, place of work, accounting records.
- Overall, it must have motive to earn/maximise profits. It may not actually be profitable but the intention must exist.
If you want to claim deductions against business income, you must be able to show you are running a business. The problem here could be when the nature of business is actually hobby for example artist, gambler, and sports professional or horse breeder.
Features of business:
The below factors can help determine whether an entity is in business:
- Nature of the Activity
We must question whether the nature of the activity is such that it can be carried out as a business?
- Period of Time
This takes into consideration how much time is spent on the activity. There should ideally be an organised and systematic operation being carried out.
- Scale of Operations and commitment of time money and effort
At what scale you are operating the business and how much money, time or effort has been invested. Scale is important but not that much, even if business is carried out on a smaller scale, it can be a business.
- Pattern of Activity
Pattern of activity is important. Courts have said frequency and systematic operation is important but not required. There may be some businesses which are seasonal. As long as you can justify the reason of idle time you can get away.
- Financial Results
There must be a prospect of making a profit. The way this is decided is whether there is a genuine intention to make a profit and not whether the prospect is reasonable.
- Comparison to similar Operations
What wud a firm of similar size and state be doing, are they doing things in a similar way? Even though you do everything differently than the other industry members, your business can still be referred as business. As long as you can justify it.
They are all part of the mix, don’t need ticks at every level. They are considered as a whole to arrive at an overall conclusion.
When does your business start?
The intention test determines when a business starts and finishes. You may have started an activity as a hobby but when you intend to continue for profit, it becomes a business. It is important to determine when trading begins as opposed to any preparatory work prior to commencement of the business. Income and deductions would be deductible from that point onwards. Pilot project/feasibility study cannot be business. The whole idea behind this is you have not made up your mind yet.
Once business is terminated you can no longer claim deductions.