House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello MP)

Chapter 2 - Extending the simplified tax system

Outline of chapter

2.1 Schedule 2 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to remove the requirement that taxpayers in the simplified tax system (STS) must use the STS accounting method (generally referred to as a cash basis of accounting). Context of amendments

2.2 In the 2004 election policy statement Promoting an Enterprise Culture, the Government announced on 26 September 2004 a number of measures designed to foster the entrepreneurial spirit of small businesses. The Government announced that it would remove the restriction on small businesses in the STS to account for their ordinary income when received and general deductions when paid. This will enable businesses to utilise the most appropriate method of determining taxable income. The decision whether or not to enter the STS will no longer impact on the most appropriate method for a business to calculate its taxable income.

2.3 The STS was introduced on 1 July 2001 as an alternative method of determining taxable income for certain businesses with straightforward, uncomplicated financial affairs who choose to enter the STS. The STS modifies the current method of determining taxable income.

2.4 The STS has three main elements:

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Modified accounting arrangements for STS taxpayers which recognise most business income and deductions only when they are received or paid.

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A simplified trading stock regime where STS taxpayers do not have to account for changes in the value of trading stock or do stocktakes at the end of the income year in certain circumstances.

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A simplified depreciation regime under which depreciating assets costing less than $1,000 are written off immediately. Most other depreciating assets are pooled and enjoy an accelerated rate of depreciation.

2.5 Under the modified accounting method (generally referred to as cash accounting) in Subdivision 328-C, an STS taxpayer is not required to bring to account, at year end, income from sales for which payment has not been received (debtors). Similarly, business expenses owing (creditors), at year end, are not deductible until paid. However, there is no change to the accounting method used for statutory income and most specific deductions. This method requires certain adjustments to ordinary income, general deductions and deductions for tax-related expenses and repairs when a business starts (entry adjustment rules) or stops (exit adjustment rules) being an STS taxpayer.

2.6 The entry adjustment rules ensure that the transition to the cash accounting method does not result in business income and expenses being recognised twice or omitted. The exit adjustment rules ensure that the transition from the cash accounting method does not result in omission of business income and expenses.

Summary of new law

2.7 To be eligible for the concessions available under the STS businesses have to adopt modified accounting arrangements which recognise most business income and deductions only when they are received or paid. This denies access to the concessions available under the STS to those businesses whose most appropriate method of calculating taxable income is different.

2.8 Schedule 2 to this Bill will amend the STS rules to remove the requirement to recognise most business income and deductions only when they are received or paid. The amendment will allow small businesses to access the benefits of the STS whilst continuing to calculate their taxable income using the most appropriate method for their circumstances.

Comparison of key features of new law and current law

Detailed explanation of new law

2.9 Schedule 2 to this Bill amends Division 328 of the ITAA 1997 to remove the requirement that taxpayers in the STS must use a cash basis of accounting. Subdivision 328-C currently specifies the accounting method for STS taxpayers. This Subdivision is repealed with effect from the first income year commencing on or after 1 July 2005. [Schedule 2, item 9]

Application and transitional provisions

2.10 The amendments apply to the first income year commencing on or after 1 July 2005. [Schedule 2, item 11]

Income Tax (Transitional Provisions) Act 1997

Meaning of STS accounting method

2.11 The term STS accounting method is defined to mean the accounting method that was required to be used by STS taxpayers for the 2004-05 income year. This was generally referred to as the cash accounting method which is being repealed with effect from the first income year commencing on or after 1 July 2005. [Schedule 2, item 10, section 328-125]

Continuing to use cash accounting

2.12 Transitional provisions will be introduced to enable businesses that have elected into the STS, prior to the first income year commencing on or after 1 July 2005, to continue to recognise most business income and deductions only when they are received or paid. This allows businesses who currently calculate their taxable income under the cash accounting method contained in the STS to continue to use that method. [Schedule 2, item 10, section 328-120]

Ceasing to use cash accounting

2.13 Transitional provisions will also allow STS taxpayers to cease to use the cash accounting method. These provisions ensure that business income and expenses (that have not been recognised under the cash accounting method because they had not been received or paid) are recognised in the first year that a business, which is currently in the STS, ceases to use the cash accounting method (changeover years). [Schedule 2, item 10, section 328-115]

Example 2.1: Remaining in the simplified tax system but ceasing to use the cash accounting method

Robert entered the STS in the 2003-04 income year.

Before entering the STS he recognised income in the year it was derived and claimed deductions in the year they were incurred (generally referred to as an accruals method).

Robert included amounts owing from customers as income derived in the 2002-03 income year.

He also claimed deductions for business expenses outstanding at the end of the 2002-03 income year.

The entry adjustment rule (see subsection 328-110(2) of the ITAA 1997) for ordinary income ensures that, when Robert entered the STS, amounts owing from a previous year were not recognised again when received.

The entry adjustment rule (see subsection 328-110(4) of the ITAA 1997) for deductions ensures that expenses outstanding from a previous year were not recognised again when paid.

Robert chooses to change back to his original method of calculating taxable income (the accruals method) in the 2009-10 income year. Robert remains in the STS.

While he was using a cash basis of accounting he had derived ordinary income for which payment had not been received. Robert did not include this amount as income as the cash accounting method does not recognise ordinary income until it is received.

While he was using a cash basis of accounting he had ordered business supplies but had not paid for them. Robert did not claim a deduction for this expense as the cash accounting method does not recognise general deductions until they have been paid.

The exit adjustment rule for ordinary income ensures that Robert includes in assessable income, amounts owing to him in the changeover year (2010-11 income year).

The exit adjustment rule for deductions ensures that he can deduct expenses owed by him in the changeover year (2010-11 income year).

Re-entry of business that previously elected to leave the STS

2.14 Under subsection 328-440(3) of the ITAA 1997, taxpayers who choose to leave the STS cannot re-enter for at least five years after the income year in which they left the STS. Transitional provisions will suspend this rule for five years from 1 July 2005 for taxpayers who have exited the STS prior to their first income year commencing on or after 1 July 2005. [Schedule 2, item 10, section 328-440]

2.15 This will allow businesses, that left the STS because the cash accounting method was no longer appropriate to their circumstances, to re-enter the STS without having to wait five years.

2.16 The five year rule will recommence for exits from the STS after the taxpayer's first income year commencing on or after 1 July 2005.

Consequential amendments

2.17 Consequential amendments are made to the following provisions to remove references to the cash accounting method in the STS:

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The note to subsection 6-5(4) of the ITAA 1997 which refers to the STS cash accounting regime is repealed [Schedule 2, item 1].

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The note to subsection 8-1(3) of the ITAA 1997 which refers to the application of the cash accounting regime to deductions is repealed and the note renumbered [Schedule 2, items 2 and 3].

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The note to subsection 70-15(3) of the ITAA 1997 which refers to the timing of deductions for trading stock is repealed and the note renumbered [Schedule 2, items 4 and 5].

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Section 328-5 of the ITAA 1997, which explains what the Division (STS) is about, is amended to remove the reference to the cash accounting system [Schedule 2, items 6 and 7].

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Section 328-10 of the ITAA 1997, which provides a map to Division 328 (the STS), is repealed [Schedule 2, item 8].