The Inland Revenue Department (IRD) recently released a new interpretation statement discussing when income from professional services is considered to be derived, and hence becomes taxable. The statement replaces several older IRD Information Bulletin's and consolidates their view, giving greater detail and more examples.
There are two main methods of recognising income, the accruals basis, which taxes income when earned and the cash basis, which taxes income when physically received.
Most businesses use the accruals basis, however professional services providers may be able to apply the cash basis. Historically, both doctors and barristers could use the cash basis because doctors could not create a lien over patients' property, whilst barristers were unable to sue their clients for unpaid fees.
The IRD's interpretation statement provides that the cash basis is not exclusively for these professions and can be applied in other circumstances. Similarly, there may be occasions where the accruals basis may be more appropriate for doctors and barristers. The statement draws on a vast body of case law and lists the following factors to help determine the most appropriate method:
The type of activity: the cash basis might be appropriate where the level of expenditure does not have a material effect on the income derived or there is a high risk of non-collectable income.
The characteristics of the type of income: the cash basis might be appropriate where there is a low expectation of payment inherent in the type of income, or where the timing of receipts are governed by legislation.
Legal and regulatory environment: standard contractual obligations may require payment at specific times, and hence it might be more appropriate to return the income on a cash basis.
Scale of the business or income earning activity: the larger the number of employees, the turnover and general size of a business will indicate the accruals basis should be adopted.
The level of sophistication or complexity of an activity: if a professional services activity requires fixed or circulating capital and accounts for trade receivables on a balance sheet, the accruals basis may be more appropriate.
The IRD provide the example of where the Court held that a pathology practice with five partners, 66 nursing staff across 21 collection centres, approximately 92,000 patients annually and gross fees of $2m per annum should apply the accruals basis. The Court held that the scale of the operation and the fact that a substantial amount of the work to derive the income was performed by nurses and not solely the taxpayer made the accruals basis more appropriate.
Conversely, the Courts determined that a solicitor who worked alone with only the assistance of a secretary should account for income on a cash basis. The size of the practice and the majority of the work being undertaken solely by the taxpayer influenced the outcome.
Use of the cash basis is relatively rare in today's modern environment, it dates back to paper based accounting records, before modern software simplified the accounting process. However, the IRD's statement does acknowledge that there are still situations where it is appropriate to recognise income on a cash basis.