Capital vs Revenue

Principles of Capital and Revenue
To fully appreciate the basis of many tax saving measures, a taxpayer must clearly understand the principles of capital and revenue and the ways these principles affect them.

How Does it Work?
It is quite simple.

There are 4 basic principles involved.

  1. Income tax is a tax on income.
  2. Income is anything that comes in.
  3. From income you deduct all expenses incurred in the production of the income.
  4. Anything that is either a capital gain or capital loss is neither taxable as income nor deductible against income.

While these principles seem simple enough, because of the combined effect of distortion by law and inflation they can become almost meaningless.

The following terms need to be understood:

  • Capital
  • Revenue 
  • Expenses

The examples below may illustrate this better.

  1. You have $1 invested in your business and at the close of business you get back $1.10. Your income for tax purposes should be the gain that you have made on that $1 invested – that is, 10c. The dollar you get back is simply a return of what you have invested (that is return on your capital). Such returns of capital are not taxable because income tax is a tax on income.

  2. If you invest your $1 and the dollar earns you 20c and this costs you 10c on top of your $1 investment, then your income would be 20c minus the 10c cost to give you a net gain of 10c. The 10c would be deductible if it was necessarily incurred in producing your 20c income. If the dollar that was returned to you is a return of capital (and therefore tax free) and your net profit, which is 20c less 10c is your net income, then that is what your tax is assessed on.

  3. If you now buy shares for $1 and you receive a dividend of 10c, and then sell the shares for $1.20 you get a capital gain of 20c plus a revenue gain of 10c. On top of that you get a return of capital of $1. The total is $1.30.

What is Capital and what is Income (Revenue)?

For tax purposes, your income based on the above illustration is 10c and you get $1.20 back tax free as a return of capital.

Why is this?

Because a dollar of that $1.20 is what you have put in originally and is thus tax free. It is only a return of capital.

But why is that other 20c tax free? Even though it is a gain, it is what is known as a capital gain.

Capital Gains and Loss
Capital gains are theoretically tax free. They are tax free to the extent that they arise on a sale of a capital asset used in the production of taxable income. Your purpose in buying the shares has to be looked at and in this case you can say that your purpose was to live on the dividend income and therefore you are selling the shares to buy other shares to provide you with income. You have sold a capital asset and the resulting gain is tax free.

Your purpose in this exercise was to provide an investment which would be stable and provide you a cash flow, independent of the gains that you would make from buying and reselling.

Conversely if the market went down and your shares dropped to 80c there would be a capital loss which could not be deducted from the income earned because it was a capital loss and not a revenue loss. However, if you were in the business of buying and selling shares then it would be a revenue loss and therefore deductible.

Another important factor to consider in taxation, aside from the principles discussed, is timing. You are only taxed on income earn during a particular tax year. If you don’t earn income in that year you can‘t be taxed on it until the next year.

Earning income has little to do with wishing to receive it. You can be (and most people are) taxed on income that is earned but not yet received. If you can understand these basic principles then you are ready to understand how tax is affected by such things as inflation and law.