Is Your Business’s Income Prepaid?

If your business receives income before a service is rendered to a client, when is the income recognised? Is it when the income is received or after the service rendered?

That was what the Arthur Murray case in tax law argued, creating a landmark decision regarding tax precedent that affected how pre-paid income derived from a contract is taxed when straddling several tax years.

In Sydney, the Arthur Murray Dance School provided lessons to its clientele after being paid for the service (payment up-front). This is not an uncommon practice in many membership/pre-paid subscription-based services.

If the school were to take income for a year’s worth of lessons up-front in June, which are to commence in July of the following financial year, when is the income to be declared? Is it in June when the money was received, or is it in the following year when he provides the dance lessons?

The Australian Tax Office believed the income should be declared when the money was initially paid.

However, Mr Murray challenged the decision in court, arguing that if the lessons weren’t provided, the money would need to be returned; thus, he was only holding it in trust until he provided the lessons.

In deciding Arthur Murray, the Court found that amounts received in advance for dancing lessons were not derived until the lessons were actually given. The payments were only considered assessable income after they had been earned by giving the lesson.

This has become known as the Arthur Murray Principle and can sometimes be applied to other types of pre-paid income that are to be provided over the following 12-month period, such as

  • Pre-paid advertising,
  • Prepaid web service fees,
  • Prepaid gym memberships, and
  • Construction contracts.

However, some rules need to be followed if you wish to follow this principle. The money must still be at risk to you – you can’t tell someone they can’t receive a refund on a full-year gym membership and then expect to defer the tax on that income. There are also instances where you will be taxed on the money when it is received. The main types of income this generally applies to are wages, interest and rents received.

This rule of income extends to businesses where the ATO believes that their income is akin to earning wages, such as accountants, solicitors and other professionals that earn all of their income from their own personal services.

If you’re unsure how these principles may apply to you or your business, do not hesitate to contact us.