In the world of professional services, understanding when income is recognised, or “derived,” for tax purposes is important. We are occasionally asked by professionals if it is possible to account for their income on a “cash basis”, as this generally results in a favourable tax position (see more below) and in the days before computerised accounting systems like Xero, it was easier.

The Income Tax Act 2007 provides that income is taxable when it is “derived” however the word “derived” is not defined in the Act meaning that taxpayers need to look elsewhere for guidance.

In the past (see PIB 159 from 1987), the IRD had issued guidance to the effect that barristers sole, medical professionals and company directors were able to use a cash basis. This position was updated in December 2016 by IS 16/06 which is the most up to date IRD publication on the issue. I have summarised the current position below together with some further explanation of the impact of each approach on the professional:

What is the difference: cash vs. accrual?

A cash basis means recognising revenue for income tax purposes when it is received. This is better from a taxpayer’s point of view as it leads to a deferral of the income tax on the accounts receivable the professional has (often significant).

An accrual basis means that as soon as a client is invoiced, this becomes “income” for income tax purposes and will usually result in earlier income tax payments and occasionally paying tax on “income” that does not end up received (although this position can eventually be corrected by writing off a bad debt).

So with all other things being equal, a professional would likely prefer to account for income on a cash basis for income tax purposes, like they are able to do for GST.

The IRD however considers that there is no choice as to which method to use, that “identifying the correct method is a question of fact” and the nature of the business for the professional needs to be considered.

Factors supporting a cash basis

In their interpretation statement, the IRD summarises that a cash basis may be suitable in the following circumstances:

• an ordinary individual who does not carry on a trade, profession, or business;
• a business or income earning activity involving a professional person marketing nothing but their own services and receiving nothing but professional fees;
• a business in which expenditure contributes to income in a subsidiary or minor degree; and
• a business in which the risk of non-collectable trade debts is unusually high.

Medical practitioners, barristers sole and directors

Despite the 1986 publication from the IRD saying that medical practitioners, barristers sole and directors could use the cash basis, the IRD’s position is now that no special rules apply to these occupations, and as noted above, that there is no choice in method but that the appropriate method depends on the facts.

Medical practitioners and barristers sole operating with no staff or only small admin staff will generally be able to use the cash basis, however it will depend on the scale and specifics of the practice.

Similarly, a company director with one or a few directorships would be able to use the cash basis, while those running larger consultancy practices would not.

OK – in simple language?

Generally for those whose business is just themselves providing services income, and where there is a material risk of non payment from their customers, a cash basis will be appropriate. Often these factors will not be present and hence the IRD will be looking for income to be reported on an accrual basis.

Of course it is possible that a business starts out as a solo practitioner but over time the scale and sophistication of that business will increase. In that case it will be necessary to shift to an accrual basis for reporting income. The opposite will sometimes be true as well.

If you’re unsure about which method applies to your professional practice or need guidance on navigating income recognition for tax purposes, we’re here to help. Contact us and we can work through your specific situation to ensure you’re compliant and making the most of your tax strategy.