Indirect taxes
Direct tax
A direct tax is charged directly on a person's or entity's income, profits or wealth, such as income tax, and is paid by the taxpayer who earns the income.
A direct tax is a tax imposed straight on the person or entity that is meant to bear it, usually based on income, profits, or capital gains. The taxpayer reports their position, calculates the tax, and pays the government directly. Income tax is the clearest Australian example, along with capital gains tax and the Medicare levy.
In Australia the main direct taxes for individuals and businesses are income tax on taxable income, with different rates for individuals, companies and trusts, and capital gains tax on the profit from selling assets. Fringe benefits tax is also a direct tax on employers in respect of certain benefits provided to employees. The Medicare levy is a direct charge, generally 2% of taxable income for those liable.
Direct taxes are usually assessed after the end of the income year. Individuals lodge a tax return, receive a notice of assessment and pay any balance. Many people also pay as they go during the year, through PAYG withholding by employers or PAYG instalments by businesses and investors. These are prepayments towards the final direct tax liability, not separate taxes.
The difference from indirect taxes such as GST matters for businesses. GST is collected on transactions and passed on, and it does not depend on whether the business made a profit. Income tax depends on profit, with deductions reducing what is taxed. A business can owe GST in a loss-making year, and can have a GST refund in a profitable one, because the two systems measure different things.
This difference also affects planning. Purchases may be deductible for income tax but have no GST credit, such as wages, or have a GST credit but not be immediately deductible, such as capital items. Keeping the two sets of rules straight in your accounting software, with proper tax codes, avoids mistakes in both the BAS and the tax return.
A common misunderstanding is that registering for GST changes income tax obligations. It does not, although a business must keep records that satisfy both. This is general information only, so confirm your situation with the ATO or a registered tax professional.
Worked example
A sole trader earns $120,000 of business income, with $20,000 of deductions, giving net business income of $100,000. Income tax is a direct tax calculated on that profit through the tax return using the resident rates. Separately, GST of one eleventh of GST-inclusive sales was collected during the year and reported on BAS. The two taxes are reported separately and calculated differently.
Practical tips
- Keep in mind that GST and income tax are calculated differently and reported on different forms.
- Plan for PAYG instalments, as they are prepayments of your income tax and affect cash flow.
- Use proper tax codes in your accounting software so both the BAS and the tax return come out correctly.