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Ruling

Subject: Emerging profit basis of assessment

Question 1

Can the company calculate its taxable income, consisting of trail commissions from purchased loan books, on a profit emerging basis?

Answer

Yes

Question 2

Does the Commissioner have a preferred method of calculating the emerging profit?

Answer

No

Relevant facts and circumstances

A is an incorporated company.

A's business consists of acting as a loan broker and receiving trail commissions, in respect of which it acts as the original broker;

Purchasing the rights to receive 'trailing commissions' and 'loan books' from mortgage brokers;

Receiving trail commissions from the purchased trail commissions and loan books.

Mortgage brokers are paid 'up front commissions' and 'trailing commissions' by institutional lenders for arranging finance products, mainly housing loans. The agreements between the mortgage brokers and financial institutions are substantially the same across the industry.

The mortgage broker's entitlement to trailing commissions arises when the loan is made and settled and is calculated each month as a percentage of the average monthly balance of each loan.

Based on industry comparisons, loans may be for periods of up to 30 years however the average period until they are either repaid or refinanced is 4.5 years. Trailing commissions are thus, on average, payable each month for 4.5 years and depend on the average monthly balance of the loan based on these statistics.

The trailing commissions are paid monthly under an arrangement whereby an independent service provider, for a fee, aggregates and collects the commission due to each mortgage broker on its behalf.

Loan books comprise the mortgage broker's records of the borrowers (including their addresses, property details, loan balances, value of prospects, unused borrowing capacity. income and repayment details) as well as a non compete agreement under which the mortgage broker agrees not to solicit or market financial products to the borrowers.

There are no regulatory restrictions on the acquisition of trailing commissions or loan books. There is a requirement by the institutions paying the commissions that the purchaser be a member of the Mortgage Industry Association of Australia (MIAA) and have appropriate professional indemnity insurance.

A negotiates the purchase price of each entitlement with the mortgage broker taking into account factors such as the amount likely to be received and the time value of money.

A is not related to the mortgage brokers from whom it has acquired the trail commissions and loan books. Each purchase has been notified to an independent service provider and to the lenders.

A's intention in respect of the acquired trail commissions and loan books is to retain the entitlement to collect the commissions.

Relevant legislative provisions

Income Tax Assessment Act 1997 - section 6-5

Reasons for decision

Question 1

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides, in brief, that an Australian resident must include in assessable income the ordinary income it derives from all sources. Ordinary income is income according to ordinary concepts.

In Federal Commissioner of Taxation v. Stone [2005] HCA 21 (2005) 222 CLR 289 (2005) 2005 ATC 4234; (2005) 59 ATR 50, the majority judgment of the High Court considered the meaning of the phrase 'income according to ordinary concepts'. The court referred to the judgment in Scott v. Commissioner of Taxation (NSW) (1935) 3 ATD 142 at 144-145, where it was considered that in determining how much of a receipt should be treated as income, regard must be had to the ordinary concepts and usages of mankind.

Upon entering into the agreement to acquire commissions, the company acquired a legal chose in action giving it the right to receive a sum of money. The transaction was entered into with the expectation of making a profit where the proceeds of collection exceed the cost of the acquired debt. The consideration paid on acquisition of the right is funded by capital being either debt, equity or a mixture of both. Any receipts from collections therefore comprise a return in the form of a partial recovery of its investment (a return of capital) and a profit component.

The taxpayer's receipts from its collection activities do not represent ordinary income. They are receipts of money, rather than ordinary income, which incorporate a mix of returned capital and profit.

For the purposes of section 6-5 of the ITAA 1997 a number of cases have determined that gross income, or ordinary income, equates with net profits. As referred to by Hill J in Federal Commissioner of Taxation v. Citibank Limited & Ors (1993) 44 FCR 434; (1993) 93 ATC 4691; (1993) 26 ATR 557 ( Citibank ), a necessary requirement of bringing a net profit into assessable income is that the gross amounts used to calculate that net profit was not itself income in ordinary concepts.

In collecting money in respect of the outstanding trailing commissions, the company recovers its capital and, in part, realises a profit. If it fails to recover its capital, it incurs a loss. Therefore, part only of the receipts could be considered income. As such, the gross receipts used in the calculation of net profit are themselves not ordinary income.

Paragraph 17 of Taxation Ruling TR 98/1 states:

When accounting for income in respect of a year of income, a taxpayer must adopt the method that, in the circumstances of the case, is the most appropriate. A method of accounting is appropriate if it gives a substantially correct reflex of income. Whether a particular method is appropriate to account for the income derived is a conclusion to be made from all the circumstances relevant to the taxpayer and the income.

In Citibank Hill J, in considering the relevance of accounting evidence in determining income tax issues, referred to the judgments in Commissioner of Taxes (SA) v. Executor Trustee & Agency Company of South Australia (1938) 63 CLR 108; (1938) 5 ATD 98; (1938) 1 AITR 416 (Carden's case) and Arthur Murray (NSW) Pty Ltd v. Federal Commissioner of Taxation (1965) 114 CLR 314; (1965) 14 ATD 98; 9 AITR 673, where it was held that such evidence is relevant and can be used to provide evidence of what constitutes income. Hill J said that where there is no impediment in the Act to bringing to account a net profit as gross income, then that profit will need to be calculated in accordance with the accounting standards.

In XCO Pty Ltd v. Federal Commissioner of Taxation (1971) 124 CLR 343; (1971) 71 ATC 4152; (1971) 2 ATR 353, (XCO) the High Court considered the application of a profit emerging basis, in circumstances similar to the present case, where a taxpayer was assigned debts at a deep discount to their face value for consideration. Gibbs J said:

Where the carrying out of a profit-making scheme extends over more than one year, the difference between receipts and disbursements in any one year may not give a true reflection of the profit arising or loss sustained in that year, and the assessment of profit on an emerging basis may be appropriate.

In determining its profit for accounting purposes, it is appropriate that the taxpayer amortises the cost of the debt ledgers. It does not calculate its profit or loss by deducting from the year's collections the total cost it outlays in acquiring trailing commissions for that year for that would distort its true position for that year. Instead, its profits are effectively determined on an emerging basis taking into account that portion of the cost relevant to the acquisition of the trailing commissions that result in collected income over the period.

Here, the company's profit making scheme extends over more than one income year. The bringing to account for tax purposes of the difference between receipts and disbursements in any one particular income year will not give a true reflection of the profit or loss sustained for that year. The assessment of profit under section 6-5 of the ITAA 1997 on an emerging profit basis is therefore considered to be the most appropriate in determining the income for taxation purposes.

Question 2

Dixon J pointed out as a general proposition in Carden's case that:

....in the assessment of income the object is to discover what gains have during the period of account come home to the taxpayer in a realized or realizable form.

Also Dixon J expressed the view that the admissibility of the chosen method of accounting for income depended on 'whether in the circumstances of the case it is calculated to give a substantially correct reflex of the taxpayer's true income'. His Honour also pointed out 'to a great degree the question whether income can be properly calculated on one basis alone or upon either, must depend upon the nature of the source of the income'.

In the light of this judicial decision and in the apparent absence of any ruling or other determination or direction by the Commissioner specifying how assessable income is to be calculated when an emerging profit basis is the appropriate form of assessment of income it is considered that more than one basis of calculating the assessable income may be contemplated as being correct.

Taxation Ruling TR 98/1 provides guidance on the accounting method likely to provide a substantially correct reflex of income in a relevant year. While this ruling is mainly concerned with distinguishing between a cash receipts basis and an earnings basis, it does note at paragraphs 27 and 28 that a taxpayer must adopt the method of accounting that, in the circumstances, is appropriate. A method of accounting is appropriate if it gives 'a substantially correct reflex' of that income. This is the principle established in Carden's case.

Whether a method gives a substantially correct reflex and therefore is appropriate, is a conclusion to be made from all circumstances relevant to the taxpayer and the income. It is necessary, according to Dixon J in Carden's case to:

'.......discover what gains have during the period of account come home to the taxpayer in a realised or immediately realizable form'

In the absence of any direct guidance as to the method to be adopted when using the emerging profits basis of assessment of income, we therefore conclude that any method will suffice so long as it produces a substantially correct reflex of the taxpayer's true assessable income.

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