Edited version of your private ruling

Authorisation Number: 1012342994878

This edited version of your ruling will be published in the public register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fact sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet.

Ruling

Subject: assessable income

Question 1

Is the reduction in the purchase price paid by Company B for the acquisition of a business that is attributable to the assumption of a deferred income liability, assessable income of the Company A consolidated group under section 6-5 of the Income Assessment Act 1997 (ITAA 1997) for the year 2011 income year?

Answer

No

Question 2

Is the revenue recognised for accounting purposes by Company B upon providing services in relation to customer contracts represented by the deferred income liability, assessable to Company B under section 6-5 of the ITAA 1997 for the purposes of the Company A consolidated group income tax return for the 2011 and 2012 income years?

Answer

No

This ruling applies for the following periods:

2011 income year

2012 income year

The scheme commenced during:

2011 income year

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Company B is a member of the Company A consolidated group.

Company B entered into an agreement with Company C to purchase a business in 2010. The completion date for the purchase was a short time later in the same income year.

The agreement provided for the purchase price to be calculated as follows:

· Purchase Price = P-Q-S, where:

· P is $X

· Q is the deferred income amount; and

· S is the total entitlements for transferring employees

The deferred income amount is defined in the agreement as the aggregate license fees under the existing customer contracts that have been invoiced and paid to Company C for which services had not yet been provided at completion.

The deferred income amount of $X was recorded by Company C in its accounts just prior to the sale.

Following completion, Company B acquired the business and assumed the deferred income amount of $X.

The purchase price was reduced by the value of the deferred income amount as set out in the agreement.

As part of the acquisition, contracts between Company C and its customers were novated to Company B. Following the purchase, Company B recognised on its balance sheet a deferred income amount of $X which represented a liability in respect of services that Company B was obliged to provide under the novated customer contracts.

During the 2011 and 2012 income years, $X, were transferred from Company B's deferred income amount to its profit and loss account in respect of services rendered by Company B pursuant to the novated customer contracts.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Reasons for decision

Question 1

To be assessable under section 6-5 of the ITAA, the reduction in the purchase price must be income according to ordinary concepts, which is called ordinary income.

Whether or not a particular receipt is income depends on its character in the hands of the recipient (Scott v Federal Commissioner of Taxation (1966) 117 CLR 514 at 526;(1966)14 ATD 286 at 293;(1966) 10 AITR 367 at 275; Hayes v Federal Commissioner of Taxation (1956) 96 CLR 47 at 55; (1956) 11 ATD 68 at 73; (1956) 6 AITR 248 at 254; Federal Coke Co Pty Ltd v Federal Commissioner of Taxation (1977) 7 ATR 519 at 539; 77 ATC 4255 at 4237; 34 FLR 375 at 402 per Brennan J).

In GP International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124; (1990) 21 ATR 1; 90 ATC 4413 at 4420, the Full High Court stated that:

To determine whether a receipt is of an income or of a capital nature, various factors may be relevant. Sometimes the character of receipts will be revealed most clearly by their periodicity, regularity or recurrence; sometimes, by the character of a right or thing disposed of in exchange for the receipt; sometimes, by the scope of the transaction, venture or business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business.

In Scott v Federal Commissioner of Taxation (NSW) (1935) 3 ATD 142; (1935) 35 SR (NSW) 215; (1935) 52 WN (NSW) 44; Jordan J stated at ATD 144-145:

The word 'Income' is not a term of art, and what forms of receipts are comprehended within it, and what principles are to be applied to ascertain how much of those receipts ought to be treated as income, must be determined in accordance with the ordinary concepts and usages of mankind, except in so far as the statue states or indicates an intention that receipts which are not income in ordinary parlance are to be treated as income, or that special rules are to be applied for arriving at the taxable amount of receipts.

The cases indicate an underlying requirement that there must be a receipt.

The purchase price for the business has been calculated with reference to the liabilities assumed by Company B. Whether this constitutes a receipt was considered in the case of TNT Skypack International (Aust) Pty Ltd v Federal Commissioner of Taxation 88 ATC 4279; 19 ATR 1067(TNT Skypak).

TNT Skypak concerned the sale of a business which had liabilities including $95,200 owing by the vendor for accrued annual leave. The purchase price for the business was based on the value of the assets less the liabilities, so the price was reduced to take account of the liability of $95,200 (and all other liabilities). The liability of $95,200 was assumed by the purchaser.

The issue was whether a reduction in the purchase price by the vendor in exchange for the purchaser assuming the accrued annual leave liability could constitute assessable income in the hands of a purchaser of the business. The Commissioner sought to assess the $95,200 to the purchaser on the basis that it had effectively received that amount of income by virtue of the set off of cross debts. It was also argued, that the purchaser derived a gain by way of compensation for assuming an obligation to pay a revenue outgoing. The compensation or gain was represented by the lower cash outlay it paid for the value of the assets acquired.

The Federal Court found that the $95,200 was not assessable to TNT Skypak because no amount had been received. All that had happened was that the taxpayer had assumed liability which had or would become due. Gummow J accepted that at general law the assumption of liability does not ordinarily constitute the derivation of income.

In TNT Skypak the assumption of liabilities was described by Gummow J at ATC 4287:

The liabilities could not be assumed in a legal sense by the taxpayer without novations with the creditors involved. For this the agreement did not provide. Rather, the assets of the business (as described in para 1(a) of the minutes) were to be purchased and there was to be, as between the taxpayer and Ipec, an assumption of liabilities (ie. a promise by the taxpayer to Ipec to pay the creditors of Ipec) together with an indemnity of Ipec by the taxpayer against claims by the creditors of Ipec. Thus from a practical point of view, it may be said that the taxpayer 'assumed' the liabilities of Ipec.

In relation to Company B, under the novated contracts Company B assumed liability for the future services. The amount of $X pre-paid by its customers to Company C was the deferred liability amount reflected in the reduced purchase price. There were no cross liabilities between Company B and the vendor which were set-off.

In effect, the assumed liability in both circumstances has the same result. As Dixon J said in Hallstoms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; 1946) 3 AITR 436; (1946) 8 ATD 190 per Dixon J at CLR 648, the answer to the income/capital question must be considered 'from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.'

In Taxation Ruling IT 2557, the Commissioner accepted this principle. IT 2557 confirms at paragraph 6, that as no amount had been received by the taxpayer '…[a]ll that had occurred was that the taxpayer had assumed a liability in respect of leave entitlements which had, or would, become due. The assumption of such a liability, said the Federal Court, does not ordinarily constitute the derivation of income.'

More recently, the Commissioner has applied this approach to the sale of retirement villages. In Taxation Ruling TR 2002/14 Income tax: taxation of retirement village operators at paragraph 53, the Commissioner ruled:

Some prepayments such as rent in advance will not be assessable in full on receipt, but assessable over time when earned, or when the amounts can be said to have 'come home' When a village is sold, the new owner may pay a lesser price by undertaking to meet contingent liabilities for pre-paid rent or other amounts repayable to outgoing residents in the future on termination of their leases. For capital gains tax purposes, the capital proceeds of the seller of the village and the cost base of the new owner will include an amount for the liabilities assumed by the new owner for unused prepaid rent or other amounts repayable to outgoing residents. Double taxation of unused prepaid rent will be prevented by section 118-20.

Further at paragraph 55 the Commissioner considered the revenue implications of such a transaction:

However, where the contract to repay unused rent in advance is novated, the rent in advance has come home to the seller of the village on novation. The amount of unused rent in advance is included in the assessable income of the seller under section 6-5 in the year of novation.

It is implicit from this paragraph that the reduction in the purchase price is not ordinary income of the purchaser.

As the reduction in the purchase price in these circumstances is not a receipt, it is not considered ordinary income and therefore is not assessable under 6-5 of the ITAA 1997.

Question 2

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year.

For the accounting revenue to be recognised as assessable income under section 6-5 there must be a receipt derived. 'Income is what comes in and if nothing comes in there is no income' (North Sydney Investment and Tramway Co Ltd v C of T (NSW) (1898) 19 NSWLR 225 at 227).

In the case where there is no receipt the adoption of standard accountancy methods to include an amount of unearned income cannot of itself constitute the derivation of ordinary income. The relevance of accountancy and book-keeping methods to the characterisation of an amount is set out in the High Court decision in Arthur Murray(NSW) Pty Ltd v Federal Commissioner of Taxation (1965) 114 CLR 314 at 318:

What ultimately matters is the concept; book-keeping methods are but evidence of the concept.

Consistent with our findings in relation to question 1, the reduction in the purchase price is not a receipt. Recognition by Company B of the deferred liability as revenue for accounting purposes does not create a receipt. It therefore does not characterise the amount as assessable income for the purposes of section 6-5 of the ITAA 1997.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).