Edited version of your private ruling

Authorisation Number: 1012441757102

Ruling

Subject: Income Tax

Question 1

Are the partly-paid shares Company X received ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Is any amount referrable to the partly-paid shares derived by Company X as assessable income in the relevant year?

Answer

No

Question 3

If an amount referrable to the shares is derived as assessable income by Company X, what principles should be used to determine the amount derived?

Answer

Decline to rule

This ruling applies for the following periods:

1 July 2011 to 30 June 2012

Relevant facts and circumstances

Background

Company X manages and operates a co-operative research centre (the Centre).

The Centre was established under the Commonwealth of Australia's co-operative research centre program (CRC program).

Company X receives funding from the Commonwealth to operate the Centre. The funding is subject to a number of conditions that Company X must satisfy. These conditions are documented in a written agreement (the Commonwealth Agreement), and include:

· applying the funds only to Activities as specified in the Commonwealth Agreement

· providing certain documents, including annual reports and performance reviews as explained in the Commonwealth Agreement

· compliance with the general obligations under the Commonwealth Agreement

Apart from administrative matters, the activities of the Centre are conducted by way of project agreements made between Company X and participants and/or third-party project participants.

The Projects

Two project agreements were entered into.

These project agreements were the first under which Company X obtained a right to receive shares rather than a conditional right to receive royalties from the commercialisation of project intellectual property.

Project A

A project participant agreed to issue shares to Company X with an agreed price per share, being the right to proceeds from the commercialisation of project intellectual property.

The participant issued these shares as partly-paid.

The issue price is treated as satisfied by the payment of the Commonwealth funding such that the amount paid to Company X on each issued share is equal to the proportion of Commonwealth Funding required to be advanced under the project agreement.

If Company X does not pay the Commonwealth funds in their entirety within the timetable outlined in the project agreement, Company X is only entitled to retain the shares issued based on the Commonwealth funds actually paid and at the assumed price per share.

Project B

The facts of Project B mirror those of Project A.

Treatment of shares from an accounting perspective

Company X has decided to recognise the Shares in its balance sheet for the relevant year to the extent that they have been treated as paid up under the relevant agreement. However, an impairment provision was made in view of several matters taken into account by the Board.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Subsection 6-5(2)

Income Tax Assessment Act 1997 Subsection 6-5(4)

Income Tax Assessment Act 1936 Subsection 25(1)

Reasons for decision

Question 1

Summary

The partly-paid shares Company X receives will be ordinary income under section 6-5 of the ITAA 1997.

Detailed reasoning

Under section 6-5 of the ITAA 1997, assessable income includes income according to ordinary concepts. The legislation, however, does not define the expression "income according to ordinary concepts".

The courts too, have declined to give the expression a definitive meaning, although various general indicators of what constitutes income can be identified from case law. These include whether or not payment was:

· part of a periodic receipt of payments or otherwise connected to the receipt of such payments

· a reward for the provision of personal services; and

· for services that were rendered for the reasons of receiving payment.

The presence or absence of any single indicator is not necessarily determinative as to whether or not a particular receipt is income.

In the present circumstances, Company X's business involves the receipt and expenditure of Commonwealth funds, the management of research projects, the receipt and use or expenditure of contributions from project participants and the commercialisation or oversight of the commercialisation of the results of projects. The amounts received in relation to the shares were as a direct result of these business activities.

As an Australian resident, under subsection 6-5(2) of the ITAA 1997 Company X's assessable income includes the ordinary income it derived directly or indirectly from all sources during the income year. Once the relevant amounts referable to the shares have been derived, they will be included in Company X's assessable income for that financial year.

Question 2

Summary

No amount referrable to the partly-paid shares has been derived by Company X in the relevant year.

Detailed reasoning

Subsection 6-5(4) of the ITAA 1997 tells us that in working out whether an amount has been derived and when you have derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct. Further guidance as to the timing of income derivation comes from consideration of relevant case law and taxation rulings.

In Brent v. FC of T (1971) 125 CLR 418; (1971) 71 ATC 4195; (1971) 2 ATR 563, the High Court said at CLR 428; ATC 4200; ATR 570:

It has become well established that unless the Act makes some specific provision on the point the amount of income derived is to be determined by the application of ordinary business and commercial principles and that the method of accounting to be adopted is that which is calculated to give a substantially correct reflex of the taxpayers true income (The Commissioner of Taxes (South Australia) v The Executor, Trustee and Agency Company of South Australia Limited (Cardens case) (1938) 63 CLR 108; 1 AITR 416; (1938) 5 ATD 98).

In Arthur Murray (NSW) Pty Ltd v. FC of T (Arthur Murrays Case) (1965) 114 CLR 314; (1965) 14 ATD 98; (1965) 9 AITR 673, the High Court affirmed the proposition from Cardens case, that in relation to the question of when income should be considered to have been derived, it was appropriate to have regard to the application of ordinary business and commercial principles. Barwick CJ, Kitto and Taylor JJ said in Arthur Murrays Case at CLR 318, ATD 99-100, AITR 688:

As Dixon J observed in Cardens Case: Speaking generally, 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 immediately realizable form. The word gains is not here used in the sense of net profits of the business, for the topic under discussion is assessable income, that is to say gross income. But neither is it synonymous with receipts. It refers to amounts which have not only been received but have come home to the taxpayer; and that must surely involve, if the word income is to convey the notion it expresses in the practical affairs of business life, not only that the amounts received are unaffected by legal restrictions, as by reason of a trust or charge in favour of the payer not only that they have been received beneficially but that the situation has been received in which they may properly be counted as gains completely made, so that there is neither legal nor business unsoundness in regarding them without qualification as income derived.

The reference by the High Court in Arthur Murrays Case to the significance of an amount not being income unless it had been earned was critical in this case. It was for this reason that prepaid fees, in relation to dancing lessons not yet delivered, were not treated as income derived at the time of receipt. In reaching this conclusion the High Court said at CLR 319, ATD 100, AITR 689:

But those circumstances nevertheless make it surely necessary, as a matter of business good sense, that the recipient should treat each amount of the fees received but not yet earned as subject to the contingency that the whole or some part of it may have in effect to be paid back, even if as only damages, should the agreed quid pro quo not be rendered in due course. The possibility of having to make such payment back (we speak, of course, in practical terms) is an inherent characteristic of the receipt itself. In our opinion, it would be out of accord with the realities of the situation to hold, while the possibility remains, that the amount received has the quality of income derived by the company.

In Henderson v. Federal Commissioner of Taxation (1970) 119 CLR 612, (1969) 15 ATD 298; 69 ATC 4049 (the Henderson Case) Windeyer J at (ATC) 4060 said:

services rendered for fees do not result in income derived until the fees are either paid or payable, income [is not earned] until it is in law recoverable as a debt.

His honour continues:

services may create debts before a bill is sent to the debtor. But services rendered do not produce taxable income until they create a debt.

On appeal from the Henderson Case, Barwick CJ extended that a recoverable debt should be included as earnings when:

the service is so far performed that according to the agreement of the parties or in default thereof, according to the general law, a fee or fees have been earned, then it or they will be income derived in the period of time in which it or they have become recoverable.

Barwick CJ clarified the meaning of recoverable later in His judgement as:

the point at which income is derived by the performance of services.

In FCT v. Australian Gas Light Co; Newcastle Gas Co Ltd (1983) 15 ATR 105; 83 ATC 4800 (the AGL Case), the Full Court provided at (ATC) 4805:

..invariably something more than provision of goods or services by the taxpayer is required. It is necessary to determine whether the consequences is that a debt has been created or whether the taxpayer is obliged to take further steps before becoming entitled to payment.

The above passages were made in relation to subsection 25(1) of the Income Tax Assessment Act 1936 (ITAA 1936). Section 6-5 of the ITAA 1997 replaced subsection 25(1) of the ITAA 1936, and these passages can be accepted as having equal relevance to the operation of section 6-5.

Having considered the AGL case, it is submitted that determining whether a recoverable debt exists is a question of fact, ascertained by reference to the contractual agreements that give rise to the legal entitlement to payment. A recoverable debt exists once a taxpayer has satisfied all conditions precedent to make the demand for payment. Steps which fall outside of the agreement are mere procedure and are not pivotal to the existence of a recoverable debt.

Furthermore, in the AGL Case, the taxpayer was governed by statue and regulations. Under the contractual agreement with their clients, AGL was required to satisfy three conditions in order to bring into existence a recoverable debt. The legal restraints can be summarised such that the taxpayer must: read the meters, give notice or invoice of the amount to the customer, at the end of a 3 month period of billing. The Full Court at (ATC) 4806 provided:

The registration of a customer's gas meter is prima facie evidence of the quantity of gas supplied and determines the quantitative basis on which he is obliged to pay. The reading of the meter and the giving of the notice to the customer of what is registered are more than mere procedure. They are conditions precedent to the making of the demand for payment.

It is considered that the consequence of the exceptional manner in which AGL operated was that payment could not be requested by AGL until these three conditions had been satisfied.

The Commissioner expresses his opinion on the two methods commonly used to determine when income is derived in Taxation Ruling TR 98/1. Ordinarily a receipt of cash is derived when it is received. In reference to the earnings method, the Commissioner states:

9. The earnings method is often referred to as the accruals method or the cash and credit method. Under the earnings method, income is derived when it is earned. The point of derivation occurs when a recoverable debt is created.

10. The term recoverable debt is used to describe the point of time at which a taxpayer is legally entitled to an ascertainable amount as the result of having performed an agreed task. A taxpayer may have a recoverable debt even though, at the time, they cannot legally enforce recovery of the debt.

11. Whether there is, in law, a recoverable debt is a question to be determined by reference to the contractual agreements that give rise to the legal entitlement to payment, the general law and any relevant statutory provisions.

In Taxation Ruling TR 96/19 the Commissioner sets out his views in relation to the derivation of income under the Pharmaceutical Benefits Scheme (PBS). In paragraph 5 the Commissioner states:

A taxpayer who returns particular income on an accruals basis derives that income once there is a recoverable debt in respect of the income; that is, once there is a presently existing right to demand payment. The term 'recoverable debt' is used to describe the point of time at which the taxpayer is entitled to an ascertainable income amount on performance of the agreed task (as distinct from the time when legal recovery may be commenced) (see Henderson v. FC of T (1970) 119 CLR 612; 70 ATC 4016; (1970) 1 ATR 596; Henderson v. FC of T 69 ATC 4049; (1969) 1 ATR 133; Barratt v. FC of T 92 ATC 4275; (1992) 23 ATR 339 (Barratts case)). Whether there is, in law, a recoverable debt is a question to be determined by reference to the contractual agreements which give rise to the entitlement to payment, the general law and any relevant statutory provisions.

In light of the above authorities, in determining whether income has been derived a taxpayer must be legally entitled to the debt in the sense that the taxpayer has done all they need to do to become entitled to the payment.

In the present circumstances, at 30 June 20XX an amount of Commonwealth funds was paid by Company X under the terms of the project agreements. The project participant issued shares at a value equal to contributions from the Commonwealth. Under the project agreements, Company X is only entitled to retain the shares issued up to the amount of Commonwealth funds unconditionally applied to the projects.

Under the terms of the Commonwealth Agreement, Company X is not entitled to retain any part of the Commonwealth funds until it has expended the amount for the conduct of the Activities or entered into a legal commitment to expend such an amount for the conduct of the Activities. Company X has paid out Commonwealth funds in accordance with the Activities during the relevant income year.

Such expenditure or commitment must further meet all the relevant requirements of the Commonwealth Agreement; including compliance with the Budget and the relevant reporting, accounting and commercialisation requirements. As it stood at 30 June 20XX, not all of these obligations to the Commonwealth had been fulfilled. Neither reporting obligations nor compliance with the Budget had been fulfilled.

If the Commonwealth funds were not applied in the necessary manner, the relevant amount could be required to be repaid or dealt with as directed by the Commonwealth.

Until all relevant reporting obligations and checks had been completed in relation to the relevant year and until the Commonwealth could properly be satisfied that the Commonwealth funds had been appropriately used in accordance with the Commonwealth Agreement, Company X has not earned the relevant Commonwealth funds. As the value of the shares being received is contingent on the relevant Commonwealth funds being unconditionally applied to the Project, Company X does not have an unconditional right to the shares and their value therefore has not been derived in the relevant income year.

Question 3

Summary

The Commissioner declines to rule on what principles should be used to determine the amount derived. A ruling is an expression of the Commissioner's opinion of the way in which a provision of a tax law applies, or would apply, to a taxpayer who has obligations or entitlements under those laws. No provision of tax law has been identified.

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