Edited version of your private ruling

Authorisation Number: 1012556998571

Ruling

Subject: Derivation of income

Question 1

Is the sales and marketing fee in the Agreement received by Entity A income derived by Entity B over the duration of the Agreement on a pro rata basis pursuant to subsection 6-5(4) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

This ruling applies for the following periods:

Income year ended 30 June 2013

Income year ended 30 June 2014

Income year ended 30 June 2015

Income year ended 30 June 2016

The scheme commences on:

During the income year ended 30 June 2013.

Relevant facts and circumstances

Entity B is the head company of an income tax consolidated group. Entity A, a subsidiary member of the income tax consolidated group, operates a business and has entered into the Agreement with Entity Z effective from the Commencement Date, being the date the Agreement was signed and executed by the parties.

The Agreement

The Agreement replaces an agreement between Entity A and Entity Z (the Previous Agreement).

Under the Agreement, Entity A is entitled to a sales and marketing fee payment (the Payment) which comprises:

(a) an amount equal to the commissions to which it is estimated Entity A would have been entitled under the Previous Agreement had it not been terminated, on renewals after the Commencement Date (as defined in the Agreement) entered into by Entity Z and arranged or referred by Entity A prior to the Commencement Date, calculated at the rates referred to in the Previous Agreement (Component 1); and

(b) an amount for Entity A agreeing to:

(i) enter into the Agreement (Component 2);

(ii) have Entity Z as its preferred supplier (Component 3); and

(iii) use its best efforts to increase sales in accordance with Entity Z's strategic objectives as agreed from time to time (Component 4).

The Payment is payable upon receipt by Entity Z of a tax invoice from Entity A. The tax invoice for the Payment under the Agreement was issued by Entity A on the Commencement Date and payment was received from Entity Z on the Commencement Date.

In the event that the Agreement is terminated or there is an Early Termination of Arrangement (as defined), Entity A is obliged to repay to Entity Z an amount of the Payment calculated in accordance with the formula in the Agreement.

Termination of the Agreement is provided for in the Agreement and may be invoked under certain circumstances including, but not limited to, where a material breach of the Agreement has occurred that, if capable of remedy, has not been remedied within 14 days after written notice is given to the other Party. The Agreement may also be terminated simply by either Party giving to the other Party thirty (30) days written notice of its intention to terminate the Agreement.

Other

· The Payment has not been split or apportioned between the above four components in the Agreement.

· The applicant has stated that Entity Z has confirmed that the above components of income are all intertwined and if one of the above criteria is not met, Entity A is not entitled to any of the Payment.

· Entity A uses the accruals method of accounting.

· For accounting purposes, upon receipt of the Payment, Entity A credits a 'deferred income' account on the Balance Sheet. This Payment is transferred to an 'income' account in the Profit & Loss statement on a pro rata basis as the marketing and sales services for Entity Z are rendered (i.e. based on the time lapsing over the term of the contract).

Relevant legislative provisions

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

Reasons for decision

Question 1

Detailed reasoning

Section 6-5 of the ITAA 1997 requires an amount of ordinary income to be brought to account as assessable income when it has been derived.

Subsection 6-5(4) of the ITAA 1997 states that in working out whether you have derived an amount of ordinary income, and when you 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.

As a general rule, it is accepted that the question of when income is derived by a taxpayer, as noted by Gibb J in Brent v. FC of T (1971) 125 CLR 418; 2 ATR 563; 71 ATC 4195:

... 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 taxpayer's true income'.

This rule has emerged from Dixon J's observation in Commissioner of Taxation (South Australia) v. Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108; (1938) 5 ATD 98 that:

...the inquiry should be whether in the circumstances of the case it is calculated to give a substantially correct reflex of the taxpayer's true income. 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 realised or immediately realisable form.

This principle was endorsed in, amongst other cases, Arthur Murray (NSW) Pty Ltd v. Federal Commissioner of Taxation (1965) 114 CLR 314; 14 ATD 98; (1965) 9 AITR 673 (Arthur Murray) and Country Magazine Pty Ltd v. Federal Commissioner of Taxation (1968) 117 CLR 162; 15 ATD 86; (1968) 10 AITR 573 (Country Magazine).

Arthur Murray involved a taxpayer who carried on a business of giving dancing tuitions. The taxpayer often received payments for tuition courses in advance. Whilst students did not have a contractual right to refunds, the taxpayer occasionally made refunds. The taxpayer lodged their income tax returns on the basis that payments received in advance of lessons taught did not form part of its assessable income immediately upon receipt. The payments were only assessable once earned by the giving of the lessons.

In deciding in Arthur Murray that amounts received in advance for dancing lessons were not derived until the lessons were actually given, the Court found that the circumstances of the receipt made it 'necessary as a matter of good business sense' that the taxpayer should treat fees received but not yet earned 'as subject to the contingency that the whole or some part of it may have to be paid back, even if only as damages, if the taxpayer failed to render agreed services'.

In Country Magazine, the Court adopted a similar approach in relation to subscriptions received by a publisher for magazines to be published in future years. The Court accepted that subscriptions received for magazines to be published in a future year were derived only when the magazines had been sent to subscribers or the moneys had been used to make refunds or meet claims in respect of magazines that had not been supplied.

Recoverable debt

Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings provides at paragraph 9 that if a taxpayer accounts for income under the earnings method, the point of derivation for income tax purposes occurs when a 'recoverable debt' is created.

A 'recoverable debt' is the point in time at which a taxpayer is legally entitled to an ascertainable amount as the result of having performed an agreed task (see Henderson v. FC of T (1970) 119 CLR 612; 70 ATC 4016; (1970) 1 ATR 596 (Henderson)). Furthermore, there may be a 'recoverable debt' even if at that point in time the recovery of the debt cannot be legally enforced (see Barratt & Ors v. FC of T 92 ATC 4275; (1992) 23 ATR 339 (Barratt)), which is also authority for the proposition that to have a present right to an amount, the amount must be earned, quantified and not contingent). The existence of a recoverable debt is to be determined by reference to the contractual agreements that give rise to the legal entitlement to payment, general law and any relevant statutory provisions.

In Taxation Ruling TR 97/5 Income tax: derivation of commission income by real estate agents, the Commissioner states at paragraph 16 that 'The Australian courts have held that income assessable on an accruals basis is 'derived' … when a recoverable debt is created such that the taxpayer is not obliged to take any further steps before becoming entitled to payment...'

In the present case, Entity A receives the Payment after receipt by Entity Z of a tax invoice from Entity A. However, unlike Arthur Murray and Country Magazine, the Payment 'comes home' to Entity A immediately upon receiving the payment in that there is nothing more for Entity A to do to earn the payment. All that Entity A is legally required to do to earn the Payment has been satisfied at the time of entering into the Agreement. The amount has been earned, quantified and is not contingent.

Component 1 of the Payment constitutes an amount equal to the commissions to which it is estimated Entity A would have been entitled under the Previous Agreement had it not been terminated, on renewals after the Commencement Date. This component is no more than a payment in advance of commissions that would otherwise have been received at a later date under the Previous Agreement. As the payment is based on renewals Entity A is not required to do any further work to be entitled to the Payment.

Component 2 of the Payment constitutes an amount for Entity A agreeing to enter into the Agreement. As such no further actions are required by Entity A to be entitled to the Payment.

Component 3 of the Payment constitutes an amount for Entity A agreeing to have Entity Z as its preferred supplier. By entering into the Agreement (and thus its acceptance of the terms of the Agreement), Entity A has agreed to have Entity Z as its preferred supplier and no further action is required on its part to be entitled to this component of the Payment.

Component 4 of the Payment constitutes an amount for Entity A agreeing to 'use its best efforts to increase sales in accordance with Entity Z's strategic objectives as agreed from time to time'. Again, similarly to above, by entering into the Agreement, Entity A has agreed (emphasis added) to use its best efforts to increase sales. This is to be distinguished from Entity A undertaking its best efforts to increase sales. No further action is required on its part to be entitled to this component of the Payment. Entity A issued a tax invoice to Entity Z on the Commencement Date and received payment of that invoice on the same date. Whether ultimately Entity A uses its best efforts to increase sales is a matter that goes to the performance of the contract over the ensuing years from the Commencement Date and has no bearing on Entity A's entitlement to this component of the Payment.

As such, the Payment is not made to Entity A in advance of the supply of services but rather for agreeing to, amongst other things, supply services. This stands in contrast to Arthur Murray, where the taxpayer there was required to render services based on the hours they were contracted to provide dance lessons, and Country Magazine where that taxpayer was required to supply to subscribers magazines issued over the contracted period.

The risk of having to repay part of the Payment is not determinative in this case. The derivation of the Payment is not of itself linked to the actual performance of services and no more needs to be done by Entity A to be entitled to the Payment. Rather the possible pro rata refund of the Payment eventuates as a result of a Termination of the agreement (including where either party provides 30 days written notice of its intention to terminate the Agreement) or where legislative or regulatory change prohibits the Payment arrangement in whole or in part (Early Termination of Arrangement).

Accordingly, pursuant to subsection 6-5(4) of the ITAA 1997, Entity A is required to include in its assessable income the full amount of the Payment in the income year in which it is received.

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