Edited version of your written advice

Authorisation Number: 1012762986503

Ruling

Subject: Maintenance Plan income recognition

Question 1

Are the proceeds from the sale of Maintenance Plans assessable under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) on an accruals basis?

Answer

Yes.

Question 2

Is the accounting methodology adopted by Company A for the recognition of Maintenance Plan income the most appropriate basis for Company A to adopt for determining the time at which assessable income from the sale of Maintenance Plans is derived?

Answer

Yes.

This ruling applies for the following period:

1 July 2011 to 30 June 2020

Relevant facts and circumstances

Introduction

Company A is a member of the Company A International Limited group, a contemporary retailer with a global presence offering a range of goods and services to its customers.

Company A conducts the group's retail operations in Australia.

Maintenance plans

Overview

Maintenance Plans were introduced as a service offering to the Australian group's customers. A Maintenance Plan is designed to mitigate the effects of wear and tear and extend the life of Company A's goods sold to a customer pursuant to a Maintenance Plan. Under a Maintenance Plan, Company A is contractually committed to provide the services and repairs covered by the Maintenance Plan when requested by the customer during the life of the Maintenance Plan.

The introduction of these plans has provided Company A with the ability to extend the life of customer's purchases with a future maintenance program.

A Maintenance Plan can be sold as a set period plan or a lifetime plan and are sold at various price points depending on the retail value of the item purchased.

A Maintenance Plan may be cancelled within 30 days of purchase, provided that no services have been provided under the Maintenance Plan within that time.

A Maintenance Plan is not an insurance policy.

Not a warranty

A Maintenance Plan is not intended to replace a warranty and other rights of customers. In accordance with the terms and conditions of a Maintenance Plan, damage covered by any other warranty or service plan is not claimable under a Maintenance Plan.

A Maintenance Plan is not provided as a form of warranty or a form of extended warranty as a warranty covers a purchased item that is faulty or not of acceptable quality at the time of purchase. Examples include where the items:

• are not fit for all the purposes for which goods of that kind are commonly supplied

• are not acceptable in appearance and finish

• have defects

• are unsafe or

• are not durable.

Warranty and a Maintenance Plan contrasted

In contrast to a warranty, the services covered by a Maintenance Plan do not relate to faults, defects etc that existed at the time of the purchase of the item. Rather, the services provided under a Maintenance Plan relate to repairs and maintenance arising from general wear and tear through use of the item following its purchase by the customer.

Company A's warranty

Company A's standard warranty period, in addition to statutory rights available to customers, is 12 months from the date of purchase. Company A does not offer extended warranties, whereby the usual period of the guarantee is extended for an additional (say) 12 or 24 months.

However, Company A does offer additional rights in relation to certain items that are included in its terms and conditions of sale and for which no additional charge is made.

Where these additional warranty type rights are available as a term of the contract under which the relevant item is sold, the rights are embedded in the price of the item and the full amount of the sale is recognised as income (for accounting and tax purposes) at the time of the sale. (The applicant has advised that this treatment will be unaffected by this ruling request).

A Maintenance Plan for eligible items is offered separately to these additional warranty rights and, as outlined below under the heading 'A Maintenance Plan is sold individually as a separate contract' a separate charge is made for a Maintenance Plan if the Maintenance Plan is purchased by the customer.

A Maintenance Plan is sold individually as a separate contract

A Maintenance Plan is sold separately to the item which it covers and is separately charged to the customer. Attached at Appendix 2 of the ruling application is a copy of Company A's Policy in relation to the sale of Maintenance Plans. In particular, the following is noted (with references to relevant paragraphs of the Policy):

• Discounting of a Maintenance Plan is prohibited

• No free Maintenance Plan may be issued

• A Maintenance Plan cannot be used as a negotiation tool

• Company A's Policy in relation to Maintenance Plans makes it clear that a Maintenance Plan purchased by a customer in conjunction with the purchase of a product is separately paid for and that purchase of a Maintenance Plan is voluntary

Further, it is not necessary that a Maintenance Plan be sold at the same time as the item it covers - a Maintenance Plan can be sold up to 30 days after the sale of the item it covers. Unlike the case with most warranties, the terms and conditions attaching to a Maintenance Plan are separate and distinct to the terms and conditions attaching to the sale of the item covered by a Maintenance Plan. This is clear from the separate terms and conditions attaching to the separate sales (even if they occur at the same time), as evidenced by the terms and conditions of a Maintenance Plan excluding items covered by other service plans or warranties.

The Company A warranty or the Maintenance Plan will apply, not both

Where an item covered by a Maintenance Plan is returned by a customer within the statutory or contractual warranty period, an assessment is made as to whether the customer's warranty or Maintenance Plan rights apply. For example, if a product is damaged or it is clear that a product had a manufacturing defect it will be replaced in accordance with the customer's warranty rights.

However, if a customer is seeking to have any maintenance services undertaken pursuant to a Maintenance Plan, the service will be provided in accordance with the customer's rights under the Maintenance Plan.

If an item covered by a Maintenance Plan is returned by a customer and not replaced (for example, in exercise of a right under warranty or a consumer law), the amount paid by the customer for the Maintenance Plan is refunded to the customer. However, if a replacement item is provided to the customer, the Maintenance Plan recommences from the time the replacement item is provided to the customer. This resets the commencement date of the service period for a set period plan and (as outlined below) resets the period over which income is recognised for accounting purposes and highlights the distinction inherent between Company A's warranty and its Maintenance Plan.

Accounting treatment for Maintenance Plans

For accounting purposes, revenue from the sale of a Maintenance Plan is treated as income at the point in time when the services under the Maintenance Plan are expected to be provided. Amounts received from the sale of Maintenance Plans are accounted for as follows:

• Proceeds from the sale of a Maintenance Plan are initially credited to a deferred revenue account in the balance sheet.

• Relevant amounts are transferred from the deferred revenue account to an income account and accordingly recognised as income in the periods in which the relevant services are expected to be provided.

• The time at which the income is recognised is based on the expected usage of the Maintenance Plans over the Maintenance Plans effective lives. The estimates are based on Company A's history of providing services under the Maintenance Plans and information obtained in relation to the operation of its service plans.

• Income is recognised in accordance with a formula that is a calculation based on the estimated usage of a Maintenance Plan (i.e. estimation of when services are expected to be provided under the Maintenance Plan). A separate formula applies for a set period plan and for a lifetime plan. For the lifetime plans, a fixed period life cycle for the plan is assumed.

• The formulas are applied to recognise income irrespective of actual usage of the Maintenance Plan. For example, if a purchaser of a set period plan does not utilise any service available under the Maintenance Plan, income is still recognised in accordance with the relevant formula even though no service is actually provided to that particular customer. Similarly, for a lifetime plan, income is recognised in accordance with the formula over the number of years of assumed life of the Maintenance Plan, even if a service is actually performed after the assumed life period.

The estimates upon which the formulas are based are reviewed regularly based on actual usage and adjusted if required. In this respect, Company A's external auditors closely review the formulas and the underlying data on which they are based and agree to the appropriateness of the formulas as a basis for recognising income.

It is Company A's experience that the introduction of Maintenance Plan's has brought forward the recognition of income for services covered by the plans. For example, income from repairs or other services that previously would have been provided say 10-15 years after purchase are, where covered by a Maintenance Plan, recognised over the number of years assumed for the Maintenance Plan acquired.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise stated.

Question 1

Section 6-5 requires an amount of ordinary income to be brought to account as assessable income when it has been derived. The Commissioner accepts that amounts received from the sale of Maintenance Plans are received in the ordinary course of Company A's retail business. Accordingly, these amounts are considered to be ordinary income for the purposes of the ITAA 1997 and therefore constitute assessable income of Company A.

Derivation of income received from the sale of a Maintenance Plan

For many taxpayers the income they derive in a year is the income received in that year - this is commonly referred to as the 'receipts' or 'cash' method: see Brent v. FC of T 3 (1971) 125 CLR 418 at 429; 71 ATC 4195 at 4200; (1971) 2 ATR 563 at 571 (Brent's case).

For other taxpayers the income they derive in a year is the income earned in that year - this is commonly referred to as the 'earnings' or accruals' method: see Henderson v. FCT (1970) 119 CLR 612; 70 ATC 4016; (1970) 1 ATR 596...

When accounting for income, for tax purposes, a taxpayer must adopt the method of accounting (the cash or accruals method) that, in the circumstances, is appropriate. 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's case:

   ... 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 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).

Whether a method gives a 'substantially correct reflex' and therefore is appropriate is a conclusion to be made from all the circumstances relevant to the taxpayer and the income. It is necessary, according to Dixon J in The Commissioner of Taxes (South Australia) v. The Executor Trustee and Agency Company of South Australia Limited (1938) 63 CLR 108 to:

... discover what gains have during the period of account come home to the taxpayer in a realized or immediately realizable form.(emphasis added)

Accordingly, rather than setting down hard and fast rules, the approach of the courts, when deciding whether one or another method of accounting for income is appropriate, has been to weigh the total circumstances of a taxpayer and the income to determine which accounting method produces the correct reflex of income for the year.

In FCT v. Dunn 11 89 ATC 4141 at 4144; (1989) 20 ATR 356 at 358 Davies J, when discussing whether one method or another was appropriate, said:

On the other hand, the question was not entirely one of law. The issue was the appropriate means of computing the income derived by the taxpayer. The circumstances of his occupation, how it was carried on and what records and books were kept were matters to be taken into account, and evidence as to accounting principles and practice was relevant. All these are matters of fact.

When does the income from Maintenance Plans 'come home' to Company A - cash or accruals?

It is widely accepted that where services are provided after the receipt of an amount in respect of the provision of those services, the time at which assessable income is recognised can be the time when the services are provided. The leading case on this point is Arthur Murray.

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.

The Arthur Murray case is not directly applicable to the facts of the present case. In the present circumstances, while the Maintenance Plan fees are provided in advance of any services provided, it is not certain when (if at all) any services will be provided. However, given the similarities between the accounting treatment in Arthur Murray and the present circumstances two general principles can be extrapolated from Arthur Murray that will assist the Commissioner in determining whether income is derived after Maintenance Plan fees have been received (that is, that Maintenance Plan income is derived on an accruals basis).

• Is a Maintenance Plan amount received in respect of services to be provided by Company A in the future?

The first principle to consider is whether the amount received is in respect of services to be provided by the taxpayer in the future. Specifically, the High Court in Arthur Murray said that the question before the Court is:

… whether, in the circumstances, it may properly be held that receipt without earning makes income … (emphasis added)

In answering this question, the Court said:

The word 'gains' is not here used in the sense of the 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 reached 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.

That is, as expressed above, the question is whether the amount has 'come home' to the taxpayer. As the Court in Arthur Murray subsequently stated, the answer lies in whether there is a 'necessity for earning which is inherent in the circumstances of the receipt' - whether the receipt still has to be earned. In Arthur Murray, the Court considered that it was clear that the proceeds were in respect of services to be provided by the taxpayer in the future and that the amounts received were not earned as assessable income until those services (i.e. the dancing lessons) had been provided.

Accordingly, the Commissioner considers for the following reasons that the amounts received by Company A from the sale of Maintenance Plans constitute assessable income on an accruals basis at the time when services are expected to be provided in accordance with the terms of the Maintenance Plans:

• Upon entering into a Maintenance Plan, Company A is under a clear contractual obligation to provide the contracted services covered by the Maintenance Plan. Further, the whole of the amount received is for the provision of those services - no question of apportionment arises as was the case in Taxation Ruling TR 2014/1 Income tax: commercial software licencing and hosted agreements: derivation of income from agreements for the right to use proprietary software and the provision of related services.

• At the time of entering into a Maintenance Plan, Company A has not done all that is necessary to earn the income from the Maintenance Plan contract. It is clear from the terms of the Maintenance Plan that Company A is legally required to provide the relevant services when requested by customers within the period covered by the plan at some future point in time (i.e. for the set number of years for the set period plan or lifetime, or until the relevant threshold for maximum services rendered is reached). That is, Company A is contractually bound to hold itself ready to provide the services when requested by a customer - there is a 'necessity of earning' inherent in the circumstances of the receipt of the Maintenance Plan proceeds by Company A. The amount in question has not yet 'come home' to Company A at the time of entering into a Maintenance Plan.

For these reasons, the amounts received from the sale of Maintenance Plans fall within this first principle of the Arthur Murray case.

Further and in addition it must be noted that, as outlined in the description of the relevant facts above, a Maintenance Plan is not a warranty and does not replace the statutory or contractual rights of customers - it does not warrant the quality of the items at the time of sale. Rather, a Maintenance Plan offers a maintenance / repair service type agreement for circumstances that arise due to normal usage of the items, such as resizing a ring or replating a white gold item.

The Commissioner states at paragraphs 29-30 of Taxation Ruling TR 93/20 Income tax: computer spare parts:

29. Proceeds from the sale of computer equipment are ordinarily derived by a computer supplier at the time of the sale. No part of the sale proceeds may be deferred on the basis of being in respect of warranty services because a warranty is essentially a term of the contract of sale. Similarly, if a computer supplier purports to enter into a separate warranty agreement, any charges under the agreement are derived as income at the time of sale of the equipment rather than over the period of the warranty. We do not accept the view that fees purported to be paid in relation to warranty services are not derived until the warranty services are provided. The reasons for that view are set out in Taxation Ruling IT 2648. In particular, if a computer supplier is not called on to meet any warranty claims, no refund is required to be made of any part of the sale proceeds. On the other hand, in the case of a true maintenance contract, a refund may be required to be made if the contract does not run its stipulated duration or if the service is not provided.

30. Whether the maintenance services are provided under warranty or under a properly characterised maintenance contract depends on the contractual arrangements between customer and computer supplier…..(emphasis added)

Accordingly, the Commissioner considers that the rights under a Maintenance Plan are clearly separate to the rights that arise under the contract for sale of the item (including the rights under any warranty) and that the Maintenance Plan is therefore in the nature of a maintenance agreement as opposed to a warranty. In addition to a Maintenance Plan providing different rights than a warranty (and in particular Company A's warranty), this is evidenced by a Maintenance Plan:

• having separate contractual terms

• being priced and charged separately to the item covered (with no discount etc. being offered for the Maintenance Plan) and

• being able to be acquired at a different time to the purchase of the item (up to 30 days after the item is purchased).

These factors help to signify the contradistinction and separateness between Company A's warranty and a Maintenance Plan.

Given the above, the Commissioner accepts that a Maintenance Plan is not a form of warranty or 'extended warranty' referred to in Taxation Ruling TR 93/20 or Taxation Ruling IT 2648 Income tax: motor vehicle manufacturers, distributors and dealers: demonstration stock valuation; holdback amounts and warranty obligations - rather, it is considered that a Maintenance Plan is in the nature of a maintenance agreement referred to in those rulings for which it is accepted that an accruals basis of recognition of income in accordance with the Arthur Murray principle is appropriate.

• Does a contingency of repayment or damages exist under a Maintenance Plan?

The second principle in the Arthur Murray case, where an amount is received in respect of services to be provided in the future, is whether the taxpayer has a contingency of repayment. This criterion was a key factor in Arthur Murray, where the Court there found that the possibility of having to refund the tuition fees was an inherent characteristic of the receipt itself. In this respect, the Court in Arthur Murray stated:

It is true that in a case like the present the circumstances of the receipt do not prevent the amount received from becoming immediately the beneficial property of the company; for the fact that it has been paid in advance is not enough to affect it with any trust or charge, or to place any legal impediment in the way of the recipient's dealing with it as he will. But those circumstances nevertheless make it surely necessary, as a matter of business good sense, that the recipient should treat each amount of 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 only as damages, should the agreed quid pro quo not be rendered in due course. The possibility of having to make such a 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.

This principle is complementary to the first - the contingency of repayments generally exists for so long as the services in respect of which the amount has been received are yet to be performed. When the services are performed, or the period for the performance of those services ends, the contingency of repayment ceases and the relevant amount is derived for income tax purposes.

The Commissioner's view is that there is a contingency of repayment for non-performance where the following circumstances exist (refer paragraphs 6 and 139 - 148 of TR 2014/1):

• a contractual obligation to make a refund

• a demonstrated commercial practice to make a refund or

• a contractual exposure exists for damages.

The terms of the Maintenance Plan clearly state that it is a legal contract between Company A and the customer. In this regard:

• Other than receiving a refund where a policy is cancelled within a 30 day cooling-off period (so long as no services have been provided under the Maintenance Plan during that period), there is no contractual right to a refund under the terms of a Maintenance Plan.

• However, there is no doubt that there is an exposure to contractual damages if Company A does not perform its obligations under a Maintenance Plan to undertake the relevant services when requested by the customer during the contracted period.

• In this respect, when an item covered by a Maintenance Plan is returned (e.g. in exercise of consumer law rights or under warranty), the amount received for the Maintenance Plan is also refunded to the customer. Further, if a replacement item is provided to the customer, the Maintenance Plan (in the case of a set period plan) commences from the time when the replacement item is supplied to the customer. This is clear evidence that a contingency of repayment exists.

Accordingly, as is the case with computer software service contracts considered by the Commissioner in TR 2014/1, a contingency of repayment exists in relation to the amounts received by Company A upon the sale of a Maintenance Plan.

Relevance of accountancy and commercial principles

As noted above, the accounting practice adopted must be capable of providing the 'correct reflex' of income earned. According to established accountancy and commercial principles, amounts received in advance of goods being sold, or of services being rendered, are not entered to the credit of any revenue account until the sale takes place or the services are rendered. In Arthur Murray their Honours said:

The Court there [Flood's case] held that, while commercial and accountancy practice may assist in ascertaining the true nature and incidence of an item as a step towards determining whether the item answers the test laid down in the Act for allowable deductions, it cannot be substituted for the test. In so far as the Act lays down a test for the inclusion of particular kinds of receipts in assessable income it is likewise true that commercial and accountancy practice cannot be substituted for the test. But the Act lays down no test for such a case as the present. The word `income', being used without relevant definition, is left to be understood in the sense which it has in the vocabulary of business affairs. To apply the concept which the word in that sense expresses is not to substitute some other test for the one prescribed in the Act; it is to give effect to the Act as it stands. Nothing in the Act is contradicted or ignored when a receipt of money as a prepayment under a contract for future services is said not to constitute by itself a derivation of assessable income. On the contrary, if the statement accords with ordinary business concepts in the community - and we are bound by the case stated to accept that it does - it applies the provisions of the Act according to their true meaning.(emphasis added)

Further, in BHP Billiton Petroleum (Bass Strait) Pty Ltd & Anor v FC of T 2002 ATC 5169:, [2002] FCAFC 433 (BHP) Hill and Heerey JJ observed:

Before turning to the accounting evidence in the present case it is important to note that while the earlier cases, such as Carden, Arthur Murray and Henderson, may be thought to have suggested that business and accounting principles are to be applied by the Court in

determining questions of derivation, some later cases, for example the Australian Gas Light Company case in this Court have made the point that accounting principles are not determinative, although they may be persuasive." (emphasis added)

Thus, the decision in Arthur Murray clearly laid down a principle of wide application, that is, that, in so far as the ITAA 1997 itself lays down a statutory test for the inclusion of particular kinds of receipt in assessable income, the statutory test is decisive and accounting and commercial principles are largely irrelevant and cannot be substituted for it. However, where, as in the case of section 6-5, there is no specific statutory test or definition in relation to the question whether a receipt is in the nature of, or has the character of `income derived', this question is to be determined in accordance with established accounting and commercial principles.

The above makes it clear that established accounting practice does not of itself determine the incidence or quantum of derivation of the contractual fee for services or the like and is merely evidence of the concept of derivation of income.

It is accepted according to established present-day accounting principles, that amounts received in advance of goods being sold, or of services being rendered, are not entered into the credit of any revenue account until the sale takes place or the services are rendered. This was the accounting principle that applied in Arthur Murray and BHP continues to be applicable.

Accordingly, the Commissioner therefore accepts that Company A's accounting treatment of revenue received from the sale of Maintenance Plans is in accordance with these established accounting principles. That is, Company A records amounts received in advance of services being rendered initially in a balance sheet in an unearned income account and subsequently credits the relevant amount to a revenue account when services are expected to be performed in accordance with the Maintenance Plan.

Conclusion

For the reasons outlined above, for the purposes of section 6-5 of the ITAA 1997 proceeds from the sale of Maintenance Plans are considered to be assessable to Company A on an accruals basis at the time when relevant services are expected to be provided by Company A under the Maintenance Plans, consistent with the principles established in the Arthur Murray case.

Question 2

The Commissioner accepts that the most appropriate accruals method of recognition of assessable income for Company A is the current accounting methodology for determining the amount of Maintenance Plan income to be recognised each year. That is, Maintenance Plan amounts received in advance of any services being rendered are not entered into the credit of any revenue account until such time as the services provided under the plan are expected to be provided in the manner set out in the facts. This is on the basis that the accounting treatment of the recognition of income is based on actual usage and estimates which are constantly updated as and when new information comes to light.

Company A accounts for income from the Maintenance Plans in accordance with relevant present-day accounting principles - that is, the revenue received in respect of the Maintenance Plans is treated as income for accounting purposes at the point in time when the services are expected to be delivered. In this respect the Commissioner notes the following:

• For the set period plan, income is currently allocated over the set period based on past history of service provided under these plans.

• The lifetime plan assumes a finite life cycle despite being a lifetime plan. The estimates of the time at which services will be performed under these Maintenance Plans is based on Company A's history of providing services under the Maintenance Plans.

With respect to both the set period plan year and lifetime plan, the estimates are reviewed regularly based on actual usage and adjusted if required. These estimates are confirmed by external auditors each year.

In this respect, it is noted that rather than recognising assessable income on the basis of an estimate of the time at which the services are expected to be provided, an alternative is to recognise assessable income at the later of the time when services are actually provided or at the end of the plan service period. However, this approach could result in amounts not being recognised as income until so many years after receipt (in the case of a set period plan) or not at all if no services are provided under a lifetime plan. As this is not considered to be a reasonable outcome, the applicant does not consider that this is a suitable method to adopt. The Commissioner agrees.

Accordingly, the Commissioner considers that Company A's current accounting treatment as outlined above and detailed in the facts provides is a considerably accurate reflex of income derived in an income year for tax purposes as the income will be assessed as and when the services are expected to be provided in accordance with Company A's obligations under the Maintenance Plans.

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