Edited version of your written advice

Authorisation Number: 1012830667417

Date of advice: 9 July 2015

Ruling

Subject: Assessability of Deferred Revenue

Question 1

Is the reduction in purchase price paid by Company A in respect of the acquisition of a particular business of Company B that is attributable to the assumption of a deferred revenue liability, assessable income of Company A pursuant to section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Is the deferred revenue recognised for accounting purposes by Company A upon providing services to discharge the deferred revenue liability, assessable to Company A pursuant to section 6-5 of the ITAA 1997 in the relevant income years in which the deferred revenue is recognised for accounting purposes?

Answer

No.

This ruling applies for the following periods:

A number of income years

The scheme commences during:

A particular income year

Relevant facts and circumstances

1. Company A entered into an agreement with Company B to acquire a particular business of Company B.

2. The business, as carried on by Company B, was in the practice of recording income on a deferred basis for accounting purposes. Service revenue, while received in advance, was recognised as income over the period of service.

3. A deferred revenue liability amount (Deferred Revenue Liability) was recorded by Company B in its accounts just prior to the acquisition.

4. Company A paid a reduced purchase price for the business due to the Deferred Revenue Liability.

5. As part of the acquisition, Company B has obtained consents for all customer contracts related to the Deferred Revenue Liability to be novated to Company A. These customer contracts were either novated or in the process of being novated upon Company A's assumption of the Deferred Revenue Liability.

6. For accounting purposes, Company A recognised the Deferred Revenue Liability in respect of the transferred contracts on its balance sheet. The Deferred Revenue Liability will be released to its profit and loss statements over a number of income years.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Question 1

Is the reduction in purchase price paid by Company A in respect of the acquisition of a particular business of Company B that is attributable to the assumption of a deferred revenue liability, assessable income of Company A pursuant to section 6-5 of the ITAA 1997?

Summary

The reduction in purchase price paid by Company A in respect of the acquisition of a particular business of Company B that is attributable to the assumption of a deferred revenue liability is not assessable income of Company A pursuant to section 6-5 of the ITAA 1997.

Detailed reasoning

7. To be assessable income to Company A under section 6-5 of the ITAA 1997, the reduction in the purchase price must be 'income according to ordinary concepts', also referred to as 'ordinary income'. The terms 'income according to ordinary concepts' is not defined by either the ITAA 1997 or the Income Tax Assessment Act 1936 (ITAA 1936).

8. The concept of 'income according to ordinary concepts' appears to have been inspired by Jordan CJ's statement in Scott v. Commissioner of Taxation (1935) 35 SR (NSW) 215 at 219:

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 statute 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 such receipts.

9. 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).

10. In G.P. International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124 at 138, 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.

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

12. The purchase price for the business has been calculated with reference to the liabilities assumed by Company A. Whether an assumption of liabilities constitutes a receipt was considered in the case of TNT Skypak International (Aust) Pty Ltd v. Federal Commissioner of Taxation 88 ATC 4279 (TNT Skypak).

13. 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.

14. 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.

15. 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.

16. In relation to Company A, under the novated contracts, Company A assumed liabilities to discharge the future services to be provided to Company B's former customers. The amount pre-paid by its customers to Company B was the Deferred Revenue Liability amount reflected in the reduced purchase price. There were no set off of cross liabilities between Company A and Company B.

17. In the present case, Company A paid a single sum to Company B which represented the net value of the business. In the words of Gummow J in TNT Skypak at ATC 4287 to 4288:

…[T]here was no payment earmarked for use by the taxpayer in discharging any liabilities… it would be a distortion of what occurred to single out one of the three steps involved, the sum paid as the second step, and threat this as 'the purchase price' in the sense of the only consideration moving from the taxpayer in connection with the acquisition of the business in question.

18. In effect, the assumed liability in both circumstances should have a similar result. As Dixon J said in Hallstoms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634 at 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.'

19. In Taxation Ruling IT 2557 Income tax: Assessability or deductibility of an amount in respect of accrued leave entitlement taken into account in the purchase price of a business (IT 2557), the Commissioner accepted this principle. IT 2557 restates the Federal Court's decision 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.'

20. Taxation Ruling TR 2002/14 Income tax: taxation of retirement village operators (TR 2002/14) considered the treatment of pre-paid rent upon the sale of a retirement village, where the new owner may pay a lesser price by undertaking to meet contingent liabilities for pre-paid rent. At paragraph 55 of TR 2002/14, the Commissioner considered the revenue implications of such a transaction and concluded:

[W]here 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.

21. It is implicit from this paragraph that the reduction in the purchase price is, generally, not ordinary income of the purchaser pursuant to section 6-5 of the ITAA 1997

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

Question 2

Is the deferred revenue recognised for accounting purposes by Company A upon providing services to discharge the deferred revenue liability, assessable to Company A pursuant to section 6-5 of the ITAA 1997 for the purposes of Company A's income tax return in respect of certain income years?

Summary

The deferred revenue recognised for accounting purposes by Company A upon providing services to discharge the deferred revenue liability is not assessable to Company A pursuant to section 6-5 of the ITAA 1997 for the purposes of Company A's income tax return in respect of certain income years.

Detailed reasoning

23. Subsection 6-5(1) of the ITAA 1997 includes in an entity's assessable income, 'income according to ordinary concepts' which is called 'ordinary income'.

24. In line with the Detailed reasoning to Question 1, for an accounting revenue to be recognised as assessable income under section 6-5 of the ITAA 1997 there must be a receipt derived.

25. 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.

26. Consistent with the findings in relation to Question 1, the reduction in the purchase price is not a receipt. Recognition by Company A of the Deferred Revenue Liability as revenue for accounting purposes does not create a receipt.

27. Accordingly, the deferred revenue recognised for accounting purposes by Company A upon providing services to discharge the Deferred Revenue Liability is not assessable to Company A pursuant to section 6-5 of the ITAA 1997 for the purposes of Company A's income tax return in respect of certain income years.

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