Edited version of your written advice

Authorisation Number: 1012989199371

Date of advice: 24 March 2016

Ruling

Subject: Ordinary income

Question 1

Is the Error amount in relation to the performance fee assessable as income to the Entity pursuant to section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) for the year ended 30 June 20X1?

Answer

No.

Question 2

For the 30 June 20X2 income year and subsequent years (up to, but not including the income year during which the claim time arises), will any 'surplus' amount in relation to the performance fee constitute assessable income of the Entity pursuant to section 6-5 of the ITAA 1997?

Answer

No.

Question 3

Will any surplus that exists at the claim time be derived by the Entity at that point in time and constitute assessable income of the Entity pursuant to section 6-5 of the ITAA 1997 in the year of derivation?

Answer

Yes.

This ruling applies for the following periods:

Years ended 30 June 20X1 to 30 June 20X3

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

1. The entity is the trustee and responsible entity (the Entity) of an investment fund.

2. The Entity is an Australian resident for tax purposes.

3. The Entity provides investment and management services to the investment fund. In return for the services provided, the Entity is entitled to various fees.

4. The Entity is entitled to charge a performance fee when certain growth benchmarks are met by the investment fund.

5. The Entity may accept a lower fee than it is entitled to receive, may waive any such fee, or may defer payment for a period on such terms as the Entity determines at its sole discretion.

6. The performance fee would be calculated at the end of each financial year and paid from the investment fund's assets. A negative amount is carried forward and offset against future performance fees.

Calculation of performance fee

7. The investment fund is responsible for the calculation of the performance fee. Once calculated, the performance fee is considered and reviewed by the Board of the Entity.

8. The investment fund requested the consulting division of the external auditors to review the performance fee calculation methodology, which was signed-off by the consulting division of the external auditors.

9. The investment fund paid the performance fee to the Entity in respect of the year ended 30 June 20X1. That amount was recorded in the financial statements of the investment fund and the Entity.

10. The accounts were audited by the external auditor. An unqualified audit report was issued in respect of the accounts for the year ended 30 June 20X1.

Calculation error

11. In calculating the performance fee after 30 June 20X1, a potential error was identified with respect to the 30 June 20X1 performance fee that had been previously calculated and invoiced. The potential error, being an understatement of the performance fee (the Error).

12. The Entity engaged the services of an independent accounting firm, which confirmed the Error.

13. The Responsible Entity may be entitled to consider pursuing the Error amount. However, the Board of the Entity has waived the Error amount as a receivable.

14. The Entity will also not seek to attempt to validate or recover any additional rights of claim.

15. The Entity (as well as the investment fund) will not be required to adjust their financial statements. That is, the performance fee reported in the accounts as at 30 June 20X1 will remain the same.

16. The Error will not be reflected in either the past or the future accounts of the Entity and the investment fund prospectively.

Future methodology and capping

17. The Entity proposes to introduce a maximum performance fee that can be claimed in any future income year. The cap will be introduced for the purpose of calculating the performance fee for the year ended 30 June 20X2 and subsequent years.

18. Under the proposal, the Entity would continue to calculate the performance fee by reference to the current formula. However, the amount of the performance fee calculated for any given calendar year would be the lesser of $X amount or the amount under the existing formula. To the extent that there is a difference, this would be regarded as a surplus, but would not form part of the performance fee for the respective year.

19. To the extent that there is any negative growth in the investment fund over the course of a year (and thus a negative performance fee calculation), a negative performance fee would be offset against any surplus amount carried forward. Essentially, in order to be entitled to receive a net surplus in a future year as a performance fee, the investment fund will need to continue to outperform.

20. Under the new capping proposal, the Entity's entitlement to any surplus balance in the performance fee (after application of negative performance fee amounts) will only be realised at the earlier of the following dates (the claim time):

• the investment fund being wound up;

• 30 June 20X3; or

• upon the investment fund's net assets falling below a threshold.

Other matters

21. The Error will not be a loss that the Entity or the investment fund will deduct.

22. The performance fee is assessable as ordinary income of the Entity pursuant to section 6-5 of the ITAA 1997.

23. The Entity and the investment fund account for income on an earnings basis, and not on a cash basis.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5.

Reasons for decision

Question 1

Summary

1. The Error amount in relation to the performance fee is not assessable as income of the Entity pursuant to section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) for the year ended 30 June 20X1.

Detailed reasoning

2. Subsection 6-5(1) of the ITAA 1997 provides that assessable income includes income according to ordinary concepts, or ordinary income.

3. Subsection 6-5(2) of the ITAA 1997 states that an Australian resident's assessable income includes ordinary income derived directly or indirectly from all sources.

Derived

4. When income is derived is to be determined in accordance with general understanding among practical business people. In Arthur Murray (NSW) Pty Ltd v FC of T (1965) 14 ATD 98 at 99-100; (1965) 114 at 318, the High Court stated:

As Dixon J observed in Carden's 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 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.

The ultimate inquiry in either kind of case, of course, must be whether that which has taken place, be it the earning or the receipt, is enough by itself to satisfy the general understanding among practical business people of what constitutes a derivation of income. A conclusion as to what that understanding is may be assisted by considering standard accountancy methods, for they have been evolved in the business community for the very purpose of reflecting received opinions as to the sound view to take of particular kinds of items. This was fully recognized and explained in Carden's Case, especially in the judgment of Dixon J; but it should be remarked that the Court did not there do what we were invited to do in the course of the argument in the present case, namely to treat the issue as involving nothing more than an ascertainment of established book-keeping methods. A judicial decision as to whether an amount received but not yet earned or an amount earned but not yet received is income must depend basically upon the judicial understanding of the meaning which the word conveys to those whose concern it is to observe the distinctions it implies. What ultimately matters is the concept; book-keeping methods are but evidence of the concept.

5. The High Court further stated that the word 'income' was to be understood in the sense which it has in the vocabulary of business affairs.

6. The Full Federal Court in BHP Billiton Petroleum (Bass Strait) Pty Ltd & Anor v FC of T 2002 ATC 5169; [2002] FCAFC 433 found that where recoverability is doubtful, a deferral of derivation is appropriate:

The only justification for the principle for which the Commissioner here contends is one that proceeds on the fiction that a successful litigant was always going to be successful and was always going to receive the amount which the arbitral or litigation result achieves. The Court should be slow to adopt a fiction in preference for reality in a case such as the present. The deferral of derivation until the conclusion of the dispute (or perhaps receipt if that occurs earlier) avoids the difficulties which arise where the accounts of the year in which the trader sells goods cannot be reopened and where the availability of a deduction for a bad debt may be the subject of doubt. It avoids too the unfairness to a taxpayer in being required to pay tax immediately where recoverability of what is owed to the taxpayer and which is the fund out of which the tax might be expected to be paid, is, as a result of a bona fide dispute, outside the control of the taxpayer.

7. In the present case, whether the Error is assessable as ordinary income in the ordinary business sense to the Entity is dependent on whether the amount has not only been received but has 'come home' to the Entity.

8. As at 30 June 20X1, the Entity was entitled to the amount paid by the investment fund in addition to the Error amount. The fact that it was incorrectly underpaid, as a result of a calculation error which gave rise to the Error, does not alter their entitlement.

9. However, whilst the Entity had a right to recover the Error amount, it has waived that right subsequent to the discovery of the Error.

10. The truth and reality of the situation is that as the right to recover the amount has been waived, the recoverability is not only doubtful, it is non-existent.

11. Ultimately, it is doubtful that the Error has been derived taking into account general understanding amongst practical business people of what constitutes derivation of income.

12. The fact that the Error was never reflected in the Entity's or the investment fund's accounts as a gain or loss for the income year ended 30 June 20X1 lends further support to this conclusion.

13. As the Error will never be recovered or come home to the Entity as a gain 'completely made', it has not been derived by the Entity. This can be contrasted from the performance fee which did come home to the Entity in a realised form in respect of the year ended 30 June 20X1.

Question 2

Summary

14. For the 30 June 20X2 income year and subsequent years in which the cap is applied, no surplus amount in relation to the performance fee will constitute assessable income of the Entity pursuant to section 6-5 of the ITAA 1997.

Detailed reasoning

15. Whether any surplus amount in relation to the performance fee is assessable as ordinary income in the ordinary business sense to the Entity is dependent on whether the amount is recoverable.

16. In Henderson v FC of T (1970) 119 CLR 612; 70 ATC 4016; (1970) 1 ATR 596 (Henderson), the High Court found that the point at which income was derived was when it became a 'recoverable debt' after an agreed task is performed:

In ascertaining such earnings, only fees which have matured into recoverable debts should be included as earnings. In presenting figures before his Honour, allowance was made for what was termed ``work in progress''. But this, in my opinion, is an entirely inappropriate concept in relation to the performance of such professional services as are accorded in an accountancy practice when ascertaining the income derived by the person or persons performing the work. 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. But until that time has arrived, there is, in my opinion, no basis, when determining the income derived in a period, for estimating the value of the services so far performed but for which payment cannot properly be demanded, and treating that value as part of the earnings of the professional practice up to that time and as part of the income derived in that period. It may be that a different course can be taken if an estimation of profits is being made for some other purpose than the present. Consequently, in determining the income of the partnership in either of the years in question for the purposes of assessment of tax, only accrued fees may be included in that income. I have used the word ``recoverable'' to describe the point at which income is derived by the performance of services. I ought to add that fees would be relatively recoverable though by reason of special arrangements between the partnership and the client, time to pay was afforded.

17. In Barratt & Ors v FC of T 92 ATC 4275; (1992) 36 FCR 222 (Barratt), the Full Federal Court found inter alia, recoverable debt must not be contingent and must be quantified:

No doubt a debt that is presently recoverable by action generally will be an amount `derived' in the relevant sense by the creditor. The creditor will have a present right to receive the amount in question, something both earned and quantified, without the presence of any element of contingency or defeasibility. At the other end of the scale, where the right of the taxpayer is contingent, there will be no derivation before the contingency is satisfied... Nor will there be derivation if the debt is yet to be quantified: see Farnsworth v FC of T...

The present case is at neither extreme of the spectrum. But it is well to bear in mind that which is being sought is a method giving, for each year of income, a substantially correct reflex of the true income of the taxpayers, having regard to what Fullagar J called the truth and reality of the situation…

The distinction between the coming into existence of a debt and the operation of impediments upon the recovery of an existing debt is well established and is drawn in many areas of the law.

18. The Commissioner in Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings (TR 98/1), expresses similar views in paragraphs 9 and 10.

19. As found in Henderson and Barratt respectively, a recoverable debt only comes into existence when income is earned, not contingent, indefeasible, and quantifiable.

20. In the present case, any surplus for the 30 June 20X2 income year and subsequent years (up to, but not including the income year during which the claim time arises) comprises a portion (if any) of the performance fee calculated for the year above the cap.

21. The surplus is then carried forward to accumulate or offset against future negative amounts as a result of negative growth in the investment fund, based on future performance.

22. The Entity is not entitled to the surplus amount, nor can its amount be quantified, until there is a surplus balance at the claim time. Put another way, at no stage until the year in which the claim time arises is the Entity entitled to an ascertainable (quantifiable) amount which is neither, contingent (on future performance of the investment fund) or defeasible (as a result of the future performance of the investment fund).

23. Therefore there is no recoverable debt in respect of any surplus which arises for the Entity in each of the income years leading up to the claim time. Furthermore, based on the principles of derivation discussed in response to Question 1 of this ruling, any surplus amount calculated in the income years leading up to the claim time cannot be said to be an amount which will come home to the Entity.

24. Accordingly no surplus amount is derived by and assessable to the Entity under section 6-5 of the ITAA 1997 when the cap is applied.

Question 3

Summary

25. A surplus balance that exists at the claim time will be derived by the Entity as assessable ordinary income pursuant to section 6-5 of the ITAA 1997.

Detailed reasoning

26. The Entity as at the claim time, being the earlier of the following dates:

• the investment fund being wound up;

• 30 June 20X3; or

• upon the investment fund's net assets falling below a threshold,

per the analysis in response to Question 2 of this ruling, will have a recoverable debt.

27. At the claim time the quantum of the surplus balance, if any, will be known and it is only at that time that the Entity has an indefeasible and non-contingent right to recover that amount.

28. Accordingly, any surplus balance that exists at the claim time will be assessable ordinary income of the Entity pursuant to 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).