Edited version of your written advice

Authorisation Number: 1051289329794

Date of advice: 3 October 2017

Ruling

Subject: Income – mortgage books – profit emerging basis – accounting treatment

Question 1:

Can you calculate your taxable income, consisting of trail commissions from purchased mortgage books, on a profit emerging basis?

Answer:

Yes.

Question 2:

Can the straight line amortisation method be used to calculate the emerging profit?

Answer:

Yes.

This ruling applies for the following period

Income year ending 30 June 2013

Income year ending 30 June 2014

Income year ending 30 June 2015

Income year ending 30 June 2016

Income year ending 30 June 2017

Income year ending 30 June 2018.

The scheme commences on

1 July 2012.

Relevant facts and circumstances

You are an incorporated company whose principle activity is mortgage broking.

Your business consists of acting as a mortgage broker and receiving commissions in addition to purchasing rights to receive “trailing commissions” for mortgage books.

You acquired multiple Register Rights for mortgage books which comprise your contractual rights and your right to receive commission, including trailing commissions, and other payments.

You receive trailing commissions after loans are settled which are calculated each month as a percentage of the average monthly balance for the life of the loan.

You acquired the Register Rights for the mortgage books as a profit making scheme that extends over more than one income year.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Reasons for decision

Question 1

Assessable income – profit emerging basis

Your assessable income includes income according to ordinary concepts, which is called ordinary income (section 6-5 of the ITAA 1997).

In Federal Commissioner of Taxation v. Stone [2005] HCA 21 (2005) 222 CLR 289 (2005) 2005 ATC 4234; (2005) 59 ATR 50, the majority judgment of the High Court considered the meaning of the phrase 'income according to ordinary concepts'. The court referred to the judgment in Scott v. Commissioner of Taxation (NSW) (1935) 3 ATD 142 at 144-145, where it was considered that in determining how much of a receipt should be treated as income, regard must be had to the ordinary concepts and usages of mankind.

Paragraph 17 of Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings (TR 98/1) states:

When accounting for income in respect of a year of income, a taxpayer must adopt the method that, in the circumstances of the case, is the most appropriate. A method of accounting is appropriate if it gives a substantially correct reflex of income. Whether a particular method is appropriate to account for the income derived is a conclusion to be made from all the circumstances relevant to the taxpayer and the income.

In Federal Commissioner of Taxation v. Cititbank Limited & Ors (1993) 44 FCR 434; (1993) 93 ATC 4691; (1993) 26 ATR 423 Hill J, in considering the relevance of accounting evidence in determining income tax issues, said:

Where there is no impediment in the Act to bringing to account a net profit as gross income, then that profit will need to be calculated in accordance with the accounting standards.

In XCO Pty Ltd v. Federal Commissioner of Taxation (1971) 124 CLR 343; (1971) 71 ATC 4152; (1971) 2 ATR 353, the High Court considered the application of a profit emerging basis, where a taxpayer was assigned debts at a deep discount to their face value for consideration Gibbs J said:

Where the carrying out of a profit-making scheme extends over more than one year, the difference between receipts and disbursements in any one year may not give a true reflection of the profit arising or loss sustained in that year, and the assessment of profit on an emerging basis may be appropriate.

In determining its profit for accounting purposes, it is appropriate that the taxpayer amortises the cost of the debt ledgers. It does not calculate its profit or loss by deducting from the year's collections the total cost it outlays in acquiring trailing commissions for that year for that would distort its true position for that year. Instead, its profits are effectively determined on an emerging basis taking into account that portion of the cost relevant to the acquisition of the trailing commissions that result in collected income over the period.

In your case, you acquired Register Rights for the mortgage books. When you entered into the agreement to acquire the mortgage books, you acquired a legal chose in action giving you the right to receive the trailing commissions, being an income stream. The transaction was entered into with the expectation of making a profit where the proceeds of collection exceed the cost of the acquired debt.

The assessment of any profit arising under section 6-5 of the ITAA 1997 on a profit emerging basis is considered to be the most appropriate method in determining your income from the Register Rights for the mortgage books for taxation purposes.

Question 2

Accounting treatment

In the absence of any ruling or other determination or direction by the Commissioner specifying how assessable income is to be calculated when an emerging profit basis using cash receipts is the appropriate form of assessment of income, it is considered that more than one basis of calculating the assessable income may be contemplated as being correct.

Possible methods that could be adopted include the straight line method (as proposed in your ruling application) and the first in/first out (FIFO) methodology.

TR 98/1 provides guidance on the accounting method likely to provide a substantially correct reflex of income in a relevant year. While this ruling is mainly concerned with distinguishing between a cash receipts basis and an earnings basis, it does note at paragraphs 27 and 28 that a taxpayer must adopt the method of accounting that, in the circumstances, is appropriate. A method of accounting is appropriate if it gives ‘a substantially correct reflex’ of that income.

Whether a method gives a substantially correct reflex and therefore is appropriate, is a conclusion to be made from all circumstances relevant to the taxpayer and the income.

In the absence of any direct guidance as to the method to be adopted when using the emerging profits basis of assessment of income, we therefore conclude that any method will suffice so long as it produces a substantially correct reflex of the taxpayer’s true assessable income.

In this case, it is considered that the methodology proposed by you is an appropriate method of returning the profit derived from acquiring the Register Rights for the mortgage books as this method gives a ‘substantially correct reflex of income in a relevant year’. Therefore, you can use the straight line amortisation method to calculate the emerging profits arising in relation to the Register Rights for the mortgage books.

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