Edited version of your written advice

Authorisation Number: 1051313200797

Date of advice: 15 December 2017

Ruling

Subject: Market investment amounts

Question 1

Will the market investment amounts paid by Company A to Company B under the Agreement be a financial arrangement for the purposes of Division 230 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Do the market investment amounts paid by Company A to Company B relate directly to the sale of trading stock to Company B, which reduces the sale price, resulting in a reduction of Company A’s sale proceeds at the time of sale for the purposes of section 6-5 and Division 70 of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods

Income tax year ended 31 December 2015

Income tax year ended 31 December 2016

Income tax year ended 31 December 2017

Income tax year ended 31 December 2018

Income tax year ended 31 December 2019

Income tax year ended 31 December 2020

Income tax year ended 31 December 2021

Income tax year ended 31 December 2022

Income tax year ended 31 December 2023

Income tax year ended 31 December 2024

Relevant facts and circumstances

Background

Company A is a company incorporated in Australia and is a resident of Australia for income tax purposes.

Company A sells its products in the ordinary course of its business.

Company A is not an authorised deposit-taking institution (ADI) or other financial sector entity for the purposes of paragraph 230-5(2)(a)(iii) of the ITAA 1997. It has an aggregated turnover of more than $100 million for the purposes of paragraph 230-5(2)(a)(iv) of the ITAA 1997.

Company B has shops in Australia and overseas. Company B, in operating its business, requires the use of products, similar to those manufactured by Company A.

Company A entered into an agreement (the Agreement) with Company B concerning the supply of the products to Company B for a maximum 10-year period from the effective date. The Agreement superseded a previous agreement between the same entities.

Summary of contract

Company A entered into the Agreement with Company B for the exclusive supply of Company A products for X years.

The total market investment amounts to be made by Company A will be made over three tranches:

● 1st tranche of 48 months

● 2nd tranche of 36 months

● 3rd tranche of 36 months

Company B is obligated to purchase over the first three tranches a quantity of Company A’s products.

If Company B’s aggregate purchases of products is less than the values agreed in the Agreement, Company B will be required to repay Company A a portion of market investment amounts.

Other relevant facts

Before settling on the dollar value of the market investment amount under the Agreement, Company A business experts made an initial projection of five-year sales targets. This projection was based on forecasted sales per shop, which was multiplied by the total number of potential shops. Company A then applied a target margin of sales for every $1 of market investment amount.

Sales for the first X years are ahead of schedule. Company A is expecting that the full target for sales under tranche 1 will be achieved ahead of time.

Commercially Company A is ultimately concerned with achieving the sales volumes. Company A anticipates that in the event that the sales volumes required under the terms of the Agreement are not being met the parties would likely undertake further discussions. In those circumstances it is possible that extensions of time would be given for the Company B to meet the sales volumes before Company A would invoke the repayment mechanism in the Agreement.

Accounting Treatment

For accounting purposes, Company A will treat each market investment amount in the following manner:

● The initial cash outlay is debited to Company A’s customer account with Company B

● When a sale with Company B is recorded, the gross revenue is recorded and a rebate is recognised on the sale that is offset against Company B’s customer account (i.e. the end result will be the recognition of sales revenue net of the calculated rebate).

● The initial cash outlay is gradually expensed throughout the duration of the tranche whenever Company A makes a sale of products to Company B.

Relevant legislative provisions

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)

Section 8-1 of the ITAA 1997

Division 70 of the ITAA 1997

Division 230 of the ITAA 1997

Section 230-5 of the ITAA 1997

Section 230-45 of the ITAA 1997

Paragraph 230-45(1)(a) of the ITAA 1997

Paragraph 230-45(1)(b) of the ITAA 1997

Paragraph 230-45(1)(c) of the ITAA 1997

Paragraph 230-45(1)(d) of the ITAA 1997

Paragraph 230-45(1)(e) of the ITAA 1997

Paragraph 230-45(1)(f) of the ITAA 1997

Paragraph 230-45(2)(a) of the ITAA 1997

Section 974-160 of the ITAA 1997

Subsection 974-160(1) of the ITAA 1997

Subsection 974-160(3) of the ITAA 1997

Section 995-1 of the ITAA 1997

Section 995-1 of the ITAA 1997

Reasons for decision

Question 1

Detailed reasoning

The Taxation of Financial Arrangements (TOFA) rules under Division 230 of the Income Tax Assessment Act 1997 (ITAA 1997) provide a comprehensive framework for taxing financial arrangements that certain taxpayers start to have in an income year commencing on or after 1 July 2010 unless the entity meets one of the exemption conditions listed at paragraph 230-5(2)(a) of the ITAA 1997:

(i) an individual; or

(ii) a superannuation entity or fund, managed investment scheme or an entity substantially similar to a managed investment scheme under foreign law with assets of less than $100 million; or

(iii) an ADI, securitisation vehicle or other financial sector entity with an aggregated turnover of less than $20 million; or

(iv) another entity with an aggregated turnover of less than $100 million, financial assets of less than $100 million and assets of less than $300 million;

The first two exemptions are not applicable to Company A, while exemptions three and four are not met as Company A does not meet those factual requirements. As Company A is not excluded under section 230-5 of the ITAA 1997, the TOFA provisions in Division 230 of the ITAA 1997 can apply.

Division 230 of the ITAA 1997 is about the tax treatment of gains and losses an entity makes from a financial arrangement. The term ‘financial arrangement’ is defined as follows in subsection 230-45(1) of the ITAA 1997:

(1) You have a financial arrangement if you have, under an arrangement:

(a) a cash settlable legal or equitable right to receive a financial benefit; or

(b) a cash settlable legal or equitable obligation to provide a financial benefit; or

(c) a combination of one or more such rights and/or one or more such obligations;

unless:

(d) you also have under the arrangement one or more legal or equitable rights to receive something and/or one or more legal or equitable obligations to provide something; and

(e) for one or more of the rights and/or obligations covered by paragraph (d):

(i) the thing that you have the right to receive, or the obligation to provide, is not a financial benefit; or

(ii) the right or obligation is not cash settlable; and

(f) the one or more rights and/or obligations covered by paragraph (e) are not insignificant in comparison with the right, obligation or combination covered by paragraph (a), (b) or (c).

The right, obligation or combination covered by paragraph (a), (b) or (c) constitutes the financial arrangement.

Paragraph 230-45(2)(a) of the ITAA 1997 defines the term ‘cash settlable’ to include a benefit which is money or a money equivalent.

The term ‘arrangement’ is broadly defined in section 995-1 of the ITAA 1997 as being any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings.

The term ‘financial benefit’ is defined in section 995-1 of the ITAA 1997 as having the meaning given by section 974-160 of the ITAA 1997. Subsection 974-160(1) of the ITAA 1997 defines the term ‘financial benefit’ as being anything of economic value, including property and services or anything that regulations provide is a financial benefit for the purposes of sub-section 974-160(3) of the ITAA 1997.

Application of the TOFA rules under Division 230

The Agreement between Company A and Company B is an agreement between two parties which is enforceable by legal proceedings. The Agreement satisfies the definition of ‘arrangement’ in section 995-1 of the ITAA 1997 and is an arrangement for the purposes of subsection 230-45(1) of the ITAA 1997.

The Agreement will be a financial arrangement if it satisfies the requirements of any of paragraphs (a)-(c) of subsection 230-45(1) of the ITAA 1997 and not paragraphs (d)-(f) of subsection 230-45(1) of the ITAA 1997.

Company A has the following rights and obligations under the Agreement:

● The obligation to make a cash payment at the start of each tranche in connection with Company B’s purchase of products;

● A right to receive payment for the sale of products to Company B;

● The obligation to provide Company B with the specified quantity of products purchased over each tranche period.

The right of Company A to receive payment for the sale of the products is a cash settlable right for the purposes of paragraph 230-45(2)(a) of the ITAA 1997. Accordingly, Company A will have a cash settlable obligation to receive a financial benefit under the arrangement constituted by the terms of the Agreement for the purposes of paragraph 230-45(1)(a) of the ITAA 1997.

The obligation of Company A to make a cash payment to Company B at the start of each tranche is a cash settlable obligation for the purposes of paragraph 230-45(2)(a) of the ITAA 1997. Accordingly, Company A will have a cash settlable obligation to provide a financial benefit under the arrangement constituted by the terms of the Agreement for the purposes of paragraph 230-45(1)(b) of the ITAA 1997.

The obligation of Company A to provide Company B with the specified minimum quantity of products over each tranche period is not a cash settlable obligation to provide a financial benefit per subsection 230-45(2) of the ITAA 1997 as the financial benefit involved cannot be settled in money or money equivalent. The obligation to provide the products is not insignificant in comparison with the other terms of the arrangement that are cash settlable rights and obligations per paragraphs 230-45(1)(a), 230-45(1)(b) and 230-45(1)(c).

As the obligation is not cash settlable and is not insignificant when compared to the cash settlable rights and obligation of the Agreement pursuant to paragraphs 230-45(1)(d), 230-45(1)(e) and 230-45(1)(f) of the ITAA 1997, we conclude that the Agreement is not a financial arrangement under subsection 230-45(1) of the ITAA 1997.

Question 2

Detailed reasoning

Where an item of trading stock is disposed of in the ordinary course of business, the consideration receivable generally constitutes ordinary income of the seller, which is assessable under section 6-5 of the ITAA 1997.

Taxation Ruling TR 96/20 Income tax: assessability and deductibility of prompt payment discounts offered by traders of goods to their customers and certain other discounts (TR 96/20) addresses the income tax treatment of settlement discounts by analysing them in terms of the law applying to the derivation of income and the deductibility of outgoings. A settlement discount generally refers to the discount percentage offered to customers for payment within the settlement period. The principles in TR 96/20 inform Taxation Ruling TR 2009/5 Income tax: trading stock - treatment of discounts, rebates and other trade incentives offered by sellers to buyers (TR 2009/5).

TR 2009/5 is about the tax consequences of a transaction between a buyer and seller of trading stock which includes a trade incentive. TR 2009/5 addresses when, and at what time, income is derived for the purposes of 6-5 of the ITAA 1997 and deductions are incurred for the purposes of sections 8-1 of the ITAA 1997 as well as the interaction of those provisions with Division 70 of the ITAA 1997.

Where a trade incentive directly relates to trading stock, TR 2009/5 states that the assessable income (sale price) that the seller derives from the transaction is reduced by the amount of any trade incentives. TR 2009/5 states at paragraphs 9 and 10:

Taxation consequences for the seller

9. Trade incentives that relate directly to the sale of trading stock, so as to reduce the sale price, are treated as a reduction of the sale proceeds for the seller for the purposes of section 6-5 and Division 70.

10. With one exception, an incentive that is subject to a condition that has not been satisfied at the time of the sale does not relate directly to the sale of trading stock and does not reduce the proceeds of sale for the seller. The exception is where there is virtual certainty at the time of sale that the condition will be satisfied. For example, a settlement discount that is always taken by the buyer will reduce the sale price for the seller. Similarly a volume rebate subject to a rebate threshold that has not been met but is certain to be met will reduce the sale price for the seller. In both instances the seller's assessable income from the sale will be the reduced amount.

Further, at paragraph 73 of TR 2009/5 it is reiterated that nothing in Division 70 of the ITAA 1997 reveals an intention that the application of section 6-5 of the ITAA 1997 and section 8-1 of the ITAA 1997 is modified for trading stock.

To determine whether a trade incentive directly relates to trading stock, TR 2009/5 states at paragraphs 13 and 14:

Whether the trade incentive directly relates to trading stock

13. Factors relevant to whether a trade incentive reduces the cost of acquiring trading stock for a buyer and the proceeds of disposal for the seller include:

● the terms of trading between the parties and other sales and transaction documentation, such as invoices, incentive claim forms and credit notes;

● an objective assessment of the intention of the parties; and

● any other relevant circumstances surrounding the payment of the incentive.

14. Where in substance a trade incentive is paid for more than one purpose, each purpose is considered in determining the extent to which the payment reduces the cost of acquiring trading stock for the buyer and the proceeds on disposal of the trading stock for the seller. If apportionment between each purpose cannot be accurately measured, the buyer should return the full amount of the trade incentive as income and the seller should return the full amount of the trade incentive as a business expense.

Therefore, there is a sequence of issues to consider, beginning with whether the trade incentive relates directly to trading stock. If that is answered in the affirmative, then consideration turns to whether the trade incentive is subject to a condition and whether there is virtual certainty at the time of sale that the condition will be met.

The term “trading stock” is defined in section 995-1 of the ITAA 1997 as having the meaning given by section 70-10 of the ITAA 1997 as modified by section 70-12 of the ITAA 1997 and sections 124ZO and 124ZQ of the Income Tax Assessment Act 1936. Section 70-10 of the ITAA 1997 states:

(1) Trading stock includes:

(a) anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business; and

(b) live stock.

(2) Trading stock does not include:

(a) a Division 230 financial arrangement; or

(b) a CGT asset covered by section 275-105 that:

(i) is owned by a complying superannuation fund, a complying approved deposit fund or a pooled superannuation trust; or

(ii) is a complying superannuation asset of a life insurance company.

There is no definition for what is in the ‘ordinary course of a business’ in the ITAA 1997. In G.P. International Pipecoaters Pty. Ltd. V FCT (1989-1990) 17 CLR 124 it was observed that what is included in the ordinary course of a business involves a factual enquiry of the scope and range of activities undertaken by a business.

The acquisition and holding of products for sale is an activity which is undertaken in the ordinary course of the business of Company A. The products sold by Company A to Company B under the Agreement are trading stock for the purposes of section 70-10 of the ITAA 1997.

Each marketing investment amount paid by Company A to Company B under the Agreement relates directly to the sale of Company A products. That is because each marketing investment amount is calculated by reference to the sale, within a specific tranche period, of a set quantity of Company A products.

The next issues to consider are whether payment of each marketing investment amount is subject to a condition and whether there is virtual certainty, at the time of sale of the relevant products, that the condition will be met. In considering those issues the following facts and circumstances concerning Company A are relevant:

● Company A entered into the Agreement with Company B for the exclusive supply of Company A products for a period of 10 years

● Throughout the life of the Agreement, amounts are paid to Company B that are solely related to the volume of products purchased by Company B, with a rebate ratio per $1 of products purchased

● The amount of the rebates was projected by the Company A business experts using their expertise to project sales per shop over a 5-year period

● Company B is currently tracking ahead of schedule with regards to the volume of Company A products purchased and it is expected that the first tranche of the Agreement will be completed early.

● Under the contract, if Company B’s aggregate purchases of products are less than the values agreed in the Agreement, Company B will be required to repay to Company A a portion of market investment amounts.

● Although the rebate is capable of returning to Company A under the terms of the Agreement, Company A have stated that commercial rationale would drive the parties to undertake further discussions and possibly extensions of time to meet the target as Company A is ultimately aiming to achieve the sales volumes.

The Agreement between Company A and Company B supports a conclusion that the market investment amounts is conditional. The condition being that in order to retain each marketing investment amount the Company B must purchase a specific volume of products over each tranche of the Agreement. Nevertheless, the facts cited above support the conclusion that the condition is virtually certain of satisfaction, due to the commercial considerations made by Company A and the extent to which the terms of trade are expected to be satisfied.

Consequently, the market investment amounts reduce the sale price of the goods supplied by Company A at the time of sale per TR 2009/5 and, in turn, reduce the assessable income included by Company A under section 6-5 of the ITAA 1997 and Division 70 of the ITAA 1997.

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