Edited version of private advice

Authorisation Number: 1051526748793

Date of advice: 29 July 2019

Ruling

Subject: Appropriate taxation treatment of purchased debt ledgers under Division 230 of ITAA 1997

Question 1

If it is assumed that each debt within a Purchased Debt Ledger is a financial arrangement for the purposes of section 230-45 of the Income Tax Assessment Act 1997, does the realisation method under section 230-180 of the Income Tax Assessment Act 1997 apply for the purposes of working out the gains and losses from each of those debts?

Answer

Yes

Question 2

Assuming the answer to Question 1 is 'yes', in working out the gains and losses from a debt under the realisation method, will the Commissioner accept the accounting method described in the private ruling application?

Answer

Yes

This ruling applies for the following periods:

From the period 1 July 20XX to 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Entity X

Entity X's main business is the purchase of overdue, non-performing and written off debts from original credit providers (such as telecommunication companies, utilities companies, credit card providers) and the subsequent collection of these debts from the debtors.

These distressed, consumer-based retail debts are grouped into 'bundles' by the original credit providers prior to being sold off and are referred to as purchased debt ledgers (PDLs) once bought by another entity.

Entity X operates in Australia and overseas.

Purchased debt ledgers

Each PDL typically comprises high volume consumer debt accounts considered to be uneconomical to collect by the original credit provider. Most debts within a PDL typically go through at least two phases of collection (first an internal process within the organisation, then an external process via a debt collector) before they are sold off as part of a PDL.

The debts comprising a PDL are purchased at a deep discount to the original face value of these individual debts.

The legal assignment of a PDL occurs via a contract between the original credit provider and Entity X. There is an individual contract for each PDL and once purchased, the legal title to the PDL (and thereby each of the individual debts with the PDL) is transferred to Entity X. This process occurs before any steps are taken by Entity X to recover the distressed debts within a PDL.

Entity X has models which estimate the expected collections for a PDL over a given period (for example, over ten years). These expected collections may also include debt amounts that are considered uncollectable. The expected collection amounts which predict the PDL cash flow are then used to produce a collection curve.

The collection curve models are based on the historical performance of previous PDLs (with similar characteristics) and are specific to the type of PDL. That is, a specific PDL will be comprised of a bundle of debts from the same telecommunications company or the same bank and not a mixture of distressed debts from different banks or a bank and telecommunications company.

The collection curve models are used to determine the bid price submitted to the original credit provider by Entity X to purchase a PDL. Such pricing is determined on the basis of the attributes of the portfolio of debts rather than the specific underlying debts (for example, it does not account for the average age of an individual debt or geography of an individual debtor but instead viewed from an aggregate perspective).

The PDLs are acquired with the intention of collecting the underlying debts within

the legal limitations governing enforcement and collection. The debts are collected by Entity X via call centres, where debtors are contacted directly to organise payment arrangements (for example, $10 a week repayment over 2 years - which are the types of terms the original credit providers would not accommodate).

As noted above, only a portion of the debts in a PDL are expected to be collected. Some debts in the PDL will be collected in full or in part, whilst for others there may be no recovery at all.

Entity X makes a profit/gain (that is, derives income) across a PDL where it collects an amount greater than the purchase price of the PDL (plus associated collection costs). Entity X will make a loss (that is, an expense or deduction) where the total amount collected from a PDL is less than the purchase price of the PDL (plus associated collection costs).

Accounting treatment of PDLs

Up to 30 June 2018, the accounting gains (reported as income) and losses (reported as an expense or deduction) from the PDLs were calculated on a monthly basis by recognising the difference between the total cash collected for a PDL and the amortisation of the PDL. This method reflects the application of the realisation method that Entity X is proposing to use in calculating the gain or loss from a PDL.

The proposed accounting treatment of a PDL purchased by Entity X is as follows:

D = B - C

The above equation assumes that:

·         D is the gain or loss from a PDL;

·         B is the actual amount collected in respect of the PDL, where each collection period is a single year (instead of monthly). It is assumed that this yearly collection amount is the aggregate of the monthly collections firm each debt within a PDL. The collection amount per year is present valued at a discount rate (where the discount rate is calculated by actuaries with reference to the collection history of PDLs with similar characteristics);

·         C is the cost of acquiring the PDL (that is, the amortisation expense for the PDL).

Amortisation expense

The amortisation expense for a PDL in relation to each period was calculated at the time of acquisition of the PDL and generally remains unchanged over the life of the PDL. This is the case for the vast majority of PDLs purchased by Entity X. Where there is a significant difference in the timing of forecasted collections, the amortisation rate is recalculated.

Tax Treatment of PDLs

For income years up to 30 June 2017, the tax treatment of PDLs held by Entity X aligned with the accounting treatment of PDLs.

However, for income years from 30 June 2017 onwards, the PDLs of Entity X came within the ambit of Division 230 of the ITAA 1997 and the method of calculating Entity X's PDL gains and losses had to be reassessed.

Going forward, it is proposed that the method described above (at paragraphs 14 - 16) will be used in calculating the Entity X's PDL gains and losses pursuant to Division 230 of the ITAA 1997.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 230-10

Income Tax Assessment Act 1997 section 230-15

Income Tax Assessment Act 1997 section 230-20

Income Tax Assessment Act 1997 section 230-40

Income Tax Assessment Act 1997 section 230-45

Income Tax Assessment Act 1997 section 230-55

Income Tax Assessment Act 1997 section 230-60

Income Tax Assessment Act 1997 section 230-70

Income Tax Assessment Act 1997 section 230-95

Income Tax Assessment Act 1997 section 230-100

Income Tax Assessment Act 1997 section 230-115

Income Tax Assessment Act 1997 section 230-180

Income Tax Assessment Act 1997 section 974-160

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

Question 1

Summary

The realisation method under section 230-180 of the Income Tax Assessment Act 1997 (ITAA 1997) may be used for the purposes of working out the gains and losses from each of the individual debts within a PDL.

Detailed reasoning

Financial arrangement definition

Subsection 995-1(1) of the ITAA 1997 defines an 'arrangement' as:

any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings.

Subsection 995-1(1) of the ITAA 1997 defines 'financial arrangement' as having 'the meaning given by sections 230-45 to 230-55 [of the ITAA 1997]'.

Section 230-45 of the ITAA 1997 relevantly provides:

230-45(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;...

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

Note 1:

Whether your rights and/or obligations under an arrangement constitute a financial arrangement can change over time depending on changes either to the terms of the arrangement or external circumstances (such as particular rights or obligations under the arrangement being satisfied by the parties). For example, a contract may provide for the transfer of a boat in 6 months time and payment of the contract price at the end of 2 years. Until the boat is delivered, there is no financial arrangement because of the operation of paragraphs (d), (e) and (f) above. Once the boat is delivered, there is a financial arrangement because those paragraphs are no longer applicable.

Note 2:

The operative provisions of this Division do not apply to all financial arrangements, and only apply partially to some: see the exceptions in Subdivision 230-H.

Note 3:

There are some rules in this Division that tell you what happens if an arrangement ceases to be a financial arrangement (see Subdivision 230-G and section 230-505).

230-45(2)

A right you have to receive, or an obligation you have to provide, a *financial benefit is cash settlable if, and only if:

(a) the benefit is money or a *money equivalent; or ...

(b) in the case of a right - you intend to satisfy or settle it by receiving money or a money equivalent or by starting to have, or ceasing to have, another *financial arrangement; or

...

230-45(3)

You satisfy this subsection if:

(a) the *financial benefit is readily convertible into money or a *money equivalent; and

(b) there is a market for the financial benefit that has a high degree of liquidity; and

(c) subsection (4) or (5) is satisfied.

230-45(4)

This subsection is satisfied if, for the recipient of the *financial benefit, the amount of the money or *money equivalent referred to in paragraph (3)(a) is not subject to a substantial risk of substantial decrease in value.

230-45(5)

This subsection is satisfied if your purpose, or one of your purposes, for entering into the arrangement under which you are to receive or provide the *financial benefit, is to receive or deliver the financial benefit:

(a) to raise or provide finance; or

(b) if paragraph (a) does not apply - so that it may be converted or liquidated into money or a money equivalent (other than as part of your expected purchase, sale or usage requirements).

Financial benefit definition

Subsection 974-160(1) of the ITAA 1997 defines 'financial benefit' to mean:

(a) ...anything of economic value; and

(b) includes property and services; and

(c) includes anything that regulations made for the purposes of subsection (3) provide is a financial benefit;

even if the transaction that confers the benefit on an entity also imposes an obligation on the entity.

Further, subsection 974-160(2) of the ITAA 1997 provides that 'In applying subsection [974-160](1), benefits and obligations are to be looked at separately and not set off against each other.'

Section 230-60 of the ITAA 1997 relevantly sets out when you are considered to have received a financial benefit under a financial arrangement:

Financial benefit received under financial arrangement

230-60(2)

You are taken, for the purposes of this Division, to have (or to have had) a right to receive a *financial benefit under a *financial arrangement if:

(a) you have (or had) a right to receive the financial benefit in relation to the arrangement; and

(b) the financial benefit would not otherwise be treated as one that you have (or had) a right to receive under the arrangement; and

(c) the financial benefit plays an integral role in determining:

(i) whether you make a gain or loss from the arrangement; or

(ii) the amount of such a gain or loss.

Paragraph (a) applies even if the entity that provides the financial benefit is not a party to the arrangement.

Note:

The financial benefits you receive may include, for example, the waiving of an obligation you have to provide a financial benefit.

Money equivalent

Subsection 995-1(1) of the ITAA 1997 defines 'money equivalent' as:

(a) a right to receive money or something that is a *money equivalent under this definition; or

(b) a *financial arrangement (within the meaning of section 230-45 [of ITAA 1997]).

Factors to consider

Section 230-55 of the ITAA 1997 sets out what must be considered in order to determine what forms part of a 'financial arrangement':

Single right or obligation or multiple rights or obligations?

230-55(1)

If you have a right to receive 2 or more *financial benefits, you are taken, for the purposes of this Division, to have a separate right to receive each of those financial benefits.

230-55(2)

If you have an obligation to provide 2 or more *financial benefits, you are taken, for the purposes of this Division, to have a separate obligation to provide each of those financial benefits.

230-55(3)

Subsections (1) and (2) apply for the avoidance of doubt.

Matters relevant to determining what rights and/or obligations constitute particular arrangements

230-55(4)

For the purposes of this Division, whether a number of rights and/or obligations are themselves an *arrangement or are 2 or more separate arrangements is a question of fact and degree that you determine having regard to the following:

(a) the nature of the rights and/or obligations;

(b) their terms and conditions (including those relating to any payment or other consideration for them);

(c) the circumstances surrounding their creation and their proposed exercise or performance (including what can reasonably be seen as the purposes of one or more of the entities involved);

(d) whether they can be dealt with separately or must be dealt with together;

(e) normal commercial understandings and practices in relation to them (including whether they are regarded commercially as separate things or as a group or series that forms a whole);

(f) the objects of this Division.

In applying this subsection, have regard to the matters referred to in paragraphs (a) to (f) both in relation to the rights and/or obligations separately and in relation to the rights and/or obligations in combination with each other.

Example 1:

Your rights and obligations under a typical convertible note, including the right to convert the note into a share or shares, would constitute one arrangement.

Example 2:

Your rights and obligations under a typical price-linked or index-linked bond would constitute one arrangement.

Note 1:

If you raised funds by means of a contract that you would not have entered into without entering into another contract, and neither contract could be assigned to a third party without the other also being assigned, this would tend to indicate that your rights and obligations under the 2 contracts together constitute one arrangement.

Note 2:

If the commercial effect of your individual rights and/or obligations in a group or series cannot be understood without reference to the group or series as a whole, this would tend to indicate that all of your rights and/or obligations in the group or series together constitute one arrangement.

Taxation Ruling TR 2012/4 Income tax: the operation of subsection 230-55(4) of the Income Tax Assessment Act 1997 (ITAA 1997) in determining what is an 'arrangement' for the purposes of the taxation of financial arrangements under Division 230 of the ITAA 1997 (TR 2012/4) relevantly states the following in relation to how subsection 255-55(4) of the ITAA 1997 must be applied:

13. In applying subsection 230-55(4), regard must be had to all of the matters referred to in paragraphs (a) to (f), although in a particular case, it may be that one matter is more influential than others. In having regard to the matters referred to in paragraphs (a) to (f), such regard must include a consideration of how the matters interact.

...

17. Paragraph 230-55(4)(c) requires consideration of the context surrounding the life cycle of the rights and/or obligations from creation to what is proposed as exercise or performance. The words 'circumstances surrounding' should be understood as qualifying both 'their creation' and 'their proposed exercise or performance'.

18. The paragraph requires an objective assessment of the purposes of the entities involved. In such assessment, evidence of the subjective purpose of such entities may be relevant, though not determinative.

...

19. ...The enquiry under ...paragraph [230-55(4)(d)] is as to legal, rather than commercial, constraint.

...

22. In having regard to the objects of Division 230, it may be necessary to consider how Division 230 would apply if rights and/or obligations were aggregated, and if they were treated separately. If a particular aggregation or separation outcome under subsection 230-55(4) leads to alignment of the tax recognition of gains and losses with the reality of what gains and losses occur and when they occur, it will tend to suggest such aggregation or separation.

23. If a particular aggregation or separation outcome under subsection 230-55(4) leads to the time of tax recognition of gains and losses from financial arrangements being reasonable, it will tend to suggest such aggregation or separation.

24. If a particular aggregation or separation outcome under subsection 230-55(4) minimises compliance costs by aligning commercial recognition of gains and losses with their tax recognition, it will tend to suggest such aggregation or separation. In considering this, it is necessary to take into account the explicit approach of Division 230 to not simply have a direct link with financial accounting. The object in paragraph 230-10(c) must be read in this context.

The Explanatory Memorandum to the Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008 (EM) also relevantly states:

2.36 Typically, an arrangement will be constituted by a contract. Generally, this would be the case for ordinary financial instruments, common hybrid instruments and derivatives. However, the concept of arrangement as used in Division 230 recognises that a contractual basis may be insufficient to reflect the substance of an arrangement in all circumstances. It is recognised that modern arrangements can be put together in very complex ways and that their substance may be different from their form.

2.37 To deal with the various forms in which relevant arrangements may take, what rights and obligations constitute the relevant arrangement for Division 230 purposes (ie, the arrangement to be tested to determine whether it is or is not a financial arrangement), is based on various factors. These factors go to the substance of these rights and obligations and the facts and circumstances surrounding them.

...

2.49 Division 230 is directed at reflecting the commercial and economic substance of arrangements; 'commercial' in this sense refers to non-tax factors driving the way in which the particular arrangement is structured.

Method to use for calculating gain or loss from financial arrangement

Section 230-40 of the ITAA 1997 relevantly sets out the methods that may be used to calculate a gain or loss from a financial arrangement:

230-40(1)

The methods that can be applied to take account of a gain or loss you make from a *financial arrangement are:

(a) the accruals and realisation methods provided for in Subdivision 230-B; or...

The accruals and realisation methods are the default methods of taxation under Division 230 of the ITAA 1997. These methods will apply to those financial arrangements that are not subject to any of the elective methods (outlined at paragraphs 230-40(1)(b) - 230-40(1)(f) of the ITAA 1997).

According to section 230-95 of the ITAA 1997, the objects of Subdivision 230-B of the ITAA 1997 (relating to when the accruals or realisation method should be used) include:

(a) to properly recognise gains and losses from *financial arrangements by allocating them to appropriate periods of time; and

(b) to reduce compliance costs by reflecting commercial accounting concepts where appropriate; and

(c) to minimise tax deferral.

Accruals method

According to subsections 230-100(2) to 230-100(4) of the ITAA 1997 below, the accruals method will apply where there is a sufficiently certain overall gain or loss, or a sufficiently certain particular gain or loss in respect of a financial arrangement:

Accruals method - sufficiently certain overall gain or loss at start time

230-100(2)

The accruals method provided for in this Subdivision applies to a gain or loss you have from a *financial arrangement if:

(a) the gain or loss is an overall gain or loss from the arrangement; and

(b) the gain or loss is sufficiently certain at the time when you start to have the arrangement; and

(c) you choose to apply the accruals method to the gain or loss, or subsection (4) applies to the gain or loss [which relates to a particular gain or loss from qualifying securities].

Note:

Subsection 230-105(1) tells you when you have a sufficiently certain overall gain or loss.

Accruals method - sufficiently certain particular gain or loss

230-100(3)

The accruals method provided for in this Subdivision also applies to a gain or loss you have from a *financial arrangement if:

(a) the gain or loss arises from a *financial benefit that you are to receive or are to provide under the arrangement; and

(b) the gain or loss:

(i) is sufficiently certain before or at the time when you start to have the arrangement and before you are to receive or provide the benefit; or

(ii) becomes sufficiently certain after the time when you start to have the arrangement and before you are to receive or provide the benefit; and

(c) the benefit has not already been taken into account in applying:

(i) the accruals method provided for in this Subdivision; or

(ii) the realisation method provided for in this Subdivision;

to another gain or loss from the arrangement.

This subsection has effect subject to subsection (4).

Note:

Subsection 230-110(1) tells you when you have a sufficiently certain gain or loss at a particular time.

Accruals method - particular gain or loss becomes sufficiently certain

230-100(3A)

The accruals method provided for in this Subdivision also applies to a gain or loss you have from a *financial arrangement if:

(a) the gain or loss arises from a *financial benefit that you are to receive or are to provide under the arrangement; and

(b) the gain or loss becomes sufficiently certain at the time you receive or provide the benefit; and

(c) at least part of the period over which the gain or loss would be spread under that method (assuming that method applied) occurs after the time you receive or provide the benefit.

This subsection has effect subject to subsection (4) [which relates to a particular gain or loss from a qualifying security].

Note 1:

Subsection 230-110(1) tells you when you have a sufficiently certain gain or loss at a particular time.

Note 2:

For the period over which the gain or loss would be spread, see subsections 230-130(3) to (5).

Realisation method

Pursuant to subsection 230-100(5) of the ITAA 1997 below, if there is neither a sufficiently certain overall gain or loss, or a sufficiently certain particular gain or loss in respect of a financial arrangement, the realisation method will apply:

Realisation method - gain or loss not sufficiently certain

230-100(5)

The realisation method provided for in this Subdivision applies to a gain or loss that you have from a *financial arrangement if the accruals method provided for in this Subdivision does not apply to that gain or loss.

Note:

Section 230-180 tells you how to apply the realisation method to the gain or loss.

Factors to consider for 'sufficiently certain'

Section 230-115 of the ITAA 1997 outlines the factors that must be considered when determining whether a gain or loss is 'sufficiently certain':

230-115(1)

In deciding for the purposes of this Subdivision whether it is sufficiently certain at a particular time that you make, or will make, a gain or loss from a *financial arrangement:

(a) have regard only to:

(i) *financial benefits that you are sufficiently certain to receive; and

(ii) financial benefits that you are sufficiently certain to provide; and

(b) have regard to those financial benefits only to the extent that the amount or value of the benefits is, at that time, fixed or determinable with reasonable accuracy.

Note:

The particular time may be the time at which you start to have the arrangement.

230-115(2)

A *financial benefit that you are to receive or provide is to be treated as one that you are sufficiently certain to receive or to provide only if:

(a) it is reasonably expected that you will receive or provide the financial benefit (assuming that you will continue to have the *financial arrangement for the rest of its life); and

(b) at least some of the amount or value of the benefit is, at that time, fixed or determinable with reasonable accuracy.

230-115(3)

In applying subsection (2) to the *financial benefit:

(a) you must have regard to:

(i) the terms and conditions of the *financial arrangement; and

(ii) accepted pricing and valuation techniques; and

(iii) the economic or commercial substance and effect of the arrangement; and

(iv) the contingencies that attach to the other financial benefits that are to be provided or received under the arrangement; and

(b) you must treat the financial benefit as if it were not contingent if it is appropriate to do so having regard to the contingencies that attach to the other financial benefits that are to be received or provided under the arrangement.

...

230-115(9)

To avoid doubt:

(a) a *financial benefit that you have already provided at a particular time is taken to be one that it is, at that time, a financial benefit that you are sufficiently certain to provide; and

(b) a financial benefit that you have already received at a particular time is taken to be one that it is, at that time, a financial benefit that you are sufficiently certain to receive.

Applying the law to your circumstances

Financial arrangement definition

An 'arrangement' is defined broadly in subsection 995-1(1) of the ITAA 1997. Section 230-45 and section 230-55 of the ITAA 1997 modifies this broad notion of 'arrangement' by providing guidance as to which specific rights and obligations constitute the relevant arrangement for the purposes of Division 230 of the ITAA 1997.

Financial arrangement under section 230-45 of ITAA 1997

An arrangement will fall within Division 230 of the ITAA 1997 if it satisfies the definition of a 'financial arrangement' under section 230-45 of the ITAA 1997 (dealing with cash settlable rights and obligations to financial benefits).

It appears that section 230-45 of the ITAA 1997 will be satisfied as Entity X's rights to receive payments from the individual debtors within a PDL are:

·         'cash settlable' as the benefit (that is, payment received for discharging a debt) is money or a money equivalent according to the definition in subsection 995-1(1) of the ITAA 1997;

·         a 'legal right' as there is a contract between Entity X and each individual debtor in respect of the outstanding debt;

·         'financial benefits' according to section 974-160 of the ITAA 1997 (as this right to receive payment is something of economic value) and subsection 230-60(2) of the ITAA 1997 (as the financial benefits received in respect of each individual debt is crucial to calculating the gain or loss from each financial arrangement, and ultimately the PDL).

Identification of financial arrangement under subsection 230-55(4) of ITAA 1997

TR 2012/4 provides that the creation and the proposed exercise or performance of the rights in question need to be considered in context of the purpose of the entities involved. That is, the gains or losses made in respect of the PDLs occur in the context of Entity X obtaining the best tax outcome and we need to consider how the right to repayment from the debts comprising the PDL will be treated.

Paragraphs 22 - 24 of TR 2012/4 provides that whether the rights under a financial arrangement should be aggregated or separated depends on the alignment between the commercial context as well as the taxation treatment. For Entity X, the fact that the individual debts are purchased in bundles does not preclude them from treated as separate financial arrangements as the gain or loss from each PDL is the aggregate of all the gains or losses from the constituent individual debts.

Further, paragraph 19 of TR 2012/4 states that the issue of whether the rights must be dealt with separately or together is to be viewed in context of how these rights are treated at law. In the case of the PDLs, it appears that Entity X has a separate 'legal contract' with the individual debtors regarding repayment of the outstanding debts.

According to the EM, even though the usual form of an arrangement may be ascertained by looking at its contractual basis, it is the substance of the arrangement rather than the form that must be considered in determining whether there is a single or multiple financial arrangement/s. Commercial and 'non-tax' factors should also be considered in this context. When viewed in context of how the PDLs are dealt with by Entity X, it is our view that the constituent debts within a PDL are themselves a financial arrangement as it is the aggregate of these debts which comprise the PDL.

Whether a number of rights and/or obligations are themselves an arrangement or are two or more separate arrangements is a question of fact and degree that must be determined having regard to each of the factors listed in subsection 230-55(4) of the ITAA 1997:

·         each individual debt is owed to Entity X by a different entity (that is, by a different individual debtor);

·         each individual debt has different terms and conditions (as determined by the characteristics of each individual debtor);

·         each debt can be and is dealt with separately (for example; when arranging repayment terms, this is done separately with each individual debtor);

·         even though a single purchase price is paid for each PDL, this purchase price is effectively calculated by aggregating the value of the individual debts (and discounting this aggregate amount by the appropriate discount rate);

·         similarly, the financial benefits received from a PDL is the aggregate of the amounts collected in respect of each individual debt;

·         there is nothing connecting each of the different debts within a PDL aside from the fact that they were bought together in a 'bundle'.

1.    Therefore, we consider that each debt within a PDL would be a separate financial arrangement for the purposes of section 230-55 of the ITAA 1997.

Calculating the gain or loss from a financial arrangement

2.    According to subsection 230-60(2) of the ITAA 1997, Entity X will have a right to receive a financial benefit under a financial arrangement as:

·         there is a contract between Entity X and each of the individual debtors for repayment of a debt;

·         aside from this contractual obligation, Entity X would not otherwise have a right to receive repayment;

·         the financial benefit received is crucial to quantifying the amount of the gain or loss from the financial arrangement.

Method to use for calculating gain or loss from financial arrangement

Sufficiently certain gain or loss

3.    According to the factors listed in subsection 230-115(3) of the ITAA 1997:

·         the terms of the financial arrangements (individual debts within a PDL) are such that the original creditor has determined that further efforts to collect these debts are unviable and has written off these debt as uncollectable;

·         the accepted pricing for a PDL takes into account this distressed nature of the individual financial arrangements, thereby pricing the PDLs at a deeply discounted value to what they may actually be worth;

·         the valuation techniques utilised to price a PDL also takes into account the low likelihood of recovering these individual debts, whereby the discounted rate of return accounts for the variation in an individual debtors' demographics;

·         further, the cash flow forecasting undertaken periodically will adopt commercially accepted actuarial techniques accounting for such variations;

·         the economic and commercial substance of the financial arrangement is such that the financial benefit received (that is, payment of the outstanding debt amounts) is uncertain until it is actually received by Entity X;

·         the contingencies listed above largely reflect the circumstances of the underlying debtors who are generally in a distressed position, creating uncertainties regarding payment of the outstanding debts and therefore, future cash flow for Entity X.

4.    Therefore, considering the factors outlined above in relation to subsection 230-115(3) of the ITAA 1997, we are of the view that the financial benefits that Entity X are certain to receive are considered not to be fixed or determinable with reasonable accuracy according to subsections 230-115(1) or 230-115(2) of the ITAA 1997.

5.    As such, we consider that the realisation method would be the most appropriate method for calculating the gains or losses for the PDLs of Entity X.

Question 2

Summary

6.    The method described in the private ruling application (whereby the gain or loss for a PDL is calculated by deducting the cost of acquiring the PDL from the total amount collected for the PDL) is accepted as an appropriate method to use.

Detailed reasoning

Calculating the gain or loss from a financial arrangement

7.    Section 230-10 of the ITAA 1997 states that the objects of Division 230 of the ITAA 1997 are:

(a) to minimise the extent to which the tax treatment of gains and losses from your *financial arrangements distorts, by providing inappropriate impediments and stimulation, your trading, financing and investment decisions and your risk taking and risk management; and

(b) to do so by aligning more closely the tax and commercial recognition of gains and losses from your financial arrangements in the following ways:

(i) by allocating the gains and losses to income years throughout the life of your financial arrangements on a reasonable basis;

(ii) by generally recognising gains and losses on revenue rather than capital account; and

(c) to appropriately take account of, and minimise, your compliance costs.

Realisation method

8.    Section 230-180 of the ITAA 1997 sets out sets out how you apply the realisation method to the gain or loss from a financial arrangement:

230-180(1)

If a gain or loss is to be taken into account using the realisation method, you are taken, for the purposes of section 230-15, to make the gain or loss for the income year in which the gain or loss occurs.

Note:

Sections 230-70 and 230-75 allow you to apportion financial benefits provided and financial benefits received in working out the amount of the gain or loss.

230-180(2)

For the purposes of subsection (1), a gain or loss from a * financial arrangement is taken to occur at:

(a) if the last of the *financial benefits, rights and obligations taken into account in determining the amount of the gain or loss is a financial benefit - the time the financial benefit:

(i) is provided; or

(ii) if the financial benefit is not provided at the time when it is due to be provided under the arrangement and it is reasonable to expect that the financial benefit will be provided - is due to be provided; or

(b) if the last of the financial benefits, rights and obligations taken into account in determining the amount of the gain or loss is a right to receive a financial benefit or an obligation to provide a financial benefit - the time:

(i) if the right or obligation ceases before the financial benefit is provided - the right or obligation ceases; or

(ii) otherwise - the financial benefit is provided.

This subsection has effect subject to subsection (3).

230-180(3)

For the purposes of subsection (1), you make a loss from a *financial arrangement from writing off, as a bad debt, a right to a *financial benefit (or a part of a financial benefit) if:

(a) the financial benefit was taken into account in working out the amount of a gain from the arrangement and the gain has been included in your assessable income under this Division; or

(b) the right is one in respect of money that you lent in the ordinary course of your *business of lending money; or

(c) the right is one that you bought in the ordinary course of your business of lending money.

230-180(4)

The loss referred to in subsection (3) occurs when you write off the right to the *financial benefit (or the part of the financial benefit) as a bad debt.

230-180(5)

The amount of the loss referred to in subsection (3) is:

(a) if paragraph (3)(a) applies - so much of the gain referred to in that paragraph as is reasonably attributable to the *financial benefit (or the part of the financial benefit); or

(b) if paragraph (3)(b) applies - the amount of the financial benefit (or the part of the financial benefit); or

(c) if paragraph (3)(c) applies - the amount of the financial benefit (or the part of the financial benefit) but only up to the value of the financial benefit you provided to acquire the right to the financial benefit (or the part of the financial benefit).

230-180(6)

For the purposes of this Act, a deduction for the loss referred to in subsection (3) is to be treated as a deduction of a bad debt.

Note:

Various provisions in this Act and the Income Tax Assessment Act 1936 restrict the availability of deductions for bad debts and make provision in relation to the recoupment of amounts in relation to bad debts that have been written off. These provisions are set out in subsection 25-35(5).

9.    Section 230-70 provides for how the gain or loss from a financial arrangement must be allocated in relation to its cost when a financial benefit is received:

230-70(1)

Apply subsection (2) in working out whether you make, or will make, a gain or loss (and the amount of the gain or loss) at a time when:

(a) you receive a particular *financial benefit under a *financial arrangement; or

(b) one of your rights under a financial arrangement ceases.

The gain or loss is to be calculated in nominal (and not *present value) terms.

230-70(2)

You must have regard to the extent to which the *financial benefits that you have provided, or are to provide or might provide, under the *financial arrangement are reasonably attributable, at the time mentioned in subsection (1), to the benefit or right referred to in paragraph (1)(a) or (b).

230-70(3)

Any attribution made under subsection (2) must reflect appropriate and commercially accepted valuation principles that properly take into account:

(a) the nature of the rights and obligations under the *financial arrangement; and

(b) the risks associated with each *financial benefit, right and obligation under the arrangement; and

(c) the time value of money.

Note

Generally, no financial benefit you have provided, or are to provide or might provide, under a financial arrangement is reasonably attributable to an amount you receive that is in the nature of interest.

10.  Section 230-15 of the ITAA 1997 relevantly states how a gain or loss should be included in your assessable income:

Gains

230-15(1)

Your assessable income includes a gain you make from a *financial arrangement.

Note:

This Division does not apply to gains that are subject to exceptions under Subdivision 230-H.

Losses

230-15(2)

You can deduct a loss you make from a *financial arrangement, but only to the extent that:

(a) you make it in gaining or producing your assessable income; or

(b) you necessarily make it in carrying on a *business for the purpose of gaining or producing your assessable income.

Note:

This Division does not apply to losses that are subject to exceptions under Subdivision 230-H [relating to exceptions for Division 230 of ITAA 1997].

11.  Section 230-20 of the ITAA 1997 also relevantly provides in relation to when a gain or loss should be included in your assessable income:

Application of section

230-20(1)

This section applies to the following:

(a) a gain that is included in your assessable income for an income year under [Division 230];

(b) a loss that is allowable as a deduction to you for an income year under [Division 230];...

Purpose of this section

230-20(2)

The purpose of this section is to ensure that your gains and losses, and *financial benefits, to which this section applies are taken into account only once under this Act in working out your taxable income.

Gain or loss to be taken into account only once

230-20(3)

A gain or loss to which this section applies is not to be (to any extent):

(a) included in your assessable income; or

(b) allowable as a deduction to you;...

again under [Division 230] for the same or any other income year.

230-20(4)

A gain or loss to which this section applies is not to be (to any extent):

(a) included in your assessable income; or

(b) allowable as a deduction to you;

under any provisions of this Act outside [Division 230] for the same or any other income year.

Section does not give rise to exempt income

230-20(5)

A gain is not to be treated as *exempt income merely because it is not included in your assessable income under this section.

12.  Paragraph 4.39 of the EM also provides for the recognition of gains or losses from separate financial arrangements:

If a gain or loss under a financial arrangement is subject to the realisation method, and a number of financial benefits are to be provided under the arrangement, there may be a number of separate gains or losses brought to account under that method at different points in time.

13.  Further, paragraph 4.52 of EM states in relation to when a gain or loss from a financial arrangement must be recognised that:

Gains and losses that are subject to the realisation method are recognised in the income year in which the time comes for the last of the financial benefits which are taken into account in calculating the gain or loss received or provided - or the income year in which the financial benefit is actually received or provided (that is, the time at which the gain or loss occurs for Division 230 purposes).

Applying the law to your circumstances

Realisation method

Gain or loss calculation

14.  The method outlined at paragraphs 14 - 15 (at the 'Relevant facts and circumstances' above) calculates the gain or loss for a PDL by deducting the amortisation expense of the PDL from the total collections for the PDL (noting that uncollectable debt amounts are not written off but still amortized).

15.  The amortisation expense is the cost (or purchase) price of the PDL for the purposes of the gain or loss calculation in the realisation method. The amortisation expense for a PDL is calculated at the acquisition of the PDL and reflects the aggregated present value of forecasted cash flows of the individual debts within a PDL. The calculation of an individual debts' present value must ensure that the gain or loss is accounted for in the actual year that the gain or loss is to occur, in accordance with subsection 230-180(1) of the ITAA 1997.

16.  A discounted rate of return is used to determine the present value of the forecasted cash flows of the PDL, whereby this rate is calculated by actuaries with reference to the collection history of PDLs with similar characteristics.

17.  The total collections for a PDL are the actual amounts received as payment in respect of each individual debt within a PDL and which is aggregated to give the PDL 'total collections' figure. Similarly, the total cost of the PDL is the aggregate of what is owing in respect of each individual debt within a PDL. This is consistent with the interpretation expressed in paragraph 4.39 of the EM regarding accounting for a number of gains or losses under the realisation method at different points in time.

Attribution of gain or loss to correct time period

18.  According to section 230-70 of the ITAA 1997, Entity X must ensure that the financial benefits received from each of the individual debt repayments are attributed to the correct time period (of receipt) and only accounted for once.

19.  Entity X ensures that it complies with section 230-70(3) of the ITAA 1997 relating to the allocation of the cost of a PDL to the proceeds from the PDL to reasonably reflect the appropriate and commercially accepted valuation techniques, by accounting for:

·                     the nature of the rights and obligations under the financial arrangement by aggregating the amounts received in respect of each individual debt within a PDL. This aggregated figure is reported by Entity X for taxation purposes as it represents the appropriate amount in 'proceeds' for the financial arrangement;

·                     the risks associated with each of the rights and financial benefits under the financial arrangement using:

-                    an expected rate of return which has been calculated by reference to historic PDLs with similar characteristics;

-                    an initial cash flow forecast (which is used to determine the purchase price for a PDL) that takes into consideration the underlying associated risks of the constituent individual debts and uses commercially accepted actuarial techniques;

·                     the time value of money by calculating the purchase price of the PDL based on the expected future monthly cash flows from a PDL (by aggregating the amount collected from each individual debt within the PDL), and subsequently discounting this aggregate PDL collection amount by the expected rate of return for the PDL. This PDL purchase price amount is then proportionally allocated to each of the debts within a PDL, over the duration of the PDL, and this is the figure used to calculate the gain or loss from each of the individual debts. Although this is currently done by Entity X at a PDL level, it is able to be mirrored at an individual debt level and should not yield a materially different result.

20.  Consistent with sections 230-15 and 230-20 of the ITAA 1997, once the gain or loss from a PDL is calculated, Entity X must report this amount once as either income or an allowable deduction provided that the gain or loss is incurred during the course of its ordinary business operations.

21.  Therefore, we consider that it is open for Entity X to utilise the realisation method in calculating the gains or losses arising from the PDLs as this method most accurately captures how and in which time period the gain or loss is incurred.

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