Edited version of private advice

Authorisation Number: 1051801241739

Date of advice: 28 April 2021

Ruling

Subject: Income and deductions

Question 1

Is the refundable portion of fees received by Company X from Members ordinary income derived by Company X pursuant to section 6-5 of the Income Tax Assessment Act 1997?

Answer

Yes.

Question 2

Is the refundable portion of fees received by Company X from Members a loss or outgoing incurred by Company X when fees are received pursuant to section 8-1 of the Income Tax Assessment Act 1997?

Answer

No.

This ruling applies for the following periods:

The income years ending 30 June 2020 and 30 June 2021.

The scheme commences on:

The date the refund agreement is entered by Company X and Company Y.

Relevant facts and circumstances

Company X provides systems to its members in accordance with its Constitution and governing documents.

Company X charges fees to members for the use of its systems and provides refunds to members if they complete certain behaviours.

Company X entered a refund agreement with Company Y setting out the behaviours that must be met before any refund will be granted and the value of any refund, which is capped at the amount of fees paid to Company X by Company Y. The behaviours include promoting and utilising Company X's system, and creating, marketing and implementing enhancements to infrastructure relating to Company X's system.

Company X has a Rebate/Refund Policy which provides that any refund is at the discretion of Company X and depends on Company X being satisfied that Company Y has completed the required behaviours, and any refund will not materially affect its overall financial position.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Question 1

Is the refundable portion of fees received by Company X from Members ordinary income derived by Company X pursuant to section 6-5 of the Income Tax Assessment Act 1997?

Assessable income

Under subsection 6-5(1), 'assessable income' includes income according to ordinary concepts (called 'ordinary income').

Under subsection 6-5(2), the assessable income of an Australian resident includes the ordinary income it derives directly or indirectly from all sources, whether in or out of Australia, during the income year.

In the absence of a specific definition of 'income', the courts have used the common law to determine what the term 'income' means, that is, income according to ordinary concepts (Scott v Commissioner of Taxation (1935) 35 SR (NSW) 215 at 219). An early conception of income is provided in Tennant v Smith [1892] AC 150 at 164: '...what comes into [the] pocket'.

In Federal Commissioner of Taxation v. Myer Emporium Ltd (1987) 163 CLR 199 at 215; 71 ALR 28 at 36 it is stated:

The periodicity, regularity and recurrence of a receipt has been considered to be a hallmark of its character as income in accordance with the ordinary concepts and usages of mankind.

The characterising of income according to ordinary concepts as having elements of periodicity, recurrence or regularity holds even if the receipts are not directly attributable to services rendered.

In the present case Company X receives fees monthly based on Company Y's monthly transaction volume.

In Allied Mills Industries Pty Ltd v Federal Commissioner of Taxation (1988) 83 ALR 368 at 380, Gummow J provides:

It also has to be borne in mind that whilst periodicity, regularity and recurrence of a receipt have been considered as a hallmark of its character as income in accordance with the ordinary concepts and usages of mankind, the significance of these considerations is diminished when the receipt in question is generated in the course of carrying on a business; that circumstance in itself is "a fact of telling significance"; nor does it detract from that significance that the particular transaction is unusual or extraordinary, judged by reference to the transactions in which the taxpayer usually engages, provided it is entered into in the course of carrying on the taxpayer's business: FCT v Myer Emporium Ltd (1967) 163 CLR 199 at 215; 71 ALR 28 at 36.

In the present case, Company X receives fees regularly (generally monthly) in the course of carrying on its business. The regularity and recurrence of Company X's receipt of fees and the fact that the fees are received in the course of carrying on a business indicate that the fees are income according to ordinary concepts (ordinary income).

Derivation of income

According to Taxation Ruling TR 2014/1 Income tax: commercial software licencing and hosted agreements: derivation of income from agreements for the right to use proprietary software and the provision of related services:

5. Where an amount properly attributable to a contractual obligation is subject to a 'contingency of repayment', the amount is derived for the purposes of section 6-5 of the ITAA 1997 when the obligation is fully performed or the contingency of repayment otherwise lapses.

6. In this Ruling, a 'contingency of repayment' in the event of future non-performance refers to there being either:

(i) a contractual obligation to make a refund;

(ii) a demonstrated commercial practice to make a refund; or

(iii) contractual exposure exists for damages in respect of the non-performance.

8. When the underlying obligation is fully performed, or the contingency of repayment otherwise lapses, the amount properly allocated to the obligation converts from 'unearned' income' to 'earned income' in the sense contemplated in Arthur Murray (NSW) Pty Ltd v. FCT (1965) 114 CLR 314; (1965) 14 ATD 98; 9 AITR 673 (Arthur Murray).

136. Ordinary income is derived when a gain has 'come home' to the taxpayer in a realised or immediately realisable form (CT v. Executor & Trustee Agency Co of South Australia (1938) 63 CLR 108 (Carden's case)).

137. For an accruals based taxpayer, a gain has 'come home' when a recoverable debt has been created. In establishing if a recoverable debt has been created it is necessary to determine whether there are further steps to be taken before the taxpayer becomes entitled to payment (Gasparin v. Commissioner of Taxation (1994) 50 FCR 73; 94 ATC 4280; (1994) 28 ATR 130, Farnsworth v. Federal Commissioner of Taxation (1949) 78 CLR 504; (1949) 9 ATD 33; Henderson v. Federal Commissioner of Taxation (1970) 119 CLR 612; 70 ATC 4016; (1970) 1 ATR 596; J Rowe & Son Pty Ltd v. Federal Commissioner of Taxation (1971) 124 CLR 421; 71 ATC 4157; (1971) 2 ATR 497).

138. Whether there is, in law, a recoverable debt is a question to be determined by reference to the contractual agreements that give rise to the legal entitlement to payment, the general law and any relevant statutory provisions.

146. It is only in cases where a relevant contingency exists in relation to the unqualified retention of the fee in whole or in part, that deferral may be valid for income tax purposes. Where no relevant contingency exists, the amount is derived when a recoverable debt arises in respect of the contractual fee.

149. The principle considered in Arthur Murray was:

whether, in the circumstances, it may properly be held that receipt without earning makes income (Arthur Murray 114 CLR 314 at 317-8 per Barwick CJ, Kitto and Taylor JJ).

150. The context was whether income received for contractual obligations yet to be performed were income.

Company X provides its system to Company Y and invoices monthly for use of the system. Invoices are paid with reference to the number of transactions utilising the system made by Company Y in the preceding month. Thus, no further service is required to be provided by Company X in respect of fees received pursuant to each monthly invoice.

Therefore, Company X circumstances are distinguishable from Arthur Murray as there is no contractual obligation to which the fees can be attributed which is yet to be performed.

Accordingly, the income has been earned by Company X at the time that Company Y utilises Company X's systems. Therefore, the fee income is derived at the time of the transaction being completed on Company X's system.

Question 2

Is the refundable portion of fees received by Company X from Members a loss or outgoing incurred by Company X when fees are received pursuant to section 8-1 of the Income Tax Assessment Act 1997?

When is expenditure incurred for the purposes of section 8-1?

Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions provides the Commissioner's view on the meaning of the term 'incurred' with respect to section 8-1.

Broadly, an outgoing is incurred at the time that you owe a presently existing liability that cannot be escaped. However, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected.

The authorities are provided at paragraphs 16 to 20 of TR 97/7, reproduced (in part) below:

16. The courts have been reluctant to attempt an exhaustive definition of a term such as 'incurred'. The following propositions do not purport to do this, they help to outline the scope of the definition. The following general rules, settled by case law, assist in most cases in defining whether and when a loss or outgoing has been incurred:

(a) a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing. That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum;

(b) a taxpayer may have a presently existing liability, even though the liability may be defeasible by others;

16. A loss or outgoing may be incurred for the purposes of section 8-1 even though no money has actually been paid out. In W Nevill & Company Ltd v. FC of T (1937) 56 CLR 290 at 302 it was said:

'the word used is 'incurred' and not 'made' or 'paid'. The language lends colour to the suggestion that, if a liability to pay money as an outgoing comes into existence, [the section is satisfied] even though the liability has not been actually discharged at the relevant time... it is only the incurring of the outgoing that must be actual; the section does not say in terms that there must be an actual outgoing - a payment out.'

(See also New Zealand Flax Investments Ltd v. FC of T (1938) 61 CLR 179 at 207 (New Zealand Flax); FC of T v. James Flood Pty Ltd (1953) 88 CLR 492 at 506 (James Flood); Nilsen Development Laboratories Pty Ltd & Ors v. FC of T (1981) 144 CLR 616 at 624 (Nilsen Development Laboratories); FC of T v. Firstenberg 76 ATC 4141 at 4148; (1976) 6 ATR 297 at 305.)

17. This proposition was recently confirmed by the High Court in FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52 (Energy Resources) when, quoting from James Flood, it said (ATC at 4539; ATR at 56):

'Section 51(1) "has been interpreted to cover outgoings to which the taxpayer is definitively committed in the year of income although there has been no actual disbursement".'

18. The liability must be 'more than impending, threatened or expected' - refer New Zealand Flax (CLR at 207). '[W]hat is clearly necessary is that there should be a presently existing liability' - Nilsen Development Laboratories (CLR at 624). It is not a presently existing liability if it is contingent - refer James Flood (CLR at 506); Nilsen Development Laboratories (CLR at 207); Marbren Pty Ltd v. FC of T 84 ATC 4783 at 4788-4789; (1984) 15 ATR 1145 at 1152.

19. A taxpayer can be completely subjected to a liability even though it is defeasible by others - refer Commonwealth Aluminium Corporation Ltd (77 ATC 4151 at 4161; (1977) 7 ATR 376 at 386).

20. But, it is to be emphasised that the taxpayer must be definitively committed to the outgoing, even though it may be defeasible. A taxpayer who takes goods on approval for example could not be said to be definitively committed to their purchase.

Accordingly, where the liability is impending, threatened or expected, or is contingent on a future event, it is not a presently existing liability.

However, the fact that a liability is contingent may not prevent the liability from being incurred if the contingency is merely theoretical. A contingency may be theoretical where the contingency can be treated as certain to be satisfied (see Coles Myer Finance Ltd v FCT (1993) 93 ATC 4214).

In the present case, a presently existing liability to refund a portion of the Scheme Fees only arises when Company Y satisfies certain conditions such as promoting and utilising Company X's system, and creating, marketing and implementing enhancements to infrastructure relating to Company X's system. These conditions are more than merely theoretical.

Accordingly, a deduction cannot be claimed under section 8-1 for the refundable portion of fees at the time of entering the refund agreement or on receipt of the fees because a presently existing liability does not exist at that time and therefore no loss or outgoing has been incurred.

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