Edited version of private advice

Authorisation Number: 1051811749455

Date of advice: 9 March 2021

Ruling

Subject: Profit emerging basis for calculating income

Question

Will the Commissioner allow Company A to account for profits relating to the income streams purchased under the Sale and Purchase Agreement on a profit emerging basis?

Answer

Yes

This ruling applies for the following periods:

Year ending 30 June 2021

Year ending 30 June 2022

Year ending 30 June 2023

Year ending 30 June 2024

Relevant facts and circumstances

Company A operates within a group of companies.

Company A carries on an investment activity in which it purchases rights to income streams associated with financial planning clients for the purpose of generating overall profit from the acquisition of those rights. Separately, it carries on a financial planning business where it provides financial advice and services.

Company A is not in the business of buying and selling the rights to income streams. It buys the rights to make a taxable revenue profit.

As part of its investment activities, Company A entered into a Sale and Purchase Agreement with Company B as the Seller and Entity C as the Covenantor (the Agreement) for the purchase of assets, including:

•         all rights to provide the financial services, provided by the Seller at the time of entering into this Agreement, to the clients listed in the Agreement;

•         the client information (meaning the records held by the Seller in respect of those clients);

•         the client list;

•         the income streams (meaning all commissions and other income streams payable in respect of those clients);

•         all servicing rights attached to the clients; and

•         the client files (meaning all records etc. in possession of or under the control of the Seller in respect of those clients).

The Agreement was not for the purchase of a going concern business but for the assets.

The role of the Covenantor is stated as the party that has agreed to guarantee the performance of the Seller's obligations under the Agreement.

To transition the clients to Company A, Entity C will provide services to Company A for a service fee (payable to Entity C) at an hourly rate.

The purchase price under the Agreement is the lower of:

•         the valuation of the income streams, valued as at 30 June 20XX; or

•         the revised purchase price which takes into account loss of income because of clients disengaging from Company B.

Company A is to pay the purchase price across x number of instalments at specified dates.

The purchase price under the Agreement is very tightly tied to the value of the ongoing income streams which Company A will be eligible to collect as a result of the Agreement. Company A considers that the purchase price paid is attributable to the income streams acquired and the rights associated with those income streams. The balance of the assets acquired under the Agreement are assessed to have minimal to no value in their own right.

Company A has entered the Agreement on the basis that it expects to make a profit (the difference between the purchase price and the income streams collected) from the client list. The other assets purchased are expected to facilitate Company A being able to provide appropriate future financial advice to the client list (as a separate fee for service arrangement).

The income stream is not a reward for the provision of professional services provided by Company A.

The income streams paid to Company A do not take the form of, or are a substitute for, a fee for any services provided by Company A.

There are no additional fees charged to clients for activities relating to the income streams purchased under the Agreement.

The value of the income streams purchased under the Agreement will progressively decrease and over time the market value of those rights will reach zero when no further income streams/fees are received in connection with that asset. There are various reasons for this natural attrition, supported by industry specific information.

The receipts of income streams and fees by Company A will comprise a return in the form of a recovery of its investment and a profit/income component.

Company A has calculated the expected revenue from the income streams over their expected lifetime to be approximately $ABC. Taking into account the purchase price of $DEF, net profit is estimated to be approximately $XYZ.

Where a client listed in the Agreement obtains/purchases further and additional financial products or services from Company A, such that it is unrelated to the income stream purchased under the Agreement, the income derived from those additional financial products and services is not covered in this ruling. All income derived by Company A that are unrelated to the income streams purchased will be ordinary business income (even where it pertains to the clients listed in the Agreement).

Relevant legislative provision

Income Tax Assessment Act 1997 Section 6-5

Reasons for decision

Summary

The Commissioner will allow Company A to account for profits relating to the income streams purchased under the Agreement on a profit emerging basis.

Detailed reasoning

Section 6-5 of the Income Tax Assessment 1997 (ITAA 1997) provides, that an Australian resident must include in assessable income the ordinary income it derives from all sources. Ordinary income is income according to ordinary concepts.

Upon entering into the agreement to acquire the income streams, Company A acquired a legal chose in action giving it the right to receive a sum of money. The transaction was entered into with the expectation of making a profit where the proceeds of collection exceed the cost of the acquired right.

The consideration paid on acquisition of the right (i.e. the purchase price), is funded by capital being either debt, equity or a mixture of both. Any receipts from collections therefore comprise a return in the form of a partial recovery of its investment (a return of capital) and a profit component.

Company A's receipts from the income streams acquired do not represent ordinary income. They are receipts of money, rather than ordinary income, which incorporate a mix of returned capital and profit.

Taxation Ruling 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 relevantly states the following at paragraph 17:

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.

For the purposes of section 6-5 of the ITAA 1997 a number of cases have determined that gross income, or ordinary income, equates with net profits. As referred to by Hill J in Federal Commissioner of Taxation v. Citibank Limited & Ors (1993) 44 FCR 434; (1993) 93 ATC 4691; (1993) 26 ATR 557, a necessary requirement of bringing a net profit into assessable income is that the gross amounts used to calculate that net profit was not itself income in ordinary concepts.

In collecting money from the income streams it purchased, Company A recovers its capital and, in part, realises a profit. If it fails to recover its capital, it incurs a loss. Therefore, only part of the receipts could be considered income. As such, the gross receipts used in the calculation of net profit are themselves not ordinary income.

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 in circumstances where a taxpayer was assigned debts at a 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, Company A amortises the cost of the income streams it acquired. Company A does not calculate its profit or loss by deducting from the year's collections the total cost it outlays in acquiring the income streams for that year, for that would distort its true position for that year. Instead, Company A's profits are effectively determined on an emerging basis taking into account that portion of the cost relevant to the acquisition of the income stream rights that result in collected income over the period, as per the calculation method in the Agreement.

Here, the company's profit-making scheme extends over more than one income year. The bringing to account for tax purposes of the difference between receipts and disbursements in any one particular income year will not give a true reflection of the profit or loss sustained for that year. The assessment of profit under section 6-5 of the ITAA 1997 on an emerging profit basis is therefore considered the most appropriate in determining the income for taxation purposes.

Note: The Commissioner does not have a preferred method that should be adopted when using the profit emerging basis of assessment of income. Any method will suffice so long as it produces a substantially correct reflex of the taxpayer's true assessable income. Whether a method gives a substantially correct reflex and therefore is appropriate is a conclusion to be made from all the circumstances relevant to the taxpayer and the income.

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