Edited version of private advice

Authorisation Number: 1051923987349

Date of advice: 19 November 2021

Ruling

Subject: Income tax - profit emerging basis and CGT

Question 1

Will the Commissioner of Taxation allow the Taxpayer to calculate its taxable income, consisting of annual and trailing commissions received from purchased trailing commission rights, on a profit emerging basis?

Answer

Yes

Question 2

Where the Taxpayer has forfeited, surrendered or abandoned its rights to trailing commission, will the Taxpayer be able to record a capital loss to the extent that the reduced cost base of the trailing commissions exceed the amount that was received when the rights were forfeited, surrendered or abandoned?

Answer

Yes

This ruling applies for the following periods:

For a number of income years commencing in the income year ending 30 June 20XX

The scheme commences on:

In the year ended 30 June 20XX

Relevant facts and circumstances

1.               The Taxpayer (You), provides financial solutions to individuals, families and businesses.

2.               In the ordinary course of your business of providing financial services to your clients You purchased rights to trailing commissions for the purpose of generating an overall profit from the acquisition and use of those rights.

3.               The trailing commissions You acquired the rights to all were arranged such that the institution that issued the policy, account or loan would then pay an amount to You (based on a formula per policy type and per institution) on the basis that You are the holder of the rights.

4.               You purchased the trailing commissions on a specific date at a purchase price of $X.

5.               The acquisition of the rights to trailing commission was financed by You through borrowings from financial institutions.

6.               Where interest was charged on those loans this gave rise to a requirement to pay interest and an income tax deduction was claimed against assessable income for the interest paid to finance the acquired rights.

7.               Considering the price paid for the trailing commissions it was expected that at the time that the rights were acquired it may take some time to break-even (on a cash-flow basis) on the acquisition of the rights.

8.               It would only be after that time that a cash profit could be generated from the acquisition of the rights to the trailing commission.

9.               The value of rights to trailing commissions progressively decreases over time and the market value of the rights will reach zero when no further commissions or fees are received from holding those rights.

10.            After purchasing the rights to the trailing commission, You used the rights for a short time to generate a profit each year.

11.            Over time, after the rights had been purchased, the original policies and products were cancelled, and regulator's policies have sought to have commission based fees removed. As a result, You expected the capacity of those rights to generate cash flow to be exhausted and the market value of those rights to reduce to zero.

12.            Soon after You purchased the trailing commissions, You commenced converting the clients on trailing commission arrangements to charging them a fee for the services provided. The conversion of clients was done progressively and over a certain number of years.

13.            When You converted clients from trailing commission arrangements to fee for service arrangements You suffered a financial loss having paid an amount for the trailing commissions but then progressively abandoning them after You acquired them.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 20-25

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 108-5(1)

Income Tax Assessment Act 1997 section 109-5

Income Tax Assessment Act 1997 subsection 110-45(3)

Reasons for decision

Question 1

Summary

You can calculate your taxable income, consisting of annual and trailing commissions received from purchased trailing commission rights, on a profit emerging basis.

Detailed reasoning

Nature of the rights

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

In Federal Commissioner of Taxation v. Stone 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.

Upon entering into the agreement to acquire the trailing commissions, you acquired a legal chose in action giving you 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 would eventually exceed the costs of acquiring the right to receive the trailing commission. The consideration paid on acquisition of the right was funded by capital, being debt in the form of borrowings. Any receipts from collections therefore do not represent ordinary income. They are receipts of money, rather than ordinary income, which incorporate a mix of returned capital and a profit component.

For the purposes of section 6-5 of the ITAA 1997 (formerly subsection 25(1) of the Income Tax Assessment Act 1936) 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 ( Citibank ), 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 in respect of the outstanding trailing commissions, you recover your capital and, in part, realise a profit. If you fail to recover your capital, you incur 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.

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 Citibank, in considering the relevance of accounting evidence in determining income tax issues, Hill J referred to the judgments in Commissioner of Taxes (SA) v. Executor Trustee & Agency Company of South Australia (1938) 63 CLR 108; (1938) 5 ATD 98; (1938) 1 AITR 416 (Carden's case) and Arthur Murray (NSW) Pty Ltd v. Federal Commissioner of Taxation (1965) 114 CLR 314; (1965) 14 ATD 98; 9 AITR 673, where it was held that such evidence is relevant and can be used to provide evidence of what constitutes income. Hill J said that 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, (XCO) the High Court considered the application of a profit emerging basis, in circumstances similar to the present case, 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 ATO Interpretative Decision ATOID 2008/39 Income Tax Acquisition of debt ledgers (ATOID 2008/39) confirms that a profit emerging basis is the appropriate method of determining assessable income under section 6-5 of the ITAA 1997 for taxpayers who carry on a business of debt acquisition and recovery. Although you do not carry on a business of acquiring debt ledgers from credit providers who have abandoned their recovery like the taxpayer in ATO ID 2008/39, the principles discussed can be applied to your situation. ATOID 2008/39 states:

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

For accounting purposes, the taxpayer does not treat the acquired debt at actual cost but on a fair value basis with benefits to be received over income years. That is, the taxpayer does not expense the acquisition cost at the time of acquisition. The release of any fair value gains backed up by actual cash receipts and conversely with any impairment may properly be aligned with t/he approach in emerging profit.

ATO ID 2008/39 then refers to Gibbs J's judgement from XCO as discussed above and concludes:

Here, the taxpayer's profit making scheme extends over more than one income year. The bringing to account for tax purposes 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 on an emerging basis is considered most appropriate in determining its income for tax purposes.

Similarly, your profit making scheme extends over more than one income year and the bringing to account for tax purposes 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.

As such, the assessment of profit under section 6-5 of the ITAA 1997 on an emerging profit basis is therefore considered to be the most appropriate in determining the income for taxation purposes.

Method of calculating the emerging profit

As discussed above paragraph 17 of TR 98/1 provides guidance on the accounting method likely to provide a substantially correct reflex of income in a relevant year and states that 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.

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.

Possible methods that could be adopted include the straight line, the first in/first out (FIFO) methodologies and a formula used in the calculation of income from debt ledgers: A - (A x B/C). Where A = Collections from the ledger; B = Cost of the ledger; and C = Total anticipated collections from the ledger.

Question 2

Summary

Each time you converted an existing right to trailing commission client, to a fee for service client CGT event C2 occurred. Where the capital proceeds from the ending are more than the cost base a capital loss occurred.

Detailed reasoning

Capital Gains Tax asset

According to subsection 108-5(1) of the ITAA 1997 a CGT asset is any kind of property, or a legal or equitable right that is not property.

As discussed in question 1 above, when the agreement to acquire the trailing commissions was entered, you acquired a legal chose in action giving you the right to receive a sum of money. The transaction was entered with the expectation of making a profit where the proceeds of collection would eventually exceed the costs of acquiring the right to receive the trailing commission.

Therefore, the right is a legal right which is not property and is viewed as a capital gains tax (CGT) asset under section 108-5 of the ITAA 1997.

Taxation Ruling TR 2000/1 Income tax: insurance registers (TR 2001/1) provides guidelines on the taxation consequences of acquiring or disposing of an insurance register. For the purposes of the ruling an insurance register is a record of the rights of an insurance agent to future commissions and a record of policyholders that an agent has an exclusive right to deal with on behalf of an insurance company. TR 2000/1 considers that an insurance register is a capital asset where it is held as part of the profit making structure of a business.

The rights to trailing commissions are comparable to insurance registers. As the trailing commissions you own form part of the profit yielding structure of your business we consider them to be CGT assets.

Cost base of the rights

Section 109-5 of the ITAA 1997 states that you acquire a CGT asset when you become its owner. According to the table set out in section 109-5, CGT event A1 occurs when an entity disposes of a CGT asset to you. You acquire the asset when the disposal contract is entered into or, if not, when the entity stops being the assets owner.

Division 110 of the ITAA 1997 describes that the cost base of a CGT asset includes five elements:

1.               Money paid or property given for the CGT asset.

2.               Incidental costs of acquiring the CGT asset or that relate to the CGT event.

3.               Costs of owning the CGT asset.

4.               Capital costs to increase or preserve the value of your asset or to install or move it.

5.               Capital costs of preserving or defending your title or rights to your CGT asset.

Subsection 110-45(3) of the ITAA 1997 provides that where the costs of acquiring the rights are recouped then the cost base will be reduced to the extent of the recoupment.

Section 20-25 of the ITAA 1997 defines a recoupment to be any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery, however described, and a grant in respect of the loss or outgoing.

Therefore any recoupment of the cost of acquiring the rights would give rise to a reduction in the cost base of the rights.

CGT event C2

CGT event C2 is described in as follows:

Cancellation, surrender and similar endings: CGT event C2

(1)             CGT event C2 happens if your ownership of an intangible *CGT asset ends by the asset:

(a)             being redeemed or cancelled; or

(b)             being released, discharged or satisfied; or

(c)             expiring; or

(d)             being abandoned, surrendered or forfeited; or

(e)             if the asset is an option - being exercised; or

(f)              if then asset is a *convertible interest - being converted.

(2)             The time of the event is:

(a)             when you enter into the contract that results in the asset ending; or

(b)             if there is no contract - when the asset ends.

(3)             You make a capital gain if the *capital proceeds from the ending are more than the asset's *cost base. You make a capital loss if those capital proceeds are less than the assets *reduced cost base.

Each time you converted an existing right to trailing commission client to a fee for service client CGT event C2 occurred. Where the capital proceeds from the ending are more than the cost base a capital loss occurred.

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