Edited version of private advice

Authorisation Number: 1052113556459

Date of advice: 5 May 2023

Ruling

Subject: Assessable income - method of calculating profit

Question 1

Can you calculate your taxable income from the insurance trail commissions on a profit emerging basis?

Answer

Yes

Question 2

If so, on what basis is the emerged profit calculated? Can you use straight line amortisation on the relevant proportion of the cost?

Answer

Yes. Any method will suffice so long as it produces a substantially correct reflex of the taxpayer's true assessable income.

This private ruling applies for the following period:

Year ended 30 June 20XX to 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The taxpayer is a company that carries on the business of financial planning.

Financial planners may be paid commissions (upfront and trailing) by institutions based on client investments. The financial planner's entitlement to the trailing commission arises when the investment is made and settled. It is calculated each month as a percentage of the average monthly balance of the investment while it is in place.

Pursuant to a Contract for Sale of Client Portfolio (the Contract), the taxpayer purchased the rights and obligations attaching to the client portfolio (listed in the annexure of the Contract) of the seller who also carried on the business of financial planning.

The Contract provides that the rights and obligations of the Client Portfolio includes trail commissions paid or payable for the clients. The Client Portfolio list comprise the details of the client and the investments made on which commissions will be paid.

The trailing commissions are paid monthly under an arrangement whereby an independent service provider, for a fee, aggregates and collects the commission due to each insurance broker on its behalf.

There are no regulatory restrictions on the acquisition of trailing commissions or client lists. There is a requirement by the institutions paying the commissions that the purchaser holds the right qualifications to provide financial advice and have appropriate professional indemnity insurance.

The taxpayer negotiated the purchase price with the seller considering factors such as the amount likely to be received and the time value of money.

The acquisition of the client book totalled $X.

An analysis of the client book showed that $Y of the previous 12 months revenue, to which the purchase price was decided upon at a multiple of Z, relates to ongoing trail commissions. Therefore, the taxpayer has apportioned the purchase price on the basis that Z × Y is the cost of the trail commissions in which to amortise.

The remaining amount relates to fee for service clients which taxpayer have treated as goodwill on the balance sheet and not amortised, as these clients require ongoing engagement to maintain the income stream.

Based on industry comparisons, insurance policies to which the book comprises, generally lapse at a rate of 15%. Trailing commissions are thus, on average, payable each month for 6.67 years (7 years, rounded).

The taxpayer is not related to the vendor from which it has acquired the trail commissions and client list.

The taxpayer's intention in respect of the acquired trail commissions and client list is to retain the entitlement to collect the commissions.

The taxpayer is not and never have been and has no intention of being in the future, in the business of trading in commission trails and client lists.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Reasons for decision

Question 1

Detailed reasoning

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 [2005] HCA 21, the majority judgment of the High Court at [8] 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.

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 accordance with ordinary concepts.

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 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.

ATO Interpretative Decision ATO ID 2008/39 Income Tax Acquisition of debt ledgers (ATO ID 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 acquiring and recovering receipts from abandoned debt ledgers. Although you do not carry on a business of acquiring debt ledgers, 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.

Application to your circumstances

Upon entering into the agreement to acquire the trailing commissions, you acquired 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. 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.

In determining its profit for accounting purposes, it is appropriate that the taxpayer amortises the cost of the trail commissions. 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.

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

Question 2

As discussed above paragraph 17 of TR 98/1 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.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).