Edited version of private advice

Authorisation Number: 1052378965147

Date of advice: 17 April 2025

Ruling

Subject: Assessable income

Question 1

Is a profit emerging basis the appropriate method of determining Company's assessable income for the purposes of section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) for trailing commissions received from purchased mortgage books?

Answer 1

Yes - and the emerging profits formula is appropriate basis for determining Company's assessable income for the purposes of section 6-5 of the ITAA 1997.

This ruling applies for the following periods:

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

1.              Company is an Australian resident private company, which operates a mortgage broking business.

2.              On xx xx xxxx, Company entered into a contract for the purchase of business assets from an unrelated party.

3.              The contract was completed (settled) on xx xx xxxx.

4.              Under the business purchase agreement, Company acquired the right to receive 'trailing commissions' from mortgage books that were held by the vendor prior to the sale (the Trailing Commissions Book).

5.              The price paid for the Trailing Commissions Book was defined in the purchase contract.

6.              The amount paid by Company on completion of the purchase was $xx.xx.

7.              Company will determine its assessable income for the purposes of section 6-5 of the ITAA 1997 on a profit emerging basis using the following emerging profits formula - allocation of cost of the Trailing Commissions Book to the income derived for that income year from the Trailing Commissions Book:

A - (A x B/C)

Where:

A = Collections from the Trailing Commissions Book for the income year.

B = Cost of the Trailing Commissions Book.

C = Total anticipated collections from the Trailing Commissions Book.

The result of this calculation is the amount of assessable income for the financial year and the remainder of the collection received is a return of capital.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Reasons for decision

Determining assessable income from the Trail Book

Subsection 4-15(1) of the Income Tax Assessment Act 1997 (ITAA 1997) states that your taxable income for the income year equals your assessable income for the income year less deductions for that year.

Section 6-5 of the ITAA 1997 provides that if you are an Australian resident your assessable income includes the ordinary income you derived from all sources during the income year. 'Ordinary income' is income according to ordinary concepts.

In Federal Commissioner of Taxation v. Stone [2005] 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.

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 (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 according to ordinary concepts.

Upon entering into the agreement to acquire the Trailing Commissions Book, Company acquired a legal chose in action giving it the right to receive trailing commissions. Company entered into the transaction with the expectation of making a profit where the proceeds of collection exceed the cost of the acquired right to receive the trailing commissions. The consideration paid to acquire the right to trailing commissions 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's receipts from its collection activities do not represent ordinary income. They are receipts of money, rather than ordinary income, which incorporate a mix of returned capital and 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.

Substantially correct reflex of income

Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings (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, paragraph 17 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 Hill J, in considering the relevance of accounting evidence in determining income tax issues, 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 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.

Company's profit-making scheme extends over more than one income year, therefore the bringing to account for tax purposes of the difference between receipts and disbursements in any one particular income year may not give a true reflection of the profit or loss sustained for that year.

To determine its profit for accounting purposes, it is appropriate that Company amortises the cost of acquiring the trailing commissions. To calculate its profit or loss by deducting the total cost from the year's collections for that year would distort its true position for that year. Instead, its profits are more appropriately determined on an emerging basis taking into account that portion of the acquisition cost that results in trailing commission collections in the period.

The 'profit emerging basis' is an appropriate method in determining Company's profit and assessable income from the right to receive trailing commissions from the Trailing Commissions Book for the purposes of section 6-5 of the ITAA 1997.

There is not a preferred method that should be adopted when using the emerging profits basis of assessment of income. Any method will suffice so long as it produces a substantially correct reflex of the entity's true assessable income.

For the purposes of calculating the net profit in respect of commissions from the Trailing Commissions Book on an emerging profits basis of assessment the emerging profits formula may be used. This method of calculating net profit arising from the acquisition of the Trailing Commissions Book provides a substantially correct reflex of Company's true assessable income for the purposes of section 6-5 of the ITAA 1997.

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