Edited version of private advice

Authorisation Number: 1052400848284

Date of advice: 26 May 2025

Ruling

Subject: Profits emerging formula

Question:

Will the Commissioner allow the Company to continue to apply the profits emerging formula to distinguish between profit and a return of capital in relation to the purchase of rights to income streams from DD MM YYYY until the cost base of the capital asset is reduced to nil?

Answer:

Yes

This ruling applies for the following periods:

DD MM YYYY to DD MM YYYY

The Scheme commenced on:

DD MM YYYY

RELEVANT FACTS AND CIRCUMSTANCES

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect, and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Extension of previous ruling

1.      The Company applied for a private ruling on DD MM YYYY regarding the purchase of rights to income streams in relation to a specified client list from AAA. This private ruling was published by the ATO in the Edited Private Rulings Register.

2.      The Company had sought a private ruling on the question 'Will the Commissioner allow the Company to account for profits relating to the income streams purchased under the Sale and Purchase Agreement on a profit emerging basis?'

3.      The Company had asked for the private ruling to cover the period from DD MM YYYY until DD MM YYYY (a total of x years).

4.      The Company has now requested that the previous private ruling be extended to cover the period DD MM YYYY until DD MM YYYY (a total of x years).

Background Information

5.      The Company operates within a group of companies known as the XXX Group, which which includes EEE, FFF (providing a managed account platform available to financial planners) and GGG (which is the holding company of the operating entities and is involved in other investment opportunities).

6.      The Company has been providing financial solutions to individuals, families and businesses since YYYY.

7.      The Company has grown rapidly since YYYY.

8.      Part of the strategy for this growth since YYYY has involved purchasing client lists with associated income stream rights.

9.      The Company 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.

10.   In addition to the acquisition of rights to income streams, the Company also carries on a financial planning business, where it provides financial advice and related services relating to investment strategy, portfolio selection and insurance, for which it derives separate income.

11.   The Company is not in the business of buying and selling the rights to income streams. The Company purchases income streams for the purpose of generating a taxable revenue profit.

12.   As part of its investment activities, the Company entered into an asset sale and purchase agreement (the Agreement) with AAA (the Seller) and ZZZ (the Covenantor) in MM YYYY, for the purchase of the client list and associated income streams for a specific list of clients, which included the following assets:

•           all rights to provide the financial services, provided by the Seller at the time of entering into the 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

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

•           the accrued rights (referring to all rights attaching to or arising from the assets on or after DD MM YYYY)

13.   The asset sale agreement was not for the purchase of a going concern business, but for the assets.

14.   The purchase price as per the Agreement was determined as the lower of:

•           the valuation in Schedule 1 (the annualised expected revenue to be earned from the clients, multiplied by the multiple of 3.2), valued as at the Valuation Date, or

•           the revised purchase price as at each determination date (5 days before each instalment date).

15.   The purchase price was agreed to be paid in x equal instalments.

16.   Further, the revised purchase price is defined as the original valuation, less any reduction to the original valuation as a result of any 'Lost Client FUM' (Funds Under Management) and any 'Net Withdrawals' applying to the methodology in Schedule 1 to the Agreement.

17.   'Lost client FUM' is defined as the FUM lost as a result of a client disengaging from the:

•           Seller, during the period commencing on the Valuation Date and ending on the completion date, or

•           Buyer, during the period commencing on the day immediately following completion date and ending on the last determination date.

18.   'Net Withdrawals' are defined as:

•           Lump Sums plus Contributions plus Gained Client FUM less Pension payments and Withdrawals, and

•           Gained Premiums less Premium Decreases.

19.   The original expected purchase price under the Agreement was calculated to be $xyz in the YYYY private ruling application; however, as a result of lost FUM and the application of the revised purchase price formula as outlined above, the final purchase price paid was only $zyx.

20.   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, including the fact that existing clients will no longer require the financial services provided, as a result of death or changed financial circumstances.

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

22.   The Company has calculated the expected revenue from the income stream rights over their expected lifetime to be approximately $xxyyzz. Taking into account the purchase price of $zyx, a net profit is anticipated.

23.   This calculation incorporated the formula to account for:

•           estimated acquisition client transition attrition (10%)

•           generational advisor change as a percentage on each generation based on client age at acquisition and industry averages for change within 3 years

•           life expectancy/attrition by age bracket (based on statistics from Australian Bureau of Statistics)

•           pension withdrawal expectations based on client age brackets, and

•           a cap at 7.5 years for the expectancy of the ongoing income stream from these rights on the basis that some change in client circumstances would typically result in a change in investment or insurance requirements for clients every 5 to 10 years and this income stream will not continue indefinitely.

24.   The Company has used the below formula for the YYYY, YYYY, YYYY and YYYY financial years to calculate the return of capital applied as a reduction to the purchase price for the rights to income streams:

A=B x C / D

where A= return of capital recorded as a reduction in the purchase price, B = total revenue received from income streams in the relevant financial year, C = purchase price and D = the total expected revenue.

25.   There is still a cost base of approximately $yyy, from the purchase price as at DD MM YYYY and the Company expect this amount will be recouped in the next x financial years from the ongoing income streams received.

Information provided

26.   You have provided a number of documents containing detailed information in relation to the applicant, including:

•           Private Binding Ruling ('PBR') Application, dated DD MM YYYY

•           Response to further questions provided DD MM YYYY

27.   We have referred to the relevant information within these documents in applying the relevant tests to your circumstances.

Assumption(s)

Not applicable.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Further issues for you to consider

Not applicable.

REASONS FOR DECISION

All legislative references are to the Income Tax Assessment Act 1997 ('ITAA 1997') unless otherwise stated.

SUMMARY

The Commissioner will allow the Company to continue to apply the profits emerging formula to distinguish between profit and a return of capital in relation to the purchase of rights to income streams from DD MM YYYY until the cost base of the capital asset is reduced to nil.

DETAILED REASONING

Ordinary Income

28.   Section 6-5 of the ITAA 1997 describes 'Income according to Ordinary Concepts (Ordinary Income)' as follows:

(1)  Your assessable income includes income according to ordinary concepts, which is called ordinary income.

Note: Some of the provisions about assessable income listed in section 10-5 may affect the treatment of ordinary income.

29.   Subsection 6-5(1) of the ITAA states that assessable income includes income according to ordinary concepts, which is called ordinary income. It does not otherwise define the term. The phrase "income according to ordinary concepts" appears to have been inspired by Jordan CJ's statement in Scott v FCT (NSW) (1935) 35 SR (NSW) 215 at 219:

The word "income" is not a term of art, and what forms of receipts are comprehended within it, and what principles are to be applied to ascertain how much of those receipts ought to be treated as income, must be determined in accordance with the ordinary concepts and usages of mankind, except in so far as the statute states or indicates an intention that receipts which are not income in ordinary parlance are to be treated as income, or that special rules are to be applied for arriving at the taxable amount of such receipts.

30.   Although Jordan CJ was talking about a different statute (the Income Tax (Management) Act 1928), this passage is commonly cited by Judges and the Commissioner in interpreting section 6-5 of the ITAA 1997 and its predecessor, section 25(1) of the Income Tax Assessment Act 1936.

31.   Legislatures and courts have consistently declined to define the limits of the term 'income', although there is a large body of case law, which expresses principles and provides examples of what may be treated as income according to ordinary concepts.

32.   According to case law, the Courts accept that ordinary income arises in one of 3 core ways:

•           as a reward for rendering personal services (eg. salary and wages and professional fees)

•           as profits from carrying on a business, including profits from unusual or isolated business transactions and

•           as a return on an investment (eg. rent, interest and dividends)

33.   Upon entering into the Agreement to acquire the income streams, the Company 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.

34.   The consideration paid on acquisition of the right (ie. 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.

Taxation Ruling TR 98/1

35.   Taxation Ruling TR 98/1 - Income tax: determination of income; receipts versus earnings provides guidance on the accounting method likely to provide a substantially correct reflex of income in a relevant year. While this private 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.

36.   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.

37.   In XCO Pty Ltd v Federal Commissioner of Taxation (1971) 124 CLR 343; (1971) 71 ATC 4152; (1971) 2 ATR 353, the High Court of Australia 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.

38.   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.

APPLICATION TO YOUR CIRCUMSTANCES

39.   In collecting money from the income streams the Company has purchased, the Company 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.

40.   The Company'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.

41.   In determining its profit for accounting purposes, the Company amortises the cost of the income streams it acquired. The Company 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.

42.   Instead, the Company'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 Schedule 1 to the Agreement.

43.   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.

44.   The purchase of the rights as per the asset sale agreement is directly linked to the ongoing revenue value and is determined using a multiplier of x times future revenue on the basis that the Company expect to make a profit on the acquisition of these rights over the expected lifetime of the rights.

45.   The Company acquired the rights with the intention of making a profit on the associated income streams that are attached to the rights. The acquisition by the Company resulted in the transfer of rights to income streams from the client list. The Company has dissected, calculated and recorded the receipts associated with this client list using the profits emerging basis to split between return of capital and profit generated from the purchase of the rights to the income streams in the YYYY, YYYY, YYYY and YYYY financial years in accordance with the previously issued Private Ruling.

46.   The calculation methodology for the profits emerging calculations prepared by the Company is as follows:

Facts/methodology:

Step 1: Calculate the forecast cash collection over the life of the service rights - the estimated amount to be received by the Company in relation to the service rights is calculated to be $xyz (including expected loss of clients during transition).

Step 2: Determine the purchase price - $zyx - as per the asset sales contract (updated to match revised purchase price)

Step 3: Determine the actual annual cash flow - the actual amount received per year- $yyy is received in year 4 (YYYY financial year).

47.   Net Profit in the YYYY year:

Calculated as being $yyy (actual cash received) less ($zzz x $xyz / $xxx) (the proportionate reduction in the value of the income rights in the YYYY year). $zzz - $sss = $aaa (Net profit).

48.   The profit of $aaa equals the assessable income derived for the YYYY financial year using the emerging profits basis formula.

49.   The Company has been accounting for profits in relation to the receipts of income streams associated with the purchase of rights to income streams on a profits emerging basis for the YYYY, YYYY, YYYY and YYYY financial years.

50.   It would therefore be appropriate for the Commissioner to allow the Company to continue to account for profits in relation to the receipts of income streams associated with the purchase of rights to income streams on a profits emerging basis until such time as the cost base (purchase price) of those assets (rights to income streams) has been reduced to nil, and after that point any future revenue derived from those client lists will be 100% on revenue account in the year of the receipt.

CONCLUSION

The Commissioner will allow the Company to continue to apply the profits emerging formula to distinguish between profit and a return of capital in relation to the purchase of rights to income streams from DD MM YYYY until the cost base of the capital asset is reduced to nil.

ATO view documents

Taxation Ruling TR 98/1 - Income tax: determination of income; receipts versus earnings

Other references (non ATO view)

Federal Commissioner of Taxation v Citibank Limited & Ors (1993) 44 FCR 434; (1993) 93 ATC 4691; (1993) 26 ATR 557

XCO Pty Ltd v Federal Commissioner of Taxation (1971) 124 CLR 343; (1971) 71 ATC 4152; (1971) 2 ATR 353

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