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Ruling

Subject: Assessability of Disputed Royalty Payments

Question

Whether the trustee derives and is assessable for income tax in respect of royalty payments to which entitlement has been claimed in legal action, but which are paid under court order into a joint account of the various claimant entities pending resolution of the commercial dispute?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commences on:

1 July 2010

Relevant facts and circumstances

By way of a Royalty Agreement and Assignment Deed, the trustee was legally entitled to a 15% interest in certain royalty payments.

The trustee has commenced legal action in a Supreme Court to determine its correct entitlement to past and future royalty payments as there is a dispute between the involved parties.

Under Orders and Direction of the Court, the disputed current monthly royalty payments are being deposited into an account jointly nominated by the claimant entities.

The account is in the name of all claimant entities and all parties to the account must sign off on any transaction involving that account.

The trustee sought and received advice on the appropriate accounting treatment for the royalty payments currently subject to dispute. This advice concluded that the disputed royalties do not meet the revenue recognition criteria under AASB 118.

Relevant legislative provisions

Section 6-5 of the Income Tax Assessment Act 1997

Section 15-20 of the Income Tax Assessment Act 1997

Reasons for decision

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a taxpayer's assessable income includes the ordinary income that the taxpayer derived from all sources during the income year.

Paragraphs 9 and 10 of Taxation Ruling TR 98/1 Income Tax: determination of income; receipts versus earnings explain that under the earnings (or accruals) method, income is derived when it is earned. The point of derivation occurs when a 'recoverable debt' is created. The tem 'recoverable debt' is used to describe the point of time at which a taxpayer is legally entitled to an ascertainable amount as the result of having performed an agreed task.

Paragraph 10 of Taxation Determination TD 2008/9 states "the proposition that a taxpayer will not derive ordinary income unless they are beneficially entitled to the amount has longstanding judicial support".

Therefore, in order to determine whether and/or when the trustee has derived the income from the royalty payments in dispute, it must be determined if it has a legal and beneficial entitlement to an ascertainable amount.

BHP Billiton Petroleum (Bass Strait) Pty Ltd and Anor v FCT (2002) 51 ATR 520; 2002 ATC 5169 (BHP) was a Full Federal Court case which considered the timing of income derivation when a bona fide dispute existed. In BHP, the issue under consideration was whether the taxpayer derived the income at the time of delivery of the product, when the product was invoiced, or at the time when the dispute between the buyer and seller (the taxpayer) was resolved

The Court held that:

· A principle that required the taxpayer to account for disputed income in the year goods were sold conflicted with accounting practice. That practice regarded income to be derived when the dispute was concluded, whether through arbitration, litigation or settlement. The deferral of derivation until the conclusion of the dispute avoided the unfairness to a taxpayer in being required to pay tax immediately where recoverability of what was owed to the taxpayer and which was the fund out of which the tax might be expected to be paid was, as a result of a bona fide dispute, outside the control of the taxpayer.

· The taxpayers derived the income only when the dispute between the buyers and the taxpayers themselves was settled.

In Harmer & Ors v FCT (1991) 173 CLR 264; 91 ATC 5000 (Harmer) the High Court was required to determine whether claimants were "presently entitled" to interest on monies deposited into a bank account pending resolution by the Court of their claims. Whilst Harmer was specifically about determining present entitlement, there are similarities that exist with this situation.

In Harmer there was a dispute between three parties over certain monies. The court ordered that an amount be paid into court and subsequently be invested into a building society in the names of the claimants' solicitors to be held on trust pending determination of the court proceedings.

It was determined by the High Court in Harmer that once the monies were deposited with the building society, monies were held by the trustees to be dealt with in accordance with the order of the court and not otherwise. No claimant was beneficially entitled to either the whole or any part of the monies paid into court or of the interest earned on it. Any beneficial interest of an individual claimant was contingent upon an order being made in their favour. Unless and until such an order was made, no claimant had a vested interest in the monies lodged with the building society or in the interest earned thereon. Therefore, the claimants had no present entitlement to the monies.

Considering the decisions in both BHP and Harmer, it is clear that in this case a bona fide dispute exists with respect to the monies which have been, and will continue to be, paid into the nominated account pending resolution of the dispute.

Therefore, any beneficial interest of the trustee to those monies is contingent upon an order being made by the court in its favour. Unless and until such time as this order is made, the trustee cannot be said to have derived this income.

The Commissioner has not fully considered the trustee's contention that the earnings (accruals) method is the most appropriate income recognition method for the purposes of this ruling.

Ultimately, the same result for taxation purposes is reached. If the income is more correctly assessable under section 15-20 of the ITAA 1997 and considered to be passive income, it would more correctly be assessable on the cash basis, that is, on receipt of the payment(s).
Considering the case law discussed above, it could not be concluded that these payments were received by the trustee until such time as the legal dispute over these monies is resolved.