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Ruling

Subject: Income Tax: Amortisation of Purchased Debt

Question 1

Can the taxpayer amortise the cost of the "purchased debt" asset over a period of five years under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

This ruling applies for the following periods:

Financial year ended 30 June 2011

Financial year ended 30 June 2012

Financial year ended 30 June 2013

Financial year ended 30 June 2014

Financial year ended 30 June 2015

Financial year ended 30 June 2016

The scheme commences on:

1 July 2010

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.

The taxpayer is a head company of a consolidated group. A Pty Ltd is one of the 100% owned subsidiary of the taxpayer. A Pty Ltd purchased a parcel of debt from X Co in September 2010.

The collectability of this parcel of debt was unknown, and would be based on the ability of the purchaser (e.g the taxpayer) to:

· attempt to trace the missing debtor….. and

· once traced to attempt to collect the outstanding debt (or part thereof)

Any revenue collected is returned by the taxpayer as income, and the taxpayer seeks to amortise the cost of the debt over a period of five years.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

Summary

The taxpayer is not eligible to amortise the cost of the purchased debt asset for five years under section 8-1 of the ITAA 1997.

However, the taxpayer is eligible to claim deduction for the cost of the debt recovered during the financial year and the debt that the taxpayer fails to recover and statutorily barred at the end of each financial year under section 8-1 of the ITAA 1997.

Detailed reasoning

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

The taxpayer purchased a parcel of debt from an unrelated entity. Upon acquiring the parcel of debt, the taxpayer 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 debt. The consideration paid on acquisition of the debt 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.

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.

Accounting

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 the approach in emerging profit.

Paragraph 17 of Taxation Ruling 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 FC of T v Citibank Limited & Ors 93 ATC 4691 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 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 this instance, it is considered that the accounting evidence is significantly relevant. It is supportive of a method adopted which gives a true reflex of the ordinary income derived by the taxpayer.

In XCO Pty Ltd v. FC of T 71 ATC 4152 (XCO) the taxpayer was assigned debts, at a deep discount to their face value, for consideration a situation similar to the present issue. The taxpayer paid $4,002 for the assignment of debts with a face value of $260,448. It was intended that the taxpayer would only receive $5,000 which it subsequently did. The Commissioner, in assessing the taxpayer on an emerging basis, assumed that the whole debt would be repaid. The amount included in assessable income, $4,923, was determined by deducting from the $5,000 received the proportional cost of the debts calculated at 1.54 cents per dollar of debts acquired. The cost of $5,000 debts acquired was considered to be $77.00.

In considering the merits of a profit emerging basis in these circumstances Gibbs J said the following at 4156:

The question remains, however, whether the Commissioner was right in assessing the amount of taxable income at $4,923. That depends on whether the Commissioner should have taken the actual surplus received by XCO, $998, as representing the profit arising during the relevant income year from the carrying out of the scheme, or whether he was entitled to assess the profit on an emerging basis. In the absence of some definite direction in the Act, the Commissioner should, in an assessment of income, adopt the method of accounting which is in fact appropriate to the circumstances of the case, or which in other words is calculated to give a substantially correct reflex of the taxpayer's true income' (Commissioner of Taxes (S.A.) v. Executor Trustee and Agency Co. of South Australia Ltd. (Carden's case) (1938) 63 CLR 108 at p.154). 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 all the circumstances, it seems to me fair and appropriate to regard $998, the actual surplus of the amount received over the cost in the year in question, as truly representing the profit arising in that year. [emphasis added]

The policy of the income tax law is to correctly assess a taxpayer in respect of a year of income. In XCO, it was recognised that where an amount to be collected under assigned debts would occur over more than one income year, it is not appropriate to deduct in full in the year of acquisition the total cost or outlay for that debt.

Amortise the cost

In determining its profit for accounting purposes, the taxpayer amortises the cost of the debt ledgers. It does not calculate its profit or loss by deducting from the years collections the total cost it outlays in acquiring debt 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 debt that results in collected income over the period.

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 arising 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.

Deduction

Accordingly, the gain or profit is not the gross proceeds realised from collecting debts in a ledger. Only, the net proceeds are brought to account as assessable income. Therefore, it will be only the loss incurred in respect of debts uncollected in the ledger that falls to be deducted under section 8-1 of the ITAA 1997. That is because no part of the gross outgoing can be the cost of a net profit.

The debts in question are plainly not fixed capital of the business; they are what are known as circulating capital. That is, the profit from its capital by realising or parting with it, not by retaining it and deriving income from it (BP Australia Ltd v. Federal Commissioner of Taxation (1965) 112 CLR 386; (1965) 9 AITR 615; (1965) 14 ATD1). The distinction between fixed and circulating capital has sometimes been criticised, but this is as clear an example as one could hope to find.

When the taxpayer collects money in respect of the debts, what it does is in part recover their capital, and in part realise a profit. Or, if the taxpayer fails to recover their capital, they incur a loss.

In London Australia Investment Co Ltd v. Federal Commissioner of Taxation (1977) 138 CLR 106; 77 ATC 4398; (1997) 7 ATR 757 Jacobs J said:

A circumstance which appears to me to be of substantial significance is that referred to by Kitto J. in National Bank of Australasia Ltd. v. F.C. of T. 69 ATC 4042 at p. 4047; (1969) 118 C.L.R. 529 at p. 537:

"... what was recovered through the sale of the shares was circulating capital, and what ultimately was not recovered was a loss on revenue account just as any excess would have been an income profit: cf. …."

Therefore it is concluded that the gross income of the taxpayer's business includes the net profit or gain you realise in the year of income from the debts you have acquired as part of the particular debt ledger: an amount that must be computed by having regard to the extent that the taxpayer outlays have been recovered in receipts to date, and the extent to which they are yet to be recovered.

It follows that section 8-1 of the ITAA 1997 has application only to the extent that upon abandonment of the particular debt ledger the taxpayer has collected less than the cost of the debt ledger's acquisition.

Therefore, the taxpayer is not eligible to amortise the debt for five years as equal amount.

However, the taxpayer is eligible to claim deduction for the cost of the debt recovered during the financial year and the debt that the taxpayer fails to recover and statutorily barred at the end of each financial year under section 8-1 of the ITAA 1997.