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Ruling

Subject: Timing of derivation of income

Question 1

For the purposes of Section 6-5 of the Income Tax Assessment Act (ITAA 1997) does the Taxpayer derive assessable income on the proceeds of the Payment Plan as each amount becomes due and payable?

Advice/Answers

No

The taxpayer will derive assessable income on the full contract value when the Product A has been installed and recoverable debt is created.

This ruling applies for the following period:

Year ended 30 June 2013

The scheme commences on:

1 July 2012

Relevant facts and circumstances

The Taxpayer operates a retail business selling Product A.

The Taxpayer accounts on an accruals basis.

The Taxpayer is intending to introduce a new sales offer which will allow customers to pay the contract value of Product A by way of a nominal up-front deposit and equal monthly instalments over Period X.

When the customer enters into a Plan the payment terms are detailed on the Work Order (the proposed sale contract) including:

· the full retail price (the contracted sum);

· a rebate that may be applicable which comes off the retail price as a discount;

· the balance of the contract sum;

· any deposit that is payable and the amount of the instalment that will be payable every month.

Normally a deposit will be taken on the signing of a contract. A separate tax invoice will be issued to the customer for the deposit and GST applicable to the deposit.

A separate tax invoice will issue initially for the deposit and then subsequently each time an individual monthly payment becomes due and payable.

Under the terms of the proposed contract the title of the goods does not pass to the customer until the final instalment is made.

It is explicit in the contract that should the customer discontinue payments that the Taxpayer can reclaim the goods without the requirement for a refund on their part nor any further obligation for payments by the customer.

The Work order and terms and conditions include the following:

2. Cancellation and Liquidated Damages

2.1 If you cancel the Work after signing the Work Order, without prejudice to any other rights we have, we will be entitled to liquidated damages in the amount of 25% of the Contract Sum less any deposit paid. Should, in our absolute opinion there be a good and sufficient reason for the cancellation of the work, we may waive our entitlement to these damages.

3. Company A to Perform Work for Contract Sum

3.1 We will perform the Work in Exchange for the Contract Sum.

3.2 We have the right to engage any suitably qualified or experienced person to perform the work.

3.3 .......

4. Retention of Title

4.1 Title to the goods does not pass until payment in full has been paid and cleared into our account.

5. ......

6. Variations

6.1 If the Work needs to be changed in any way or more work is required we will tell you and let you know of any additional costs. If you agree with the additional cost we will carryout the extra work and you will pay us the additional cost (plus a X% administration fee) when the extra work has been completed.

6.2 ......

7. Payment

7.1 You will pay us the contract Sum on completion of the works in the manner stipulated in the Work Order.

7.2 If the Work Order provides for payment by instalments, you:

7.2.1 will make payment on receipt of a tax invoice issued by us in respect of any payment due;

7.2.2 .....

7.2.3 .....

7.2.4 acknowledge that we have advised you that if you are unable to make any payment, you must contact us no later than X business days before the payment is due and we will attempt to come to another arrangement with you in relation to the payment.

7.2.5 agree that you will refund to us on demand any fee or charge incurred by us (including any interest payable by us) as a result of your failure to make a payment under the arrangement.

7.2.6 ....

7.2.7 acknowledge that if you are unable to continue to make payments under the arrangement you can give to us notice that you wished to terminate the agreement whereupon we will arrange for our contractors to remove the Goods from the Property at your cost whereupon no further payments will be due and you further acknowledge that you will not be entitled to any refund of monies already paid.

7.2.8 will pay to us the balance of the contract sum together with any other amounts due under this agreement (for which we will issue a tax invoice) if you vacate the premises, and

7.2.9 acknowledge that you are at liberty at any time to pay the remaining amount due as a lump sum without penalty, for which we will issue a tax invoice on request.

11. Discounted Payment

11.1 Except if an Instalment payment plan has been agreed upon, payment of contract sum is due and payable upon completion.........

Relevant legislative provisions

Section 6-5 of the Income Tax Assessment Act (ITAA 1997)

Reasons for decision

Discussion of law

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that your assessable income includes income according to ordinary concepts. It is an accepted principle of income tax law that the method which a taxpayer accounts for its business for purposes of income tax must `give a substantially correct reflex of the taxpayer's true income' (see Dixon J in The Commissioner of Taxes (South Australia) v. The Executor Trustee and Agency Company of South Australia (1938) 63 CLR 108 at 154; (1938) 5 ATD 98 at 131 (Carden's case).

Taxation Ruling TR 98/1 sets out the Commissioner's guidelines on the earnings method for the treatment of income as follows:

Under the `earnings' method, income is derived when it is earned. The point of derivation occurs when a `recoverable debt' is created.

The term `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.

Whether there is, in law, a recoverable debt is a question to be determined by reference to the contractual agreements that give rise to the legal entitlement to payment, the general law, and any relevant statutory provisions.

Taxation Ruling 97/15 considers when income is derived under section 6-5 of the ITAA 1997 by the seller of goods under a conditional contract. As outlined in this ruling the Commissioner considers that income from the sale of goods under a conditional contract, which is assessable to the seller on an accruals basis, is derived under section 6-5 of the ITAA 1997 when a debt for the sale of those goods is created under the contract of sale. We consider that a debt is created under the contract of sale when the goods are delivered by the seller to the purchaser once the seller has accepted the purchaser's order. The seller is then presently entitled to demand payment of the sale price within a specified period.

Associated Case Law

An instalment method of accounting for the sale of land was originally accepted in FC of T v. Thorogood [1927] ALR 400; 40 CLR 454. However, the Full High Court in J Rowe & Son Pty Ltd v. FC of T (1971) 154 CLR 42; (1971) 124 CLR 1; (1971) 2 ATR 497; 71 ATC 4157 (Rowe's case) did not consider that a `profit emerging basis of assessment' was appropriate to section 25(1) of the Income Tax Assessment Act 1936 (ITAA 1936) (section 6-5 of the ITAA 1997).

In Rowe's case, the taxpayer sold household goods where a majority of the sales were time payment or term sales. Menzies J, with whom Barwick CJ agreed, considered a `profit emerging' basis of assessment was inappropriate for all but a few provisions of the ITAA 1936. It was held that the 'profit emerging' basis of assessment was inconsistent with the fundamental scheme of the ITAA 1936. The exception being provisions such as the former section 26(a) ITAA 1936 where it is expressly provided that a calculated profit is to be treated as assessable income.

Menzies J, referring to Carden's case, held that the accounting method to be adopted is that which is `calculated substantially correct reflex of the taxpayer's true income.

Although Rowe's case dealt with the sale of goods, it is considered that the decision in Rowe's case would also apply to the sale of land. This is supported by Von Doussa J in Gasparin v. FC of T 94 ATC 4280; (1994) 28 ATR 130 (Gasparin's case). Gasparin's case concerned the derivation of income from the sale of land as trading stock. His honour said (ATC at 4285; ATR at 136) that it was'.

` .... correct to lay stress upon the prominence given in Carden and Rowe to the importance of there being a debt in conjunction with a sale of trading stock before income is derived'.

It is clear from the line of cases that account for sales using an instalment method of accounting, that this method is not acceptable. The sale price of trading stock is derived as income of the seller where the sale price becomes a presently existing debt (see paragraph 28 of Taxation ruling TR 97/15).

Trading Stock

Also from Rowe's case, per Menzies J. (Barwick C.J. concurring): The provisions of the Act relating to trading stock assume that stock on hand at the beginning of the year and not on hand at year's end will be accounted for, and that the proceeds of stock sold in the ordinary course of business will be brought to account in the year of sale.

Business considerations would require, in a system of annual accounting, that debts owed to a trader for stock sold during the year should be brought to account in some way to balance the reduction in trading stock effected by the sale. For tax, as well as business purposes, a trader's income is derived when it is earned even though not received. Income from the sale of stock is income when the stock is sold and a debt is created, notwithstanding the debt is not payable until a future year.

The profit emerging basis is inappropriate where gross income is assessable as distinct from a calculated profit (as under sec. 26(a)) and the scheme of the Act is inconsistent with an attempt to calculate the profit element in each business transaction of a person carrying on business and to aggregate those profits as assessable income, or taxable income, or something in between.

Accountancy Practice

The Commissioner's view also reflects that of the Australian Accounting Standard Board 118 (AASB 118). The objective of AASB 118 is to prescribe the accounting treatment of revenue from certain types of transactions, including the revenue arising from the sale of goods, of which paragraphs 14-19 provide:

Sale of goods

Each of the five following criteria must be met in order to recognise revenue from the sale of goods:

1. The significant risks and rewards of ownership have been transferred to the buyer.

2. There is no continuing managerial involvement or effective control over the goods transferred.

3. The amount of revenue can be measured reliably.

4. It is probable that the economic benefits from the transaction will flow to the entity; and

5. The costs incurred or to be incurred in respect of the transaction can be measured reliability.

Application of the law to your circumstances

The Taxpayer operates a retail business selling Product A, as one of their products.

Recoverable Debt

As the Taxpayer accounts on an accruals basis the point of derivation will occur when a `recoverable debt' is created, the point of time at which a taxpayer is legally entitled to an ascertainable amount as the result of having performed an agreed task.

Upon a Customer signing a Work Order (the Contract) the Taxpayer will have made a sale and agreed to carry out the installation of Product A to the Customer's property.

Upon installation, as provided by the terms of the `Work Order' (the Contract of sale), the Taxpayer will have performed the agreed task upon completion of the installation of Product A. It is at this point that a `recoverable debit' will have been created as there is nothing else that the Taxpayer has to do to be entitled to the debt.

The Contact provides the following in support of this:

· The Taxpayer will perform the Work in exchange for the Contract Sum.

· The Customer will pay the contract Sum on completion of the work in the manner stipulated in the Work Order, which may include the option to pay by instalments through a 'Pensioner Payment' Plan (the Plan). The Customer is also at liberty at any time to pay the remaining amount due as a lump sum without penalty and will advise the Taxpayer if they are unable to make any payment no later than X days before the payment is due so that an attempt can be made to come to another arrangement in relation to the payment.

· Should the customer cancel the Work after signing the Work Order the Taxpayer Company will be entitled to liquidated damages in the amount of X% of the contract sum less any deposit paid.

· The Customer will agree to refund on demand any fee incurred by the Taxpayer Company (including interest) as a result of failing to make a payment under the arrangement.

· If the Customer takes up the option to pay for the installation by the Plan and is at some point unable to continue making payments under the arrangement they may give notice that they wish to terminate the agreement whereupon the Taxpayer will arrange the removal of the Goods from the Property at cost to the Customer whereupon no further payments will be due and there will be no entitlement to any refund of monies already paid.

As the Goods would be removed at the cost of the Customer it would not be likely that the intention of the either party would be that the debt had not been established once the goods had been installed.

This is further supported by the fact that the Customer will pay the balance of the contract sum together with any other amounts due under the agreement if they vacate the premises.

Except if an Instalment payment plan has been agreed upon, payment of contract sum is due and payable upon completion.

This indicates it is the intention of both the Taxpayer and the Customer that the full amount of the debt is established after installation whether or not payment will be paid in full or by instalments.

Conclusion

Regardless of the fact that the title of the goods does not pass until the final instalment payment, the goods will have been installed at the Customers property. The installation is all that is required by the Taxpayer in order to become entitled. The facts demonstrate there is intention by both parties to create a debt of the fully contracted amount at the point that the sales agreement has taken place, and that termination of the agreement is not intended nor expected by either party.

The mere existence of a payment agreement such as an option to pay by instalments through a 'Payment' Plan (the Plan) as outlined in the `Work Order' would effectively allow for the deferral of payment until after the provision of services. Such an arrangement cannot be regarded as a contingency which defers derivation of the sale amount. A payment arrangement is a financial arrangement which does not alter the income transaction and therefore it is not considered that the contractual arrangement which provides the option to pay by instalments after which the installation has taken place, and the contractual amount earned, will defer the point at which income is derived.

To account any other way would detract from the intention of the law as this would not give a substantially correct reflex of the Taxpayer's true income.