Edited version of your private ruling

Authorisation Number: 1012498374468

Ruling

Subject: Assessable income - derivation of income

Question 1

Are surplus Contributions, being payments in excess of your expenses for the relevant year, which are received from the Contributors income 'derived' by you for the purposes of section 6-5 of the Income Tax Assessment Act 1997 ('ITAA 1997') in the year of receipt?

Answer

No.

Question 2

Are surplus Contributions to be excluded from your assessable income under section 6-5 of the ITAA 1997 for the year ended 30 June 2012 on the basis it was not derived?

Answer

Yes.

This ruling applies for the following periods:

1 July 2011 to 30 June 2012

The scheme commences on:

The scheme has commenced

Relevant facts and circumstances

A Pty Ltd is a company.

A Pty Ltd represents Member Organisations.

In furtherance of its purpose, A Pty Ltd undertakes various activities.

A Pty Ltd is financially supported by the Contributors through the provision of funding to help it meet its expenses. The Contributors are A Pty Ltd's sole source of funding.

Funding provided is under an oral agreement ('the Funding Agreement') and there is no written agreement which sets out the terms of the funding.

The key terms of the Funding Agreement are as follows:

1 The Contributors would provide sufficient funding to A Pty Ltd to meet the necessary expenses incurred;

2 A Pty Ltd was to use such funding solely for the purpose of meeting its reasonable expenses;

3 A Pty Ltd would not use the funding for any other purpose; and

4 To the extent that any of the funding provided by the Contributors was surplus to what was required by A Pty Ltd to meet its expenses, that surplus would be refunded to the Contributors in proportion to their contributions.

Statutory declarations from directors of A Pty Ltd evidence the key terms of the Funding Agreement ('Statutory Declarations'). The Statutory Declarations indicate that:

· the Board of Directors of A Pty Ltd met with representatives of one Contributor who acted on behalf of all the Contributors;

· the key terms are as described above;

· the funding arrangements between the Contributors and A Pty Ltd have always operated according to the key terms as described above;

· as A Pty Ltd's activities have been ongoing, no refunds have been made, however if such activities cease at any time, all surplus funds will be proportionately refunded to the Contributors.

The parties altered their arrangement slightly. A Pty Ltd would indicate what its likely expenses would be, the Contributors would make a proportionate contribution to those expenses each month, and A Pty Ltd would render an invoice for each payment received. This was considered a more streamlined process given A Pty Ltd's activities were ongoing in nature.

For the year ended 30 June 2012, A Pty Ltd incurred expenses less than the Contributions for that year. The surplus was due to the fact that it was difficult to predict in advance the precise amount and timing of expenses. The balance was ultimately applied against expenses that were incurred in the following year, being the 2012-13 income year.

A Pty Ltd treated the Contributions as income, and to the extent the Contributions exceeded the amount spent by the end of the 2011-12 income year, those amounts were treated as 'unearned income' in A Pty Ltd's accounts. For the year ended 30 June 2012, A Pty Ltd had surplus funds which were reported as 'unearned income' for accounting purposes.

The A Pty Ltd Financial Statements for the year ended 30 June 2012 show this amount as a bracketed negative amount indicating that it was deducted from or written back in the calculation of total income.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 6-5(1)

Income Tax Assessment Act 1997 subsection 6-5(2)

Income Tax Assessment Act 1997 subsection 6-5(4)

Reasons for decision

Question 1

Detailed reasoning

Derivation of income

Under subsection 6-5(2) of the ITAA 1997 ordinary income of an Australian resident that is derived directly or indirectly from all sources during the income year is included in assessable income.

'Ordinary income' includes income according to ordinary concepts under subsection 6-5(1) of the ITAA 1997. Its characteristics are established by case law.

A summary of the guidelines which have been developed to determine the nature of a receipt are collected at paragraph 85 of Taxation Ruling TR 2006/3 Income Tax: government payments to industry to assist entities (including individuals) to continue, commence or cease business ('TR 2006/3').

The High Court stated in GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124 at 138:

To determine whether a receipt is of an income or of a capital nature, various factors may be relevant. Sometimes, the character of receipts will be revealed most clearly by their periodicity, regularity or recurrence; sometimes, by the character of a right or thing disposed of in exchange for the receipt; sometimes, by the scope of the transaction, venture or business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business. The factors relevant to the ascertainment of the character of a receipt of money are not necessarily the same as the factors relevant to the ascertainment of the character of its payment.

A Pty Ltd undertakes various activities and necessarily incurs expenditure in its work. The funding A Pty Ltd receives from the Contributors is intended to meet these ongoing expenses, that is, A Pty Ltd's revenue expenses. The Contributions are paid to A Pty Ltd regularly on a monthly basis, and exhibit the 'periodicity, regularity or recurrence' characteristic of ordinary income. The Contributions received by A Pty Ltd from the Contributors constitute ordinary income of A Pty Ltd.

Such a conclusion is consistent with the view taken at paragraph 13 of TR 2006/3 that government payments to industry which reimburse, assist with, or directly pay on behalf of the recipient, the costs of obtaining legal, business, accounting, financial or other professional advice in the ordinary course of business, are ordinary income.

The point at which income is derived depends upon the method of accounting adopted, whether upon a receipts or an earnings basis. The first method brings to account income when it is received, either actually or constructively under subsection 6-5(4) of the ITAA 1997; and the second when it is earned, being when a recoverable debt is created: see par 8 and 9 of Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings ('TR 98/1').

The adoption of either accounting method is appropriate if in the circumstances it gives a substantially correct reflex of the income: see Commissioner of Taxes (South Australia) v The Executor Trustee and Agency Company of South Australia Limited (1938) 63 CLR 108 ('Carden's Case') per Dixon J at 154. For this reason it is usual for income from a business of trading or manufacturing to be practically computed on an earnings basis, whilst professional income is more appropriately accounted for under the receipts method. TR 98/1 reflects this distinction at paragraphs 18 to 20. There will of course be exceptions.

Whether an accounting method gives a substantially correct reflex is a conclusion to be made from the circumstances relevant to the taxpayer and the income. In Carden's Case, which concerned unpaid professional fees of a medical practitioner, and whether book debts should have been included in assessable income in the relevant year, Dixon J stated at p155 that 'in the assessment of income the object is to discover what gains have during the period of account come home to the taxpayer in a realized or immediately realizable form.'

For an amount to have 'come home' requires the amounts received to be unaffected by legal restrictions such as by reason of a trust or charge, and that the situation is reached in which they might properly be counted as gains completely made, so that there is neither legal nor business unsoundness in regarding them without qualification as income derived: see Arthur Murray (NSW) Pty Limited v the Federal Commissioner of Taxation (1965) 114 CLR 314 ('Arthur Murray') at 318.

Generally for non-trading income it is when amounts are received that they have come home to the taxpayer; however trading income generally includes debts due but not yet paid on the basis book debts represent what was previously trading stock or circulating capital: see par 40, 41 and 49 of TR 98/1; Dixon J at 156 and 158 in Carden's Case. Where the distinction is unclear, the factors described at paragraphs 53 to 59 in TR 98/1 are relevant to the determination.

In the circumstance of an advance payment, a receipt may not be derived as income when it is received, but as it is earned.

The case of Arthur Murray considered the derivation of fees paid in advance for services where the taxpayer held fees in a separate account as 'unearned income' until services were rendered. Although the fees were not subject to any contractual right of refund, in practice refunds were sometimes given. The Commissioner assessed the fees received in advance as possessing the character of income from the moment of receipt; the taxpayer however accounted for the fees at the point services were rendered.

In determining whether actual earning was to be added to receipt in order to find income in the case before it, the High Court stated at 319 that the answer must be given in the light of the necessity for earning which is 'inherent in the circumstances of the receipt'. Whilst the fees received by the taxpayer were not prevented from being considered immediately the beneficial property of the taxpayer, as payment in advance was not sufficient to affect any trust or charge or to place any legal impediment barring any dealing with the fees, it was a matter of business good sense that the taxpayer treat the fees received but not yet earned as subject to the contingency that the whole or part may have to be paid back should the agreed quid pro quo not be rendered in due course. Such an approach was in accord with established accountancy and commercial principles regarding payments received in advance of goods being sold or of services being provided. It was only with the discharge of the obligations attached to the prepaid fees that the amounts acquired the character of income.

However, the mere possibility of a refund of amounts received is not alone sufficient to defer derivation of income. Taxation Ruling TR 96/5 Income Tax: take or pay contracts (TR 96/5) notes at paragraph 26, that if that were the case, a vendor of goods would otherwise not derive income from a sale during a period by reason of the possibility of a damages claim in respect of the goods. What was crucial in the Court's reasoning in Arthur Murray was the possibility of a refund arising should the agreed quid pro quo not occur.

Thus, for gas sales contracts with take or pay clauses where the buyer was required to make a payment to the gas producer for 'make-up gas' which was accessible to the buyer in a subsequent year once certain conditions were met, the future obligation of the gas producer to deliver the 'make-up gas' was the quid pro quo for the payment. Although a recoverable debt existed for the gas producer and the amounts paid were beneficially received and no legal restrictions upon the payment existed at the time of receipt and prior to delivery of the 'make-up gas', in the event the gas producer was unable to supply the 'make-up gas' or its quality was not up to the required standard, the buyer might have a claim for a return of the price instead of or as well as an action in damages. As such, payments received did not have the character of income until the make-up gas was actually supplied or the gas producer no longer had any contractual obligation to supply the gas.

Case T6 86 ATC 141, in which Arthur Murray was distinguished, further illustrates that the fact that a receipt is contingent does not necessarily deprive the receipt of the character of income when received or derived.

In that case, the taxpayer company received insurance commissions. Part of the commissions were calculated including an amount payable upon anniversary dates of the policy, and part had to be repaid where renewal premiums were not paid by policy holders for subsequent years. No actual refunds were made, but in the monthly statements non renewals were recorded against gross commissions, and a net total was shown. The evidence failed to establish correct figures and thus failed to show that the assessment was incorrect. However, in respect of 'unearned commission advances' excluded by the taxpayer from assessable income on the basis certain amounts were not derived until the policy was renewed, and there was a requirement to repay certain amounts, the Tribunal considered that no further work had to be done by the taxpayer; all that was necessary had been done in relation to the amounts received to constitute it as income. Arthur Murray was distinguishable as the commissions, when credited to the taxpayer, had already been earned, and the contractual obligations to repay certain sums under various contingencies did not deprive those commissions of the character of income derived.

In Case 13/2005 2005 ATC 213, the possibility of the return of an amount was found not to be an inherent characteristic of the receipt where it arose as part of separate rights and obligations. The taxpayer in that case granted an exclusive licence for core technology to a joint venture syndicate for a period of 25 years in return for a licence fee of $2.4 million. The major investor in the syndicate was Lafoten Pty Ltd, which was a wholly owned subsidiary of Lopphaver Pty Ltd. To fund its contribution to the syndicate's capital requirements Lafoten Pty Ltd obtained a loan from ABN AMRO, and issued shares to Lopphaver Pty Ltd. Under an indemnity arrangement, the taxpayer was required to deposit an amount, which included the licence fee, with ABN AMRO. Ultimately, Lafoten failed to pay the monies, a demand was made upon the taxpayer, and ABN AMRO applied the deposit in satisfaction of monies owing to it. On the basis the funds on deposit could not be accessed until the exercise or not of the put option, the taxpayer, relying upon Arthur Murray, contended that the $2.4 million was not received in such a way as to make the amount assessable. The possibility of a payment back or to a third party placed a relevant charge upon the deposit money, and more so where the obligation 'to pay back' was 'an inherent characteristic of the receipt of the money'.

The Tribunal did not accept the taxpayer's position. The possibility of making a payment to the lender was not a characteristic of the receipt of the money. The receipt and possible payment were separate and distinct rights and obligations; the one was not dependent upon the other. The Tribunal considered the taxpayer to have been beneficially entitled to the funds from the time it received them, following which the amount was placed with ABN AMRO for an agreed period of time. There was no charge upon the funds but an agreement as to how and in what circumstance they were to be applied at the end of the period.

Similarly, in Case 22/95 95 ATC 243, a partnership received an incentive payment for the relocation of the business and the taking up of a lease in new premises. As the relocation would result in substantial costs for the partnership arising from the fit-out, any partner resigning from the partnership (thereby leaving the remaining partners to bear the commitment of costs), would forfeit their pro rata share of the incentive amount. To that end, a claw back agreement was put in place which in effect provided for payment by any partner retiring within 5 years of an amount calculated by reference to the incentive payment received by that partner. No restrictions were placed on the use of the incentive payment when it was paid. The taxpayer contended that the claw back agreement was related to the receipt, and that the incentive amount was not wholly derived until the expiration of the 5 year period.

The Tribunal, in finding that the incentive amount was derived in the year of receipt, considered that the taxpayer had done all that was required of him to earn the income in the year when it was paid to him. The amount received was the beneficial property of the partner; it was unaffected by any trust or charge and there was no legal impediment to the partners dealing with the money. A liability to pay, even though calculated on the basis of the amount of the incentive, arose from circumstances unassociated with the receipt of the money, being retirement from the partnership.

By contrast, in Case U7 87 ATC 127 the taxpayer had entered into a written agreement with the Government in respect of a project grant to cover half the expenditure incurred for research on a specified project. Under the terms of the agreement, payments required approval by the Board subsequent to receipt of reports detailing the taxpayer's expenditure for a period. The grant was to be repaid in the event of breach of the agreement, and also where the grant was in excess, given the amount was limited to half the net expenditure on the project. Prior to the parties entering into the agreement, an advance payment was made to the taxpayer of $150,000 which would be credited against anticipated expenditure on the project, and subject to repayment if the grant was not payable or the amount of the grant was less than the advance. At issue was whether the whole of the amount received by the taxpayer during the year was assessable.

The taxpayer's case was presented in the alternative. It was contended that the advance was paid as a loan, and until an amount of grant was approved and set off against the loan, it was not income. Alternatively, the advance was said to be a prepayment of the grant, but, as it was contingent upon expenditure being incurred on the project, it was not income until such time as the expenditure was incurred.

The Tribunal considered the advance to be a prepayment of the grant. As the amount was a prepayment, provision was made for repayment if no work was done or if the grant payable was less than the amount prepaid. Although there was a factual difference between a prepayment of a grant and a prepayment under a contract for future services as occurred in Arthur Murray there was a close analogy between the two. In the circumstances, the grant had still to be earned by incurring expenditure on the research project. The Tribunal stated:

24…Although there was a prepayment of grant, the grant might in fact never have become payable. In that event there would have been an obligation to repay what had been prepaid. The entitlement to receive the grant was to arise only when expenditure had been incurred by the applicant.

Thus, in the relevant year, the taxpayer had not done all that was required of it to earn the full amount prepaid to it, and only so much of the advance as was earned upon the incurrence of expenditure had been derived in that year.

The decisions of Arthur Murray and Case U7 support the position taken in TR 2006/3 at paragraphs 23 and 24, which state that government payments made in advance of the performance of the conditions attached to the grant, where the amount must be repaid unless the conditions are met, becomes unconditional when the recipient satisfies the conditions. It is at that time that the payment is taken to be received, and not when it is paid. Further, the advance payment is derived to the extent the recipient has done everything necessary to be entitled to retain the amount received; any overpaid amount to which the recipient is not entitled and that must be repaid is not derived.

The position is also reflected in ATO ID 2006/122 Income Tax: Assessable Income: derivation of Commonwealth funding - Cooperative Research Centres (CRC) Programme ('ATO ID 2006/122') where instalments paid to a taxpayer under Commonwealth Agreements which were to be applied only to the conduct of the agreed Activities, and subject to repayment if not so applied, were not derived upon receipt. Rather, the instalments were derived when, and only to the extent, in an income year, they were applied toward the conduct of the Activities.

Additionally, ATO ID 2004/193 Income Tax: Assessable Income: derivation of government grant funds - conditional upon funds being expended ('ATO ID 2004/193'), considered Government grant funds provided under Deed which were to be used for approved purposes including the acquisition of assets. Repayment occurred in the event of excess at the end of the grant period, and where the grantee sold an asset acquired with grant funds during the period and did not otherwise use the funds recovered in accordance with the terms of the Deed. The funds were considered to have 'come home' to the taxpayer when expended, quid pro quo occurring when the grant monies had been spent for the intended purpose. It was at that point that the taxpayer had done everything necessary to earn the income. Further, it was not sufficient that the Deed provided for a possibility, should certain events occur, that an amount expended be refunded, to defer the point of derivation of the income.

Conclusion

The funding was ordinary income that was assessable income in the hands of A Pty Ltd. However, the question at issue here is when that assessable income was derived for the purposes of section 6-5 of the ITAA 1997.

From the above examination of the relevant case law and the documents containing a discussion of the ATO view on the derivation of assessable income it is concluded that receipt of the funding by A Pty Ltd and its derivation do not coincide. This is because it is considered that the arrangement regarding the funding of A Pty Ltd is like that of the provision of the Government funding of grant funds in Case U7. In that case it was held that in the hands of the recipient of the grant the funds were considered to 'come home' to the taxpayer when expended, that is, when the grant monies were expended for the intended purpose. Therefore, in applying that finding to this case, the contributions advanced to A Pty Ltd 'come home' to A Pty Ltd when expended in the course of the activities. The funding is not derived until expended upon the activities.

Question 2

Detailed reasoning

The conclusion reached in answer to Question 1 above is that the contributions advanced to A Pty Ltd 'come home' to A Pty Ltd when expended in the course of the activities. In other words the funding is not derived by A Pty Ltd until expended upon the activities.

Accordingly, in an income year where there is a surplus being the amount by which the Contributions from the Contributors exceed the expenses incurred by A Pty Ltd, that surplus is not derived by A Pty Ltd.

Therefore the surplus which arose in the income year ended 30 June 2012 was not derived by A Pty Ltd in that income year. The surplus is excluded from assessable income.