Edited version of private advice

Authorisation Number: 1051673744494

Date of advice: 09 March 2020

Ruling

Subject: Derivation of professional work in progress amounts

Question 1

Have each of the Taxpayers, in their capacity as partners in a partnership of XX (consisting of the Taxpayers and X (collectively, the Old Partnership)), derived assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) for work-in-progress (WIP) accrued by the Old Partnership in respect of which no remuneration determination has been made pursuant to section 60-5 of the Insolvency Practice Schedule contained in Schedule 2 of the Corporations Act 2001 (Remuneration Determination) and no invoice has been raised?

Answer 1

No.

Question 2

Have each of the Taxpayers, in their capacity as partners in the Old Partnership, derived assessable income under section 6-5 for WIP accrued by the Old Partnership in respect of which a Remuneration Determination has been made, but no invoice has been raised in respect of that WIP?

Answer 2

No.

Question 3

If a WIP amount is transferred for no consideration from the Old Partnership to XX Pty Ltd (the Transferred WIP):

3.1 where no Remuneration Determination has been made and no invoice has been raised, will each of the Taxpayers, in their capacity as partners in the Old Partnership, derive assessable income under section 6-5 in respect of that Transferred WIP?

3.2 where no Remuneration Determination has been made and no invoice has been raised, will XX derive assessable income under section 6-5 in respect of that Transferred WIP when received from the Old Partnership?

3.3 where a Remuneration Determination has been made and an invoice is raised by XX, will X derive assessable income under section 6-5 in respect of that Transferred WIP?

Answer 3

3.1 No

3.2 No

3.3 Yes

This ruling applies for the following periods:

Income years ending XX.

The scheme commences on:

1 July 20XX.

Relevant facts and circumstances

·         In this ruling a reference to the 'Taxpayers' is a reference to:

XX

in their respective capacities as partners in the Old Partnership, which conducted a XX practice known as 'XX' (ABN XX).

·         The Taxpayers are all Australian residents for taxation purposes.

·         Between approximately July 20XX and November 20XX the Taxpayers conducted XX business.

·         The Old Partnership accounts for their income on an accruals basis.

Winding up the Old Partnership

·         On or around November 2019 it was agreed to wind-up the Old Partnership.

·         A and B agreed to form a new company, XX, through which they continued to operate as corporate insolvency practitioners and personal bankruptcy trustees. XX is wholly owned by the Taxpayers.

·         XX accounts for their income on an accruals basis.

·         The Old Partnership has WIP accrued but unbilled (i.e. no invoice issued) for professional services rendered in whole or in part, some of which is covered by a Remuneration Determination, and some which does not yet relate to a Remuneration Determination.

·         Through the winding up process, the Old Partnership agreed that XX and XX would either complete the work to which the outstanding WIP related in the name of the Old Partnership and seek a Remuneration Determination and subsequently bill the work, or, they would transfer the WIP to XX to complete the work, after which they would seek a Remuneration Determination and subsequently bill the work (i.e. the Transferred WIP).

·         No invoices have been raised for any amount of Transferred WIP.

·         No consideration has or will be paid by the Taxpayer's or XX for the Transferred WIP.

WIP and receiving fees for services

·         Individual liquidators are generally appointed by the Court or by creditors to act as the administrator or liquidator of insolvent companies.

·         In some cases WIP is accrued before creditor approval for the work is granted (called 'speculative' work) and in other cases creditor approval is sought before accruing WIP.

·         There is no written agreement between the liquidator and the firm in relation to the payment of fees. The only arrangements for fees are between the creditors and the liquidator.

·         The liquidator must first issue a 'Remuneration Request Approval Report' (RRAR), which is used by creditors to inform their decision as to the liquidator's remuneration.

·         Section 60-5 of the Insolvency Practice Schedule contained in Schedule 2 of the Corporations Act 2001 (Insolvency Schedule) then provides that a liquidator is 'entitled to receive' remuneration for either:

o   services performed under a Remuneration Determination, or

o   if no Remuneration Determination is in force, no more than the maximum default amount, which is indexed and is currently $XXXX

·         Under section 60-10(1) of the Insolvency Schedule, Remuneration Determinations can be made by a resolution of the creditors, by a committee of inspection or by the Court.

·         This can be done before or after the relevant services are performed, but in most cases is done after those services are performed.

·         The creditors generally resolve to pay 'the fees of the Liquidator and his staff' rather than resolving to pay the firm. However in practical terms once the approval is given, the firm raises an invoice to the company in liquidation for the work, and thereafter the liquidator will transfer funds from the company to his firm for payment of fees.

·         However, the liquidator does not always receive the full amount sought in the RRAR. If the creditors refuse to agree a satisfactory Remuneration Determination, the liquidator may need to apply to the Court for a determination. A Court may or may not agree to the liquidator's request.

·         Once a Remuneration Determination is made, an invoice is generated for a specific sum, which may or be equal to or less than the amount stipulated in the Remuneration Determination.

Reasons for Decision

Summary

The Taxpayers, in their capacity as partners in the Old Partnership, do not derive assessable income under section 6-5 for WIP accrued by the Old Partnership until both a Remuneration Determination is made and an invoice has been raised.

Similarly, the Transferred WIP will only be taken as derived and assessable income to X under section 6-5 when both a Remuneration Determination is made and an invoice has been raised, not when it is transferred to it.

Since no consideration is paid for the Transferred WIP, there is no amount for which the Taxpayers, in their capacity as partners in the Old Partnership, will derive when the WIP is transferred to X.

Detailed reasoning

Question 1

1.    Principles of Derivation

Subsection 6-5(2) provides that the assessable income of an Australian resident includes ordinary income (including business income) derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Under the accruals method of accounting, income is derived when the right to receive it comes into being. It is not the actual receipt of money but the right to receive that is critical. That is, the point of derivation occurs when a recoverable debt is created.

The term 'derived' is not defined in the ITAA 1997. As such, to determine derivation (which is essentially a timing question), consideration must be had to the principles provided by case law as to its meaning.

Further, the Commissioner's view on income derivation is contained in Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings (TR 98/1)

TR 98/1paragraphs 9 and 11 state:

.... The point of derivation occurs when a 'recoverable debt' is created.

...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. (emphasis added)

Section 6-5(4) states that when working out when income is derived 'you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct'.

TR 93/11 also contains the Commissioner's view on income derivation with respect to professional fees, and the impact of statutory impediments to recovering those fees by commencing legal proceedings. Broadly, TR 93/11 provides that in ascertaining when an amount is derived, each case must be determined by reference to its facts, and having reference to any contract or arrangement in place (though this is only indicative).

In particular, TR 93/11 provides that a recoverable debt arises when 'the taxpayer is not obliged to take any further steps before becoming entitled to payment'.

Barratt v. FC of T 92 ATC 4275; (1992) 23 ATR 339 (Barratt's case) is authority for the position that 'a statutory impediment to a professional person commencing legal proceedings for recovery of fees does not defer the time at which he or she derives the income' (Paragraph 10, TR 93/11). However, this case also notes that it is important to distinguish between the coming into existence of a debt and the operation of impediments to recovery of that debt, and there may be condition(s) precedent to satisfy before a recoverable debt arises.

An amount is not considered to have been derived if the taxpayer's right to receive is contingent (Ballarat Brewing Co Ltd v FC of T (1951) 82 CLR 364 and Arthur Murray). Similarly, if the amount due to the taxpayer cannot be ascertained, then no amount has been derived (Farnsworth v FC of T (1949) 78 CLR 504)

In FC of T v Australian Gas Light Company 83 ATC 4800 (the AGL case), the taxpayer was precluded by the regulations from demanding payment for gas supplied until an account had been rendered, and furthermore, an account could not be rendered until the consumer's meter had been read. As such no income was derived by the taxpayer until both of those steps had been completed.

At [4806] of the AGL Case:

The registration of a customer's gas meter is prima facie evidence of the quantity of gas supplied and determines the quantitative basis on which he is obliged to pay. The reading of the meter and the giving of notice to the customer of what is registered are more than mere procedure. They are conditions precedent to the making of demand for payment. (emphasis added)

In reaching this conclusion, the Court applied two tests:

1)    whether a recoverable debt, in the sense of a debt for which an immediate demand for payment could be made, had arisen; and

2)    whether the taxpayers had completed all steps they were obliged to take before becoming entitled to payment.

The Court took the view that, as a consequence of the exceptional manner in which the taxpayers operate, their claims against customers for current liabilities for gas supplied as at 30 June in each year had not matured into recoverable debts. The Court went on to examine the legislative framework in which the taxpayers operated and concluded that no debt existed in respect of unbilled gas because the earning process was not completed as at 30 June.

In particular, reference was made to sub-regulation 42(1) of the Regulations made under the Gas and Electricity Act 1935 (NSW) which provides that:

42(1) A demand for payment for gas supplied shall not be made by a gas company or an officer of a gas company until an account therefor has been rendered'.

In this regard their Honours found that the reading of the meter and the giving of accounts for gas supplied were more than mere procedures: they were conditions precedent to the making of a demand for payment.

Numerous tests have been propounded and many expressions adopted by the Courts in attempting to state when income is derived - each of them has been conceived in and applied to varied and contrasting circumstances.

2.    Application to the Taxpayers

The fees for the liquidator's services will be derived when they are recoverable in law and become receivable.

Whilst typically reference is given to the terms of a written contract or arrangement governing the professional fees (see paragraph 3-4, TR 93/11), the taxpayers do not have a written agreement in place with their respective clients. We must look at all other facts and circumstances surrounding the derivation of fees.

We understand that the Remuneration Determination must be sought and made before an account for their services can be raised, and once made, sets the maximum amount the creditors authorise the liquidator to charge the company under liquidation. Creditors must approve / determine an amount before the liquidator can generate an account.

The Taxpayers have also demonstrated a commercial practice of issuing an invoice before it receives fees from companies under administration, since the Remuneration Determination sets the amount that 'can' be charged, but not necessary the amount the taxpayers must charge, to the relevant company. The quantum of recoverable debt cannot be determined until an invoice has been issued. In effect, the Remuneration Determination consequence is merely the creation of a right to generate an account rather than entitlement to a debt (Farnsworth v. F.C. of T. (1949) 78 C.L.R. 504; (1949) 9 A.T.D. 33).

Relevantly, TR 93/11 provides, at paragraph 5:

The proper construction of the particular contract or arrangement may be that a recoverable debt for the professional work done is created only when the professional person bills the client. This is the most common arrangement for professional work, particularly if the terms of the contract or arrangement are not in writing. In these circumstances, the fee income is derived in the income year in which the professional person presents the bill to the client. This is so even if the bill allows additional time for payment.

Both the Remuneration Determination and invoice must therefore be issued before the income is derived, and are in effect conditions precedent to the making of demand for payment. This is analogous to the reading of the meter and rendering of an account in the AGL Case. This differs from a statutory impediment to recovering debt (i.e. per Barratt's case), since these steps are not to commence legal proceedings to recover the fees, but rather, conditions precedent before the debt can arise.

Accordingly, a recoverable debt is not created if no Remuneration Determination has been issued, or a Remuneration Determination has been issued but no invoice has been generated. Both are conditions precedent to the deviation of the corresponding income.

Therefore, the Taxpayers, in their capacity as partners in the Old Partnership, will not have derived assessable income under section 6-5 for WIP accrued by the Old Partnership in respect of which no Remuneration Determination has been made and no invoice has been raised.

Question 2

For those reasons outlined at Question 1, the Taxpayers, in their capacity as partners in the Old Partnership, will also not derive assessable income under section 6-5 for WIP accrued by the Old Partnership in respect of which a Remuneration Determination has been made, but before an invoice has been issued in respect of that WIP. Both steps are conditions precedent to the deviation of the corresponding income.

Question 3

The same reasoning applies to WIP transferred from the Old Partnership to X for no consideration.

Where no Remuneration Determination has been made and no invoice has been raised, each of the Taxpayers, in their capacity as partners in the Old Partnership, will not be taken to have derived assessable income under section 6-5 in respect of any Transferred WIP. This is because at that time, it has not been derived, since the conditions precedent have not been met.

Further, where no Remuneration Determination has been made and no invoice has been raised, X will not be taken to have derived assessable income under section 6-5 in respect of that Transferred WIP when received from the Old Partnership. This is because no consideration is received by the Old Partnership for that Transferred WIP, nor has the Transferred WIP been derived by it.

However, once both a Remuneration Determination has been made and an invoice is raised by X in respect of the Transferred WIP, X will then be taken to have derived assessable income under section 6-5, since both procedures are conditions precedent to the creation of a recoverable debt.