Edited version of private advice

Authorisation Number: 1051994840722

Date of advice: 30 June 2022

Ruling

Subject: Assessable income - method of calculating profit

Issue 1

Question 1

Can the taxpayer apply the profits on an emerging basis methodology when generating assessable income consisting of trailing commissions from the purchase of a loan book?

Answer

Yes.

Question 2

Does the Commissioner accept the profit emerging calculations provided in the taxpayer's application for private ruling produce a substantially correct reflex of the taxpayer's assessable income?

Answer

Yes.

This ruling applies for the following periods:

Financial year ended 30 June 20XX

Financial year ended 30 June 20XX

Financial year ended 30 June 20XX

Financial year ended 30 June 20XX

Financial year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The 'taxpayer', operates from a unit trust structure. The taxpayer operates as a mobile business banking and mortgage lender/broker who earns commissions from the bank based on facilitation of loans applications where the taxpayer facilitates the loan transaction.

Income earned from the taxpayer's business is derived from two sources, upfront commissions - commissions paid upon application approval, and trailing commissions - commissions paid based on the life of a loan in a broker's loan book. The loan is actively managed by the broker and they will further act as the first point of contact for customers. This income structure is consistent throughout the industry where the agreement is between the broker and an institutional financial entity. Specifically, trailing commissions are calculated, aggregated, and paid out each month by an independent service provider who manages the broker's relationship with the financial institution, ensuring they received the appropriate level of trail commission.

The source and rate of the trailing commission is derived from a document called a loan book. This book is a ledger of loans that a broker will accumulate and manage. Loan books carry a significant amount of goodwill and value, being freely sold and purchased with no regulatory limitations on acquisition or sale of these books. This makes them common transactions within the industry. Obligations in owning a loan book include all obligations to service customers, with the benefit of continuing to collect entitlements and trail commission.

Loans can range up to 30 years however, where a loan is refinanced, it is classified as a new loan. The average time between a refinanced loan is roughly 4.5 years based on industry average. Upon a refinance brokers are able to move loans into their other book where circumstance allows. Loan books summarily comprise of the brokers client list and include important personal details.

Loan book characteristics also include the owners of the loan book having to be a member of the Mortgage Industry Association of Australia (MIAA), the requirement for professional indemnity insurance, and containing non-compete clauses regarding the selling of financial products or market products to borrowers under the loan book.

Recently, the taxpayer has purchased a new loan book comprising of a few locations from another mobile lender. The cost base of the loan book was calculated based on an averaged multiplier of the expected annual trail commission to be received from the loan book across the locations.

The taxpayer has an agreement in place with the bank to solidify this contract. Consideration for the loan book purchase has been split into 3 parts, an upfront deposit, an upfront payment for the book less the already paid deposit, with the remaining to be paid in instalments over the next 24 months. Irrespective of the payment plan, the asset has been transferred to the taxpayer in which the taxpayer has full control and rights to the loan book.

The trail income to be received by the taxpayer has commenced, whereby the taxpayer began receiving trail commission from the bank and by definition, begun receiving economical inflows from the asset.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 4-15(1)

Income Tax Assessment Act 1997 section 6-5

Reasons for decision

Issue 1

Question 1

Summary

The taxpayer can determine the component of its assessable income relating to the trailing commissions from the loan book on a profit emerging basis.

Detailed reasoning

Subsection 4-15(1) of the Income Tax Assessment Act 1997 (ITAA 1997) states that your taxable income for the income year equals your assessable income for the income year less deductions for that year.

Section 6-5 of the ITAA 1997 provides that if you are an Australian resident your assessable income includes the ordinary income you derived from all sources during the income year. 'Ordinary income' is income according to ordinary concepts.

In Federal Commissioner of Taxation v Stone [2005] HCA 21 (2005) 222 CLR 289 (2005) 2005 ATC 4234; (2005) 59 ATR 50, the majority judgment of the High Court considered the meaning of the phrase 'income according to ordinary concepts'. The court referred to the judgment in Scott v Commissioner of Taxation (NSW) (1935) 3 ATD 142 at 144-145, where it was considered that in determining how much of a receipt should be treated as income, regard must be had to the ordinary concepts and usages of mankind.

Upon entering into the agreement to acquire the loan book, the taxpayer acquired a legal chose in action giving it the right to receive trailing commissions. The taxpayer entered into the transaction with the expectation of making a profit where the proceeds of collection exceed the cost of the acquired right to receive the trailing commissions. The consideration paid to acquire the right to trailing commissions is funded by capital being either debt, equity or a mixture of both. Any receipts from collections comprise a return in the form of a partial recovery of its investment (a return of capital) and a profit component.

For the purposes of section 6-5 of the ITAA 1997 a number of cases have determined that gross income, or ordinary income, equates with net profits. As referred to by Hill J in Federal Commissioner of Taxation v Citibank Limited & Ors (1993) 44 FCR 434; (1993) 93 ATC 4691; (1993) 26 ATR 557 (Citibank), a necessary requirement of bringing a net profit into assessable income is that the gross amounts used to calculate that net profit was not itself income according to ordinary concepts.

The trust's receipts from its collection activities do not represent ordinary income. They are receipts of money, rather than ordinary income, which incorporate a mix of returned capital and profit. If it fails to recover its capital, it incurs a loss. Only part of the receipts could be considered income. As such, the gross receipts used in the calculation of net profit are themselves not ordinary income.

Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings provides guidance on the accounting method likely to provide a substantially correct reflex of income in a relevant year. While this ruling is mainly concerned with distinguishing between a cash receipts basis and an earnings basis, paragraph 17 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 Citibank 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 (Carden's case) 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 XCO Pty Ltd v Federal Commissioner of Taxation (1971) 124 CLR 343; (1971) 71 ATC 4152 at 4156; (1971) 2 ATR 353 Gibbs J said:

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.

As the trust's profit-making scheme extends over more than one income year, the bringing to account for tax purposes of the difference between receipts and disbursements in any one particular income year may not give a true reflection of the profit or loss sustained for that year.

ATO Interpretative Decision ATO ID 2008/39 Income tax: Acquisition of debt ledgers outlines that a profit emerging basis is the appropriate method of determining assessable income for the purposes of section 6-5 of the ITAA 1997 in relation to a taxpayer carrying on a business of acquiring and recovering receipts from abandoned debt ledgers. The acquisition of debt ledgers involves the acquisition of a right to receive a sum of money with the expectation that collections will exceed the cost of the acquired debt. Any receipts from collections are a mix of a return of capital (the investment) and a profit component. Given the similarities between the acquisition of debt ledgers and the acquisition of loan books for the right to receive trailing commissions it is appropriate to apply the principles in ATO ID 2008/39 to the acquisition of loan books.

To determine its profit for accounting purposes, it is appropriate that the trust amortises the cost of acquiring the trailing commissions. To calculate its profit or loss by deducting the total cost from the year's collections for that year would distort its true position for that year. Instead, its profits are more appropriately determined on an emerging basis taking into account that portion of the acquisition cost that results in trailing commission collections in the period.

The profit emerging basis is an appropriate method in determining the trust's profit and assessable income from the right to receive trailing commissions from the loan book for the purposes of section 6-5 of the ITAA 1997.

Question 2

Summary

The trust's emerging profits method of calculating the profit from its receipts of trailing commissions is appropriate because this method gives a substantially correct reflex of income.

Detailed reasoning

TR 98/1 states:

27. A taxpayer determines when income is derived by adopting a method of accounting for income. When accounting for income, for tax purposes, a taxpayer must adopt the method of accounting that, in the circumstances, is appropriate. A method of accounting is appropriate if it gives a 'substantially correct reflex' of that income. This is the principle established in Carden's case.

28. Whether a method gives a 'substantially correct reflex' and therefore is appropriate is a conclusion to be made from all circumstances relevant to the taxpayer and the income. It is necessary, according to Dixon J in Carden's case, to:

'... discover what gains have during the period of account come home to the taxpayer in a realized or immediately realizable form.'

The Commissioner does not have a preferred method that should be adopted when using the profit emerging basis of assessment of income. Any method will suffice so long as it produces a substantially correct reflex of the trust's true assessable income. One method that can be adopted is the straight-line method. Another method is the emerging profits basis of assessment.

For the purposes of calculating the net profit in respect of debt ledgers on an emerging profits basis of assessment the following formula may be used:

A - (A x B/C)

Where: A = Collections from the ledger

B = Cost of the ledger

C = Total anticipated collections from the ledger.

The result of this calculation is the amount of assessable income for the financial year and the remainder of the collection received is a return of capital.

This method of calculating net profit arising from the acquisition of debt ledgers has been accepted by the Commissioner as also being applicable in respect calculating net profit from trailing commissions where the method provides a substantially correct reflex of the taxpayer's true assessable income.

The trustee has provided a calculation where they have applied the above emerging profit basis of assessment, making its calculations on a monthly basis. The trustee considers the emerging profit basis of assessment produces the most substantially correct reflex of the net profit from the trailing commissions.

The trustee has included in its calculation of the monthly anticipated collections from the loan book, a monthly diminishing rate of return of x%, based on an actual period. The application of a monthly diminishing rate of return recognises that the benefit provided by the trailing commissions acquired (being the uncertain future cash flow) reduces over time. That is, trailing commissions are payable each month and depend on the average monthly balance of the loan. Further, the trailing commissions in respect of each particular loan cease when the loan itself expires (for example, due to repayment, refinance, default, etc). The application of a monthly diminishing rate of return to the anticipated collections from the loan book is appropriate to recognise the expected reduction in cash flow.

The emerging profit basis of assessment also requires the cost of the loan book to be accounted for. Loans may be on foot for up to 30 years, however they generally expire over a much shorter period and in this regard the industry average effective life of property loans (ie from commencement until repayment, refinance or default) is assumed to be 4.5 years. The trustee has made its monthly calculations by apportioning the cost of the loan book over a period of 54 months (ie 4.5 years).

The trustee's emerging profit method of calculating the profit from its receipts of trailing commissions is appropriate because this method produces a substantially correct reflex of the taxpayer's income from trailing commissions received from the loan book. The trust can use this method to calculate the emerging profits from the trailing commissions for income tax purposes.