Edited version of private advice

Authorisation Number: 1052035816465

Date of advice: 30 September 2022

Ruling

Subject: Business income - trailing commissions - emerging profit basis

Question 1

Will the Commissioner allow the taxpayer to calculate its taxable income, consisting of annual trailing commissions received from purchased trailing commission rights, on a profit emerging basis?

Answer

Yes. The profit emerging basis is an appropriate method for the taxpayer to calculate taxable income from the right to receive trailing commissions from the loan book for the purposes of section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997).

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The taxpayer is a private company in the business of loan brokering services, superannuation and insurance. It holds an Australian Financial Services Licence and an Australian Credit Licence. It receives trailing commissions in respect of its business activities.

All rights to trailing commissions have the character that the lending institution pay an amount (based upon a formula, per loan and per institution) to the taxpayer, on the basis that it is the holder of such rights.

The taxpayer purchased rights to trailing commissions for a loan book (wholly related to residential borrowings) it acquired from a third party in the 20XX financial year. The purchase price was $X.

The taxpayer's acquisition of the rights to trailing commissions was financed through financial institutions and other sources. Over time, the original borrowing has been partially refinanced internally by replacing some of the external borrowings with the taxpayer's after-tax retained earnings.

The receipt of trailing commissions represents a return of the purchase price; an amount to recoup financing costs; and a profit component. The recoupment of the purchase price is a return of capital; the profit component, and the recoupment of an amount to compensate for the borrowing cost, are assessable income.

The purchase price reflects factors including the trailing commissions likely to be received. At the time the rights were acquired, the purchase price was determined as being a multiple of 2.3 times the annual amount of trailing commission expected to be received. The multiple of 2.3 was the industry standard at that time.

Based on industry data, the average life of a right to trailing commissions (for residential borrowings) is 5 years. This average life has reduced due to an increase in refinancing activity in the market, which itself has been influenced by lower interest rates previously set by the Reserve Bank of Australia.

Over time, the trailing commission rights will reduce due to various factors including:

•                     borrowers paying out their borrowings

•                     borrowers refinancing to a new loan facility with new trailing rights (resulting in cancellation of the original rights)

•                     borrowers selling their property and paying out the remaining borrowings

•                     the taxpayer writing new business for which it is entitled to new trailing commissions, to replace an original trailing commission

This has resulted in an acceleration of the cancellation of the rights to trailing commissions, and a lesser number of rights to trailing commissions being in existence. As such, over the average lifetime of a particular borrowing arrangement, in aggregate the value of that asset will reduce, and when none of the original trail commission rights exist, their value will be nil.

In determining its accounting profits, the taxpayer recognises the annual reductions in the value of rights to trailing commissions over the period that the rights continue to exist. These annual reductions are based on prime cost methodology which assumes that the rights expire evenly over the period they are held. The reductions are offset against annual commissions received to determine annual profits.

The taxpayer will calculate its taxable income from annual trailing commissions on an emerging profit basis.

Relevant legislative provisions

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

Income Tax Assessment Act 1997 section 6-5