Edited version of private advice

Authorisation Number: 1052058093317

Date of advice: 18 November 2022

Ruling

Subject: Time of derivation of income

Question

Does the taxpayer include fees invoiced in advance as assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) when the services for which the fees are paid are fully provided or the contingency of repayment otherwise lapses?

Answer

Yes.

This ruling applies for the following periods:

A number of income years

The scheme commences on:

The start of an income year

Relevant facts and circumstances

1.    A taxpayer generates revenue by licensing its products to licensees for a fee which is invoiced in advanced for a defined term. The licensing arrangement is governed by a Licence Agreement between the taxpayer and the licensee.

2.    The Licence Agreement contains clauses that:

(a)   requires the taxpayer to refund any unused portion of the fees if the taxpayer elects to terminate, and the licensee is not in breach of, the agreement

(b)   requires the taxpayer to warrant the quality of its product to a particular industry standard, and

(c)   limits the taxpayer's damages for breach of warranty to replacing or repairing the defective product.

3.    For accounting purposes, the taxpayer recognises the fees as income on a pro-rata daily basis over the period of the defined term.

4.    The taxpayer has a corporate cancellation and refund policy guiding its treatment of a licensee's request for a refund (Licensee Refund Requests). The refund policy documents the principles applied by the taxpayer in assessing Licensee Refund Requests and outlines a number of circumstances where a cancellation and refund will be provided to the licensee (although the refund policy specifically states that the examples provided in the document are not a comprehensive list).

5.    Notwithstanding the provisions of the Licence Agreement, the taxpayer has a demonstrated commercial practice of agreeing to a Licensee Refund Request where the licensee has not breached any of the provisions in the Licence Agreement and can provide bona fide reasons for the request.

6.    The taxpayer has no intention of changing its treatment of Licensee Refund Requests in the foreseeable future.

Relevant legislative provisions

Section 6-5 of the ITAA 1997

Reasons for decision

Summary

The fees are derived and assessable to the taxpayer under section 6-5 of the ITAA 1997 when the services for which the fees are paid are fully provided or when the contingency of repayment otherwise lapses

Detailed reasoning

All legislative references are to the provisions of the ITAA 1997 unless otherwise indicated.

Section 6-5 provides that a taxpayer's assessable income includes the ordinary income derived by the taxpayer during the income year.

The term 'derived' is not defined in the Income Tax Assessment Act 1936 or the ITAA 1997. As such, consideration must be given to the principles provided by case law as to its meaning.

The meaning of the words 'income derived' was considered by the High Court in Arthur Murray (NSW) Pty Ltd v Commissioner of Taxation (Cth) [1965] HCA 58 (Arthur Murray).

In Arthur Murray, the taxpayer received amounts in advance for a specified number of dance lessons to be given over a period of time. Whilst students did not have any contractual right to a refund, it was the general practice of the taxpayer to give refunds where not all lessons were taken. The taxpayer's books of account recognised fees as income when the lessons to which the fees related were taught.

Their Honours relevantly held in Arthur Murray that:

It is true that in a case like the present the circumstances of the receipt do not prevent the amount received from becoming immediately the beneficial property of the company; for the fact that it has been paid in advance is not enough to affect it with any trust or charge, or to place any legal impediment in the way of the recipient's dealing with it as he will. But those circumstances nevertheless make it surely necessary, as a matter of business good sense, that the recipient should treat each amount of fees received but not yet earned as subject to the contingency that the whole or some part of it may have in effect to be paid back, even if only as damages, should the agreed quid pro quo not be rendered in due course. The possibility of having to make such a payment back (we speak, of course, in practical terms) is an inherent characteristic of the receipt itself. In our opinion it would be out of accord with the realities of the situation to hold, while the possibility remains, that the amount received has the quality of income derived by the company.

The principles from Arthur Murray are captured in Taxation Ruling TR 2014/1 Income tax: commercial software licencing and hosted agreements: derivation of income from agreements for the right to use proprietary software and the provision of related services. TR 2014/1 provides that where an amount properly attributable to a contractual obligation is subject to a 'contingency of repayment', the amount is derived for the purposes of section 6-5 when the obligation is fully performed or the contingency of repayment otherwise lapses.

A 'contingency of repayment' in the event of future non-performance refers to there being either:

(a)  a contractual obligation to make a refund

(b)  a demonstrated commercial practice to make a refund, or

(c)   the existence of contractual exposure for damages in respect of the non-performance.

It is only in cases where a 'contingency of repayment' exists that deferral of the amount derived until the obligation is fully performed or the contingency of repayment otherwise lapses is valid for income tax purposes. Where no relevant contingency exists, the amount is derived when a recoverable debt arises: Henderson v Commissioner of Taxation (Cth) [1970] HCA 62.

The context of the reference to damages in Arthur Murray was to contractual damages for breach. Damages pursuant to consumer protection law, or damages in tort, were not contemplated in Arthur Murray and are not relevant to the question of determining the incidence of derivation of 'unearned income'.

An exposure to contractual damages will exist where at the end of the licence agreement (or at some other time specified in the contract), the taxpayer is exposed to a provable cause of action for failure to fully perform on the contract.

Pursuant to TR 2014/1, a commercial practice in relation to refunds must be evidence-based and not merely an assertion. Evidence may include a demonstrated practice over time or a stated practice in corporate policy documents.

In the context of the present case, the taxpayer has a contractual obligation to refund any unused portion of the fees if it elects to terminate, and the licensee is not in breach of, the Licence Agreement. Consequently, the taxpayer has a contractual obligation to make refunds.

Further, the taxpayer has a contractual exposure to damages if it breaches its warranty of providing products to the quality of a particular industry standard.

The taxpayer has also demonstrated a commercial practice of making refunds upon a licensee's request of the unused portion of the fees and has a corporate refund policy guiding its treatment of Licensee Refund Requests.

The taxpayer accounts for the fees on a pro-rata daily basis over the period of the defined term for accounting purposes and has no intention of changing its treatment of Licensee Refund Requests in the foreseeable future.

Consequently, the fees are derived and assessable under section 6-5 when the services for which the fees are paid are fully provided or when the contingency of repayment otherwise lapses.