Edited version of private advice

Authorisation Number: 1052377116288

Date of advice: 26 March 2025

Ruling

Subject: Trailing commissions

Question 1

Can you calculate your taxable income, consisting of trailing commissions from purchased loan books, on an emerging profits basis?

Answer 1

Yes.

Question 2

Does the Commissioner have a preferred method of calculating the emerging profit generated from the loan books acquired?

Answer 2

No.

Question 3

Is a loan book a capital gains tax (CGT) asset and will the gain made on its disposal at 2.5-3 times the annual trail income be assessed under the CGT provisions?

Answer 3

Yes.

Question 4

Is a loan book considered an active asset for the purposes of the CGT small business concessions?

Answer 4

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 April 20XX

Relevant facts and circumstances

Your business consists of acting as a loan broker and receiving trail commissions, in respect of which you act as the original broker.

The trail income received can be generated from new loans written with financial institutions by you or from existing loan books of other third-party loan brokers which you can acquire.

Your entitlement to trailing commissions arises when the loan is made and settled and is calculated each month as a percentage of the average monthly balance of each loan. The longer the loan remains part of your loan book, the more trailing commissions are received over time.

Based on industry comparisons, loans may be for periods of up to XX years, however the average period until a loan is either repaid or refinanced is X years. Trailing commissions are thus, on average, payable each month for X years and depend on the average monthly balance of the loan based on these statistics.

The trailing commissions are paid monthly under an arrangement whereby an independent service provider, for a fee, aggregates and collects the commissions due to each mortgage broker on its behalf.

There are no regulatory restrictions on the acquisition of trailing commissions or loan books. There is a requirement by the institutions paying the commissions that the purchaser be a member of the Mortgage Finance Association of Australia (MFAA) and have appropriate professional indemnity insurance.

You acquired a loan book asset from a third party, unrelated mortgage broker. Your intention in acquiring the trailing commission on this new loan book is to retain the entitlement to collect the future commissions it generates.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 subsection 108-5(1)

Income Tax Assessment Act 1997 Subdivision 152-A

Income Tax Assessment Act 1997 paragraph 152-40(1)(a)

Income Tax Assessment Act 1997 paragraph 152-40(1)(b)

Reasons for decision

Question 1

Your assessable income includes income according to ordinary concepts, which is called ordinary income (section 6-5 of the ITAA 1997).

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.

When you entered into the agreement to acquire a loan book, you acquired a legal chose in action giving you the right to receive trailing commissions. You entered into the transaction with the expectation of making a profit where the proceeds from the trailing commissions would exceed the cost of the acquired right to receive them. The consideration paid on acquisition of the right is funded by capital being either debt, equity or a mixture of both. Any receipts from collections therefore comprise a return in the form of a partial recovery of your investment (a return of capital) and a profit component.

As such, the receipt of trailing commissions from the loan book purchased by you, do not represent ordinary income. They are receipts of money, rather than ordinary income, which incorporate a mix of returned capital and profit.

Paragraph 17 of Taxation Ruling TR 98/1 (Income tax: determination of income; receipts versus earnings) 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 Federal Commissioner of Taxation v. Citibank Limited & Ors (1993) 44 FCR 434; (1993) 93 ATC 4691; (1993) 26 ATR 423 Hill J, in considering the relevance of accounting evidence in determining income tax issues, said:

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; (1971) 2 ATR 353, the High Court considered the application of a profit emerging basis, where a taxpayer was assigned debts at a deep discount to their face value for consideration 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.

In determining its profit for accounting purposes, it is appropriate that the taxpayer amortises the cost of the debt ledgers. It does not calculate its profit or loss by deducting from the year's collections the total cost it outlays in acquiring trailing commissions for that year for that would distort its true position for that year. Instead, its profits are effectively determined on an emerging basis taking into account that portion of the cost relevant to the acquisition of the trailing commissions that result in collected income over the period.

In your case, your 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 will not give a true reflection of the profit or loss sustained for that year. The assessment of profit under section 6-5 of the ITAA 1997 on a profit emerging basis is therefore considered to be the most appropriate method in determining your income (from the acquired loan book) for taxation purposes.

Question 2

In The Commissioner of Taxes (South Australia) v The Executor Trustee and Agency Company of South Australia Limited (1938) 63 CLR 108 Dixon J pointed out as a general proposition 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 realizable form.

Dixon J also expressed the view that the admissibility of the chosen method of accounting for income depended on 'whether in the circumstances of the case it is calculated to give a substantially correct reflex of the taxpayer's true income'. His Honour also pointed out 'to a great degree the question whether income can be properly calculated on one basis alone or upon either, must depend upon the nature of the source of the income'.

In light of this judicial decision, and in the apparent absence of any ruling or other determination or direction by the Commissioner specifying how assessable income is to be calculated when an emerging profit basis is the appropriate form of assessment of income, it is considered that more than one basis of calculating the assessable income may be contemplated as being correct.

Consequently, 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 taxpayer's true assessable income. Whether a method gives a substantially correct reflex and therefore is appropriate is a conclusion to be made from all the circumstances relevant to the taxpayer and the income.

Additional information

Possible methods that could be adopted include the straight line and the first in/first out (FIFO) methodologies.

A further method for your consideration is a formula used in the calculation of income from debt ledgers:

A − (A × B÷C)

Where A = Collections from the ledger; B = Cost of the ledger; and C = Total anticipated collections from the ledger.

The result of the calculation is the amount of assessable income for the financial year and the remainder of the collections is a return of capital. This method could equally apply to the receipt of trailing commissions.

Question 3

A CGT asset is any kind of property, or a legal or equitable right that is not property (subsection 108-5(1) of the ITAA 1997).

Taxation Ruling TR 2000/1 (Income tax: insurance registers) provides guidelines on the taxation consequences of acquiring or disposing of an insurance register. For the purposes of the ruling an insurance register is a record of the rights of an insurance agent to future commissions and a record of policyholders that an agent has an exclusive right to deal with on behalf of an insurance company. TR 2000/1 considers that an insurance register is a capital asset where it is held as part of the profit-making structure of a business.

Loan books are comparable to insurance registers. As the loan book you own forms part of the profit yielding structure of your loan broking business, we consider the loan book to be a CGT asset.

Amounts you receive for disposing of the loan book would be of a capital nature and constitute capital proceeds for the disposal of a CGT asset. Any gain made on that disposal would be assessed under the CGT provisions.

Question 4

A CGT asset is an active asset at a time if, at that time, you own the asset (whether the asset is tangible or intangible) and it is used or held ready for use, in the course of carrying on a business that is carried on by you, your affiliate or another entity that is connected with you (paragraph 152-40(1)(a) of the ITAA 1997). If the asset is an intangible asset, it will be an active asset if, at that time, you own it and it is inherently connected with a business that is carried on by you, your affiliate, or another entity that is connected with you (paragraph 152-40(1)(b) of the ITAA 1997).

Your loan book is an intangible CGT asset that is inherently connected with your loan broking business and is therefore an active asset.

When you dispose of a loan book CGT event A1 will happen (section 104-10 of the ITAA 1997). For that disposal to qualify for the small business concessions you will need to satisfy the basic conditions in Subdivision 152-A of the ITAA 1997.