ATO ID 2012/26: Deductibility of outgoings incurred for the acquisition of purchased pools of debts
Date of decision: 2 April 2012
Year of income: Year ending 30 June 2012
Business line: Public Groups and International

Issue
Where a taxpayer uses a profit emerging basis as the appropriate method of determining assessable income for the purposes of section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997), are the outgoings incurred in the acquisition of the debts deductible under section 8-1 of the ITAA 1997?

Decision
No. A deduction is not allowable under section 8-1 of the ITAA 1997 for the purchase price of the pools at the time of acquisition.

Facts
The taxpayer is an Australian resident who's business is to acquire for valuable consideration, pools of unpaid loans (for example: credit card and personal) and billing receivables held by its clients (the pools). The pools are acquired by the taxpayer at a discount to their face value and the taxpayer subsequently seeks to collect the debts contained within the pools. The acquisition of the pools of unpaid loans occurs by way of acquisition/assignment agreements. Under these agreements, the taxpayer has the full rights to the unpaid debts, including the right to collect each discrete debt within the pool. The taxpayer has adopted a 'profit emerging' basis as the appropriate means of determining assessable income for the purposes of section 6-5 of the ITAA 1997.

Reasons for decision
Summary: Section 8-1 of the ITAA 1997 provides in relation to a taxpayer's year of income that: 8-1(1) You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a * business for the purpose of gaining or producing your assessable income. Paragraph 8-1(1)(b) of the ITAA 1997 entitles a taxpayer, where they are carrying on a business, to deduct an amount for a loss or outgoing if it is necessarily incurred for the purpose of gaining or producing assessable income. However, the loss or outgoing is subject to the tests within subsection 8-1(2) of the ITAA 1997. Paragraph 8-1(2)(a) of the ITAA 1997 precludes a taxpayer from claiming a deduction where the loss or outgoing can be characterised as being capital in nature. The outgoing that arises upon the purchase of the pools of unpaid loans in this case are clearly incurred in the course of the taxpayer's business and used to produce or gain their assessable income. The necessary inquiry is whether the loss or outgoing is capital in nature. This is determined by reference to the various principles that have been established through the case law. The nature of the outgoings in relation to the pools The judgment of Dixon J in Sun Newspapers & Anor v. Federal Commissioner of Taxation (1938) 61 CLR 337 at page 363 ( Sun Newspapers ) provides the leading distinction for characterising expenditure as revenue or capital in nature. Essentially, after reviewing the existing authorities Dixon J observed that the distinction should be determined by reference to certain practical business considerations, described in the following terms: There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment. In the present circumstances, the individual debts which form the pool are acquired with the intention of collecting the debts within the legal limitations governing enforcement and collection for example limitation by statute etc. Therefore, the individual debts, or pools overall, can reasonably be characterised as forming the core assets used and relied upon by the taxpayer to derive a profit in the operation of its business. Further, the taxpayer's outlay can reasonably be regarded as once-off in regard to securing the right to the assignments under the various pools. Accordingly, it is reasonable to characterise the acquisition of the pools as part of the taxpayer's business structure or its 'profit-yielding subject'. This was articulated by Dixon J in his judgment in Sun Newspapers at pages CLR 359 to 360: 'The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss. The business structure or entity or organization may assume any of an almost infinite variety of shapes and it may be difficult to comprehend under one description all the forms in which it may be manifested... But in spite of the entirely different forms, material and immaterial, in which it may be expressed, such sources of income contain or consist in what has been called a "profit-yielding subject " the phrase of Lord Blackburn in United Collieries Ltd. v. Inland Revenue Commissioners' [(1930) SC 215, at p. 220; (1929) 12 Tax Cas. 1248, at p. 1254] For without the pools, the taxpayer would be unable to neither conduct its business nor be able to gain or produce what is in essence its gains or profits, being constituents of its assessable income. In this case, the pools are an integral part of the taxpayer's business structure and the process used to obtain a return or profit is by the process of working the pools in the expectancy of collecting an amount owing under each debt. This reflects the fact that the debts are a legal chose in action which comprises a bundle or proprietary rights. Therefore, the outgoing incurred in relation to the acquisition of the pools being the 'profit-yielding subject' of the business, are properly characterised as capital in nature. Generally, a business is able to operate on two types of capital, fixed or circulating capital. The distinction between fixed and circulating capital as a principle was articulated by Lord Hanworth in Mallet v Staveley Coal and Iron Company Limited (1928) 2 KB 405; 13 TC 772; [1928] All ER Rep. 644 at pages 645-646. Essentially, fixed capital is that "...which is laid out in the fixed plant, whereby the opportunity of making profits or gains is secured". In contrast, circulating capital is that "...which is turned over and over in the course of the business which is carried on". The taxpayer in this case uses available sources to fund its acquisitions of the pools. It does so in the expectation that these acquisitions will be turned to account and return a profit. This is similar to where the taxpayer is in the business of finance and money is characterised as its' circulating capital (see AVCO Financial Services v. Federal Commissioner of Taxation (1982) 150 CLR 510; 82 ATC 4246; (1982) 13 ATR 63). Thus, the taxpayer's circulating capital is expended with the acquisition of each pool in the expectation that collections will provide a return of the capital expended and more. This, clearly, is an outgoing of circulating capital and any return would generally constitute a mixture of circulating capital and profit. In the case of the taxpayer in the business of finance, money expended as circulating capital in the process of generating profit is precluded from deduction as a revenue expense.

Legislative references: Income Tax Assessment Act 1997 section 6-5 section 8-1 section 8-1(1) Paragraph 8-1(1)(b) section 8-1(2) Paragraph 8-1(2)(a)
Case references: Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 (1938) 5 ATD 87
Related ATO interpretative decisions: ATO ID 2008/39
Subject references: Accounting & record keeping Assignment of rights & entitlements Business income Capital assets Debt related transactions Profits