ATO ID 2008/39: Acquisition of debt ledgers
Date of decision: 11 December 2007
Year of income: Year ended 30 June 2006
Business line: Private Groups and High Wealth Individuals

Issue
Is a profit emerging basis the appropriate method of determining assessable income for the purposes of section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) where a taxpayer carries on the business of acquiring and recovering receipts from abandoned debt ledgers ?

Decision
Yes. A profit emerging basis is the appropriate method of determining assessable income under section 6-5 of the ITAA 1997 for a taxpayer who carries on the business of debt acquisition and recovery.

Facts
The taxpayer is an Australian resident who carries on the business of acquiring debt ledgers from credit providers who have abandoned their recovery. Its income is generated from the expectation that the amount it recovers will be in excess of the amount outlaid in acquiring the debt. Acquired debts are generally kept on the taxpayer's books until such time as the statute of limitations applies. However, the debts may be abandoned where the costs of collection make pursuit of a particular debt non-profitable. In 2005, the taxpayer entered into an agreement with a credit provider under which it acquired outstanding debts at a heavily discounted cost to their face value. The cost of acquisition was based on a number of factors including the face value of the debts, risk, debtor's credit rating and profile. The consideration paid on acquisition of the debt ledgers was funded by a mix of debt and equity.

Reasons for decision
Summary: Section 6-5 of the ITAA 1997 provides, in brief, that an Australian resident must include in assessable income the ordinary income it derives from all sources. 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 outstanding debt, the taxpayer acquired a legal chose in action giving it the right to receive a sum of money. The transaction was entered into with the expectation of making a profit where the proceeds of collection exceed the cost of the acquired debt. The consideration paid on acquisition of the debt 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 its investment (a return of capital) and a profit component. The taxpayer'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. For the purposes of subsection 25(1) of the Income Tax Assessment Act 1936 (now 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. Cititbank Limited & Ors (1993) 44 FCR 434; (1993) 93 ATC 4691; (1993) 26 ATR 423 ( 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 in ordinary concepts. In collecting money in respect of the outstanding debts, the taxpayer recovers its capital and, in part, realises a profit. If it fails to recover its capital, it incurs a loss. Therefore, part only of the receipts could be considered income. As such, the gross receipts used in the calculation of net profit are themselves not ordinary income. For accounting purposes, the taxpayer does not treat the acquired debt at actual cost but on a fair value basis with benefits to be received over income years. That is, the taxpayer does not expense the acquisition cost at the time of acquisition. The release of any fair value gains backed up by actual cash receipts and conversely with any impairment may properly be aligned with the approach in emerging profit. Paragraph 17 of Taxation Ruling TR 98/1 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 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 this instance, it is considered that the accounting evidence is significantly relevant. It is supportive of a method adopted which gives a true reflex of the ordinary income derived by the taxpayer. 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, in circumstances similar to the present case, 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, 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 debt 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 debt that results in collected income over the period. Here, the taxpayer's profit making scheme extends over more than one income year. The bringing to account for tax purposes 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 on an emerging basis is considered most appropriate in determining its income for tax purposes.

Legislative references: Income Tax Assessment Act 1997 section 6-5
Case references: XCO Pty Ltd v. Federal Commissioner of Taxation (1971) 124 CLR 343 (1971) 71 ATC 4152 (1971) 2 ATR 353
Related public rulings and determinations: Taxation Ruling TR 98/1
Subject references: Accounting & record keeping Business income Capital assets Debt related transactions Profits Transfer of book debts