Private ruling: Profit emerging basis
Date of advice: 11 October 2016
Published: November 2016
Ruling period: Year ended 30 June 20XX | Year ended 30 June 20XX | Year ended 30 June 20XX | Year ending 30 June 20XX | Year ending 30 June 20XX | Year ending 30 June 20XX | Year ending 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Can the entity calculate its taxable income, consisting of upfront commissions, annual commissions, trailing commissions and fees earned from purchased financial planning clients, on a profit emerging basis? | A1: Yes.


Relevant legislative provisions: Income Tax Assessment Act 1997 Section 6-5

Reasons for decision: Summary: Section 6-5 of the Income Tax Assessment Act 1997 (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. The entity acquires servicing rights for financial planning clients but is not authorised to provide financial services. Consequently it enters into arms-length agreements with other entities which provide the financial services and in return pay a percentage of the resulting commissions and fees to the entity. In practical terms, by entering into such an arrangement, the entity essentially acquires a right to receive a sum of money. The arrangement is entered into with the expectation of making a profit where the proceeds of collection exceed the cost of the acquired right to receive a share of the commissions and fees from the licensed financial planning entity. The consideration paid for that right is funded by capital being either debt, equity or a mixture of both. Accordingly 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 entity's receipts from its collection activities do not represent ordinary income in its hands. They are receipts of money, rather than ordinary income, which incorporate a mix of returned capital and profit. For the purposes of section 6-5 of the ITAA 1997 (formerly subsection 25(1) of the Income Tax Assessment Act 1936 ) 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. Citibank Limited & Ors (1993) 44 FCR 434; (1993) 93 ATC 4691; (1993) 26 ATR 557 ( Citibank ), a necessary requirement of bringing a net profit into assessable income is that the gross amounts used to calculate that net profit were not themselves income according to ordinary concepts. In collecting money in respect of the commissions and fees from the financial planner, the entity 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. 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 (Carden's case) 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 XCO Pty Ltd v. Federal Commissioner of Taxation (1971) 124 CLR 343; (1971) 71 ATC 4152; (1971) 2 ATR 353, (XCO) 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, 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 this case, the entity's 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 an emerging profit basis is therefore considered to be the most appropriate in determining the income for taxation purposes. | Detailed Reasoning - Accounting treatment: In the 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 using cash receipts 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. Taxation Ruling TR 98/1 provides guidance on the accounting method likely to provide a substantially correct reflex of income in a relevant year. While this ruling is mainly concerned with distinguishing between a cash receipts basis and an earnings basis, it does note at paragraphs 27 and 28 that a taxpayer must adopt the method of accounting that, in the circumstances, is appropriate. A method of accounting is appropriate if it gives 'a substantially correct reflex' of that income. Whether a method gives a substantially correct reflex and therefore is appropriate, is a conclusion to be made from all circumstances relevant to the taxpayer and the income. In the absence of any direct guidance as to the method to be adopted when using the emerging profits basis of assessment of income, we therefore conclude that any method will suffice so long as it produces a substantially correct reflex of the taxpayer's true assessable income. In this case, it is considered that the methodology proposed by the entity is an appropriate method of returning the profit derived from acquiring the servicing rights as this method gives a 'substantially correct reflex of income in a relevant year' for the entity.

Relevant facts: The entity carries on an investment activity in which it purchases servicing rights associated with financial planning clients for the purpose of generating an overall profit which is the difference between the entity's share of commissions/fees received over the life of the servicing rights and the cost of purchasing the servicing rights. | The entity does not hold a proper authority to provide financial advice and enters into service agreements (on an arm's length basis) with entities appropriately licensed to provide financial advice and those entities provide the actual financial advice to those clients who are the subject of the servicing rights. | Those other parties receive professional fees directly for the provision of financial advice to the clients in addition to upfront and trailing commissions. In consideration for entering into the service agreements the entity receives a share of those professional fees as well as a share of the upfront commissions and trailing commissions from the licenced financial service providers for using the servicing rights. | Over time, the commissions and fees derived from the clients who are the subject of the purchased servicing rights will diminish (due to many factors including for example the fact that clients will no longer require the services due to changed financial circumstances or changed financial product requirements) until eventually reaching nil. | The company proposes to adopt the following accounting methodology in determining its annual assessable income using a profit emerging basis: | Where A = Commissions/fees received during the income year from the servicing rights; B = Cost of the servicing rights; and C = Total anticipated commissions/fees that will be received over the life of the servicing rights.