Private ruling: Income Tax - Profit Emerging Basis
Published: September 2017
Ruling period: Year ended 30 June 2015 | Year ended 30 June 2016 | Year ending 30 June 2017 | Year ending 30 June 2018 | Year ending 30 June 2019 | Year ending 30 June 2020
Date scheme commenced: 1 July 2014

Ruling: Q1: Will the Commissioner of Taxation allow Z to calculate its taxable income, consisting of annual and trailing commissioners received from purchased trailing commission rights, on a profit emerging basis? | A1: Yes.

Relevant facts and circumstances: Z has been operating a business since 20XX. Z also carries on an investment activity in which it purchases rights to trailing commissions associated with financial planning clients for the purpose of generating overall profit from the acquisition of those rights. In addition to the acquisition of rights to trailing commission Z carries on a financial planning business where it provides financial advice and related services for which it derives separate income streams. Z commenced operations in 20XX and at that time purchased a substantial amount of rights to trailing commissions. The rights to trailing commissions can be classified as being related to: Ø Insurance policies Ø Superannuation/investment products Ø Retail investment accounts Ø Loan registers/mortgage bonds Given the nature of the purchased rights to trailing commissions their value progressively decreases and over time the market value of those rights will reach zero when no further commissions/fees are received from holding those rights. The critical determinant of the commercial return on the investment is the duration or period of time that the trailing commissions will be received. The terminology used by industry parties for trailing commission includes trailing commissions, product trail, etc. Notwithstanding, all rights to commissions have the character of the institution that issued the policy, account or loan then pay an amount to Z on the basis that Z is the holder of the rights. Once Z became entitled to trailing commissions from those policies, accounts and loans the trailing commission amount was paid 'automatically' into the bank account of Z. To receive commission Z must hold an Australian Financial Services License however the holders of the policies, accounts or loans did not have to approve the payment of the trailing commissions to Z. Z is not and has never had the intention and has no intention of being in the future, in the business of buying and selling the rights to trailing commissions. Z plans to make further purchases of trailing commissions in the future. By acquiring the rights to the trailing commissions Z has the opportunity to market to the group of clients but little else.

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. Upon entering into the agreement to acquire commissions, Z 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 right to receive trailing commissions associated with financial planning clients. 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 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 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 and 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 was not itself income in ordinary concepts. In collecting money in respect of the outstanding trailing commissions, Z 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 and 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, Z'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.