Private ruling: Derivation of income on prepaid services
Published: March 2014
Ruling period: 2014 income year
Date scheme commenced: 2014 income year

Ruling: Q1: For the purpose of section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) will the Commissioner confirm that assessable income will not be derived from the sales of prepaid but unredeemed services under the amended terms of sales, until such time as the services are provided to customers? | A1: Yes. | Q2: Will the Commissioner confirm that a calculated estimate of income from prepaid services which are never expected to be redeemed should be brought into account as assessable income under section 6-5 of the ITAA 1997 at year end, notwithstanding the services have not been provided? | A2: No. Income from prepaid services expected never to be redeemed are required to be brought into account as assessable income at the expiry of the two years' period from the date of sales. | Q3: On the basis that income from prepaid services in the 20XX income year under the current terms of sales were brought into account as assessable income in that year, will the Commissioner confirm that this income should not again be brought into account as assessable income under section 6-5 of the ITAA 1997 in a later year when these services are redeemed? | A3: Yes.

Relevant facts and circumstances: Company C operates a business providing services to customers. Services are pre-purchased and prepaid by customers. Customers have 2 years to redeem and use the services. Under the current terms of sales Company C strictly does not provide refunds to its customers. Company C has brought into account all income from the sales of its services as assessable income at the time of sales before services are provided. Company C is now giving consideration to amending the terms of sales to allow refunds in certain circumstances to increase its competitiveness. The accounting treatment for income on the sales of prepaid services remains unchanged. Income from the sales has been and will continue to be recognised on an earnings basis.

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

Reasons for decision: Summary: Section 6-5 of the ITAA 1997 provides that a taxpayer's assessable income includes ordinary income derived by the taxpayer during the income year. Ordinary income is derived when a gain has 'come home' to the taxpayer in a realised or immediately realisable form (F CT v. Executor & Trustee Agency Co of South Australia (1938) 63 CLR 108 ( Carden's Case ). For an amount to have 'come home' requires the amounts received to be unaffected by legal restrictions such as by reason of a trust or charge, and that the situation is reached in which they might properly be counted as gains completely made, so that there is neither legal nor business unsoundness in regarding them without qualification as income derived: see Arthur Murray (NSW) Pty Limited v the Federal Commissioner of Taxation (1965) 114 CLR 314 ( Arthur Murray ) The case of Arthur Murray considered the derivation of fees paid in advance for services where the taxpayer held fees in a separate account as 'unearned income' until services were rendered. Although the fees were not subject to any contractual right of refund, in practice refunds were sometimes given. The Commissioner assessed the fees received in advance as possessing the character of income from the moment of receipt; the taxpayer; however, accounted for the fees at the point services were rendered. The High Court held that it was not appropriate to assess the taxpayer on a cash receipts basis. Two factors which influenced the Court to favour the taxpayer's method of returning income were the possibility of the taxpayer being required to refund some of the amounts it had received for dancing lessons and the correct accounting treatment of payments received in advance of services to be rendered. In determining whether actual earnings were to be added to receipts in order to find income in the case before it, the High Court referred to the judgement in the Carden's Case and stated that the answer must be given in the light of the necessity for earning which is 'inherent in the circumstances of the receipt'. Whilst the fees received by the taxpayer were not prevented from being considered immediately the beneficial property of the taxpayer, as payment in advance was not sufficient to affect any trust or charge or to place any legal impediment barring any dealing with the fees, it was a matter of business good sense that the taxpayer treat the fees received but not yet earned as subject to the contingency that the whole or part may have to be paid back should the agreed quid pro quo not be rendered in due course. It was only with the discharge of the obligations attached to the prepaid fees that the amounts acquired the character of income. The situation with respect to prepaid services is that the obligation to provide the service is the quid pro quo for receiving the payment. The amounts received on the sales of prepaid services acquire the character of income when the services are performed. From the above examination of the relevant case law it is concluded that amounts received from the sales of prepaid services are ordinary income derived when the services are provided. There is no basis for the Commissioner to accept a calculated estimate as an amount of assessable income to be brought into account at year end. Income received but never earned cannot escape tax altogether. Adjustments are required to be made so that receipts are treated as income after a reasonable time has passed and there is no longer any likelihood that a taxpayer will be called upon to earn the income. Customers of Company C have to redeem and use its services within 2 years of purchase. If they are not used within this period Company C is required to bring into account as assessable income the sales of these services at the expiry of the 2 years' period from the date of sales. In the 20XX income year Company C had an unconditional entitlement to retain the income from prepaid services at the time of receipts due to the no refund policy. What was considered 'derived' in that year was, therefore, appropriately determined and returned as income. Due to the change of policy to allow refunds under certain circumstances, derivation of income is deferred until performance of service. Therefore, income appropriately returned in the 20XX year is not required to be returned again in a later income year when services are performed. No amendment to the income tax return for the 20XX year is required.