Private ruling: Trailing commissions and profit emerging basis
Published: July 2012
Ruling period: For years ended 30 June 2011 to 2015
Date scheme commenced: 1 July 2010

Ruling: Questions and Answers | 1. Is the expenditure incurred in acquiring trailing commissions deductible in accordance with section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | No. | 2. Can a deduction be claimed in relation to the decline in value of trailing commissions in accordance with section 40-25 of the ITAA 1997? | No. | 3. Is the expenditure incurred in acquiring trailing commissions, deductible over five years in accordance with section 40-880 of the ITAA 1997? | No. | 4. Can the profit emerging basis, calculated using cash receipts be used to include trailing commissions (acquired) in assessable income in accordance with section 6-5 of the ITAA 1997? | Yes.


Relevant legislative provisions: Income Tax Assessment Act 1997 Section 6-5 | Income Tax Assessment Act 1997 Section 8-1 | Income Tax Assessment Act 1997 Section 40-25 | Income Tax Assessment Act 1997 Section 40-30 | Income Tax Assessment Act 1997 Section 40-880 | Income Tax Assessment Act 1997 Section 108-5 | Income Tax Assessment Act 1997 Section 110-25

Reasons for decision: Summary: Is the expenditure incurred in acquiring trailing commissions deductible in accordance with section 8-1 of the ITAA 1997? Expenditure is not deductible in accordance with Section of 8-1 of the ITAA 1997 where it is a loss or outgoing of capital, or of a capital nature . The purchase of the trailing commissions, being a one off transaction paid for by way of lump sum consideration, will increase the profit yielding structure. Therefore, the expenditure incurred to acquire the trailing commissions is of a capital nature and accordingly not deductible in accordance with section 8-1 of the ITAA 1997. Can a deduction be claimed in relation to the decline in value of trailing commissions in accordance with section 40-25 of the ITAA 1997? In accordance with section 40-25 of the ITAA 1997, the decline in value of a depreciating asset held by a taxpayer may be deducted in that income year if the asset was used for the purpose of producing assessable income during that year. Trailing commissions, being contractual rights to future cash flows from independent third parties, are intangible assets. Trailing commissions do not comprise a type of intangible assets listed in subsection 40-30(2) of the ITAA 1997. Therefore, the trailing commissions cannot be depreciating assets in accordance with section 40-30 of the ITAA 1997 and no deductions are available in accordance with section 40-25 of the ITAA 1997. Is the expenditure incurred in acquiring trailing commissions, deductible over five years in accordance with section 40-880 of the ITAA 1997? Capital expenditure is not deductible in accordance with section 40-880 of the ITAA where it could, apart from this section, be taken into account in working out the amount of a capital gain or capital loss from a CGT event. In this regard, in accordance with section 108-5 of the ITAA 1997, a CGT asset includes: (a) any kind of property; or (b) a legal or equitable right that is not property . Trailing commissions are legal rights, and therefore satisfy the definition of a CGT asset. Capital expenditure incurred to acquire trailing commissions will form part of the first element of the cost base of a CGT asset in accordance with paragraph 110-25(2)(a) of the ITAA 1997, and can thus be taken into account in working out the amount of a capital gain or loss from a CGT event. Therefore, the expenditure incurred to acquire the trailing commissions is not deductible in accordance with section 40-880 of the ITAA 1997. Can the profit emerging basis, calculated using cash receipts be used to include trailing commissions (acquired) in assessable income in accordance with section 6-5 of the ITAA 1997? 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 commissions, the entity 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. 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 entity'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 & 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, 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. Here, 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, calculated using cash receipts is therefore considered to be the most appropriate in determining the income for taxation purposes. | Detailed Reasoning - Additional information: 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, calculated 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. Some possible options are: 1. Loan acquisition costs would be amortised on a straight line basis over the average life of the loans. 2. The first in/first out (FIFO) methodology, where a taxpayer is able to determine a reasonably accurate estimate of the balance of acquired loans annually by undertaking the following analysis: o determine the balance of loans on the books at year end; deduct any new loans made during the year and prior years; adopt a FIFO basis assumption for loans being refinanced. 3. A method has been used in calculating net profit arising from the acquisition of debt ledgers: A - (A x B / C) Where A = Collections from the ledger; B = Cost of the ledger; and C = Total anticipated collections from the ledger.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet. | Purchase of Trailing Commissions: In accordance with the Agreement, the entity purchased from the Vendor: | · The "Commission Rights" for an amount, being rights to receive trailing commissions in respect of the loans listed in the Agreement, which were assigned to the entity (with consent from third parties where necessary); and | · The "Records" for an amount, being all documents and information of the Vendor in relation to the trailing commissions (i.e. books, files, reports, records, correspondence, contracts, documents and other materials). | There are no regulatory restrictions on the acquisition of trailing commissions (i.e. receipt of commissions is dependent upon the loans remaining on foot). Their acquisition therefore provides the entity with an uncertain future cash flow, and accordingly, the purchase price paid was determined by reference to the entities estimate of the present value of the expected future commission receipts. | The management of the entity intends to retain the assets acquired, and is not in the business of trading rights to trailing commissions. | Profile of Trailing Commissions: The benefit provided by the trailing commissions acquired by the entity, being the uncertain future cash flow, reduces over time. That is, the trailing commissions in respect of each particular loan cease when the loan itself expires (for example, due to repayment, refinance, default etc). | Loans may be on foot for up to 30 years however they generally expire over a much shorter period. In this regard, the management of the entity understands the industry average effective life of property loans (i.e. from commencement until repayment, refinance or default) in Australia is 4.5 years. This is supported by the Australian Securities and Investment Commission's (" ASIC ") Review of Mortgage Entry and Exit Fees dated April 2008, which indicates the average Australian mortgage is terminated or refinanced within 3 years. | The management of the entity expects a similar effective life to the industry average of 4.5 years will apply to the trailing commissions acquired from the Vendor.