Private ruling: Calculation of taxable income
Date of advice: 19 July 2019
Published: September 2019
Ruling period: Year ending 30 June 2017 | Year ending 30 June 2018 | Year ending 30 June 2019 | Year ending 30 June 2020 | Year ending 30 June 2021
Date scheme commenced: 1 July 2016

Ruling: Q1: Can you calculate your taxable income, consisting of trailing commissions, on a profit emerging basis | A1: Yes | Q2: Does the Commissioner of Taxation have a preferred method of calculating the emerging profit generated from the loan books acquired? | A2: Any method will suffice so long as it produces a substantially correct reflex of the taxpayer's true assessable income. | Q3: When the right to receive trailing commissions from a loan book is sold would the sale proceeds be subject to the capital gains tax provisions? | A3: Yes | Q4: As the future sale of the trailing commissions from a loan book is considered a CGT event, are the trailing commissions from the loan book considered an active asset such that the capital gains tax small business concession may be applied? | A4: Yes

Relevant facts and circumstances: Your business consists of acting as a loan broker and receiving trailing commissions, in respect of which it acts as the original broker. The trail income received can be generated from new loans written with financial institutions by the taxpayer or from existing loan books of other third party loan brokers which can be acquired by the company. When a loan book is acquired from another mortgage broker, the purchaser is paying a capital sum that gives it the right to receive future trailing commissions on the existing customer loans within that loan book. The sum paid depends on the amount of annual trailing commissions generated by the loan book, the number of loans and size in dollar terms of the loans within the loan book acquired and the time value of money. Mortgage brokers are paid 'up front commissions' on writing new financial products (mainly home loans) with banks & other financial institutions and 'then trailing commissions while the loan/financial product remains on hand and the customer isn't in default. The agreements between mortgage broker and the financial institution are substantially the same across the finance/lending industry. The mortgage broker's entitlement to trailing commissions arises when the loan is made and settled and is calculated each month as a percentage of the average monthly balance of each loan. The longer the loan remains part of the broker's loan book the more trailing commissions are received over time. Based on industry comparisons, loans may be for periods of up to X years however the average period until they are either repaid or refinanced is Y years. Trailing commissions are thus, on average, payable each month for Y years and depend on the average monthly balance of the loan based on these statistics. The trailing commissions are paid monthly under an arrangement whereby an independent service provider, for a fee, aggregates and collects the commission due to each mortgage broker on its behalf. Loan books comprise the mortgage broker's records of the borrowers (including their addresses, property details, loan balances, value of prospects, unused borrowing capacity. income and repayment details) as well as a non-compete agreement under which the mortgage broker agrees not to solicit or market financial products to the borrowers/customers. There are no regulatory restrictions on the acquisition of trailing commissions or loan books. There is a requirement by the institutions paying the commissions that the purchaser be a member of the Mortgage Finance Association of Australia (MFAA) and have appropriate professional indemnity insurance. You acquired a loan book from a third party, unrelated mortgage broker. Your intention in respect to the acquiring the trailing commissions and this new loan book is to retain the entitlement to collect the future commissions it generates. The purchase of the loan book has been notified to the independent service provider, the costumers, and financial institutions.

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, the company 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 from loan books. 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 & 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. In this case, the company'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. In Carden's case Dixon J pointed out as a general proposition that: ....in the assessment of income the object is to discover what gains have during the period of account come home to the taxpayer in a realized or realizable form. Dixon J also expressed the view that the admissibility of the chosen method of accounting for income depended on 'whether in the circumstances of the case it is calculated to give a substantially correct reflex of the taxpayer's true income'. His Honour also pointed out 'to a great degree the question whether income can be properly calculated on one basis alone or upon either, must depend upon the nature of the source of the income'. In the light of this judicial decision and in the apparent 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 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. There are a number of options for the calculation of the emerging profit, i.e. the straight line approach over 5 years and the actual loan book method assuming the first in/first out (FIFO) methodology. 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. This is the principle established in Carden's case. 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. It is necessary, according to Dixon J in Carden's case to: '.......discover what gains have during the period of account come home to the taxpayer in a realised or immediately realizable form' 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 conclude that any method will suffice so long as it produces a substantially correct reflex of the taxpayer's true assessable income. A further method of calculating the net profit for the purposes of an emerging profits basis of assessment is provided for your consideration as follows: A - (A x B/C) Where A = Collections from the ledger; B = Cost of the ledger; and C = Total anticipated collections from the ledger. This method has been used in calculating net profit arising from the acquisition of debt ledgers. Ordinary income Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income). Ordinary income has generally been held to include 3 categories, namely income from rendering personal services, income from property and income from carrying on a business. Other characteristics of income that have evolved from case law include receipts that: · are earned; · are expected; · are relied upon; and · have an element of periodicity, recurrence or regularity. Capital gains tax (CGT) CGT is the tax you pay on certain gains you make. Section 102-20 of the ITAA 1997 provides that you make a capital gain or capital loss as a result of a CGT event happening to an asset in which you have an ownership interest. Section 108-5 of the ITAA 1997 provides that a CGT asset is any kind of property; or a legal or equitable right that is not property. Taxation Ruling TR 2000/1 discusses insurance registers. Paragraph 17 states a sale of an insurance register constitutes an assignment of property when an agent assigns a presently existing right to future renewal, CPI and/or orphan policy commissions, which has been severed from the remainder of the agent's interest under the agency agreement. Such an assignment confers an immediate entitlement on an assignee with respect to those future commissions. Paragraph 18 states when a chose in action consisting of a right to renewal, CPI and/or orphan policy commissions is severed from an agency agreement and assigned to a purchaser, there is a disposal of a CGT asset (section 104-10, CGT event A1). The cost base of the severed chose in action is worked out under subsections 112-30(2) and (3). The capital proceeds for the CGT event are the amount received from the purchaser or if no amount is received the market value of the CGT asset at the time of the event (section 116-30). The capital gain (or loss) is then worked out under subsection 104-10(4) by subtracting the (reduced) cost base from the capital proceeds. However, a capital gain (or loss) is disregarded if the agency agreement was entered into before 20 September 1985 (paragraph 104-10(5)(a)). In this case you purchased a right to receive income in the form of trailing income from a loan book. This is considered a chose in action which is severed when it is sold, consequently CGT event A1 occurs when the right to receive trailing commissions from a loan book are sold. There are four CGT concessions for small businesses which can apply to CGT events. To qualify for CGT concessions for small business you must satisfy a number of conditions. One of the basic conditions is whether the asset satisfies the active asset test. Section 152-40 outlines the meaning of the term "active asset". Subsection 152-40(1) of the ITAA states a CGT asset is an active asset at a time if, at that time: (a) you own the asset (whether the asset is tangible or intangible) and it is used, or held ready for use, in the course of carrying on a business that is carried on (whether alone or in partnership by: (i) you; or (ii) your affiliate; or (iii) another entity that is connected with your or; (b) If the asset is an intangible - you own it and it is inherently connected with a business that is carried on (whether alone or in partnership) by you, your affiliate, or another entity that is connected with you. In this case the right to receive the trailing commissions from the loan book is owned by you and it is used in the course of carrying on its business, therefore it is an active asset. In order to pass the active asset test Section 152-35 of the ITAA 1997 outlines the conditions to be met. Subsection 152-35(1) of the ITAA 1997 states a CGT asset satisfies the active asset test if: (a) you have owned the asset for 15 years or less and the asset was an active asset of yours for a total of at least half of the period specified in subsection (2); or (b) you have owned the asset for more than 15 years and the asset was an active asset of yours for a total of at least 7.5 years during the period specified in subsection (2). In this case the loan book was acquired in July 2016. Because of the nature of the loan book it is considered that it will always remain an active asset in your hands so it is irrelevant whether the company owns the loan book for less or more than 15 years. It is considered that the loan book meets the active asset test.

Reasons for decision: While the ruling is favourable, the Commission advises that the actual amounts paid for the Loan Book appears to be less than the amount you state as being paid for the Loan Book. | The sale agreement deals with a number of other assets which would have some value and hence reduce the amount paid for the loan book.