Private ruling: Derivation of income
Published: March 2013
Ruling period: Year ending 30 June 2013; | Year ending 30 June 2014; | Year ending 30 June 2015; | Year ending 30 June 2016; | Year ending 30 June 2017; | Year ending 30 June 2018.
Date scheme commenced: On or after 1 July 2012

Ruling: Q1: Is the payment, received by the entity under the Agreement, derived under section 6-5 (4) of the Income Tax Assessment Act 1997 (ITAA 1997) progressively over the duration of the Agreement? | A1: No. Only the amount of the payment that relates to the undertaking by the entity to use its best efforts to increase insurance sales is derived progressively over the duration of the Agreement.

Relevant facts and circumstances: The entity is a privately owned Australian unit trust which operates a business. It uses the accruals method of recognising income. The entity is a casual insurance agent who arranges insurance as an incidental part of their business. In the relevant year, the entity entered into an Agreement (the Agreement) with an insurance company. The Agreement replaces an Agreement between the entity and the insurance company (the Previous Agreement). Under the Agreement, the entity is entitled to a payment (the Payment) which comprises: (a) an amount equal to the commissions to which it is estimated the entity would have been entitled under the Previous Agreement had it not been terminated, on renewal after the relevant year of insurance contracts entered into by the insurance company and arranged or referred by the entity prior to the relevant year, calculated at the rates referred to in Section 1 of Schedule 1 of the Previous Agreement; and (b) an amount for the entity agreeing to: (i) enter into the Agreement; (ii) have the insurance company as its preferred supplier for insurance (as defined in the Agreement); and (iii) use its best efforts to increase sales of insurance contracts in accordance with the insurance company's strategic objectives as agreed from time to time. Section 3 of Schedule 1 to the Agreement states that the Payment is payable upon receipt by the insurance company of a tax invoice from the entity. Upon the termination or early termination of the Agreement the entity is obliged to repay to the insurance company an amount of the Payment calculated in accordance with the formula in the Agreement (the Repayment Formula). The amount that the entity is obliged to repay to the insurance company is determined as a proportion of the Payment calculated ratably over a period of years.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5; | Income Tax Assessment Act 1997 section 104-35; | Income Tax Assessment Act 1997 section 116-40.

Reasons for decision: Summary: Subsection 6-5(2) of the ITAA 1997 provides that an Australian resident is assessable on ordinary income derived directly or indirectly from all sources, whether in or out of Australia during the income year. Ordinary income is derived when a gain has "come home" to the taxpayer in a realised or immediately realisable form ( Commissioner of Taxes (SA) v. Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108 (Carden's case)). For an accruals based taxpayer, a gain has "come home" when a recoverable debt has been created and the taxpayer is not obliged to take any further steps to be entitled to payment ( FCT v. Australian Gas Light Co 83 ATC 4800; (1983) 15 ATR 105; Henderson v. FCT (1970) 119 CLR 612; 70 ATC 4016; (1970) 1 ATR 596; J Rowe & Son Pty Ltd v. FCT (1971) 124 CLR 421; 71 ATC 4157; (1971) 2 ATR 497). Whether there is, in law, a recoverable debt is a question to be determined by reference to the contractual agreements that give rise to the legal entitlement to payment, the general law and any relevant statutory provisions (paragraph 11 of Taxation Ruling TR 98/1 Income tax: determination of income; receipts vs earnings ). | Detailed Reasoning - Apportionment of the Payment: The Payment to which the entity is entitled is explicitly stated as being made up of amounts that relate to a number of different objects. Specifically, it is stated as being made up of: (a) an amount that is an estimate of commissions that would have been payable had the Previous Agreement not been terminated (b) an amount that relates to: (i) the entity entering into the Agreement (ii) the entity having the insurance company as its preferred supplier, and (iii) the entity using its best efforts to increase sales of insurance contracts. Where a single payment is consideration for a mix of discrete promises, and where the component amounts are ascertainable by calculation, the single payment may be apportioned amongst the several heads to which it relates ( McLaurin v. FCT (1961) 104 CLR 381). With respect to the Payment, it is clear that the amount that relates to commissions may be identified. The quantum of this amount is a question of fact to be determined in all of the circumstances. However, it appears reasonable to conclude that an amount that is an "estimate" was calculated at some stage through the negotiation process. The remainder of the Payment must relate to the entity agreeing to do certain things (the other three heads). | Detailed Reasoning - Commission Income: Taxation Ruling IT 2626 Income tax: Commission income of insurance agents and brokers provides the ATO view in relation to the derivation of commission income received by casual insurance agents. It specifically considers circumstances in which some amount of commission received by an agent in advance may be required to be repaid. Paragraph 19 of Taxation Ruling IT 2626 states: If the payment of the commission has matured into a recoverable debt, and the agent or broker is not obliged to take any further step before becoming entitled to payment of the commission, this would strongly indicate that the commission income has been derived ( Henderson v. F.C. of T. (1970) 119 CLR 612, 70 ATC 4016, (1970) 1 ATR 596; Rowe J & Son Pty Ltd v. F.C. of T. (1971) 124 CLR 421, 71 ATC 4157, (1971) 2 ATR 497 and F.C. of T. v. Australian Gas Light Co. 83 ATC 4800, (1983) 15 ATR 105). With respect to repayment of previously assessable commission income, paragraph 24 of IT 2626 states: Where the amount repaid had been previously included in assessable income of the agent or broker, the amount of the repayment would represent a loss or outgoing incurred in gaining or producing the assessable income of the agent or broker. It would therefore be allowable as an income tax deduction under subsection 51(1) of the Act in the year in which the repayment occurs. To the extent that the Payment comprises an amount described by section 1(a) of Schedule 1 of the Agreement as being equal to commission to which it is estimated the entity would have been entitled, the view in IT 2626 applies. Upon providing the insurance company with a tax invoice in accordance with section 3 of Schedule 1 of the Agreement, the entity has undertaken all steps that it is required to take to be entitled to payment. The fact that an amount may be required to be repaid upon the termination of the Agreement does not defer derivation. The amount is derived by the entity in the subsequent income year. | Detailed Reasoning - The Other Three Heads: The amount that remains after the commission income is apportioned out essentially comprises: (a) an incentive for the entity to enter into the Agreement (b) a restrictive covenant against the entity entering into another insurance agency agreement, and (c) an amount in return for the entity promoting the insurance company's product. | Detailed Reasoning - (a) Incentive payment amount: Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income (TR 92/3) provides the ATO view of the application of the decision of the Full Court of the High Court of Australia in Federal Commissioner of Taxation v The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; 18 ATR 693 ( Myer Emporium Case ) in relation to determining whether profits or gains from isolated transactions are ordinary income. Paragraph 6 of TR 92/3 states: Whether a profit from an isolated transaction is income according to the ordinary concepts and usages of mankind depends very much on the circumstances of the case. However, a profit from an isolated transaction is generally income when both of the following elements are present: (a) the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain; and (b) the transaction was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction. In this case, the relevant transaction consists of the entity entering into an agreement to provide insurance services, as an agent of the insurance company, for a specified period of time. In return, the entity received a lump sum incentive payment. The transaction was entered into by the entity both: (a) in the course of carrying on a business, and (b) with the intention of making a profit from entering into the transaction. Accordingly, it is our view that the amount of the Payment that is an incentive for the entity entering into the Agreement is ordinary income, and assessable in the income year in which it is derived. Upon providing the insurance company with a tax invoice in accordance with section 3 of Schedule 1 of the Agreement, the entity has undertaken all steps that it is required to take to be entitled to payment. The fact that an amount may be required to be repaid upon the termination of the Agreement does not defer derivation. The amount is derived by the entity in the subsequent income year. | Detailed Reasoning - (b) Amount for entering into restrictive covenant: Amounts received in consideration of a restrictive covenant, where the recipient undertakes not to use specified assets or to trade only with the other party to the agreement, are generally of a capital nature. CGT event D1 happens if a taxpayer creates a contractual right or other legal or equitable right in another entity (subsection 104-35(1) of the ITAA 1997). The time of the event is when the contract is entered into or right is created (subsection 104-35(2) of the ITAA 1997). The entity entered into the Agreement with the insurance company in the relevant year. The Agreement created a contractual right in the insurance company to terminate the Agreement if the entity breaches a material term of the contract, and the right to demand a payment from the entity if they breach the contract before the expiry date. A clause of the Agreement, under which the entity agrees that the insurance company will be its preferred supplier for a period of years, is a restrictive covenant. Under that clause, the entity agrees not to provide a Financial Service (defined in the Agreement), pass on prepared documents or make a referral on behalf of any other person. Therefore, CGT event D1 happened when the entity entered into the agreement. Accordingly, the entity will make a capital gain from the event if the capital proceeds from creating the right are more than the incidental costs that related to the event (subsection 104-35(3) of the ITAA 1997). Where, as in this case, a payment relates to a CGT event and to something else, the capital proceeds that relate to the CGT event are so much of the payment that is reasonably attributable to the event (subsection 116-40(2) of the ITAA 1997). Accordingly, so much of the Payment that the entity received under the Agreement, that is reasonably attributable to the restrictive covenant, is capital proceeds in relation to CGT event D1. To the extent that the capital proceeds exceed the incidental costs that related to the event, the entity have made a capital gain in the subsequent income year. | Detailed Reasoning - (c) Amount for promoting the insurance company's product: As discussed above, for an accruals based taxpayer, a gain is derived when a recoverable debt has been created and the taxpayer is not obliged to take any further steps to be entitled to payment. However, an exception to this rule is that amounts received in advance of services being provided, in companion with a legal or commercial requirement for a refund to the extent of non-performance, are not derived until the services have been provided ( Arthur Murray (N.S.W.) Pty Ltd v. Federal Commissioner of Taxation (1965) 114 CLR 314; 14 ATD 98; (1965) 9 AITR 673). In relation to the amount of the Payment that relates to the entity undertaking to use its best efforts to increase the sales of the insurance company's insurance products, the undertaking to which the payment relates obliges the entity to "do" something for a period of some years. That is, unlike the other components of the Payment, it is not sufficient for the entity to simply provide the insurance company with an invoice requesting payment. The entity is required to actively market the insurance component of their business, of which the insurance company is a sole preferred supplier In the event of non-performance, evidenced by an early termination of the contract by the insurance company, the entity is required to repay a pro rata amount of the Payment that relates to the unexpired term of the Agreement. For accounting purposes, the entity uses an accruals method of accounting and upon receipt of the Payment, it is credited to an unearned income account and only transferred to an income account in the Profit & Loss statement on a pro rata basis as the services are rendered. In all of the circumstances, a true reflex of the entity's income would appear to be that the amount of the Payment that relates to the entity undertaking to use its best efforts to increase the sales of the insurance company's insurance products is derived progressively over the first X years of the term of the Agreement as the services are provided.