Edited version of private advice

Authorisation Number: 1051784967778

Date of advice: 27 November 2020

Ruling

Subject: Trailing commissions - loan book - profit emerging basis

Question 1

Can the Taxpayer calculate its taxable income, consisting of trailing commissions from a purchased loan book (the Loan Book), on a profit emerging basis?

Answer

Yes

Question 2

Insofar as it relates to trailing commissions from the Loan Book, does the Commissioner accept the profit emerging calculations provided in the Taxpayer's application for private ruling produce a substantially correct reflex of the Taxpayer's assessable income?

Answer

Yes

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Taxpayer is an incorporated company.

The Taxpayer's business consists of acting as a loan/mortgage broker and it receives commissions in respect of business activities where it was the original broker.

Mortgage brokers are paid up front commissions and trailing commissions by institutional lenders for brokering finance products (predominantly main residence loans and investment loans). The agreements between mortgage brokers and financial institutions are substantially the same across the 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 (0.XX%) of the average monthly balance of each loan.

The trailing commissions are paid monthly under an arrangement whereby an independent service provider aggregates and collects the commissions due to brokers on their behalf.

Loan books comprise of a mortgage brokers client list including, addresses, property details, loan balances, value of prospects, unused borrowing capacity, income and repayment details, entitlement to trailing commissions, etc.

Loan books can be purchased/sold between various entities. There are no regulatory restrictions on the acquisition of loan books. There is, however, a requirement by the institutions paying the commissions that the purchaser be a member of the Mortgage Industry Association of Australia (MIAA) and have appropriate professional indemnity insurance.

Based on industry comparisons, loans may be for periods of up to 30 years however the average period until loans are either repaid or refinanced is 4.5 years. Trailing commissions are thus, on average, payable each month for 4.5 years and depend on the average monthly balance of the loan.

The Taxpayer purchased the Loan Book from a third independent party. The purchase price took into account factors, including the trailing commissions likely to be received and the time value of money.

The Taxpayer's current intention in respect of the Loan Book is to retain entitlement and continue collecting the trailing commissions and service borrowers in the Loan Book. Where applicable, any refinances are removed from the Loan Book into its own (separate) portfolio.

The Taxpayer has reviewed two methods to calculate emerging profit of the Loan Book, the straight line method and the emerging profit formula. The Taxpayer considers the emerging profit approach is the most accurate method for income tax purposes because it incorporates actual and expected trailing commissions into its formula as opposed to a straight line method.

The Taxpayer proposes to continually calculate the emerging profit of the Loan Book in the same manner until the cost base has been exhausted over the 4.5 years and it is confident that 100% of trailing commissions will be taxable.

The Taxpayer's calculations provided with the application for private ruling form part of the facts.

Assumption

The average life of the Australian secured property loan is 4.5 years (54 months).

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 4-15(1)

Income Tax Assessment Act 1997 section 6-5

Reasons for decision

Question 1

Summary

The Taxpayer can determine the component of its assessable income relating to the trailing commissions from the Loan Book on a profit emerging basis.

Detailed reasoning

Subsection 4-15(1) of the Income Tax Assessment Act 1997 (ITAA 1997) states that your taxable income for the income year equals your assessable income for the income year less deductions for that year.

Section 6-5 of the ITAA 1997 provides that if you are an Australian resident your assessable income includes the ordinary income you derived from all sources during the income year. '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 the Loan Book, the Taxpayer acquired a legal chose in action giving it the right to receive trailing commissions. The Taxpayer entered into the transaction with the expectation of making a profit where the proceeds of collection exceed the cost of the acquired right to receive the trailing commissions. The consideration paid to acquire the right to trailing commissions 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.

For the purposes of section 6-5 of the ITAA 1997 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 according to ordinary concepts.

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. If it fails to recover its capital, it incurs a loss. Therefore, only part of the receipts could be considered income. As such, the gross receipts used in the calculation of net profit are themselves not ordinary income.

Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings (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, paragraph 17 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 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.

The Taxpayer's profit-making scheme extends over more than one income year, therefore the bringing to account for tax purposes of the difference between receipts and disbursements in any one particular income year may not give a true reflection of the profit or loss sustained for that year.

ATO Interpretative Decision ATO ID 2008/39 Income tax: Acquisition of debt ledgers (ATO ID 2008/39) outlines that a profit emerging basis is the appropriate method of determining assessable income for the purposes of section 6-5 of the ITAA 1997 in relation to a taxpayer carrying on a business of acquiring and recovering receipts from abandoned debt ledgers. The acquisition of debt ledgers involves the acquisition of a right to receive a sum of money with the expectation that collections will exceed the cost of the acquired debt. Any receipts from collections are a mix of a return of capital (the investment) and a profit component. Given the similarities between the acquisition of debt ledgers and the acquisition of loan books for the right to receive trailing commissions it is therefore appropriate to apply the principles in ATO ID 2008/39 to the acquisition of loan books.

To determine its profit for accounting purposes, it is appropriate that the Taxpayer amortises the cost of acquiring the trailing commissions. To calculate its profit or loss by deducting the total cost from the year's collections for that year would distort its true position for that year. Instead, its profits are more appropriately determined on an emerging basis taking into account that portion of the acquisition cost that results in trailing commission collections in the period.

The profit emerging basis is an appropriate method in determining the Taxpayer's profit and assessable income from the right to receive trailing commissions from the Loan Book for the purposes of section 6-5 of the ITAA 1997.

Question 2

Summary

The Taxpayer's emerging profits method of calculating the profit from its receipts of trailing commissions is appropriate because this method gives a substantially correct reflex of income.

Detailed reasoning

TR 98/1 states:

27. A taxpayer determines when income is derived by adopting a method of accounting for income. When accounting for income, for tax purposes, 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.

28. 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 realized or immediately realizable form.'

The Commissioner does not have a preferred method that should be adopted when using the profit emerging basis of assessment of income. Any method will suffice so long as it produces a substantially correct reflex of the taxpayer's true assessable income. One method that can be adopted is the straight line method. Another method is the emerging profits basis of assessment.

For the purposes of calculating the net profit in respect of debt legers on an emerging profits basis of assessment the following formula may be used:

A - (A x B/C)

Where: A = Collections from the ledger

B = Cost of the ledger

C = Total anticipated collections from the ledger

The result of this calculation is the amount of assessable income for the financial year and the remainder of the collection received is a return of capital.

This method of calculating net profit arising from the acquisition of debt ledgers has been accepted by the Commissioner as also being applicable in respect calculating net profit from trailing commissions where the method provides a substantially correct reflex of the taxpayer's true assessable income.

The Taxpayer has applied the above emerging profit basis of assessment, making its calculations on a monthly basis. The Taxpayer considers the emerging profit basis of assessment produces the most substantially correct reflex of the net profit from the trailing commissions because it incorporates actual and expected trailing commissions into its formula providing greater reflex than a straight line method approach.

The Taxpayer has included in its calculation of the monthly anticipated collections from the Loan Book, a monthly diminishing rate of return of x%. This is based on its experience with an existing loan book purchased previously, where the trailing commissions received from that loan book diminished by an average rate of x% per month over the past years. The application of a monthly diminishing rate of return recognises that the benefit provided by the trailing commissions acquired (being the uncertain future cash flow) reduces over time. That is, trailing commissions are payable each month and depend on the average monthly balance of the loan. Further, the trailing commissions in respect of each particular loan cease when the loan itself expires (for example, due to repayment, refinance, default, etc). The application of a monthly diminishing rate of return to the anticipated collections from the Loan Book is appropriate to recognise the expected reduction in cash flow.

The emerging profit basis of assessment also requires the cost of the Loan Book to be accounted for. Loans may be on foot for up to 30 years, however they generally expire over a much shorter period and in this regard the industry average effective life of property loans (i.e. from commencement until repayment, refinance or default) is assumed to be 4.5 years. The Taxpayer has therefore made its monthly calculations by apportioning the cost of the Loan Book over a period of 54 months (i.e. 4.5 years).

The Taxpayer's emerging profit method of calculating the profit from its receipts of trailing commissions is appropriate because this method produces a substantially correct reflex of the Taxpayer's income from trailing commissions received from the Loan Book. The Taxpayer can use this method to calculate the emerging profits from the trailing commissions for income tax purposes.

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