Rethink your drive to derive
Tax Telegraph, July 2013
A lot of businesses make a living from commission income. These commissions can be paid upfront or at various stages depending on the agreement. The question often arises as to what point these commissions should be brought to account as income.
Many businesses in the motor industry would be familiar with comprehensive third party (CTP) insurance commission income. Often these agreements are structured in a way that is not tax effective. Before finalising your next agreement, consideration should be given to commercial ways in which it can be structured to ensure that revenue is deferred over the life of the contract rather than the total amount being assessable upfront. This deferral of income means less tax to pay upfront and more cash in the bank for your business (well at least until a later year!).
Many motor dealers act as casual insurance agents who arrange insurance as an incidental part of their motor dealer business. Agreements with the relevant insurance agents are entered into which can have different tax consequences depending on how they are worded. Quite frequently, a lump sum payment is received upfront for sales and referral services which can span out over years and if the contracts are not drafted correctly, the Australian Taxation Office (ATO) may deem this payment to be derived upfront and the total amount will be assessable in the first year.
The derivation of income
Taxpayers must include gross income derived in their assessable income. There is no specific method which determines the amount of income derived by a taxpayer. Accordingly, the term ‘derive’ bears its ordinary meaning and an appropriate method of accounting must be adopted.
Taxation Ruling No. IT 2626 provides guidance as to when commission income is derived for income tax purposes by insurance agents. It also deals with repayments of commissions paid in advance by insurance agents.
The Australian courts have held that income assessable on an accruals basis is 'derived' when a recoverable debt is created, such that the taxpayer is not obliged to take any further steps before becoming entitled to payment. Accordingly, the terms of an agency agreement are critical as to the timing of when the commission income will be derived.
With respect to commission income payable to insurance agents, the Commissioner considers in Taxation Ruling No. IT 2626 that:
‘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, this would strongly indicate that the commission income has been derived’.
Taxation Ruling No. IT 2626 also provides that where an agent or broker is required to repay commissions paid in advance, if the amount repaid has previously been included in assessable income, the amount of the repayment will be an allowable deduction.
Agreements between motor dealers and insurance companies commonly state that an upfront payment will be received and is made up of amounts relating to a number of different objects which can include:
- An amount that is an estimate of commissions that would have been payable had the previous agreement not been terminated (this may be inserted if there is an overlap of the old agreement and the new agreement)
- For the motor dealer to have this insurance company as its preferred supplier for insurance business
- The motor dealer must use its best efforts to increase insurance sales with the preferred supplier, by promoting, referring and selling insurance policies, often over a period of years.
The agreements will typically contain a clause stating that the above amounts will be payable by the insurance companies upon receiving a tax invoice from the motor dealer.
They also usually contain a clause requiring that in the event that the agreement is terminated prior to the completion date of the contract, the motor dealer will repay part of this upfront payment back to the insurance company on a pro rata basis.
This clause generally implies that the motor dealer is obliged to continue selling, promoting and increasing sales activities for the insurance products for the whole period of the agreement, before they actually become entitled to the total payment (i.e. no refund). This implies that the payment should be derived over the term of the agreement.
The ATO’s response!
As mentioned above, income which is assessable on an accruals basis is 'derived' when a recoverable debt is created, such that the taxpayer is not obliged to take any further steps before becoming entitled to payment. Prima facie where commission payments are received upfront, they will be deemed derived and assessable at that time. However, if you can break up the payment received, there may be aspects which can be deferred until a later year.
The ATO have recently released a private ruling relating to the derivation of commission income from insurance companies. It states that where a single payment is consideration for a mix of discrete objects and where the component amounts are ascertainable by calculation, the payment may be apportioned amongst the several heads to which it relates.
Commission income - If the payment of the commission has matured into a recoverable debt and the agent or broker is not obliged to take any further steps before becoming entitled to payment of the commission, this would strongly indicate that the commission income has been derived. The ATO considers that once a tax invoice is issued for the commission income, this amount is assessable (i.e. taxed upfront). This is because the taxpayer has taken all steps that it is required to take to be entitled to the payment.
Incentive for the entity to enter into the Agreement – this would be considered ordinary income and assessable in the year in which it is derived i.e. the year in which the taxpayer provides the insurance company with a tax invoice.
To have this insurance company as its preferred supplier for insurance business – where the taxpayer undertakes to trade only with the specific insurance company in the agreement, the ATO considers this to be a restrictive covenant. A capital gain will arise if the capital proceeds from creating the right are more than the incidental costs that relate to the event. The time of the event is when the contract is entered into.
Amount for promoting the insurance company's product - 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. The amounts will not be derived until the services have been provided which will be on a pro rata basis over the length of the agreement. The legal or commercial requirement for a refund to be given if the taxpayer fails to render the agreed services means that the income is not derived until the services have actually been provided (Arthur Murray (NSW) Pty Ltd v. Federal Commissioner of Taxation).
As there can be different tax consequences depending on the term of the agreement it is important for it to be structured in the correct manner and thought should be given to the break-up of each component.
If you would like further advice on how to effectively structure these agreements to ensure that tax is deferred over the life of the contract, talk to your Deloitte Private tax adviser.
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