Derivation of Income: unbilled supply of energy

Does the taxpayer derive assessable income for the purposes of section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) where it supplies electrical and gas energy to New South Wales (NSW) mass market customers but that supply remains unbilled at the end of the income year?

Yes. The taxpayer derives assessable income for the purposes of section 6-5 of the ITAA 1997 where it supplies electrical and gas energy to NSW mass market customers but that energy remains unbilled at the end of the income year.

The taxpayer is an energy retailer, purchasing electrical and gas energy from the relevant national wholesale markets and subsequently on-selling that energy to mass market customers located in NSW.

The taxpayer has no control over the supply of electricity and gas to mass market customers. Energy is supplied through the distribution network simultaneously with customer demand.

With full retail competition in the energy industry in NSW, mass market customers are able to choose their supplier.

Distribution Network Operators (DNOs) connect customers' premises to the supply networks, deliver the electricity or gas and read customers' meters. The DNOs charge the taxpayer for those services. The taxpayer passes those costs on to its customers when it bills them for energy supplied.

Except for a small percentage with time-of-use ('smart') electricity meters that are read remotely by DNOs on a daily basis, customer premises are equipped with accumulation meters that are physically read by meter readers visiting the premises.

DNOs provide the taxpayer with meter reading data for each customer. The taxpayer then determines the quantity of energy consumed by each customer, calculates the amount owed, by reference to scheduled fees and charges, and bills the customer accordingly.

Meter readings are taken by DNOs in line with each customer's usual billing cycle, except where a special meter reading is required (for example, where a customer vacates the premises). The taxpayer does not have the ability to determine the time at which DNOs read customers' meters, with the exception of special meter readings.

The taxpayer may estimate the amount of energy consumed in a range of circumstances, including where the meter is found to be defective, the meter cannot be accessed or a meter reading has not been taken.

The supply of electrical and gas energy to mass market customers in NSW is principally governed by the Electricity Supply Act 1995 , Electricity Supply (General Regulation 2001, Gas Supply Act 1996 and the Gas Supply (Natural Gas Retail Competition) Regulation 2001.

The legislation and regulations provide for two types of contracts between energy retailers and mass market customers - a standard form customer supply contract and a negotiated customer supply contract.

Under the legislation and regulations, mass market customers with a standard form customer supply contract must be billed at least once every three months, but shorter billing periods can be accommodated. Customers with a negotiated customer supply contract can negotiate a different billing period.

Neither the standard form customer supply contract nor the negotiated customer supply contract expressly or impliedly points to an agreement for the supply of energy over an entire period. Under the contracts, customers assume responsibility to pay for all energy as consumed, regardless of whether that energy relates to an entire billing period or not. The billing frequency under the contracts is at least once every three months, or a different agreed billing frequency.

Unlike the facts in FC of T v. Australian Gas Light Co 83 ATC 4800; (1983) 15 ATR 105 ( AGL case ), there is no statutory provision in NSW prohibiting an energy retailer from demanding payment until an account has been rendered to the customer showing consumption by reference to actual meter readings for the billing period.

The Independent Pricing and Regulatory Tribunal (IPART) is responsible for setting maximum average energy rates for mass market customers that have a standard form customer supply contract. Mass market customers that have a negotiated customer supply contract do not have regulatory price protection.

The usual billing cycles of the taxpayers' customers are staggered and consequently a significant number of customers' meters are not read on, and bills are not generated for the period up to, the last day of the income year.

The taxpayer uses the accruals or earnings method of accounting for determining when income is derived. The taxpayer uses a complex methodology to estimate the unbilled supply of energy at the end of the income year and includes that amount as unbilled revenue in its financial accounts in accordance with Australian Accounting Standard AASB 118 Revenue (AASB 118).

Subsection 6-5(2) of the ITAA 1997 provides that an Australian resident's assessable income includes ordinary income derived from all sources during the income year. The supply of electricity and gas to mass market customers in NSW is made in the ordinary course of the taxpayer's business and income derived from those supplies is income according to ordinary concepts.

Under the accruals or earnings method of accounting, the point of derivation of income occurs when a 'recoverable debt' is created. This means the point of time at which a taxpayer is legally entitled to an ascertainable amount as the result of having performed an agreed task ( Henderson v. Federal Commissioner of Taxation (1969) 119 CLR 612; 69 ATC 4049; (1969) 1 ATR 133 ( Henderson's case ).

A taxpayer may have a recoverable debt even though, at the time, they cannot legally enforce the recovery of the debt. 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.

In establishing if a recoverable debt has been created at the point of supply, it is necessary to determine whether there are further steps (or conditions precedent) to be taken (or met) before the taxpayer becomes entitled to payment ( Gasparin v. Commissioner of Taxation (1994) 50 FCR 73; 94 ATC 4280; (1994) 28 ATR 130 and Farnsworth v. Federal Commissioner of Taxation (1949) 78 CLR 504; (1949) 9 ATD 33 ( Farnsworth's case )).

In the AGL case , the court decided that the taxpayers operated under exceptional circumstances which meant that certain conditions precedent were required to be satisfied before a customer's liability for unbilled gas matured into a recoverable debt.

The taxpayers in the AGL case operated as statutory monopolies in respect of which gas prices were regulated by an independent body. The determination of tariffs was related to the billing cycle. The taxpayers were obliged to supply gas to their customers on a quarterly basis. Regulations made under the statute prohibited the taxpayers from demanding payment for gas until an account had been rendered. Further, an account could not be rendered until the customer's gas meter had been read to determine the amount of gas consumed for the quarter.

The court found that the reading of a customer's meter and notice to the customer of measured consumption were conditions precedent to the existence of a debt.

However, it is necessary to draw a distinction between conditions precedent to a recoverable debt being created and impediments to the collection of a recoverable debt ( Barratt v. FC of T 91 ATC 4869; (1991) 22 ATR 691). An impediment to the recovery of a debt (such as the inability to sue for recovery until the expiration of a number of days) does not defer the time at which income is derived.

Section 22 of the Sale of Goods Act 1923 (NSW ) provides that where there is a contract for the sale of specific or ascertained goods, the property in them is transferred to the buyer at such time as the parties to the contract intend it to be transferred ( AGL Victoria Pty Ltd v. David Neil Lockwood and Allianz Australia Insurance Limited [2003] VSC 453).

Under the terms and conditions of the taxpayer's energy supply contracts, customers assume responsibility for all energy consumed regardless of whether that energy relates to an entire billing period or not.

Further, paragraph 14 of AASB 118 requires a transfer to the buyer of the significant risks and rewards of ownership of the goods before bringing to account an amount for unbilled revenue.

Mass market customers consume energy when it passes the meter and enters the system that services their addresses. At that point, the taxpayer loses its dispositive power over the energy and the customers are contractually committed to pay, at some future date, for energy they have consumed at that point in time.

The taxpayer's entitlement to payment for energy consumed is unconditional at this point. The income earning process is complete and the taxpayer has an existing right to demand payment of an ascertainable amount.

The raising of a bill is not a condition precedent to a recoverable debt being created, but rather the mechanism by which the debt collection process commences.

The exceptional circumstances that led the court in the AGL case to decide that conditions precedent existed so that a recoverable debt was not created at the point of supply are not evident in the legislative, regulatory and market environment in which the taxpayer operates. Distinguishing features of that environment are: • full retail competition supported by a legislative and regulatory framework • the absence of regulatory limitations or requirements in relation to an energy retailer's accumulated profits, distributions or accounts • limited price control under which maximum average energy rates are fixed by the IPART only in relation to the standard form customer supply contract • retail energy tariffs are not set on a quarterly basis and do not apply by reference to quarterly usage but to a customer's average daily usage over the billing period (except for time-of-use metering) • regulated billing periods apply only to a standard form customer supply contract and are expressed in terms of 'at least once every three months'; billing periods for negotiated customer supply contracts are a matter of contractual agreement • a wider range of circumstances in which the retailer can estimate the quantity of energy supplied, including where there has been no meter reading for the period • no legislative or regulatory requirement that an account must be rendered by the taxpayer before a demand for payment of energy supplied to the customer can be made based on actual quantities of energy supplied • no requirement that a bill must be based on measured consumption in every instance, and • the taxpayer brings to account an amount for unbilled revenue for energy supplied in their financial statements in accordance with Australian accounting standards.

Given the circumstances in which the taxpayer earns its income by supplying energy to customers on a continuous basis, the inclusion of an estimate of income relating to unbilled supplies at year end (in keeping with the taxpayer's accounting practice) does not produce a misleading result but, on the contrary, gives a 'substantially correct reflex' of the taxpayer's true income: ( Commissioner of Taxes (SA) v. Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108; (1938) 5 ATD 98).

In order for income to be derived, the amount must be ascertainable (Farnsworth's case). However, that does not mean that the exact amount needs to be ascertained - a reasonable estimate based on a bona fide judgement or opinion to form an approximation of an ascertainable amount is sufficient ( Australia and New Zealand Banking Group Ltd v. Commissioner of Taxation (1994) 48 FCR 268; 94 ATC 4026; (1994) 27 ATR 559). The figure determined as income may be the result of estimation, as well as of calculation, and its determination may involve the acceptance of opinions, expert or otherwise ( Henderson's case ).

In accordance with AASB 118, the taxpayer can and does reliably estimate the amount of income that is unbilled at the end of the income year when preparing its financial statements.

Accordingly, the taxpayer derives assessable income under subsection 6-5(2) of the ITAA 1997 for energy supplied to customers but remaining unbilled at the end of the income year. The Commissioner considers that the amount of that assessable income is the estimated amount recognised by the taxpayer for financial accounting purposes. Note: For the purposes of this ATO Interpretative Decision, 'mass market customer' means 'small retail customer' as defined in the Electricity Supply Act 1995 (NSW) and the Gas Supply Act 1996 (NSW), respectively.