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Transcript of Corporate Tax Masterclass - Greenwoods & Herbert … of foreign exchange gains and losses for...
© Mostafavi and Marston, Greenwoods & Freehills 2013
Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.
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Corporate Tax Masterclass
Taxation of foreign exchange gains and
losses for corporates
Written and
presented by:
Abdol Mostafavi
Special Counsel
Greenwoods &
Freehills
Craig Marston
Senior Associate
Greenwoods &
Freehills
New South Wales Division
23 October 2013
Doltone House Hyde Park, Sydney
Mostafavi and Marston Taxation of foreign exchange gains and losses for corporates
© Mostafavi and Marston, Greenwoods & Freehills 2013 2
CONTENTS
1 Introduction .................................................................................................................................... 6
1.1 Scope of Paper and overview ................................................................................................... 6
1.2 Foreign exchange rate volatility ................................................................................................ 7
2 Division 3B ...................................................................................................................................... 8
2.1 Background ............................................................................................................................... 8
2.2 Continuing application of Division 3B – the transitional rules ................................................... 8
2.3 Overview of Division 3B .......................................................................................................... 10
2.3.1 Operative provisions ........................................................................................................ 10
2.3.2 Eligible contract ............................................................................................................... 10
2.3.3 “Currency exchange gain” / “currency exchange loss” .................................................... 11
2.3.4 Translation rules .............................................................................................................. 11
2.4 Conversion (exchange) vs. translation ................................................................................... 11
2.4.1 Taxation Ruling TR 93/8 .................................................................................................. 12
2.4.2 The High Court’s decision in ERA ................................................................................... 12
2.4.3 Withdrawal of TR 93/8 ..................................................................................................... 15
2.4.4 Chief Tax Counsel’s letter – ostensible re-instatement of TR 93/8 ................................. 15
2.4.5 The Full Federal Court’s recent decision in Messenger Press ........................................ 16
2.4.6 ATO’s Decision Impact Statement on Messenger Press ................................................ 17
3 Division 775 .................................................................................................................................. 19
3.1 Background ............................................................................................................................. 19
3.2 Continuing application of Division 775 – the transitional rules ............................................... 19
3.2.1 Interaction with Division 3B ............................................................................................. 19
3.2.2 Interaction with Division 230 (TOFA) ............................................................................... 20
3.3 Overview of Division 775 ........................................................................................................ 22
3.4 Operative provisions of Division 775 ...................................................................................... 23
3.5 The most “common” FREs ...................................................................................................... 23
3.5.1 FRE 1: Disposal of foreign currency or right to receive foreign currency ........................ 23
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3.5.2 FRE 2: Ceasing to have a right to receive foreign currency ............................................ 24
3.5.3 FRE 3: Ceasing to have an obligation to receive foreign currency ................................. 24
3.5.4 FRE 4: Ceasing to have an obligation to pay foreign currency ....................................... 24
3.5.5 FRE 5: Ceasing to have a right to pay foreign currency .................................................. 24
3.6 Assistant Treasurer’s Media Release ..................................................................................... 25
3.6.1 Amendments to the foreign currency provisions ............................................................. 25
3.6.2 Compliance cost saving measures .................................................................................. 26
4 The translation rules in Subdivisions 960-C and 960-D (and the associated Regulations) . 27
4.1 Subdivision 960-C ................................................................................................................... 27
4.2 Regulations ............................................................................................................................. 28
4.3 Subdivision 960-D ................................................................................................................... 30
5 The TOFA regime (Division 230) ................................................................................................. 31
5.1 Introduction ............................................................................................................................. 31
5.2 Transitional rules ..................................................................................................................... 31
5.3 Thresholds for the mandatory application of TOFA ................................................................ 32
5.4 Financial arrangements .......................................................................................................... 32
5.4.1 Primary definition of “financial arrangement” ................................................................... 33
5.4.2 Extended definition of “financial arrangement” ................................................................ 34
5.5 Main exceptions from the application of TOFA ....................................................................... 35
5.6 Operative provisions of TOFA................................................................................................. 35
5.7 Tax-timing methods under TOFA ........................................................................................... 37
5.7.1 Overview of the methods ................................................................................................. 37
5.7.2 The default methods ........................................................................................................ 38
5.7.3 Foreign exchange retranslation method .......................................................................... 40
5.7.4 Fair value method ............................................................................................................ 42
5.7.5 Reliance on financial reports method .............................................................................. 43
5.7.6 Hedging financial arrangement method........................................................................... 44
6 Case studies: Abbott Limited ..................................................................................................... 46
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7 Case study 1: US$ borrowing ..................................................................................................... 47
7.1 The facts ................................................................................................................................. 47
7.2 The TOFA regime - general .................................................................................................... 47
7.3 Financial arrangement ............................................................................................................ 47
7.4 Interest on the Notes ............................................................................................................... 48
7.4.1 Accruals method vs. realisation method .......................................................................... 48
7.4.2 Translation into A$ ........................................................................................................... 49
7.4.3 Running balancing adjustment ........................................................................................ 51
7.5 Repayment of US$10 million principal .................................................................................... 51
8 Case study 2: FX Forward ........................................................................................................... 53
8.1 The facts ................................................................................................................................. 53
8.2 Financial arrangement under TOFA ....................................................................................... 53
8.3 No application of the accruals method .................................................................................... 53
8.4 Balancing adjustment .............................................................................................................. 54
9 Case study 3: Historic rate roll-over of FX Forward ................................................................. 55
9.1 The facts ................................................................................................................................. 55
9.2 Balancing adjustments ............................................................................................................ 55
9.2.1 “Roll” of FX Forward ........................................................................................................ 55
9.2.2 Final settlement of the FX Forward ................................................................................. 57
10 Case study 4: Cross-Currency Swap ..................................................................................... 59
10.1 The facts .............................................................................................................................. 59
10.2 Financial arrangement......................................................................................................... 59
10.3 No application of the accruals method to the swap ............................................................ 60
10.4 Disposal of US$ at the spot rate ......................................................................................... 60
10.5 Balancing adjustment .......................................................................................................... 60
11 Case study 5: FX Option .......................................................................................................... 62
11.1 The facts .............................................................................................................................. 62
11.2 Financial arrangement......................................................................................................... 62
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11.3 Application of the tax-timing method(s) ............................................................................... 62
11.4 Balancing adjustment .......................................................................................................... 65
12 Case study 6: Acquisition of a depreciating asset ............................................................... 66
12.1 The facts .............................................................................................................................. 66
12.2 Whether the TOFA regime applies ...................................................................................... 67
12.2.1 The construction contract for the vessel .......................................................................... 67
12.2.2 The US$ bank account .................................................................................................... 67
12.3 The FX gains and losses recognised for income tax purposes .......................................... 67
12.3.1 The US$ bank account generally .................................................................................... 67
12.3.3 The payment of the US$5 million deposit on 1 January 2014 ......................................... 68
12.3.4 The withdrawal of US$10 million from the bank account on 1 December 2014.............. 68
12.3.5 The making of the US$10 million progress payment on 1 December 2014 .................... 68
12.3.6 The withdrawal of US$10 million from the bank account on 1 January 2016 ................. 70
12.3.7 The payment of the final instalment of the purchase price on 1 January 2016 ............... 70
12.3.8 The “cost” of the vessel for tax depreciation purposes .................................................... 71
13 Case study 7: US$ borrowing to finance an offshore equity investment ........................... 73
13.2 Financial arrangement......................................................................................................... 73
13.3 TOFA balancing adjustment gain ........................................................................................ 73
13.4 Nexus with NANE income ................................................................................................... 74
14 Case study 8: Hedging the FX risk on an offshore equity investment ............................... 75
14.2 Financial arrangement......................................................................................................... 75
14.3 TOFA balancing adjustment gain ........................................................................................ 76
14.4 Nexus with NANE income ................................................................................................... 76
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1 Introduction
1.1 Scope of Paper and overview
The Australian income tax treatment of foreign exchange (“FX”) gains and losses has had a long and
chequered history.
This Paper1 provides an overview of the various regimes that govern the taxation of FX gains and
losses made by Australian taxpayers, and the manner in which they interact. The focus of the Paper
is on corporate taxpayers other than financial institutions.
In particular, this Paper considers:
Division 3B of Part III of the Income Tax Assessment Act 1936 (“Division 3B”);
Division 775 (“Division 775”) of the Income Tax Assessment Act 1997;
the currency “translation” rules in Subdivisions 960-C (“Subdivision 960-C”) and 960-D
(“Subdivision 960-D”) and the associated Regulations; and
the “Taxation of Financial Arrangements” (“TOFA”) regime in Division 230 (“Division 230”).
This Paper also considers the extent to which Division 3B and Division 775 can now be considered as
“legacy” regimes, and the extent to which they have on-going relevance for taxpayers. As will
become apparent, Division 775 is still very much relevant, even for taxpayers who are now subject to
the TOFA regime.
After addressing the above background, this Paper then examines several practical case studies that
address the way in which the “current” TOFA regime treats FX gains and losses in certain common
situations. The case studies consider the following scenarios for a “typical” Australian corporate
taxpayer:
entry into a borrowing arrangement in foreign currency;
entry into foreign currency derivatives (i.e. FX forwards, swaps and options); and
the making of investments using foreign currency; and
the making of outbound investments in foreign currency.
1 This Paper contains the views of the authors, which are not necessarily the views of Greenwoods & Freehills, the Tax Institute
or any other organisation.
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Unless indicated otherwise, all legislative references in this Paper are to the Income Tax Assessment
Act 1936 (“ITAA 1936”) or the Income Tax Assessment Act 1997 (“ITAA 1997”), as the context
requires.
The law and practice discussed in this Paper is that applicable as at 30 September 2013.
1.2 Foreign exchange rate volatility
The graph below depicts the significant fluctuations that we have witnessed in the A$:US$ exchange
rate since January 2000:
source: www.oanda.com
The volatility in the exchange rate, and the income tax treatment of FX gains and losses, can have a
significant impact on the financial performance of Australian corporate taxpayers.
If a taxpayer has an A$ functional currency, then any transactions that it enters into in a foreign
currency will have FX implications for income tax purposes. The types of transactions would include
(but is by no means limited to):
borrowing or lending in a foreign currency;
holding foreign currency denominated assets, such as shares, depreciating assets and “in-the-
money” FX derivatives; and
having foreign currency denominated liabilities, such as loans and “out-of-the-money” FX
derivatives.
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2 Division 3B
2.1 Background
For many decades, Australia did not have any tax rules specifically dealing with FX gains and losses,
and various cases were handed down dealing with the revenue/capital distinction and timing
recognition.2 Only FX gains/losses that were considered to be on “revenue account” were included in
a taxpayer’s assessable income (under former s.25(1)) or deductible (under former s.51(1)).
The capital gains tax (“CGT”) regime3 was enacted with effect from 20 September 1985. The CGT
regime attempted to capture (in a relatively basic fashion) foreign exchange gains/losses as a
component of the overall capital gain/loss on a CGT asset.4 However, the CGT regime only applied
to “CGT assets” as defined, and it did not deal at all with liabilities denominated in a foreign currency.
It was not until 1987 that the first set of specific rules dealing with FX gains and losses (in Division 3B
of Part III of the ITAA 1936) was enacted. The objective of Division 3B, which took effect from
19 February 1986, was to ensure that foreign exchange gains and losses that were considered to be
of a capital nature under the case law, particularly in relation to liabilities denominated in foreign
currency, would be recognised for income tax purposes on revenue account when they were
“realised”.
2.2 Continuing application of Division 3B – the transitional rules
As discussed below, Division 3B applies to “eligible contracts”. That is, eligible contracts are the “unit
of taxation” to which Division 3B applies.
Division 3B continues to apply to gains and losses of a capital nature arising from eligible contracts
entered into on or after the “commencing day” (19 February 1986) but before the “applicable
commencement date”5 of Division 775 (generally the first day of the taxpayer’s 2004 income year, ie
1 July 2003), subject to the following exceptions:
If the taxpayer made an election under s.775-150 to “un-grandfather” transactions (including
eligible contracts) that the taxpayer had entered into before the applicable commencement date of
2 Refer, for example, the Full Federal Court decision in FCT v Hunter Douglas Ltd (1983) 80 FLR 143, which broadly speaking,
dealt with the tax consequences of having US$-denominated working capital. 3 The current CGT provisions are contained in Parts 3-1 and 3-3 of the ITAA 1997.
4 Refer s.103-20, which was essentially a currency translation rule.
5 Refer s.775-155.
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Division 775, Division 775 would potentially apply to the eligible contract from the applicable
commencement date of Division 775.
If:
o under a “pre-Division 775” loan agreement (ie a loan agreement entered into before the
“applicable commencement date” of Division 775), there is an extension (after the applicable
commencement date) of the period for which the money has been lent; and
o either:
the contract is separate from the original loan contract; or
the extension amounts to a variation of the original contract,
then Division 3B will not apply to the extended loan (refer ss775-165(3) and 775-165(5)). Instead,
Division 775 will apply to the extended loan from the time of the extension.
If the taxpayer made an election under sub-item 104(2) of the Tax Laws Amendment (Taxation of
Financial Arrangements) Act 2009 (the “TOFA Act”) to un-grandfather its pre-TOFA “financial
arrangements”, ie financial arrangements that the taxpayer “started to have” before the
commencement date of the TOFA regime6, the TOFA regime would potentially apply to the pre-
existing eligible contract from the commencement date of TOFA.
If the taxpayer made both un-grandfathering elections (under Division 775 and TOFA), then:
Division 775 should have potential application to the transaction from the applicable
commencement date of Division 775; and
the TOFA regime should have potential application to the arrangement from the commencement
date of TOFA.
Given that many corporate taxpayers have never made either of the above un-grandfathering
elections, Division 3B continues to play a role in the taxation of FX gains and losses for such
taxpayers. However, that role is diminishing as pre-1 July 2003 eligible contracts mature.
Furthermore, in some cases where a transaction has ostensibly taken place under an eligible
contract, it is possible that, due to the extent of the subsequent “variations” made to the contract, the
taxpayer may be regarded as having entered into a new transaction or financial arrangement (with the
effect that the new transaction or arrangement is in fact subject to Division 775 and/or TOFA).
For example, a draw-down by a taxpayer before 1 July 2003 under a foreign currency denominated
facility agreement entered into before that day would generally remain subject to Division 3B.
6 The commencement date of the TOFA regime was the first day of the income year commencing on or after 1 July 2010 (refer
sub-item 103(1) of the TOFA Act), unless the taxpayer also made the “early start” election under sub-item 103(2) of the TOFA
Act to apply TOFA from the start of its income year commencing on or after 1 July 2009.
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However, a difficult issue arises if the taxpayer makes a draw-down after 1 July 2003 under the same
facility agreement. Provided that there has been no extension or variation of the facility agreement
since 1 July 2003, it could be argued that, for the purposes of Division 3B, the relevant “eligible
contract” is the facility agreement (which remains subject to Division 3B), such that all subsequent
draw-downs under the same facility should be grandfathered under Division 3B. In the authors’ view,
this is an issue that should be governed by contract law, and it may be necessary for the taxpayer to
obtain advice from a contract lawyer on the point.
2.3 Overview of Division 3B
2.3.1 Operative provisions
Section 82Y provides:
“The assessable income of a taxpayer of a year of income shall include any currency exchange
gain made by the taxpayer in the year of income under an eligible contract.” [underlining added]
Subsection 82Z(1) provides that (subject to certain exceptions):
“... a currency exchange loss incurred by a taxpayer in a year of income under an eligible
contract is an allowable deduction in respect of the year of income.” [underlining added]
Accordingly, there are three key concepts here: “eligible contract”, “currency exchange gain” and
“currency exchange loss”. These concepts are considered below. Also considered below are the
translation rules that complemented Division 3B.
The references in the above provisions to a gain being “made” and a loss being “incurred” were
understood to mean that currency exchange gains/losses were to be recognised on “realisation”.
2.3.2 Eligible contract
Division 3B applies to “eligible contracts”. As noted above, eligible contracts are the “unit of taxation”
to which Division 3B applies. In this regard, s.82V (in Division 3B) defines an eligible contract as
follows:
“eligible contract”, in relation to a taxpayer, means –
(a) a contract entered into by the taxpayer on or after the commencing day, other than a
hedging contract; or
(b) a hedging contract entered into by the taxpayer, on or after the commencing day, in
relation to a contract to which Paragraph (a) applies.
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Division 3B only applies to gains and losses to the extent that they are of a capital nature (having
regard to the case law).
2.3.3 “Currency exchange gain” / “currency exchange loss”
Subsection 82V(1) provides the following definitions:
“currency exchange gain means a gain to the extent to which it is attributable to currency
exchange rate fluctuations”
“currency exchange loss means a loss to the extent to which it is attributable to currency
exchange rate fluctuations”
2.3.4 Translation rules
Division 3B, where it applies, is supported by a number of currency translation rules.
Former s.20(1) provided a general translation rule requiring that, “for all purposes of the Act” income
and expenses wherever derived and incurred must be expressed in Australian dollars. Subsections
(2), (3) and (4) of former s.20 then provided specific rules for when certain types of income and
expenses are to be translated into A$.
For the purpose of calculating “capital gains” and “capital losses” arising before the applicable
commencement date of Division 775, the CGT regime contained its own translation rule in former
s.103-20:
“If a transaction or event involving an amount of money or the *market value of other property:
(a) is to be taken into account under this Part or Part 3-3; and
(b) the money or market value is in a foreign currency;
the amount or value is to be converted into the equivalent amount of Australian currency at
the time of the transaction or event.”.
Former s.20 and s.103-20 were repealed by the New Business Tax System (Taxation of Financial
Arrangements) Act 2003 (the “2003 Act”). The 2003 Act also repealed Division 3B and introduced
Division 775 and the current translation rules in Subdivisions 960-C and 960-D.
2.4 Conversion (exchange) vs. translation
As mentioned above, it was generally understood that currency exchange gains/losses were to be
recognised under Division 3B on “realisation”.
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An enduring “conundrum” of Division 3B is whether, for realisation to occur, it is necessary that there
be an actual conversion or exchange of foreign currency into A$.
2.4.1 Taxation Ruling TR 93/8
In Taxation Ruling TR 93/8, the Commissioner expressed the view that no actual conversion to
Australian currency is required for Division 3B to apply. The Commissioner stated the following
regarding his view as to when an FX gain or loss is “realised” under Division 3B.
“8. The general principles are as follows. If a foreign exchange gain or loss arises from a liability in a foreign currency, the taxpayer realises the gain or loss when the liability is discharged by actual or constructive payment. Conversely, if a foreign exchange gain or loss arises from a right to receive foreign currency, the taxpayer realises the gain or loss on the actual or constructive receipt of payment.
9. If a taxpayer has a liability in a foreign currency and pays part of that liability, the taxpayer realises any foreign exchange gain or loss on the amount repaid at the time of the part payment. Similarly, if a taxpayer entitled to receive an amount of foreign currency receives part of that amount, the taxpayer realises any foreign exchange gain or loss on the amount received at the time the taxpayer receives part payment. In this regard, the Ruling provides the following comments regarding the “realisation”.
10. A taxpayer can realise a foreign exchange gain or loss arising from a liability in a foreign currency without outlaying Australian dollars to acquire the relevant currency to satisfy the liability. Similarly, a taxpayer can realise a foreign exchange gain or loss arising from a right to receive foreign currency without converting the amount received to Australian dollars. [emphasis added]
Consequently, adopting the Commissioner’s interpretation, in broad terms, when an arrangement
denominated in a foreign currency ends, a currency exchange gain/loss would be realised having
regard to the A$ equivalents of the foreign currency amounts at the start and end of the transaction.
On one view, the Commissioner’s position in this Ruling seems quite defensible. It reflects the
economics of the situation – where A$ is the taxpayer’s functional currency, the taxpayer makes an
economic gain or loss in A$ that should be recognised for income tax purposes. However, as
discussed below, in 1996, the High Court in Federal Commissioner of Taxation v Energy Resources
of Australia Ltd (1996) 185 CLR 66; 96 ATC 4536 (“ERA”) rejected the Commissioner’s interpretation
in TR 93/8. In doing so, the High Court exposed a seemingly major defect in the drafting of Division
3B.
2.4.2 The High Court’s decision in ERA
In ERA, the taxpayer, an Australian mining company, had issued a series of US$ denominated 90 day
Euronotes (“Notes”) at a discount through a number of banks. The taxpayer used the US$ issue
proceeds from the first series of Notes to discharge its US$ liabilities under an earlier facility which
had been used to finance the development and operation of a uranium mine in the Northern Territory.
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Each series of Notes were refinanced after their 90 day term. That is, the US$ proceeds from
subsequent issues of Notes under the facility were used to discharge the taxpayer’s liabilities to pay
the US$ face value of each preceding issue of Notes. None of the proceeds of any issue of Notes
were converted into A$ or remitted to Australia.
Three alternative approaches were considered by the High Court regarding the calculation of the
deductible discount on the Notes:
Taxpayer’s calculation: Translate the US$ amount of the “discount” (ie the difference between the
face value of a Notes and the issue proceeds) into A$ using the spot rate on the maturity date.
Commissioner’s calculation: Translate into A$ the US$ amounts:
o the US$ issue proceeds of the Notes into A$ using the spot rate at the issue date of the
Note; and
o the US$ face value of the Note paid on maturity into A$ using the spot rate on the
maturity date.
The difference between these A$ amounts would be the deductible amount of the “discount”.
High Court’s calculation: Translate the US$ discount into A$ using the spot rate at the issue date
of the Note. In this regard, the High Court reasoned that the deduction was “incurred” when the
relevant Note was issued. This was because, at that time, the Note was issued at a discount and
the obligation to pay the face value arose at that time.
The consequence of the High Court’s view was that economic gains and losses due to FX movements
between the issue date of a Note and the maturity date of a Note were not factored into the
calculation of the discount expense incurred by the taxpayer on the Notes.
The High Court rejected the Commissioner’s “assumption that a notional conversion of the proceeds
of each issue and a notional conversion of the payments in discharge of each issue had to be made
on the day that each of those events took place and that the difference between the respective sums
was the taxpayer’s gain or loss”. The High Court rejected this assumption because:
“the Commissioner treated the lack of any actual conversion of the proceeds or payments as
irrelevant. But there is nothing in the Act that requires the making of notional conversions of
the taxpayer’s transactions.”7
The Court was of the view that the US$ issue proceeds of each Note was not “income”, as they were
on capital account, and that the US$ principal repayments made by the taxpayer on maturity were not
“expenses”. In the Court’s view, the only expense incurred by the taxpayer under each Note was the
discount expense, and that it was the discount expense which needed to be translated into A$ for the
purposes of former s.20(1) (discussed above).
7 ERA, op. cit., 96 ATC 4536, at 4540.
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Whilst the central issue in this case was whether the taxpayer was entitled to a deduction for the
discount expense under former s.51(1) (and if so, how much), the High Court also considered the
application of Division 3B. The Court held that Division 3B did not apply in this case because the
discount on the Notes represented a revenue loss, and as discussed above, Division 3B only applies
to gains and losses to the extent that they are of a capital nature.
In addition, the Court concluded that, in terms of Division 3B, the taxpayer made no currency
exchange gain or loss, nor was there any gain or loss that was “attributable to currency exchange rate
fluctuations”. In this regard, the Court made the following comments:
“This case has nothing to do with currency gains and losses, for the simple reason that the
taxpayer dealt only in US dollars. The taxpayer made no currency gains or losses because it
never converted any of the proceeds of the notes into Australian dollars. For Australian tax
purposes, the only relevant conversion was the cost in Australian dollars of the loss made in
US dollars when the taxpayer incurred its liability to pay the face value of the notes.”8
“The taxpayer received US dollars, paid US dollars, and did not convert the US dollars into
Australian dollars. Where a taxpayer borrows money on capital account in US dollars and
repays the loan in US dollars, it makes no revenue profit or loss from the borrowing even
though the exchange rate may be different at each date. Indeed, arguably, it makes no profit
or loss….For income tax purposes, the fluctuations of the US/Australia exchange rate were as
irrelevant to the taxpayer’s transactions as the fluctuations in the Japan/Australia exchange
rate.”9
“….for the reasons that we have already given, the taxpayer made no currency exchange
gain or loss. The unit of account and the unit of payment under the contract or contracts
involved in this case were US dollars.”10
The High Court’s decision in ERA caused considerable confusion and uncertainty.
Seemingly, the implication of this case was that a taxpayer having an FX-denominated liability on
capital account would not make an FX gain or loss recognised for tax purposes without an actual
physical conversion of the foreign currency into A$. On the other hand, in relation to FX-denominated
assets, FX gains/losses would still be recognised at least under the CGT regime even if no actual
conversions took place, and possibly also under the general assessing provisions (s.6-5 and s.8-1)
and/or the “traditional securities” provisions in ss.26BB/70B. This resulted in asymmetry between the
tax treatment of FX-denominated assets and FX-denominated liabilities.
8 Loc. cit.
9 ERA, op. cit. 96 ATC 4536, at 4542.
10
ERA, op. cit. 96 ATC 4536, at 4543.
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2.4.3 Withdrawal of TR 93/8
Shortly after the High Court’s decision in ERA, the Australian Taxation Office (“ATO”) withdrew
Taxation Ruling 93/8. The Withdrawal Notice for the Ruling indicated that “the case necessitates a
review of matters addressed by the Ruling”.
2.4.4 Chief Tax Counsel’s letter – ostensible re-instatement of TR 93/8
In response to concerns expressed by a taxpayer representative body regarding the implications of
ERA, on 17 February 1997, the ATO’s then Chief Tax Counsel, Mr Michael D’Ascenzo (who
subsequently became the Commissioner), sent a letter to various external stakeholders, including the
National Tax Liaison Group. The letter stated:
“The High Court has thrown considerable doubt on the Commissioner’s view in Taxation
Ruling TR 93/8 that conversion between foreign currency and Australian dollars is not
necessary for a foreign exchange gain or loss to be brought to account for tax purposes.
It is now not at all clear whether Division 3B does or does not apply…..
To alleviate these uncertainties, unless there is clearer legislative or judicial direction on these
matters, or until it is considered necessary and appropriate to issue or amend Taxation
Rulings on the matters, the ATO’s practice will be to…..not disturb assessments which bring
or have brought to account for tax purposes foreign exchange gains and losses in accordance
with the principles in Taxation Ruling TR 93/8 [notwithstanding the High Court’s decision in
ERA].”
Therefore, there was a de facto interim “re-instatement” of TR 93/8 by the ATO. However, although it
was not stated in the letter, the authors understand that the ATO intended that taxpayers should
consistently apply either TR 93/8 or ERA principles (rather than “cherry-picking” individual
transactions for either treatment).
Since it was published, many taxpayers have relied upon this letter for the purposes of Division 3B
(and continue to do so).11
The status of the letter for the purposes of administrative law is as
interesting as it is unclear. Could a taxpayer who relies on this letter in good faith seek an estoppel
under principles of administrative law if the Commissioner sought to resile from it?
11 Refer the Full Federal Court’s decision in Victoria Co Ltd v Deputy Commissioner of Taxation [2001] FCA 641, where the
Commissioner sought not to follow the principles in TR 93/8, and the Court ruled in favour of the ATO, as the transaction
entered into by the taxpayer pre-dated the date of effect of TR 93/8.
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2.4.5 The Full Federal Court’s recent decision in Messenger Press
The scope of Division 3B was recently considered again by the Full Federal Court in Commissioner of
Taxation v Messenger Press Pty Ltd [2013] FACFC 77 (“Messenger Press”), in a decision which was
handed down on 25 July 2013. Justices Jessup, Robertson and Griffiths JJ unanimously held that
some 20 News Corp group companies were entitled to claim tax deductions for more than A$2 billion
of foreign exchange losses under Division 3B. Those losses had arisen in the relevant taxpayers’
2001 and 2002 income years.
The foreign exchange losses had arisen because of a restructure of the funding/debt arrangements of
the News Corp global group. The restructure involved a complicated series of “internal” transactions,
including various issuances and endorsements of promissory notes. However, two transactions were
of particular relevance:
1. (Transaction 1) On 8 June 2001, News Publishers Holdings Pty Limited (“NPHP”) purchased
two US$-denominated promissory notes with face values of US$750 million and
US$265 million respectively from The News Corporation Limited (“TNCL”) in consideration for
approximately A$1.9 billion (ie A$ consideration. NPHP then endorsed these two promissory
notes in favour of News Publishers Investments Pty Limited (“NPIP”) in partial reduction of a
pre-existing US$-denominated loan which had been advanced from NPIP to NPHP.
2. (Transaction 2) On 28 June 2002, NPIP issued two promissory notes (with face values of
approximately US$3.4 billion and A$1.2 billion) to NPHP in satisfaction of an A$-denominated
liability that NPIP owed to NPHP. NPHP then presented the US$ denominated promissory
note (with a face value of approximately US$3.4 billion) back to NPIP in satisfaction of a US$-
denominated liability that NPHP owed to NPIP. In other words, the US$ amounts that NPIP
and NPHP owed to each other were effectively set-off against each other.
NPHP claimed a tax deduction under Division 3B for FX losses that it incurred when it undertook each
of these two transactions. Specifically, NPHP argued that it incurred currency exchange losses when
it endorsed the two promissory notes (under Transaction 1) and when it presented the US$
denominated promissory note (under Transaction 2).
The first issue addressed by the Full Federal Court in this case was whether there had been a
realisation of a currency exchange loss for the purposes of Division 3B.
The Commissioner argued that there had been no physical exchange of foreign currency, and that
there had been merely an exchange of promissory notes (also referred to as an “exchange of
liabilities”). In this regard, the Commissioner contended that the High Court’s decision in ERA stood
as authority for the proposition that an actual exchange or physical conversion of currencies was
necessary for a foreign exchange loss to arise under Division 3B, and that in the present case there
had been none.
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The Full Federal Court noted that the deductible loss needed to be attributable to “currency exchange
rate fluctuations” according to the definition of “currency exchange loss” in s.82V(1). In this regard,
the Court said (at paragraph 81):
“But the term [“currency exchange loss”] is defined and the grammatical sense of the
provision is materially affected by the definition. A “currency exchange loss” is “a loss to the
extent to which it is attributable to currency exchange rate fluctuations”. Considering the
definition, the loss must be attributable to fluctuations in the currency exchange rate; that is to
say, “currency exchange” is now to be read as adjectival apropos “rate”.”
Accordingly, the Court held that it was not necessary for there to be an actual exchange of currency
involving A$. It was sufficient that there was some involvement of A$ in the transaction, and that
there were movements in exchange rates for a “foreign currency loss” (as defined) to arise. The
Court found that:
the involvement of A$ in Transaction 1 was that NPHP purchased the US$-denominated
promissory notes from TNCL by paying A$ consideration; and
the involvement of A$ in Transaction 2 was that NPHP subscribed for a US$-denominated
promissory note (plus a separate A$-denominated promissory note) issued by NPIP in
satisfaction of an A$-denominated loan that NPHP had previously advanced to NPIP.
Based on these facts (and specifically, the “involvement” of A$), the Full Federal Court in Messenger
Press distinguished the High Court’s decision in ERA, in which the taxpayer dealt in US$ only at all
relevant times. In this regard, the Full Federal Court stated (at paragraph 83):
“The circumstances take the present case outside anything said by the High Court in ERA. If
there be a need to identify an “exchange transaction”, it was satisfied by the exchange of the
assets for which NPHP had paid in Australian currency for the discharge of the debt.”
The second issue addressed by the Full Federal Court was whether the “foreign exchange loss” arose
under an “eligible contract”. The Court referred to the Full Federal Court’s decision in ERA and
concluded that “a loss might be realised under a contract for the purposes of Div 3B where the
contract neither required nor contemplated the conversion of currency”.
Accordingly, it was held that NPHP’s foreign exchange loss arose “under” an eligible contract for the
purposes of entitling NPHP to a deduction under Division 3B.
2.4.6 ATO’s Decision Impact Statement on Messenger Press
On 19 September 2013, the ATO published a Decision Impact Statement regarding the Full Federal
Court’s decision in Messenger Press (the “DIS”).
In the DIS, the ATO has made the following comments:
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“The Commissioner had taken the view that the High Court’s decision in ERA had so
restricted the application of Division 3B that that [sic] there were very few transactions to
which it could be applied. The decision of the Full Court and the way in which the Full Court
distinguished ERA, means that Division 3B may apply to foreign currency liabilities which are
discharged using a promissory note (or foreign currency) obtained on that day:
• in return for an increase in the taxpayer's Australian currency borrowings, or
• in exchange for an asset denominated in Australian dollars.”
It appears from the DIS that the Commissioner accepts that ERA remains authority for the proposition
that there is no requirement for a notional exchange (ie translation) of foreign currency into A$, and
thus the taxpayer does not make any FX gain or loss under Division 3B, where the taxpayer deals
exclusively in foreign currency in relation to the relevant transaction (at least in the context of FX-
denominated liabilities).
The DIS also refers to TR 93/8 and the Chief Tax Counsel’s letter. The Commissioner has noted that
the Chief Tax Counsel’s letter is now “withdrawn” because:
“The Commissioner considers that the decision of the Full Federal Court represents clearer
judicial direction on the application of Division 3B. ... The ATO will consult with affected taxpayers
and stakeholders concerning the timing and implications of the withdrawal of this administrative
practice.”
The ATO has invited affected taxpayers to contact the ATO by the due date of 14 November 2013.
The ATO’s “withdrawal” of the Chief Tax Counsel’s letter, and the fact that the Full Federal Court in
Messenger Press distinguished the High Court’s decision in ERA (instead of rejecting it), suggests
that taxpayers may no longer be able to rely upon TR 93/8 principles, and that the principles in ERA
will need to be applied instead (at least in the context of FX-denominated liabilities where there is no
physical conversion of currencies).
It is to be hoped that further clarity will emerge from the ATO’s consultation with affected taxpayers.
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3 Division 775
3.1 Background
In light of the technical defects in Division 3B that were exposed by the High Court’s decision in ERA
(discussed in section 2 above), and as part of Stage 2 of the long-running overhaul of the taxation of
financial arrangements (“TOFA”), a new and much more detailed regime for the taxation of FX gains
and losses was enacted in 2003.12
The new regime comprised:
Division 775, which contained the core rules; and
the comprehensive currency translation rules in Subdivisions 960-C and 960-D.
However, the previous regime (consisting of Division 3B and the associated translation rules) was
retained for financial institutions pending Stages 3 and 4 of the TOFA reforms (which would result in a
fundamental overhaul of the taxation of FX gains and losses for financial institutions).
3.2 Continuing application of Division 775 – the transitional rules
In considering the extent to which Division 775 continues to apply, it is necessary to consider its
interaction with both Division 3B and Division 230. Importantly, unlike Division 3B (which was
repealed with prospective effect), Division 775 has not in fact been repealed. Rather, Division 775
continues to operate “alongside” the TOFA regime. The interaction issues are explored below.
3.2.1 Interaction with Division 3B
Division 775 applies to all “forex realisation gains” and “forex realisation losses” arising from several
defined “forex realisation events” (“FREs”), subject to the following transitional exceptions:
If the FRE happened before a taxpayer’s “applicable commencement date”13
for Div 775, then
Division 775 would not apply, and Division 3B continued to apply to the extent that the currency
exchange gain/loss arose under an “eligible contract” (refer s.775-160).
If a taxpayer’s right to receive, or obligation to pay, foreign currency arose under an “eligible
contract” that was entered into before the taxpayer’s applicable commencement date for Division
12 Refer the 2003 Act. Paragraph 4(1) of the Explanatory Memorandum specifically indicated that the new FX tax regime
restored the policy setting which had been undermined by the High Court’s decision in ERA. 13
The “applicable commencement date” of Division 775 is defined in s.775-155. For the vast majority of taxpayers, it is the first
day of the 2004 income year (generally 1 July 2003).
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775, and the taxpayer did not make the “un-grandfathering” election in s.775-150, then the
taxpayer’s right or obligation under that contract is “grandfathered” under Division 3B (refer
ss.775-165(1), (2) and (4)). Consequently, Division 3B would continue to have exclusive
application to any currency exchange gain/loss arising from that right/obligation under the
contract.
Similarly, if the taxpayer acquired the relevant foreign currency, the right to receive foreign
currency, or the obligation to pay foreign currency, before the taxpayer’s applicable
commencement date for Division 775, and the taxpayer did not make the “un-grandfathering”
election in s.775-150, then the foreign currency or the taxpayer’s right or obligation (as the case
may be) under any “eligible contract” is also “grandfathered” under Division 3B (also refer ss.775-
165(1), (2) and (4)). Consequently, Division 3B would continue to have exclusive application to
any foreign exchange gain or loss arising from such foreign currency, right or obligation.
However, as mentioned in section 2.2 above, if:
o under a “pre-Division 775” loan agreement (i.e. a loan agreement entered into before the
applicable commencement date of Division 775), there is an extension (after the applicable
commencement date) of the period for which the money has been lent; and
o either:
the contract is separate from the original loan contract; or
the extension amounts to a variation of the original contract,
then Division 3B will not apply to the extended loan (refer ss.775-165(3) and 775-165(5)).
Instead, Division 775 will apply to the extended loan from the time of the extension.
Division 775 did not apply to “authorised deposit taking institutions” (“ADI”) and non-ADI financial
institutions until the TOFA regime in Division 230 came into force (refer former s.775-170).
Division 775 was then “switched on” for ADIs and non-ADI financial institutions from the
commencement date of the TOFA regime.
3.2.2 Interaction with Division 230 (TOFA)
As mentioned above, Division 775 continues to operate “alongside” the TOFA regime in Division 230.
When the TOFA regime was enacted, it did not “switch” off Division 775. In fact, when the TOFA
regime came into force, it “switched on” Division 775 for ADIs and non-ADI financial institutions (who
had been carved-out from Division 775 until that point).
However, where the taxpayer falls within the TOFA regime, it is likely that most (but not all) FX gains
and losses on the taxpayer’s financial arrangements will be taxed under Division 230 rather than
Division 775. Although both regimes can simultaneously apply to the same transaction, s.230-20
provides an “anti-overlap” rule which gives priority to TOFA. In particular, s.230-20(4) provides:
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“A gain or loss to which this section applies is not to be (to any extent):
(a) included in your assessable income; or
(b) allowable as a deduction to you;
under any provision of this Act outside this Division for the same or any other income year.”
It is possible that the amount of a gain or loss calculated in accordance with Division 230 may be
different from the amount of the gain or loss calculated in accordance with Division 775. In those
circumstances, by virtue of the above anti-overlap rule, the gain or loss under Division 230 will be
recognised for tax purposes, while the gain or loss under Division 775 will be disregarded in its
entirety (even if it exceeds the amount of the Division 230 gain or loss, it seems). Of course, in order
to reach this position, it would be necessary to conclude that the Division 230 gain or loss arises from
the same transaction or event as the Division 775 gain or loss (which may not be true in all cases).
In many cases, it is expected that the TOFA rules “cover the field” of typical FX transactions such that,
where the taxpayer is subject to TOFA, Division 775 is likely to have limited application.
In saying this, listed below are various instances where Division 775 continues to have exclusive
application (ie where the TOFA regime does not apply):
The TOFA regime does not apply to the taxpayer – ie the taxpayer falls below the asset/turnover
thresholds in s.230-455 for the mandatory application of TOFA, and the taxpayer has not made
an irrevocable election under s.230-455(7) to be subject to the TOFA regime on a voluntary basis.
An “arrangement” that is not subject to TOFA because:
o it is not a “financial arrangement” within the primary definition of the term in s.230-45 (eg an
arrangement that is not “cash settlable” within the meaning of s.230-45(2)), nor within the
secondary definition of the term in s.230-50 (in relation to “equity interests” and rights or
obligations in relation to equity interests); or
o the arrangement is an equity interest or involves a right or obligation in relation to an equity
interest (within the secondary definition of “financial arrangement” in s.230-50), and the
taxpayer has not made the “fair value” election or the “financial reports” election under TOFA.
A “financial arrangement” that a taxpayer “started to have” before the TOFA regime first applied to
the taxpayer (ie a pre-TOFA financial arrangement), and the taxpayer did not make the “un-
grandfathering” election under sub-item 104(2) of the TOFA Act to apply the TOFA regime to its
pre-existing financial arrangements.
Where the “short-term non-monetary arrangement” exception in s.230-450 applies. Broadly,
s.230-450 addresses the situation where the taxpayer acquires or provides goods or other
property under a short-term (ie no longer than 12 months) credit arrangement.
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Where another exception from the TOFA regime (as set out in Subdivision 230-H) applies.
Subdivision 230-H sets out various arrangements that, whilst they constitute “financial
arrangements”, are specifically excluded from the operation of Division 230. Instead, other
provisions (including Division 775) operate to address the taxation consequences of such
arrangements. By way of example, the exclusion in s.230-460 covers the following:
o Leasing arrangements (refer s.230-460(2)(b)). Therefore, if lease payments are
denominated in a foreign currency, Division 775 may apply to the lease payments.
o A right or obligation that arises under a direct interest in a “controlled foreign company”
(“CFC”) (refer s.230-460(12)). It should also be noted that, in the calculation of the
“attributable income” of a CFC, Division 230 is specifically required to be disregarded
(refer s.389(ba)).
The TOFA regime is considered in further detail in section 5 below.
3.3 Overview of Division 775
Much like the CGT regime, Div 775 operates by prescribing a series of specific “forex realisation
events” or “FREs”. If an FRE does not happen, then Division 775 does not apply. If an FRE is
“triggered”, the relevant provisions set out the way in which a “forex realisation gain” or a “forex
realisation loss” arising from that FRE is to be calculated. That “forex realisation gain” or “forex
realisation loss” is then generally assessable or deductible (respectively) on revenue account.
Importantly (and, in part, in response to the High Court’s decision in ERA), it is not necessary that an
actual or ”physical” exchange or conversion of a foreign currency amount into A$ takes place for an
FRE to happen.
Subject to some limited exceptions, all forex realisation gains and all forex realisation losses under
Division 775 are on “revenue account”. Thus, under Division 775, it is not necessary to consider
whether the underlying transaction or event relates to the capital yielding subject of the taxpayer’s
business (and is therefore on capital account) or whether it relates to the taxpayer’s day-to-day
activities (and is therefore on revenue account). This was one of the issues that the High Court had
to consider in ERA in the context of Division 3B.
Some of the major exceptions to “revenue account” treatment under Division 775 are included in the
tables in ss.775-70 and 775-75 (the “short-term FX rules”), which are designed to achieve character
matching for tax purposes in limited situations. Section 4.1 and Case Study 6 (refer section 12)
discuss examples of the way in which the short-term FX rules can operate to achieve character
matching for tax purposes (eg by converting an FX gain or loss that would otherwise be recognised
on revenue into account into a capital gain/loss).
Set out below is a brief discussion of the operative provisions and the most “common” FREs (ie FREs
1 to 5).
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3.4 Operative provisions of Division 775
Section 775-15 provides that a taxpayer’s assessable income for an income year includes a “forex
realisation gain” that the taxpayer makes as a result of an FRE that happens during the relevant
income year. However, this is subject to certain exceptions, including those listed in the table in
s.775-15(2) and in s.775-70. The exceptions include situations where the forex realisation gain
relates to deriving exempt or “non-assessable non-exempt” (“NANE”) income.
Conversely, s.775-30 provides that a taxpayer is entitled to claim a deduction for an income year for a
“forex realisation loss” that the taxpayer makes as a result of an FRE that happens during the relevant
income year. However, there are exceptions to this general rule, including situations where the forex
realisation loss relates to deriving exempt or NANE income.
3.5 The most “common” FREs
FREs 1 to 5 are the most “common”, in the sense that such FREs are likely to arise for corporate
taxpayers undertaking typical borrowing and lending, investment and hedging transactions in foreign
currencies.
Central to each of these FREs is identifying a “currency exchange rate effect”. That term is defined in
s.775-105 as follows:
“A currency exchange rate effect is:
(a) any currency exchange rate fluctuations; or
(b) a difference between:
(i) an expressly or implicitly agreed currency exchange rate for a future date or time;
and
(ii) the applicable currency exchange rate at that date or time.”
3.5.1 FRE 1: Disposal of foreign currency or right to receive foreign currency
An FRE 1 happens if CGT event A1 (in s.104-10) happens as a result of the taxpayer disposing of
foreign currency or a right to receive foreign currency (refer s.775-40).
A “forex realisation gain” arises if a capital gain arises under the CGT provisions from the event, and
some part or all of that gain is attributable to a “currency exchange rate effect”. Conversely, a “forex
realisation loss” arises if a capital loss arises under the CGT provision from the event, and some part
or all of that gain is attributable to a “currency exchange rate effect”.
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The typical example of FRE 1 is the assignment by the taxpayer of a foreign currency receivable to a
third party.
3.5.2 FRE 2: Ceasing to have a right to receive foreign currency
An FRE 2 happens if a taxpayer ceases to have a right, or part of a right, to receive foreign currency
and certain other conditions are satisfied, for example, that the right was created or acquired in return
for the payment of A$ or foreign currency (refer s.775-45). Typical examples of FRE 2 are the receipt
of the repayment of a foreign currency denominated loan, and the withdrawal of funds from a foreign
currency denominated bank account.
3.5.3 FRE 3: Ceasing to have an obligation to receive foreign currency
An FRE 3 happens if the taxpayer ceases to have an obligation, or part of an obligation, to receive
foreign currency and certain other conditions are satisfied, for example, that the obligation was
incurred in return for the creation or acquisition of a right to pay A$ or foreign currency (refer s.775-
50). A typical example of FRE 3 is the close-out of certain types of FX derivatives (eg certain FX
options or FX swaps).
3.5.4 FRE 4: Ceasing to have an obligation to pay foreign currency
An FRE 4 happens if the taxpayer ceases to have an obligation, or part of an obligation, to pay foreign
currency and certain other conditions are satisfied, for example, that the obligation was incurred in
return for the creation or acquisition of a right to receive A$ or foreign currency (refer s.775-55).
Typical examples of FRE 4 include the repayment by the taxpayer of a borrowing denominated in
foreign currency, and the close-out of certain types of FX derivatives (eg an FX forward contract under
which the taxpayer is required to pay an amount of foreign currency in exchange for receiving A$ on
close-out).
3.5.5 FRE 5: Ceasing to have a right to pay foreign currency
An FRE 5 happens if the taxpayer ceases to have a right, or part of a right, to pay foreign currency
and certain other conditions are satisfied, for example, that the right was created in return for the
assumption of an obligation to pay A$ or foreign currency (refer s.775-60).
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3.6 Assistant Treasurer’s Media Release
On 5 August 2004, the then Assistant Treasurer (Mal Brough) issued Media Release No. 002
regarding proposed reforms to the taxation of FX gains and losses. The two key focus areas of the
Media Release (relevant to FX gains and losses) were as follows:
Amendments to Division 775 and the translation rules in Subdivisions 960-C and 960-D, to ensure
that they operate as intended; and
Regulations to introduce certain compliance cost saving measures.
3.6.1 Amendments to the foreign currency provisions
The Media Release identified several types of “amendments” that the former Coalition Government
proposed to make to the foreign currency provisions in the income tax law. These were:
amendments constituting a policy change;
technical amendments; and
minor technical amendments.
Many of the changes representing “minor technical amendments” have since been enacted. Those
proposals fixed several blatant errors in the drafting of the legislation. For the most part, these
amendments were made with retrospective effect from the applicable commencement date of Division
775 (generally 1 July 2003).
The vast majority of the proposed amendments to fix technical defects in the foreign currency
provisions (other than the minor ones), as well as the amendments constituting a policy change, have
never seen the floor of Parliament and remain un-enacted to this day (even though the Media
Release stated that they would also take effect from 1 July 2003). The subsequent (now former)
Labor Government announced in its May 2008 Budget that it would proceed with the remaining
amendments in the above Media Release, generally with retrospective application from 1 July 2003.
Given the large volume of announced but un-enacted tax measures that the new Coalition
Government is faced with, it seems likely that the above Media Release will reach its 10th anniversary
without enactment of its many outstanding measures.
The authors understand that, in practice, taxpayers and their advisers have interpreted and applied
Division 775 and the translation rules (since they were enacted) in a way that makes commercial
sense. In many cases, this has involved taxpayers assuming that the amendments proposed in the
Media Release will eventually be enacted. In other cases, taxpayers have had to make certain
assumptions in order to make the provisions “work” effectively. In this regard, a “lore” seems to have
evolved over the interpretation and application of these provisions.
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Unfortunately, the list of technical defects that were identified in the Media Release is not a
comprehensive list of all of the defects that taxpayers have encountered in practice in applying
Division 775 and the translation rules. Encouragingly, the Media Release specifically stated that “the
[then] Government will also consider making further amendments to the foreign currency provisions,
in response to concerns raised by taxpayers. These issues will be subject to further consultation.” It
is to be hoped that the consultation process will get underway at some stage under the new Coalition
Government.
3.6.2 Compliance cost saving measures
The above Media Release foreshadowed the making of regulations “to allow for the use of rates of
exchange other than those rates prescribed in the foreign currency provisions of the law”. The
proposed regulations were said to include the following:
allowing taxpayers to use weighted average rates when calculating the cost of their foreign
currency gains and losses from foreign currency denominated fungible rights and obligations
(such as bank accounts);
ensuring that, in certain cases, a foreign realisation gain or forex realisation loss does not arise on
a transaction for the “spot” sale or purchase of foreign currency or a security for an amount of
foreign currency;
permitting taxpayers that prepare audited financial statements (that comply with Australian
accounting standards) to use the same exchange rates used for accounting purposes in
calculating FX gains and losses for tax purposes; and
permitting taxpayers to use a single exchange rate for all transactions occurring on a particular
day.
Happily, these proposals have been mostly implemented already. They take the form of the
Regulations under the translation rules in Subdivisions 960-C and 960-D. These Regulations are
discussed in section 4.2 below. The Regulations have gone a long way towards improving the
practical application of the foreign exchange rules, not just under Division 775, but also under the
TOFA regime.
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4 The translation rules in Subdivisions 960-C and 960-D
(and the associated Regulations)
4.1 Subdivision 960-C
As discussed in section 3 above, Division 775 seeks to tax gains and losses to the extent that they
are attributable to a “currency exchange rate effect”. Accordingly, when Division 775 was introduced,
it was considered necessary to also introduce detailed rules for translating currencies.14
The core
translation rules were enacted as Subdivisions 960-C and 960-D. These rules remain relevant in
applying the TOFA regime.
The translation rules work alongside the TOFA provisions in Division 230 and the FX rules in Division
775. Whilst the rules in Division 230 and Division 775 prescribe taxing points and “realisation” events,
the translation rules prescribe the exchange rates that should be used for the translation of
currencies.
Section 960-50 provides for the translation of amounts into A$. Subsection 960-50(1) provides the
general rule that:
“[f]or the purposes of this Act, an amount in a *foreign currency is to be translated into
Australian currency”
The table in s.960-50(6) then provides certain specific translation rules. By way of example:
Item 2 of the table provides that the “cost” of a depreciating asset under Division 40 must be
translated into A$ either at the time when the taxpayer starts to “hold” the asset or when the
obligation that the taxpayer incurred in return for starting to hold the asset is satisfied (whichever
happens earlier). Case study 6 (in section 12) contains a practical application of this item.
Item 5 of the table provides that amounts that are relevant for CGT purposes must be translated
to A$ at the exchange rate applicable at the time of the transaction or event that is relevant for
CGT purposes. By way of example:
o If a taxpayer enters into a contract on 1 January 2014 for the acquisition of a CGT asset,
and the taxpayer pays a foreign currency amount on 1 December 2014, then the foreign
currency amount must be translated into A$ using the spot exchange rate on
1 January 2014 (the contract date), as the contract date is the date of acquisition of the
CGT asset (in accordance with Division 109).
14 Refer the 2003 Act.
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Prima facie, any FX gain/loss that the taxpayer makes on the payment of the foreign
currency amount on 1 December 2014 (measured by reference to the movement in the
exchange rate between 1 January and 1 December 2014) would be disregarded and
would be “wrapped” into the CGT cost base of the asset (as a reduction or an increase)
under the “short-term FX rules” in s.775-70 and s.775-75. This is because the foreign
currency amount is paid within 12 months after the acquisition date of the asset (ie the
contract date). However, if the taxpayer has made an election under s.775-80 to
disregard the short-term FX rules, the FX gain/loss would be recognised as
assessable/deductible to the taxpayer on 1 December 2014 under Division 775.
o If the taxpayer enters into a contract to sell a CGT asset on 1 June 2013 but the foreign
currency capital proceeds are not received until 31 July 2013, the amount of the “capital
proceeds” (for CGT purposes) must be translated into A$ using the spot exchange rate
on 1 June 2013 (ie the contract date). This is because the CGT event occurs on the
contract date under CGT event A1 (refer s.104-10).
However, on 31 July 2013, when the taxpayer receives the capital proceeds, an FRE 2
happens for the taxpayer, as a result of which the taxpayer makes a forex realisation
gain/loss (measured by reference to the movement in the exchange rate between the
contract date of 1 June 2013 and the payment date of 31 July 2013).
Prima facie, any forex realisation gain/loss would be disregarded, and the taxpayer would
instead be taken to make either a capital gain under CGT event K10 (s.104-260) or a
capital loss under CGT event K11 (s.104-265) (refer item 1 of the table in s.775-70(1) and
s.775-75(1)). This is because the foreign currency capital proceeds are received within 12
months after the time of the CGT event. The effect of these provisions is that an FX gain
or loss of a revenue nature is converted into a capital gain or loss (to match the tax
character of the capital gain or loss on the sale of the CGT asset). However, if the
taxpayer has made an election under s.775-80 to disregard the short-term FX rules, the
forex realisation gain/loss would be recognised as assessable/deductible to the taxpayer
under Division 775 (on revenue account).
4.2 Regulations
As mentioned in section 3.6.2 above, regulations have been made under Subdivisions 960-C and
960-D. These regulations were made as compliance cost saving measures for the translation of
currencies. In this regard, Regulation 960-50.01 of the Income Tax Assessment Regulations 1997
(the “Regulations”) modifies the table in s.960-50(6) by inserting two additional items: 11A and 12.
In particular, item 12 provides that, for the purpose of translating certain amounts into Australian
currency, the amount may be translated using any of the rules set out in Schedule 2 to the
Regulations. In this regard, the rules in Part 1 of Schedule 2 encompass the following:
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1.1 Exchange rate – Consistency with accounting standards used by entity
Where a taxpayer prepares an audited financial report which complies with the accounting
standards, and which translates amounts into A$ using particular exchange rates, then the
taxpayer can choose to use those rates for tax purposes. If the taxpayer does choose to do so,
then it must translate all amounts into A$ using the exchange rates that were used in that financial
report to translate corresponding amounts.
1.2 Choice of daily exchange rate
A taxpayer can choose a particular exchange rate that is applicable on a particular day for the
purpose of translating all relevant transactions for that day. This is relevant where, for example, a
loan in US$ is drawn-down in the morning, but then the amount is paid to a swap counterparty (for
example, to hedge its exposure under the loan) later that day. It would avoid the recognition for
tax purposes of any foreign currency gain or loss arising from movements in the exchange rate
during that day.
However, if the taxpayer makes this choice, then item 1.2(2) provides:
“If the entity chooses a daily exchange rate relating to a particular day, the entity must choose
a daily exchange rate relating to each subsequent day in the income year using the same
time of the day as the time to which the first daily exchange rate relates.”
For example, if the taxpayer uses the 4 pm Reuters exchange rate to translate an amount on
31 December 2012, it must also use the 4 pm Reuters exchange rate to translate an amount on
30 June 2013.
1.3 Choice of average exchange rate
A taxpayer can choose to translate:
“an amount into Australian currency using an exchange rate that is an average of all of the
exchange rates that are applicable during a period, not exceeding 12 months, that is chosen by
the entity (an average exchange rate)”
However, a taxpayer can only adopt an average exchange rate if:
“it appears to the entity on reasonable grounds that the rate would be a reasonable
approximation of the exchange rate or rates that the entity would have used if the entity had
used the exchange rate required by another appropriate item of the table in subsection 960-
50(6) of the Act”
Furthermore, if the taxpayer chooses to use an average exchange rate for a period, it must use
the same average rate to translate all amounts relating to that period.
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4.3 Subdivision 960-D
Subdivision 960-D contains the functional currency rules. These rules permit certain taxpayers to
make a functional currency choice. The consequence of making such a choice is that the taxpayer
(or, if applicable, a part of that taxpayer, such as its foreign branch) is permitted to calculate its
taxable income or tax loss in a currency other than A$ (ie its “applicable functional currency”). The
functional currency chosen must be the “sole or predominant” foreign currency in which that taxpayer
(or part of that taxpayer) keeps its financial accounts.
Once the taxpayer’s taxable income or tax loss has been calculated in its applicable functional
currency, then that amount must be translated into A$ using prescribed rates.
Pursuant to s.960-60, a functional currency choice can only be made for the purpose of calculating:
the taxable income or tax loss of an Australian resident who is required to prepare financial
reports under s.292 of the Corporations Act 2001;
the taxable income or tax loss made by an Australian resident from an activity or business carried
on at or through its overseas permanent establishment;
the taxable income or tax loss made by a non-resident from an activity or business carried on at
or through its Australian permanent establishment;
the “total assessable OB income” and the “total allowable OB deductions” of an “offshore banking
unit” (“OBU”)15
;
the attributable income of a CFC; and
the attributable income of a transferor trust.
Subdivision 960-D was introduced as a compliance cost saving measure. Since its introduction, many
corporate taxpayers have made the functional currency choice, particularly in respect of their
branches and CFCs.
15 Refer Division 9A of Part III of the ITAA 1936.
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5 The TOFA regime (Division 230)
5.1 Introduction
Providing a comprehensive analysis of the TOFA regime is beyond the scope of this Paper.
Notwithstanding this “caveat”, for completeness, we have set out below an overview of some of the
key aspects of the TOFA regime, at least as far as they are relevant to the taxation of FX gains and
losses.
The stated objectives of the TOFA regime are to achieve:
greater efficiency, including through closer alignment of tax and commercial recognition of gains
and losses from financial arrangements, reducing tax-timing and tax-character mismatches, and
increasing reliance on economic substance over legal form;
the lowering of compliance costs, especially through greater reliance on financial reports as the
basis for taxation where appropriate.16
5.2 Transitional rules
The transitional rules of the TOFA regime have been alluded to in sections 2.2 and 3.2.2 of this
Paper.
In summary, the TOFA regime applies only to certain “financial arrangements” that an eligible
taxpayer first “started to have” on or after the “first applicable income year”.17
The “first applicable income year” was the income year commencing on or after 1 July 2010, unless
the taxpayer made the “early start” election in sub-item 103(2) of the TOFA Act, in which case the first
applicable income year was the income year commencing on or after 1 July 2009.
A taxpayer could make an “un-grandfathering” election in sub-item 104(2) of the TOFA Act to bring its
“pre-TOFA” financial arrangements within TOFA’s ambit.
16 Refer paragraphs 1.13 to 1.18 of the Explanatory Memorandum to the TOFA Act.
17 Refer item 102, sub-item 103(1), and sub-item 104(1) of the TOFA Act.
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5.3 Thresholds for the mandatory application of TOFA
A taxpayer is eligible for the mandatory application of the TOFA regime only if it satisfies certain
threshold tests, which are set out in s.230-455.
There are different threshold tests depending on the type of taxpayer involved, eg individual,
superannuation entity or managed investment scheme, ADI or financial entity, another type of entity
such as a company etc (refer s.230-455(1)(a)).
In relation to a general company taxpayer, the company is mandatorily subject to the TOFA regime,
unless all of the following conditions are satisfied:
the company’s “aggregated turnover”18
for a relevant income year (generally, the income year
immediately preceding the one in which the company starts to have the relevant financial
arrangement) is less than $100 million (refer s.230-455(4)(a)); and
the book value of the company’s “financial assets” at the end of that income year is less than
$100 million (s.230-455(4)(b)); and
the book value of the company’s “assets” at the end of that income year is less than $300 million
(s.230-455(4)(c)); and
either:
o the relevant financial arrangement is not a “qualifying security” within the meaning of Division
16E of Part III of the ITAA 1936; or
o it is a qualifying security which has a remaining life at the time of acquisition of 12 months or
less.
A taxpayer who is not subject to the mandatory application of TOFA can make an irrevocable election
under s.230-455(7) to be subject to TOFA in respect of financial arrangements that it starts to have
after the beginning of the income year in which it makes the election.
5.4 Financial arrangements
The TOFA regime applies to tax gains and losses from certain “financial arrangements”. That is,
financial arrangements (as defined) are the “unit of taxation” to which TOFA applies.
18 It is important to note that the “aggregated turnover” of a taxpayer includes the turnover of its “connected entities” and of its
“affiliates” (refer Division 328).
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5.4.1 Primary definition of “financial arrangement”
The “primary” definition of “financial arrangement” is set out in s.230-45(1), which provides:
“You have a financial arrangement if you have, under an *arrangement;
(a) a *cash settlable legal or equitable right to receive a *financial benefit”; or
(b) a *cash settlable legal or equitable obligation to provide a “financial benefits”; or
(c) a combination of one or more such rights and/or one or more such obligations.
unless:
(d) you also have under the arrangement one or more legal or equitable rights to receive
something and/or one or more legal or equitable obligations to provide something; and
(e) for one or more of the rights and/or obligations covered by paragraph (d):
(i) the thing that you have the right to receive, or the obligation to provide, is not
a financial benefit; or
(ii) the right or obligation is not cash settlable; and
(f) the one or more rights and/or obligations covered by paragraph (e) are not insignificant in
comparison with the right, obligation or combination covered by paragraph (a), (b) or (c).
Pursuant to s.230-45(2), in general terms, a right to receive, or an obligation to provide, a financial
benefit is “cash settlable” if one (or more) of the following applies:
the benefit is money or a “money equivalent”; or
the taxpayer intends to settle the right/obligation by receiving or providing money or a money
equivalent, or by starting to have, or ceasing to have another financial arrangement; or
the taxpayer has a practice of satisfying or settling similar rights/obligations in the above manner;
the taxpayer deals with the right/obligation, or with similar rights/obligations, in order to generate a
profit from short-term fluctuations in price, from a dealer’s margin or from both; or
the financial benefit that is readily convertible into money or a money equivalent, there is a highly
liquid market for the financial benefit, and either:
there is no substantial risk of a substantial decrease in value of the money or money
equivalent; or
at least one of the taxpayer’s purposes for entering into the arrangement is to receive or
deliver the financial benefit:
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to raise or provide finance; or
so that the financial benefit may be converted or liquidated into money or a money
equivalent (other than as part of the taxpayer’s expected purchase, sale or usage
requirements).
The term “money equivalent” is defined in s.995-1(1) (somewhat curiously in a circular fashion) as:
a right to receive money; or
a right to receive something that is a money equivalent; or
something that falls within the primary definition of financial arrangement.
Although the term “money” is not defined in the Act, it is generally accepted that it should include
foreign currency.
At a very high level, the primary definition of financial arrangement encapsulates arrangements where
there are rights and/or obligations, and both “sides” of the transaction involve flows of cash or cash
settlable things.
It covers borrowing and lending in foreign currency, as well as most types of FX derivatives.
5.4.2 Extended definition of “financial arrangement”
In addition to the primary definition, the following are expressly defined to be “financial arrangements”:
an “equity interest” in a company, trust or partnership (refer s.230-50(1));
a right to receive, and/or an obligation to provide, an equity interest (refer s.230-50(2));
foreign currency (refer s.230-530(1));
a non-equity share (refer s.230-530(2)); and
commodities that are held by an entity who deals in both the commodity and derivatives over the
commodity, and who has elected to apply either the “fair value” tax-timing method or the “financial
reports” tax-timing method under TOFA (refer s.230-530(3) and (4)).
It should be noted that, in the case of an equity interest or a right/obligation in relation to an equity
interest (s.230-50), the TOFA regime applies to tax gains and losses from the financial arrangement
only if the taxpayer has made either the fair value election or the financial reports election (refer
ss.230-40(4)(e), 230-270(1), and 230-330(1)).
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5.5 Main exceptions from the application of TOFA
While TOFA only applies to financial arrangements, not all financial arrangements are subject to
TOFA. This is because there are numerous exceptions from the application of TOFA. Most of the
exceptions are contained in Subdivision 230-H and include the following:
certain short-term non-monetary arrangements (refer s.230-450). Broadly, this exception
addresses the situation where the taxpayer acquires or provides goods or other property under a
short-term (ie no longer than 12 months) credit arrangement;
most leasing, licensing and property arrangements, including hire-purchase arrangements that fall
within Division 240 (refer s.230-460(2));
certain interests in partnerships and trusts (refer s.230-460(3));
most insurance policies (refer s.230-460(5) and (6));
certain types of guarantees and indemnities (other than those given in relation to a financial
arrangement): refer s.230-460(8);
superannuation and pension benefits (refer s.230-460(11));
a right or obligation arising under a direct interest in a CFC (refer s.230-460(12));
earn-out arrangements (refer s.230-460(13));
registered emissions units (refer s.230-481).
There are certain other exceptions contained in ss.230-455 to s.230-480.
As noted above, if an arrangement is covered by any of the exceptions from TOFA, then Division 775
should typically have exclusive application to the FX gains and losses arising under that arrangement.
5.6 Operative provisions of TOFA
The operative provisions of the TOFA regime are similar to the operative provisions of Division 775.
A TOFA gain is generally included in the taxpayer’s assessable income (on revenue account)
pursuant to s.230-15(1).
Pursuant to s.230-15(2), a TOFA loss is generally deductible, to the extent that:
it is made in gaining or producing the taxpayer’s assessable income; or
it is necessarily made in carrying on a business for the purpose of gaining or producing the
taxpayer’s assessable income.
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Section 230-30 addresses the treatment of TOFA gains and losses that relate to the derivation of
exempt income or NANE income. In this regard, s.230-30 provides:
“(1) Despite section 230-15, a gain that you make from a *financial arrangement:
(a) to the extent that it reflects an amount that would be treated, or would reasonably
expected to be treated, as *exempt income under a provision of this Act if this
Division were disregarded - is exempt income; and
(b) to the extent that it reflects an amount that would be treated or would reasonably
expected to be treated, as *non-assessable non-exempt income under a provision of
this Act if this Division were disregarded - is not assessable income and is not exempt
income.
(2) Despite section 230-15, a gain that you make from a *financial arrangement:
(a) to the extent that, if it had been a loss, you would have made it in gaining or
producing *exempt income - is exempt income; and
(b) to the extent to which, if it had been a loss, you would have made it in gaining or
producing *non assessable non-exempt income - is not assessable income and is not
exempt income.
(3) A loss you make from a *financial arrangement is not allowable as a deduction to you
under any provision of this Act (other than subsection 230-15(3)) to the extent that you make
it in gaining or producing your:
(a) *exempt income; or
(b) *non-assessable non-exempt income.”
In Taxation Ruling TR 2012/3, the Commissioner has set out his views regarding the nature and
extent of the nexus that is required between the TOFA gain/loss and the derivation of exempt or
NANE income for the TOFA gain/loss to be treated as non-assessable/non-deductible. In the
Commissioner’s view, the use of the words “in gaining or producing” in s.230-30 means that the nexus
inquiry for TOFA purposes is the same as the nexus inquiry under s.8-1 (the general deduction
provision).19
In other words, having regard to the case law on s.8-1 (and its predecessor, s.51(1)), a
TOFA gain/loss is made in gaining or producing exempt or NANE income to the extent that the
gain/loss is “incidental and relevant” to the exempt or NANE income producing activity of the
taxpayer.20
The Ruling also considers the practical application of these principles to various
hypothetical scenarios.
19 Refer paragraphs 7 to 16 of TR 2012/3.
20 Refer Ronpibon Tin NL and Tongkah Compound NL v FCT (1949) 78 CLR 47); Amalgamated Zinc (De Bavay’s) Ltd v FCT
(1935) 54 CLR 295; Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344.
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The application of the nexus requirement can be quite important in various contexts, for example, the
assessability/deductibility of FX gains/losses made by a taxpayer in relation to the funding of its
offshore equity investments. Case studies 7 and 8 of this Paper examine such scenarios.
5.7 Tax-timing methods under TOFA
5.7.1 Overview of the methods
Under the TOFA regime, “gains” and “losses” on a financial arrangement are required to be
determined in accordance with one of the default tax-timing methods, unless one of the elective tax-
timing methods is applicable to the financial arrangement. Generally, if an elective method applies, it
has priority over the default methods (refer s.230-40(3)).
The default methods are:
the “accruals” method in Subdivision 230-B; and
the “realisation method”, which is also contained in Subdivision 230-B.
Division 230 contains four elective tax-timing methods. The elective methods are:
the “foreign exchange retranslation method” in Subdivision 230-D;
the “fair value” method in Subdivision 230-C;
the “reliance on financial reports” method in Subdivision 230-F; and
the “hedging financial arrangement” method in Subdivision 230-E.
A taxpayer may elect any or all of the elective methods. However, if a taxpayer makes the hedging
election, it will “trump” all of the others, and the second ranking election is the financial reports method
(refer s.230-40).
Generally, on ceasing to have a financial arrangement, the taxpayer makes a gain or loss under the
“balancing adjustment” in Subdivision 230-G. The balancing adjustment is intended to provide a
“true-up” between the amounts assessable/deductible to the taxpayer during the life of the financial
arrangement, and the total amount of financial benefits that the taxpayer received and provided under
the financial arrangement (refer the method statement in s.230-445).
Taxpayers that have elected one or more of the fair value, foreign exchange retranslation or reliance
on financial report methods are generally required to recognise FX gains and losses on an unrealised
basis for income tax purposes, essentially “picking up” FX gains and losses recognised in the profit
and loss statement in the taxpayer’s financial accounts.
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The vast majority of corporate taxpayers (ie entities other than financial institutions) have not made
the tax-timing elections (except perhaps the “retranslation” election for “qualifying forex accounts”).
Accordingly, under TOFA, the vast majority of corporate taxpayers have generally continued to
recognise FX gains and losses on a realisation basis (under the default “realisation” method plus
under the TOFA “balancing adjustment” provisions). The case studies provide several examples of
the application of the realisation method and the balancing adjustment to a “typical” corporate
taxpayer, as these play a large role in the TOFA treatment of FX gains and losses.
Each of the tax-timing methods is briefly discussed in the sections that follow.
5.7.2 The default methods
The default position under the TOFA regime is that gains and losses from financial arrangements are
taxed on an accruals basis if they are “sufficiently certain”. Where gains and losses are not
“sufficiently certain”, they are taxed on a realisation basis (refer s.230-100). In other words, the
“sufficiently certain” test acts as the delineator between applying the “accruals method” or the
“realisation method”.
The accruals method applies to either a sufficiently certain “overall” gain or loss from a financial
arrangement or sufficiently certain “particular” gains and losses from the financial arrangement.
As a result of recent retrospective legislative amendments21
, if at the time a taxpayer starts to have a
financial arrangement, the taxpayer is sufficiently certain of both an overall gain or loss and particular
gains and losses from the arrangement, the taxpayer can only apply the accruals method to the
overall gain or loss if:
the taxpayer chooses to do so; or
the taxpayer cannot apply the accruals method to the particular gains and losses arising from the
arrangement (refer s.230-100(2)(c)).
In other words, the particular gain or loss approach now takes priority and is the default approach.
In this regard, s.230-110(1) provides:
“You have a sufficiently certain gain or loss from a *financial arrangement at a particular time
if it is a sufficiently certain at that time that you will make a gain or loss from the arrangement
of:
(a) a particular amount; or
(b) at least a particular amount;
21 Refer items 11 and 14 of Schedule 8 to Tax and Superannuation Laws Amendment (2013 Measures No. 2) Act 2013 (the
“2013 Act”).
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when one of the following occurs:
(c) you receive a particular *financial benefit under the arrangement or one of your rights
under the arrangement ceases;
(d) you provide a particular financial benefit under the arrangement or one of your
obligations under the arrangement ceases.
The amount of the gain or loss is the amount referred to in paragraph (a) or (b).”
Also as a result of the recent legislative amendments, a taxpayer can now have a sufficiently certain
particular gain or loss from a financial arrangement, even if there are financial benefits under that
arrangement that are not sufficiently certain (refer s.230-110(2)(a)).22
That is, in determining if a
particular gain or loss is sufficiently certain, taxpayers need only have regard to the financial benefits
that are reasonably attributable to the particular financial benefit which gives rise to that gain or loss.
Section 230-115 then sets out several matters to which regard must be had in deciding “whether it is
sufficiently certain at a particular time that you will make a gain or loss from a *financial arrangement”.
Subsection 230-115(1) provides that, in deciding whether a gain or loss is sufficiently certain:
you only have regard to financial benefits that you are sufficiently certain to receive or provide (as
the case may be); and
you have regard to those financial benefits only to the extent that the amount or value of the
benefits is, at the relevant time, “fixed or determinable with reasonable accuracy”.
Subsection 230-115(2) then provides:
“A financial benefit that you are to receive or provide is to be treated as one that you are
sufficiently certain to receive or to provide only if:
(a) it is reasonably expected that you are to receive or provide the financial benefit (assuming
that you will continue to have the *financial arrangement for the rest of its life); and
(b) at least some of the amount or value of the benefit is, at that time, fixed or determinable
with reasonable accuracy.”
Furthermore, paragraph 230-115(8)(b) provides relevantly:
“If all of the *financial benefits provided and received under the *financial arrangement are
denominated in a particular *foreign currency, those financial benefits are not to be translated
into ... Australian currency, for the purposes of applying subsection (2) to that arrangement.”
22 Refer item 10 of Schedule 8 to the 2013 Act.
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As Case Study 1 illustrates, the above paragraph is particularly relevant in cases of borrowings in
foreign currency, where all the financial benefits under the arrangement are denominated in a
particular foreign currency.
In many FX-denominated transactions (particularly, derivative transactions), there is unlikely to be any
sufficient certainty regarding the amount of the financial benefits that the taxpayer will receive or
provide until the financial benefit is actually received or provided (as the case may be). This is
because the spot exchange rate prevailing at the time when the financial benefit is received/provided
will not be known until then (and therefore, the A$ value of the financial benefit will not be known until
that time). It is not surprising therefore, that the accruals method does not apply to many FX-
denominated transactions (which are generally taxed on a realisation basis).
5.7.3 Foreign exchange retranslation method
The TOFA regime contains an elective foreign exchange retranslation method, which allows certain
FX-denominated positions to be recognised for tax purposes on a “retranslation” (ie unrealised) basis.
Two alternative types of elections are possible under this method:
General retranslation election
A taxpayer is eligible to make the “general” retranslation election in s.230-255(1) if:
the taxpayer prepares financial reports in accordance with the Australian accounting standards (or
equivalent foreign standards); and
the financial report is audited in accordance with the Australian auditing standards (or equivalent
foreign standards).23
If the taxpayer validly makes the election, then the retranslation method would generally apply to each
TOFA financial arrangement of the taxpayer which is:
recognised in the taxpayer’s audited financial reports; and
generates amounts that are attributable to changes in currency exchange rates, and which are
required by AASB 121 “The Effects of Changes in Foreign Exchange Rates” (or an equivalent
foreign standard) to be recognised in the taxpayer’s profit or loss statement (“P&L”).24
Pursuant to s.230-280(1), a taxpayer generally makes a TOFA gain or loss from a financial
arrangement for an income year if AASB 121 (or an equivalent foreign standard) requires the
23 Refer s.230-255(2).
24 Refer s.230-265(1).
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taxpayer to recognise a particular amount in the P&L in relation to that arrangement for the relevant
income year.
The retranslation method measures the gain or loss from translating a given number of units of one
currency into another currency, where the gain or loss arises from the different exchange rates at
different points in time. This method allows taxpayers to restate the amount of their FX-denominated
positions (ie their assets and liabilities) at their A$ value for tax purposes, adjusting for the movement
in exchange rates during the income year.
The consequence of applying the retranslation method is that unrealised FX gains and losses are
recognised for income tax purposes in respect of all of the taxpayer’s TOFA financial arrangements
(in line with their accounting treatment in the P&L).
If the taxpayer or the arrangement no longer qualifies for the retranslation method, the taxpayer
makes a balancing adjustment gain or loss (refer s.230-290). Thereafter, the default accruals or
realisation method will apply, as appropriate.
It is worth noting that, if a taxpayer makes a valid retranslation election under TOFA, then the
retranslation method will also generally apply (albeit via Division 775) to any FX gains and losses
arising in relation to arrangements that do not constitute TOFA financial arrangements (eg because
they do not fall within the definition of the term or because they are covered by an exception from
TOFA under Subdivision 230-H). Such gains and losses are taxed under FRE 9 in s.775-305, which
was enacted at the same time as TOFA. The policy rationale for FRE 9 is avoiding the compliance
costs and difficulties that would otherwise arise from having to separately identify and track FX gains
and losses on TOFA financial arrangements from FX gains and losses on other arrangements.
It is not surprising that the general retranslation election has been of interest mainly for financial
institutions.
Qualifying forex account election
The alternative retranslation election in s.230-255(3) is narrower and more limited, in the sense that it
only applies to the taxpayer’s “qualifying forex accounts”. A “qualifying forex account” is defined in
s.995-1(1) as an account denominated in a foreign currency which:
has the primary purpose of facilitating transactions; or
is a credit card account (refer to s.995-1).
The qualifying forex account election only applies if a taxpayer has not made the general retranslation
election.
Unlike the general election, the taxpayer does not need to have audited financial reports which
comply with the accounting and auditing standards to be eligible to make the election.
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Subsection 230-280(2) provides that a taxpayer makes a TOFA gain or loss from a qualifying forex
account for an income year if AASB 121 (or an equivalent foreign standard) requires the taxpayer to
recognise a particular amount in the P&L in relation to that account for the relevant income year.
The consequence of making this election is that unrealised FX gains and losses which are recognised
in the P&L in relation to the forex account must be recognised for income tax purposes.
The election applies on an account-by-account basis. Therefore, a separate election needs to be
made for each qualifying forex account. If a taxpayer wishes to apply the retranslation method to its
qualifying forex accounts, the taxpayer should make an election for each new account by the end of
the income year in which the account is opened (to ensure that the retranslation method applies to the
account from the time when the account is opened).
For “pre-TOFA” forex accounts, unless the taxpayer has made the “un-grandfathering” election under
TOFA, Subdivision 775-E should continue to apply to those accounts if the taxpayer had previously
chosen retranslation for those accounts. Subdivision 775-E provided a (limited) form of retranslation
for qualifying forex accounts, but the amount of FX gains and losses recognised for tax purposes was
not driven by the FX gains and losses recognised in the P&L. Rather, in calculating the amount of FX
gains and losses in relation to the account for tax purposes, the taxpayer was technically required to
translate the opening and closing balances of the account for each income year, as well as each
deposit and each withdrawal, using spot exchange rates (refer FRE 8 in s.775-285). Whether or not
taxpayers have strictly applied this methodology in practice is a different question!
If the TOFA retranslation method does not apply to a qualifying forex account, then the taxpayer
would need to recognise FX gains and losses each time when it makes a deposit into, or withdraws
an amount from, the account (under the default realisation method and the balancing adjustment
provisions). For the purpose of calculating the amount of the FX gain or loss, the taxpayer would
need to trace the “cost” of foreign currency that “moves” through the account from time to time (which
would be a compliance burden if a large volume of transactions goes through the account).
As such, the retranslation election for qualifying forex accounts has been popular with some corporate
taxpayers (other than financial institutions), particularly if the balances of the accounts are not
significant, and if the compliance burden of applying the default realisation method and the balancing
adjustment provisions is considered to be excessive.
5.7.4 Fair value method
The eligibility requirements for a taxpayer to make a fair value election are similar to the eligibility
requirements to make the general retranslation election (in regards to having audited financial
reports): refer s.230-210(2).
If the taxpayer makes a valid election, then by virtue of s.230-220, the fair value method would
generally apply to each TOFA financial arrangement of the taxpayer which:
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is recognised in the taxpayer’s audited financial reports; and
is an asset or liability that the taxpayer is required by the Australian accounting standards (or
equivalent foreign standards) to classify or designate as “at fair value through profit or loss”.
The types of financial arrangements that can be designated as “at fair value through profit or loss” for
accounting purposes may include FX-denominated assets and liabilities, such as investments in
offshore securities and FX derivatives.
Pursuant to s.230-230, a taxpayer generally makes a TOFA gain or loss from a financial arrangement
of the type described above for an income year equal to the amount that the Australian accounting
standards (or equivalent foreign standards) require the taxpayer to recognise in its P&L for that
income year.
In other words, the fair value method measures a TOFA gain/loss as the change in the fair value of
the relevant asset or liability (as calculated under the accounting standards) between income years.
Accordingly, taxpayers applying the fair value method generally recognise for tax purposes unrealised
FX gains and losses arising from such assets and liabilities. However, it should be noted that the fair
value method recognises more than just movements in foreign currency values. For example, it also
picks up movements in value that are due to change in other variables, such as interest rates, credit
risk, etc.
The fair value method has been of most interest to financial institutions.
5.7.5 Reliance on financial reports method
The eligibility requirements for making the financial reports election are more onerous than the
eligibility requirements for the retranslation method or the fair value method. In addition to having
audited financial reports that comply with the relevant accounting standards, the taxpayer must satisfy
certain conditions regarding the reliability of its audited financial reports, and the reliability of its
accounting systems and controls and its internal governance processes (refer s.230-395(2)).
However, the Commissioner does have a discretion to waive some of these conditions (refer s.230-
405).
In broad terms, if a financial reports election applies to a TOFA financial arrangement, the taxpayer
makes a TOFA gain or loss from the arrangement for an income year equal to the gain or loss that
the taxpayer is required to recognise in relation to that arrangement in its P&L for that income year
(refer s.230-420).
The most critical restriction is contained in s.230-410(1)(f). That paragraph states that the financial
reports method applies to a particular financial arrangement only if the difference between the results
of the following methods would “reasonably be expected not to be substantial”:
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the method used in the taxpayer’s financial reports to work out the amounts of gain/loss from the
arrangement for each year; and
the method that would be applied under Div 230 to work out the gains/losses if the financial
reports method did not apply. (For this purpose, it can be assumed that the fair value and
retranslation elections have been made, even if not, in fact, made.)
The above requirement means that a taxpayer must (at least theoretically!) have a system in place to
assess the gain/loss that would arise under Division 230 (absent the financial reports election) and
compare the results to the accounting outcomes in the financial reports.
Most financial institutions have made the financial reports election.
5.7.6 Hedging financial arrangement method
If a taxpayer has A$ as its functional currency, the holding of assets or liabilities in a foreign currency,
or having a right to receive or an obligation to pay foreign currency, means that the taxpayer has an
“exposure” to foreign currency.
Depending on the taxpayer’s circumstances (and, in particular, its appetite for FX risk), it is common
for that “exposure” to be hedged. Hedging is undertaken by entities to manage FX risk by entering
into transactions (such as derivative contracts) which will result in gain/losses that offset (at least to
some extent) the losses/gains on the underlying hedged items. Some of the case studies examined
in this Paper canvass scenarios where a taxpayer hedges its FX risk.
The intention of the hedging method in the TOFA regime is to permit gains and losses on a “hedging
financial arrangement” to match the losses and gains (respectively) on an underlying hedged item for
tax purposes. Significantly, the TOFA treatment of the hedging financial arrangement seeks to match
both:
the timing of any gains or losses made under the hedged item; and
the tax character of any gains or losses made under the hedged item.
Therefore, if the hedging method applies, the tax timing and the tax characterisation of the gain/loss
on the hedge will be aligned, broadly speaking, with that of the hedged item. This may change the tax
character of a gain/loss on the hedge to capital, exempt, NANE, etc.
Hedging financial arrangements are typically derivatives such as swaps, options, forward exchange
contracts etc. FX-denominated borrowings can also qualify as hedging financial arrangements.
There are a wide variety of things that are capable of being “hedged items”, including assets,
liabilities, “firm commitments”, highly probably forecast transactions and net investments in foreign
operations (so called “NIFOs”).
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In an FX context, a typical example of a hedging arrangement would be where an Australian taxpayer
hedges its exposure in respect of the payments of foreign currency interest and the repayment of
foreign currency principal under a borrowing by entering into a cross-currency swap.
Another example is where a taxpayer enters into an FX forward to hedge its investment in a capital
asset (denominated in a foreign currency) (ie the “hedged item”). In this case, if the TOFA hedging
method applies to the FX forward:
any gain or loss on the FX forward should be recognised at the same time that the capital asset is
ultimately realised (even if some years later) – such that there is timing matching; and
any gain or loss on the FX forward should be on “capital account” (rather than on “revenue
account”) – such that there is tax character matching.
The ability to achieve an effective hedge on a post-tax basis under the TOFA hedging method,
especially in relation to FX hedging situations, can be quite important to a taxpayer. In some cases,
this method can lead to the indefinite deferral of what would otherwise be gains on “revenue account”
(for instance, where the hedged item is equity in an overseas subsidiary, and the hedging financial
arrangement is an FX derivative).
As such, given the advantages of tax timing matching and tax character matching, a number of
corporate taxpayers (other than financial institutions) have made the hedging election under TOFA.
In order to make a valid hedging election, and for the hedging method to apply to a hedging financial
arrangement, a number of strict and detailed financial reporting, documentation and other
requirements must be satisfied. These are scattered throughout Subdivision 230-E.
At the time of writing, there are still many unresolved interpretational issues as well as practical issues
in the application of the hedging method.
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6 Case studies: Abbott Limited
The facts listed below are relevant to the case studies that are examined in the remainder of this
Paper:
Abbott Limited (“Abbott”) is an Australian resident public company.
Abbott is involved in the travel and transport industry.
Abbott has A$ as its functional currency. That is, Abbott has not made a functional currency
election under Subdivision 960-D.
Abbott’s year-end for tax purposes is 30 June.
Abbott is subject the TOFA regime on a mandatory basis because its assets and turnover both
exceed the relevant thresholds.
Abbott did not make the “early start” election to apply the TOFA regime from 1 July 2009.
Abbott did not make the election to “un-grandfather” any of the financial arrangements that it
“started to have” before 1 July 2010.
Abbott has made the TOFA retranslation election in relation to its “qualifying forex accounts”, but
it has not made an election to adopt any of the other elective tax-timing methods in TOFA.
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7 Case study 1: US$ borrowing
7.1 The facts
On 1 March 2013, Abbott issues Notes in the aggregate principal amount of US$10 million in the
US capital market.
The spot exchange rate on 1 March 2013 is A$1 = US$1.03.
Abbott uses the proceeds from the issue of the Notes in carrying on its business for the purpose
of producing assessable income.
The Notes are issued for their face value (i.e. there is no discount or premium on the issue of the
Notes).
The Notes have a fixed term of 2 years. That is, Abbott is scheduled to redeem the Notes on
28 February 2015.
The spot exchange rate on 28 February 2015 is A$1 = US$0.90.
The Notes bear interest at a fixed rate of 8% per annum.
Interest is payable in US$ on a semi-annual basis in arrears.
7.2 The TOFA regime - general
If the Notes issued by Abbott are “financial arrangements” (refer 7.3 below) and the TOFA regime in
Division 230 applies to the Notes, then:
any “gains” made by Abbott in relation to the Notes must be included in Abbott’s assessable
income (refer s.230-15(1)); and
Abbott should be entitled to claim a deduction for any “losses” that it makes in relation to the
Notes, on the basis that any such losses should have the requisite nexus with Abbott carrying on
a business for the purpose of gaining or producing assessable income (refer s.230-15(2)).
7.3 Financial arrangement
Each Note issued by Abbott should constitute a “financial arrangement” under the primary definition of
the term in s.230-45 for the following reasons:
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under a Note, Abbott has:
o a legal right to receive the issue proceeds of the Note; and
o a legal obligation to repay the principal amount of the Note on redemption;
o legal obligations to pay interest on a semi-annual basis during the term of the Note;
the above rights and obligations are “cash settlable” within the meaning of s.230-45(2) because
Abbott intends to satisfy or settle those rights and obligations by receiving and paying money
(respectively); and
the exception outlined in paragraphs (d), (e) and (f) of the definition do not apply.
None of the exceptions to the application of the TOFA regime are relevant in this case (refer
Subdivision 230-H).
Accordingly, any gain or loss arising for Abbott in relation to a Note should be taxed under the TOFA
regime in Division 230.
7.4 Interest on the Notes
7.4.1 Accruals method vs. realisation method
As Abbott has not made an election to adopt any of the elective tax-timing methods in Division 230,
the default “accruals/realisation methods” in Subdivision 230-B should apply in respect of the Notes.
Specifically, the “accruals method” will apply to tax any “sufficiently certain” gain or loss arising from
Abbott's financial arrangements. Gains and losses which are not “sufficiently certain” will be taxed
under the “realisation method”.
Importantly in this case, paragraph 230-115(8)(b) provides relevantly:
“If all of the *financial benefits provided and received under the *financial arrangement are
denominated in a particular *foreign currency, those financial benefits are not to be translated
into ... Australian currency, for the purposes of applying subsection (2) to that arrangement [ie
for the purpose of determining whether the financial benefits are “sufficiently certain”].”
In this case, all of the financial benefits received and provided under each Note are denominated in
US$. Therefore, they should not be translated into A$ for the purpose of determining whether those
financial benefits are sufficiently certain.
Furthermore, in this case, each Note bears interest at a fixed rate.
Having regard to the above factors, at the time when a Note is issued, it is sufficiently certain that
Abbott will make a “particular” loss each time that it makes a payment of interest on the Note (refer
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s.230-100(3)). Each particular loss should be “spread” over the 6-month period to which it relates
under the accruals method (refer s.230-130). As discussed below, the amount that must be “spread”
is the US$ amount of interest (without translation into A$). By virtue of s.230-135(2) and s.230-140,
each loss must be spread using:
compounding accruals; or
a method whose results approximate those obtained using the accruals method (e.g. the
“effective interest” method in AASB 139).
It is assumed that, in Abbott’s financial statements, the Notes will be measured at amortised cost
using the effective interest method in AASB 139. The effect of this should be that Abbott’s TOFA
particular loss (in US$) for a period should be equal to the accrual of interest (in $US) reflected in
Abbott’s financial statements.
By way of example, the interest payment made by Abbott on 30 September 2013 would relate to the
6-month period from 1 March to 30 September 2013. The amount of the particular loss would be say
US$4 million (being interest for 6 months at 8% per annum on US$10 million on a simple interest
basis). That interest payment (ie the “TOFA loss”) should be spread over that period. On that basis,
Abbott should be entitled to deduct $2 million in the 2013 income year and $2 million in the 2014
income year (on account of the 30 September 2013 interest payment).
7.4.2 Translation into A$
Abbott’s “TOFA loss” for each semi-annual period (ie the period over which the interest is effectively
spread) should initially be calculated in US$ (as discussed above).
Abbott’s TOFA loss for each interest period (stated in US$) should then be translated into A$ in
accordance with the foreign currency translation rules in Subdivision 960-C. Section 960-50 provides
rules for the translation of amounts into Australian currency. In this regard, s.960-50(1) provides:
“For the purposes of this Act, an amount in a *foreign currency is to be translated into
Australian currency.”
Relevantly, s.960-50(5) provides:
“In applying this section:
(a) calculate a *special accrual amount without translation; and
(b) then, translate the special accrual amount.”
Abbott’s “TOFA loss” should be a “special accrual amount” because it is an amount deductible under
Division 230 (refer to the definition of “special accrual amount” in s.995-1(1)).
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Subsection 960-50(6) provides a table that contains the “special translation rules”. Item 8 of that table
provides translation rules in the case of “an amount that you deduct (other than under Division 40)”. In
this situation, item 8 provides that the amount should be translated into A$ using the spot exchange
rate applicable at the earlier of the time the amount became deductible or when it was paid. In the
present case, each semi-annual interest payment is made after the interest amount becomes
deductible (as the deduction for the interest amount is spread over the 6-month period under the
accruals method). Therefore, strictly speaking, the spot rate at the time when the amount of interest
is deductible must be used to translate the interest into A$.
Applying item 8 literally to an interest accrual would cause a considerable compliance burden for
taxpayers. Where interest is spread under the “accruals method” in the manner described above,
then, technically, each day a small amount of interest is deductible – ie for Abbott, this would be
approximately US$21,917 per day. If item 8 were to be applied literally, there would need to be a
translation into A$ of US$21,917 each day using daily spot rates. This approach would seem to defeat
the concept of translating a “special accrual amount” as a single amount, but it seems to be a
consequence of applying the legislation literally.
To mitigate the compliance burden, Abbott can choose to translate the accrued interest amounts
using an average exchange rate for a period not exceeding 12 months, provided that the use of the
average rate gives rise to a reasonable approximation of the actual result of translating the accrued
amounts on a daily basis using daily spot exchange rates. In this regard, Reg 960-50.01(1) of
Regulations inserts a new item (item 12) into the table in s.960-50(6). That item contains modifications
to the way foreign currency is translated by using method in the rules in Schedule 2 to the
Regulations. In particular, item 1.3 of Part 1 of Schedule 2 to the Regulations provides for the
adoption of an average exchange rate.
As an alternative, translation into A$ at the exchange rate used in Abbott’s financial report for a
particular income year is permitted, provided that the financial report complies with the Australian
accounting standards and has been audited, and provided also that Abbott translates other foreign
currency amounts for the same income year into A$ at the exchange rates used in the same financial
report.25
The interest payments made on the Notes will not coincide with Abbott’s 30 June year-end.
Accordingly, under the TOFA regime, Abbott should recognise the accrued/“spread” US$ interest for
the period from 1 March to 30 June, translated into A$ (using a three month average rate in
accordance with item 1.3 of Part 1 of Schedule 2 to the Regulations - refer above) when calculating its
deductible “TOFA loss” for the 2013 income year .
25 Refer item 12 of the table in s.960-50(6) of the Act, as modified by Regulation 960-50.01(1), and item 1.1 of Part 1 of Schedul
e 2 to the Income Tax Assessment Regulations 1997.
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7.4.3 Running balancing adjustment
When the interest is actually paid on 1 October 2013, Abbott should recognise the interest accrued for
the period from 1 July to 31 August, together with a gain or loss under the “running balancing
adjustment” (“RBA”) in s.230-175. This should reflect any difference between the relevant accrued
amounts for the six monthly interest period (translated into A$ as described above) and the A$
equivalent of the US$4 million of interest that is actually paid on 1 October 2013 (translated into A$
using the spot exchange rate on 1 October 2013).
In particular, either s.230-175(3) or (4) may be relevant. Subsection 230-175(3) would apply to deem
Abbott to make a gain on a Note if the amount of the A$ amounts of interest accrued for a 6-month
period had been overestimated compared to the amount of interest actually paid. In this regard, for
example, if:
the total of the A$ equivalents of the two lots of US$2 million accrued over the two three month
periods (using the average exchange rates as discussed above) is more than
the A$ equivalent of the US$4 million actually paid on 1 October 2013,
then, under s.230-175(3), Abbott is deemed to have made a “TOFA gain” on 1 October 2013 equal to
the amount of the excess.
Conversely, s.230-175(4) would apply to deem Abbott to have made a loss on a Note if the A$
amounts of interest accrued for a 6-month period had been underestimated compared to the amount
of interest actually paid. That is, if the total A$ amount spread under the “accruals method” was less
than the A$ equivalent of the US$4 million actually paid on 1 October 2013, then Abbott would be
taken to have made a “TOFA loss” on 1 October 2013 equal to the shortfall.
7.5 Repayment of US$10 million principal
The repayment of the principal amount of a Note on its redemption should trigger a “balancing
adjustment” under Subdivision 230-G. In this regard, a balancing adjustment must be made if,
relevantly, “all of your rights and/or obligations under a financial arrangement otherwise cease” (refer
s.230-435(1)(b)).
Section 230-445 provides the “method statement” for the calculation of the balancing adjustment.
The method statement determines the amount of the balancing adjustment and whether that amount
is deemed to be either an assessable “TOFA gain” or a deductible “TOFA loss”.
The method statement involves the calculation of two amounts: the step 1 amount and the step 2
amount. In this regard, these amounts include, in respect of the taxpayer’s financial arrangement:
Step 1
the total of all of the “financial benefits” received by the taxpayer; plus
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broadly, the total of the amounts previously allowed/allowable as a deduction for the taxpayer.
Step 2
the total of all of the “financial benefits” provided by the taxpayer; plus
broadly, the total of the amounts previously (or in some instances, that will be) included in the
taxpayer’s assessable income.
If the step 1 amount exceeds the step 2 amount, then the excess is the balancing adjustment amount,
and is deemed under step 3 of the method statement to be a gain on the relevant financial
arrangement. Conversely, if the step 2 amount exceeds the step 1 amount, then the excess is the
balancing adjustment amount, and is deemed under step 3 of the method statement to be a loss on
the relevant financial arrangement.
In the context of the Notes, the total amount deductible on the Notes should equal the amount of
financial benefits in the form of interest provided on the Notes. Accordingly, given that the Notes will
be redeemed for the same redemption price as their issue price (in US$ terms), the only reason for
any balancing adjustment amount will be a movement in the spot exchange rate between the issue
date and the redemption date.
Specifically, the balancing adjustment should be the difference between:
the US$ principal amount that Abbott will repay to holders of the Notes on the redemption of the
Notes on 28 February 2015, translated into A$ using the spot exchange rate on that date; and
the US$ issue proceeds of the Notes, translated into A$ using the spot exchange rate on the
issue date of the Notes (ie 1 March 2013).
Accordingly, given that the spot exchange rate on 1 March 2013 was A$1 = US$1.03, and the spot
rate on 28 February 2015 is A$1 = US$0.90, Abbott should have a TOFA balancing adjustment loss
of A$1.40 million on the redemption of the Notes on 28 February 2015. This loss is calculated as:
the A$ equivalent of the US$10 million issue proceeds of the Notes, translated using the spot rate
on 1 March 2013 (ie A$9.71 million); less
the A$ equivalent of the US$10 million redemption proceeds of the Notes, translated using the
spot rate on 28 February 2015 (ie A$11.11 million).
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8 Case study 2: FX Forward
8.1 The facts
Abbott enters into an US$/A$ FX Forward contract with a bank (the “counterparty”) on
1 January 2013 (the “trade date”).
The spot exchange rate on the trade date is A$1 = US$1.05.
Under the contract, Abbott agrees to take delivery of US$10 million on 1 January 2014 (the
“forward date”) in exchange for the payment of A$10 million. In other words, the agreed forward
exchange rate is A$1 = US$1. The forward rate reflects the current spot rate on the trade date
and an adjustment for “forward points” (which takes into account the interest rate differential
between the US$ and the A$, and the term of the Forward).
Abbott’s purpose for entering into the FX forward is to hedge the foreign exchange risk arising
from its obligation to pay US$10 million of purchase price on 1 January 2014 to the supplier of a
vessel.
The spot exchange rate at the time of settlement of the FX Froward on the forward date is
A$1=US$0.95.
8.2 Financial arrangement under TOFA
The FX Forward should be a TOFA “financial arrangement” under the primary definition in s.230-45.
This is because, under the contract, Abbott has a combination of a cash settlable legal right to receive
financial benefits (in the form of US$), and a cash settlable legal obligation to provide financial
benefits (in the form of A$). In this regard, both the right to receive, and the obligation to provide,
financial benefits are “cash settlable” within the meaning of s.230-45(2)(a).
8.3 No application of the accruals method
Abbott “starts to have” the financial arrangement when it enters into the FX Forward contract on the
trade date. It is not “sufficiently certain” at that time, nor at any time during the 1 year term of the
contract, whether Abbott will make a gain or loss under this arrangement. This is because the spot
exchange rate at the time of settlement will not be known with any degree of certainty until settlement.
Accordingly, the accruals method in Subdivision 230-B should not apply to spread any gain or loss
during the 1 year term of the Forward.
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8.4 Balancing adjustment
When the FX Forward settles on 1 January 2014, a “balancing adjustment” should occur because
Abbott’s right to receive US$ and obligation to pay A$ under the arrangement will both cease at that
time (refer s.230-435(1)(b)).
The step 1 amount in the method statement in s.230-445(1) should be the A$ equivalent of the
US$10 million received on settlement translated using the spot exchange rate at the time of
settlement on 1 January 2014. Given that the spot rate on 1 January 2014 is A$1 = US$0.95, the A$
equivalent would be approximately $10.52 million.
The step 2 amount in the method statement should be A$10 million, being the amount paid by Abbott
on settlement.
In this situation, the step 1 amount exceeds the step 2 amount. Accordingly, the amount of the
excess (approximately A$520,000) is the balancing adjustment amount, and is deemed under step 3
of the method statement to be a TOFA gain on the FX Forward. This gain should be included in
Abbott’s assessable income under s.230-15(1) for the 2014 income year (ie the income year in which
settlement occurs).
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9 Case study 3: Historic rate roll-over of FX Forward
9.1 The facts
This case study is a continuation of case study 2, with the following additional facts:
There is an unforeseen delay of 9 months in the delivery of the vessel by the supplier. The vessel
will not be ready for delivery to Abbott until 30 September 2014.
Therefore, on 1 January 2014 (the original settlement date), Abbott and the Forward counterparty
agree to extend or “roll” the FX Forward for six months (until 30 September 2014, being the
revised settlement date).
Under the terms of the “roll”, Abbott agrees to pay A$10.5m to the counterparty on
30 September 2014, but it will still receive only US$10 million on that date. The additional amount
of A$0.5 million that Abbott will be required to pay on settlement reflects an “extension margin”.
The extension margin takes into account inter alia the revised forward rate, the current spot rate,
and the revised interest rate differential between the US$ and the A$, as at the date of the roll.
The spot exchange rate on 30 September 2014 is A$1 = US$0.83.
9.2 Balancing adjustments
9.2.1 “Roll” of FX Forward
Arguably, at the time of the “roll” of the FX Forward on 1 January 2014, Abbott’s rights and obligations
under the FX Forward would not “cease” for the purposes of s.230-435(1)(b). On that basis, it is
arguable that a balancing adjustment would not occur for Abbott at that time.
However, to address this uncertainty, s.230-435(5) specifically provides:
“Historic rate rollover of derivative financial arrangement
For the purposes of paragraph 1(b), all of your rights and/or obligations under a *financial
arrangement that is a *derivate financial arrangement are taken to cease if there is an historic
rate rollover of the arrangement.”
The FX Forward constitutes a “derivative financial arrangement” as defined in s.230-350(1) because:
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It is a financial arrangement whose value changes in response to changes in a specified variable
(namely, the US$/A$ exchange rate); and
there is no requirement under the Forward for a net investment.
As such, the deeming rule in s.230-435(5) should apply to the Forward.
The TOFA EM provides limited guidance on the way in which this “deeming” should operate. It merely
states:
“Historic rate roll-over
10.52 The term of a derivative financial arrangement may be able to be extended or 'rolled
over' at a nonmarket or 'off market' rate which reflects the original or 'historic' rate at which the
financial arrangement was entered into, and the extension of credit by the party that has a
gain in relation to the financial arrangement, at that time, to the other party. This is commonly
referred to as an 'historic rate roll-over'.
10.53 In substance, at the roll-over date, there is a cessation by way of expiry of the rights
and/or obligations under the derivative financial arrangement. Whether there is an expiry as a
matter of contract law is unclear. Accordingly, to avoid doubt, there is a specific rule in
Subdivision 230-G to provide that an historic rate rollover of a derivative financial
arrangement is taken to be a ceasing of all the rights and/or obligations under the
arrangement. [Schedule 1, item 1, subsection 230-435(5)]”
However, the TOFA EM does not provide guidance on the way in which the balancing adjustment
gain/loss on a “roll” should be calculated under the method statement in s.230-445(1). The difficulty
with calculating gains/losses on historic rate rollovers is that no cash/monetary amounts (ie “financial
benefits”) are actually provided or received when the derivative is “rolled” over.
This issue was first raised by the professional bodies at an NTLG TOFA working group meeting on
31 May 2011. It became “TOFA Issue 280: Historical rate rollovers”. Since then, it has been referred
to Treasury (refer to NTLG TOFA Working Group Minutes 20 March 2012), although the issue has still
not been resolved or clarified.
It seems fairly clear that the intended result is that the balancing adjustment provisions in Subdivision
230-G should operate to assess a gain or allow a deduction for a loss in the event of an historic rate
roll-over. Accordingly, it would seem that the most appropriate way of achieving the result would be to
amend the legislation (with retrospective effect from the start date of the TOFA regime), so that there
are financial benefits deemed to be provided and received by the counterparties to the derivative
instrument at the time of the “roll” (with these amounts being reflected in Steps 1(a) and 2(a) of the
method statement in s.230-445(1)). The financial benefit amounts deemed to be provided and
received on the “roll” would be based on the fair value of the relevant derivative instrument at the time
of the “roll”.
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If the above approach is adopted in Abbott’s case, the amount of the balancing adjustment arising for
Abbott on 1 January 2014 because of the “roll” would depend on the spot exchange rate at that time.
In this regard:
the step 1 amount of the method statement should be the A$ equivalent of the US$10 million
which Abbott is deemed to receive at the time of the roll on 1 January 2014 translated using the
spot exchange rate at that time (ie approximately A$10,520,000); and
the step 2 amount of the method statement should be A$10 million, being the amount that Abbott
is deemed to provide at that time.
Therefore, under this approach, the amount of the excess of the step 1 amount over the step 2
amount (approximately A$520,000) would be the balancing adjustment amount, and it would be
deemed under step 3 of the method statement to be a TOFA gain for Abbott on the historic rate roll-
over of the FX Forward. This gain would be included in Abbott’s assessable income under s.230-
15(1) for the 2014 income year (ie the income year in which historic rate roll-over occurs).
9.2.2 Final settlement of the FX Forward
On 30 September 2014, when Abbott’s right to receive US$ and obligation to pay A$ both actually
cease, Abbott will again make a balancing adjustment in respect of the FX Forward.
Step 1
The step 1 amount in the method statement in s.230-445(1) should be the A$ equivalent of the
US$10 million that Abbott actually receives on settlement, translated using the spot exchange rate at
the time of payment on 30 September 2014. Given that the spot rate on 30 September 2014 is A$1 =
US$0.83, the step 1 amount is approximately $12.05 million.
Step 2
The step 2 amount in the method statement should be $11.02 million, which is calculated as:
A$10.5 million, being the amount (including the extension margin) that Abbott actually pays to the
counterparty on settlement; plus
the balancing adjustment gain of A$520,000, which was included in Abbott’s assessable income
at the time of the “roll” on 1 January 2014 (as noted above).
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The balancing adjustment gain
In this situation, the step 1 amount exceeds the step 2 amount. Accordingly, the amount of the excess
(ie approximately $1.03 million) is the balancing adjustment amount, and it is taken under step 3 of
the method statement in s.230-445(1) to be a final TOFA gain on the FX Forward. This gain should
be included in Abbott’s assessable income under s.230-15(1) for the 2015 income year (in the income
year in which final settlement occurs).
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10 Case study 4: Cross-Currency Swap
10.1 The facts
On 1 February 2014, Abbott enters into a US$ loan facility with a US bank and draws-down
US$1 million from a US bank for a term of 6 months.
Abbott has an immediate need for A$ funding for its Australian operations.
Also on 1 February 2014, Abbott enters into a cross-currency swap with a bank. On entering into
the cross-currency swap, Abbott delivers the US$1 million loan proceeds that it has received
under the loan in exchange for receipt of A$909,000 on the same day. These amounts are based
on the then prevailing spot rate of A$1 = US$1.10.
Also under the cross-currency swap, Abbott agrees to “buy” back US$1 million from the
counterparty on 1 August 2014 in exchange for A$917,000 (which reflects the forward exchange
rate of A$1 = US$1.09).
On the settlement of the swap on 1 August 2014, Abbott will use the US$1 million received from
the swap counterparty to repay the US$1 million principal on the loan.
10.2 Financial arrangement
The US$ loan should be a “financial arrangement” under the primary definition in s.230-45.
The cross-currency swap should also be a “financial arrangement” under the same definition because
under the swap, Abbott has cash settlable legal rights to receive, and cash settlable legal obligations
to provide, financial benefits (namely, A$ and US$).
The swap has 2 components:
a swapping of currencies at the spot rate on 1 February 2014 (a “spot” transaction); and
a forward transaction, involving the agreement for Abbott to take delivery of US$1 million at the
pre-determined forward rate on 31 August 2014 (the “forward” transaction).
Notwithstanding that there are two “aspects” to the swap arrangement, the swap should constitute a
single “financial arrangement” for the purposes of the TOFA regime. In this regard, s.230-55(4)
provides some guidance on the matters which are relevant in identifying the rights and obligations that
constitute a single financial arrangement. That guidance is considered by the Commissioner in
Taxation Ruling TR 2012/4. It is evident from that Ruling that the Commissioner would generally
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regard a cross-currency swap to be a single financial arrangement (refer Example 3 at paragraph 39
of that Ruling).
Despite the fact that the swap was entered into in order to hedge Abbott’s US$ exposure in relation to
the principal of its US$ denominated borrowing (and despite the fact that the execution of the swap
and the draw-down occurred on the same day), these are generally considered to be two separate
financial arrangements (again, refer Example 3 of TR 2012/4).
10.3 No application of the accruals method to the swap
The treatment of a foreign currency denominated loan is addressed in case study 1 and is not
repeated here.
Abbott “starts to have” the cross-currency swap on 1 February 2014 (the trade date). It is not
“sufficiently certain” at that time, nor at any time during the 6 month term of the swap, whether Abbott
will make a gain or loss under the arrangement. This is because the A$ value of the US$1 million
which Abbott will take delivery of on settlement (which will depend on the spot exchange rate at that
time) will not be known with any degree of certainty until settlement. Accordingly, the accruals
method in Subdivision 230-B should not apply to spread any gain or loss during the 6 month term of
the swap.
10.4 Disposal of US$ at the spot rate
The “sale” of US$1 million by Abbott at the spot exchange rate on 1 February 2014 should not give
rise to any taxable gain or deductible loss for Abbott under either Division 775 or the TOFA rules. In
this regard, because Abbott drew-down the US$ loan and immediately sold the US$ proceeds on the
same day at the spot exchange rate prevailing on that day, Abbott should not have any gain or loss
attributable to foreign exchange movements under the spot transaction element of the swap.
10.5 Balancing adjustment
On the settlement of the cross-currency swap on 31 July 2014, Abbott will make a “balancing
adjustment” under s.230-435(1)(b) because Abbott’s right to receive US$ and obligation to pay A$ will
both cease.
The step 1 amount in the method statement in s.230-445(1) should be A$1,909,000, which is
calculated as:
the amount of A$909,000 received by Abbott from the swap counterparty at the inception of the
swap; plus
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the A$ equivalent of the US$1 million received by Abbott on 31 July 2014, translated using the
spot exchange rate on that day (ie A$1 million, based on the spot rate of A$1 = US$1)..
The step 2 amount in the method statement should be $1,826,000, which is calculated as:
the A$ equivalent of the US$1 million that Abbott delivers to the swap counterparty at the
inception of the swap, translated using the spot exchange rate at that time (ie A$909,000, based
on the spot rate of A$1 = US$1.10); plus
the amount of $A917,000 that Abbott pays to the counterparty on 31 July 2014 when the swap is
settled.
In this situation, the step 1 amount exceeds the step 2 amount. Accordingly, the excess amount
(A$83,000) should be the balancing adjustment amount, and is deemed under step 3 of the method
statement in s.230-445(1) to be Abbott’s gain on the cross-currency swap. This gain should be
included in Abbott’s assessable income under s.230-15(1) in the 2015 income year (ie the income
year in which the swap settles).
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11 Case study 5: FX Option
11.1 The facts
On 1 January 2014, Abbott buys an option to purchase US$10 million in 9 months (ie on
1 October 2014) at the exercise price of A$9.5 million. Abbott pays an option premium in the
amount of A$300,000 to the counterparty at the time of buying the option.
On 1 October 2014, Abbott exercises the FX option and pays the exercise price of A$9.5 million in
exchange for acquiring US$10 million. The spot exchange rate at the time of exercising the
option is A$1=US$1.
11.2 Financial arrangement
The FX option should constitute a “financial arrangement” under the primary definition in s.230-45.
This is because under the option contract, Abbott has cash settlable legal obligations to provide, and
a cash settlable legal right to receive, financial benefits.
11.3 Application of the tax-timing method(s)
Abbott starts to have the financial arrangement when it enters into the FX option contract with the
counterparty on 1 January 2014. It is not “sufficiently certain” at that time, nor at any time during the
9-month term of the option, whether Abbott will make an “overall” gain or loss under the arrangement.
This is because the question of whether Abbott will exercise the option or allow it to lapse depends on
the spot exchange rate at the maturity of the option on 1 October 2014 (which will not be known with
any degree of certainty until that date). Therefore, the A$ value of the US$10 million which Abbott will
take delivery of if and when it exercises the option will not be known with any degree of certainty until
the option is exercised. As such, the accruals method in Subdivision 230-B should not apply to
spread any overall gain or loss during the 9-month term of the option.
However, at the time when the option contract is entered into, Abbott does provide a financial benefit
to the counterparty in the form of the option premium of A$300,000 (refer s.230-115). As a result of
recent retrospective legislative amendments, it is arguable that Abbott should have a sufficiently
certain “particular” loss of A$300,000 arising from the upfront payment of the premium, even though
there are other financial benefits under the arrangement which are not sufficiently certain until the
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exercise date (namely, the US$10 million that Abbott is entitled to purchase if and when it chooses to
exercise the option).26
Prior to the legislative amendments, Abbott would have been required to have regard to the risk that
the receipt or provision of financial benefits on the expiry of the option (which are not sufficiently
certain until the expiry of the option) may reduce the sufficiently certain loss arising from the upfront
premium, and on that basis, the particular loss representing the upfront premium would not have been
sufficiently certain. Therefore, under the former law, the premium of A$300,000 would have been
“wrapped up” in an “overall” gain or loss which Abbott would have been recognised on the expiry of
the option (probably as a balancing adjustment under Subdivision 230-G).
Paragraph 8.32 of the Explanatory Memorandum to the 2013 Act (the amending legislation) indicates
that “taxpayers ought to be able to have a sufficiently certain particular gain or loss from a financial
arrangement even if there are financial benefits under that arrangement that are not sufficiently
certain”. Paragraph 8.33 then states that “the amendments [to s.230-110(2)(a)] clarify that, when
determining if a particular gain or loss is sufficiently certain, taxpayers need only have regard to
financial benefits reasonably attributable to the financial benefit giving rise to that gain or loss”.
On one view, the financial benefits on the exercise of the option (ie the payment of the exercise price,
and the receipt of the US$10 million) are integral to, and therefore, reasonably attributable to the
premium. This is on the basis that the premium plays an integral role is determining the taxpayer’s
gain or loss from the option. On the other hand, it is also possible to argue, and in the authors’
opinion, it is the better view, that those other financial benefits are not integral or reasonably
attributable to the premium. This is on the basis that the premium is an upfront lump sum amount
which is payable by the taxpayer, irrespective of whether or not the taxpayer ultimately exercises the
option.
The 2013 Act also enacted new s.230-100(3A), which ensures that a TOFA gain/loss arising from a
prepayment should be spread under the accruals method over the period to which it relates. The
effect of this new provision is that the accruals method applies to a gain/loss from a financial
arrangement if:
the gain/loss arises from a financial benefit that the taxpayer is to receive/provide under the
arrangement;
the gain/loss becomes sufficiently certain at the time the taxpayer receives/provides the benefit;
and
at least part of the period over which the gain/loss would be spread under the accruals method
(assuming that method applied) occurs after the time the taxpayer receives/provides the benefit.27
26 Refer s.230-110(2)(a) as amended by item 10 of Schedule 8 to the Tax and Superannuation Laws Amendment (2013
Measures No. 2) Bill 2013 (the “2013 Act”). 27
Refer items 15 to 21 of Schedule 8 to the 2013 Act.
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It is possible that the accruals method would apply to the premium by virtue of the above provision if
the loss representing the premium us regarded as relating to the term of the option (which is a distinct
possibility).
It should be noted that the 2013 Act also amended the “realisation method” in s.230-180(2) by
providing that, if a right or obligation is taken into account in determining a gain or loss from a financial
arrangement, and the cessation of the right or obligation occurs after the provision or receipt of the
last financial benefit taken into account in determining the gain or loss, the taxpayer must recognise
the gain or loss in the income year in which the cessation of the right or obligation occurs.28
Interestingly, Example 8.5 in the Explanatory Memorandum then discusses the lapse of a call option
over shares in the context of the amended s.230-180(2), and it concludes that, on the lapse of the
option, the taxpayer makes a TOFA loss under the realisation method, the amount of the loss being
equal to the upfront premium that the taxpayer paid when it bought the call option.
However, the realisation method is not relevant unless the taxpayer does not make a sufficiently
certain loss from the financial arrangement. In the authors’ view, as a result of the amendment to
s.230-110(2)(a) and the new s.230-100(3A) (discussed above), it seems (although it is not beyond
doubt) that Abbott may have a sufficiently certain particular loss of A$300,000 representing the
premium at the time when it is paid upfront (on 1 January 2014). On this reasoning, the accruals
method should apply to the premium, with the effect that the loss of A$300,000 should be spread over
the period to which it relates (refer s.230-130(3)). Another critical question would be the period to
which the premium relates.
On one view, it would seem appropriate to spread the premium of A$300,000 over the 9-month term
of the option on a compounding accruals basis. Whether this view is correct may be influenced by
whether it is considered that the premium is consideration for entry into the FX option, or for the
continuing existence of that option during its term. In this regard, if the FX option is an “American
style option” (ie if it permits Abbott to exercise the option at any time up to and including its expiry on
1 October 2014), there may be stronger arguments that the premium relates to the continuing
existence of the option.
The remainder of this case study assumes that the option is deductible either over the 9-month term
of the option on a compounding accruals basis or upfront when it is paid, that the option is a
“European style” option. However, it should be noted that it is not at all clear whether this is the
intended policy outcome of the amendments in the 2013 Act, particularly given that prior to the
amendments, it was generally accepted that the premium should be “wrapped up” in the calculation of
the balancing adjustment at the end of the arrangement.29
28 Refer item 33 of Schedule 33 to the 2013 Act.
29 Refer the comments and examples in the Explanatory Memorandum to the TOFA Act.
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11.4 Balancing adjustment
Abbott should have a balancing adjustment on 1 October 2014 when the option expires, irrespective
of whether the option is exercised or it lapses (refer s.230-435(1)(b)). This is because Abbott’s right
to receive US$ and obligation to pay A$ on the exercise of the option will cease in either event.
If the option lapses, then the amount of the balancing adjustment for Abbott should be nil (on the
basis of the assumption that it has already claimed a deduction for the premium of A$300,000 either
over the term or upfront, as discussed above).
On the other hand, if Abbott exercises the option, it will make a balancing adjustment gain of
A$500,000, calculated as follows:
The step 1 amount in the method statement in s.230-445(1) should be A$10.3 million, which is
calculated as:
the A$ equivalent of the US$10 million that Abbott receives on the exercise date
(1 October 2014), translated using the spot rate on that date (ie A$10 million, based on a spot
rate of A$1 = US$1 at that time); plus
the deduction of A$300,000 which, it is assumed, has already been claimed for the premium.
The step 2 amount in the method statement should be A$9.8 million:
A$9.5 million, being the exercise price which is paid by Abbott on the exercise date; plus
A$300,000, being the premium paid by Abbott.
In this situation, the step 1 amount exceeds the step 2 amount. Accordingly, the excess amount of
A$500,000 is the balancing adjustment amount, and it is taken under step 3 of the method statement
in s.230-445(1) to be a gain for Abbott on the FX option. This gain should be included in Abbott’s
assessable income under s.230-15(1) for the 2015 income year (ie the income year in which the
option is exercised).
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12 Case study 6: Acquisition of a depreciating asset
12.1 The facts
Abbott enters into a joint venture with 2 other Australian resident companies, Bishop Limited
(“Bishop”) and Morrison Limited (“Morrison”), for the operation of passenger vessels between
Australia, Indonesia and Papua New Guinea.
Abbott, Bishop and Morrison establish a new company, ABM Limited (“ABM”), with each joint
venture party owning 1/3rd
of the shares in ABM.
On 1 January 2014, ABM enters into a contract with an Indonesian manufacturer, Susilo PT
(“Susilo”) for the construction and delivery of a vessel. The vessel is to be delivered in 2 years
(ie 1 January 2016).
The purchase price for the boat is US$25 million, to be paid in 3 instalments as follows:
o a deposit of US$5 million is to be paid on execution of the contract;
o a progress payment of US$10 million is to be paid on 1 December 2014 (ie 11 months after
execution of the contract); and
o a final payment of US$10 million is to be paid when the vessel is delivered (on
1 January 2016).
The spot exchange rate on 1 January 2014 is A$1=US$1.07.
The spot exchange rate on 1 December 2014 is A$1=US$1.
The spot exchange rate on 1 January 2016 is A$1=US$0.85.
To the extent possible, ABM’s commercial objective is to be in a tax-neutral position from an FX
perspective.
On 1 January 2014 (ie when the contract for the construction of the vessel is executed), the
shareholders subscribe for share capital in ABM of A$23,364,486 (which is equal to US$25 million
translated into A$ using the spot exchange rate of A$1=US$1.07 which prevailed on that day).
Also on 1 January 2014, ABM converts the A$ proceeds from the share subscription into
US$25 million through a spot transaction with an Australian bank.
ABM immediately deposits the amount of US$25 million received under the spot transaction into a
new interest-bearing bank account which it opens on the same day (1 January 2014).
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As and when ABM is required to pay US$ instalments of the purchase price to Susilo under the
construction contract, ABM will withdraw funds from the US$ bank account equal to the amount of
the relevant instalment.
Construction of the vessel commences on 1 January 2014 (as soon as the contract is executed).
ABM exceeds the turnover/asset thresholds in s.230-455 for the TOFA regime.
12.2 Whether the TOFA regime applies
12.2.1 The construction contract for the vessel
Even if ABM exceeds the turnover/asset thresholds in s.230-455 for the TOFA regime, the TOFA
regime would not have any application in respect of the contract for the construction and delivery of
the vessel, as the contract does not give rise to any TOFA “financial arrangements”. This is because
until the vessel is delivered to ABM, ABM has a legal right to receive the vessel (a financial benefit),
that right is not cash settlable, and that right is not insignificant in comparison with ABM’s obligations
to pay the various instalments of the purchase price (refer s.230-45(1)(d), (e) and (f)).
12.2.2 The US$ bank account
However, the TOFA regime should apply in respect of the US$ bank account, which constitutes a
financial arrangement under the primary definition in s.230-45.
12.3 The FX gains and losses recognised for income tax purposes
12.3.1 The US$ bank account generally
To the extent possible, ABM’s commercial objective is to be in a tax-neutral position from an FX
perspective. Accordingly, it is important that ABM does not make a TOFA retranslation election for
qualifying forex accounts in relation to the US$ bank account. Otherwise, ABM would need to
recognise unrealised FX gains and losses in relation to the US$ bank account under the TOFA
retranslation method. The unrealised gains and losses would reflect the amounts of FX gains and
losses recognised in ABM’s P&L in accordance with AASB 121 in relation to the bank account.
ABM should make a TOFA gain or loss under the “realisation method” in s.230-180 each time that it
withdraws an amount from the US$ bank account.
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12.3.2 The withdrawal of US$5 million from the bank account on 1 January 2014
ABM should not make any gain or loss on 1 January 2014 as a result of withdrawing US$5 million
from the bank account. This is because ABM immediately deposited the US$ proceeds it received
under the spot transaction into the account on the same day that ABM withdraws the US$5 million
from the account.
12.3.3 The payment of the US$5 million deposit on 1 January 2014
ABM should not make any gain or loss on 1 January 2014 as a result of paying the deposit of
US$5 million to Susilo under the construction contract. This is because ABM pays the US$ deposit on
the same day that its obligation to pay the US$ deposit arises (on the execution of the contract).
12.3.4 The withdrawal of US$10 million from the bank account on 1 December 2014
ABM should make a TOFA gain under the “realisation method on 1 December 2014 when it withdraws
an amount of US$10 million to make the progress payment under the construction contract. The
amount of the gain should be approximately A$650,000, which is calculated as:
the A$ equivalent of the US$10 million which is withdrawn from the account on 1 December 2014,
translated using the spot exchange rate on that day (ie A$10 million, based on a spot rate of
A$1=US$1); less
the A$ equivalent of US$10 million which was deposited into the account on 1 January 2014,
translated using the spot exchange rate on that day (ie approximately A$9,350,000, based on a
spot rate of A$1=US$1.07).
The TOFA gain of A$650,000 should be included in ABM’s assessable income under s.230-15(1) on
1 December 2014 (ie in the 2015 income year).
12.3.5 The making of the US$10 million progress payment on 1 December 2014
A “forex realisation event 4” (“FRE 4”) should happen for ABM under s.775-55 when it makes the
progress payment of US$10 million to Susilo under the construction contract on 1 December 2014.
This is because:
at that time, ABM will cease to have an obligation to pay foreign currency (US$); and
ABM’s obligation to pay US$ to Susilo was incurred in return for ABM starting to hold the vessel
(which is a “depreciating asset” as defined in s.40-30), and ABM will be entitled to deduct
amounts under Division 40 for the “decline in value” (ie tax depreciation) of the vessel (as ABM
will use the vessel for the purpose of producing assessable income).
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As a result of FRE 4, ABM should make a forex realisation loss under s.775-55(5) to the extent that:
the amount that ABM pays in respect of the FRE 4 happening exceeds the proceeds of assuming
its obligation to pay the US$ progress payment (the proceeds being worked out as at the “tax
recognition time”); and
the excess is attributable to currency exchange rate movement.
The amount that ABM pays in respect of the happening of FRE 4 should be equal to the progress
payment of US$10 million made by ABM, translated into A$ using the spot exchange rate (of
A$1=US$1) at the time when it makes the payment on 1 December 2014, ie A$10 million (refer item
11 of the table in s.960-50(5)).
According to item 5 of the table in s.775-55(7), the “tax recognition time” would be the time when ABM
begins to “hold” the vessel as a depreciating asset for the purposes of Division 40. Division 40 merely
identifies who “holds” an asset (refer s.40-40). In this case, ABM would clearly be the holder (as the
owner of the vessel): refer item 10 of the table in s.40-40). Division 40 does not seem to prescribe the
time when the holder begins to hold the asset. In order to apply the legislative provisions in a
sensible way, it is necessary to conclude that ABM begins to hold the vessel under Division 40 on
1 January 2014 when construction of the vessel commences.
Therefore, it is necessary to determine ABM’s proceeds of assuming its obligation to pay
US$10 million as at 1 January 2014. There is a conceptual difficulty in applying the definition of
“proceeds of assuming the obligation” in s.775-95 in this context. This definition refers to the market
value of any “non-cash benefit” that ABM is entitled to acquire or obtain in return for incurring the
obligation to pay the US$10 million instalment. “Non-cash benefit” is defined in s.995-1(1) as property
or services in any form except money. A relevant property in this case is the vessel itself. Another
potentially relevant property is the US$10 million itself (if the reference to “money” is read as being
limited to A$). Despite the difficulty in applying the definition, the intention seems to be that ABM’s
proceeds of assuming the obligation to pay US$10 million (worked out as at 1 January 2014) should
be determined as the A$ equivalent of the US$10 million, translated using the spot exchange rate (of
A$1=US$1.07) as at 1 January 2014, ie an amount of A$9,350,000.
Therefore, ABM should make a “forex realisation loss” of approximately A$650,000 under FRE 4 on
1 December 2014 when it makes the US$10 million progress payment to Susilo under the
construction contract.
However, unless ABM makes an irrevocable choice in writing under s.775-80, ABM would not be
entitled to claim a deduction for the forex realisation loss of A$650,000, and this loss would instead be
“wrapped” into the tax cost of the vessel for the purposes of Division 40 (refer item 3 of the table in
s.775-75(1)). This is because the progress payment due on 1 December 2014 will be due for
payment within the 24-month period that began 12 months before the time when ABM begins to “hold”
the vessel for Division 40 purposes. On the basis that ABM begins to hold the vessel for Division 40
purposes on 1 January 2014 when construction of the vessel starts, the 24-month period should have
started on 1 January 2013 and should end on 1 January 2015.
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Given that ABM’s commercial objective is to be in a tax-neutral position from an FX perspective (to
the extent possible), it is important that ABM makes the irrevocable choice in writing under s.775-80 to
disregard the “short-term FX rules” in s.775-70 and s.775-75. Otherwise, ABM will not have a
matching deductible FX loss in relation to the making of the progress payment to offset the
assessable TOFA gain arising from the withdrawal of US$ from the bank account.
Under s.775-80 as currently drafted, it is not possible for entities that come into existence more than
90 days after the “applicable commencement date” of 1 July 2003 to make the choice. However,
according to item A1.4 of the Attachment to the former Assistant Treasurer’s press release dated 5
August 2004, s.775-80 is proposed to be amended (with retrospective effect from 1 July 2003) to
allow newly established entities “a period of time after they come into existence” to make the choice.
The press release does not state the maximum period of time that will be allowed for making the
choice. As such, it would be prudent for ABM to make the choice as soon as possible after it comes
into existence.
Provided that ABM makes a valid choice under s.775-80, it should be entitled to claim a deduction for
the forex realisation loss of A$650,000 from FRE 4 happening on the making of the US$10 million
progress payment on 1 December 2014. This deductible loss should offset the assessable TOFA
gain of the same amount that ABM makes on the same day as a result of the withdrawal of the US$10
million from its US$ bank account. The matching FX positions should result in tax-neutrality for ABM
on that day.
12.3.6 The withdrawal of US$10 million from the bank account on 1 January 2016
ABM should make a TOFA gain on 1 January 2016 when it withdraws an amount of US$10 million
from its US$ bank account to make the final payment under the construction contract. The amount of
the gain should be approximately A$2,410,000, which is calculated as:
the A$ equivalent of the US$10 million which is withdrawn from the account on 1 January 2016,
translated using the spot exchange rate on that day (ie approximately A$11,760,000, based on a
spot rate of A$1=US$0.85); less
the A$ equivalent of US$10 million which was deposited into the account on 1 January 2014,
translated using the spot exchange rate on that day (ie approximately A$9,350,000, based on a
spot rate of A$1=US$1.07).
The TOFA gain of A$2,410,000 should be included in ABM’s assessable income under s.230-15(1)
on 1 January 2016 (ie in the 2017 income year).
12.3.7 The payment of the final instalment of the purchase price on 1 January 2016
For the same reasons that were discussed above in the context of the progress payment, an FRE 4
should happen again for ABM under Division 775 when it makes the final payment of US$10 million of
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the purchase price to Susilo under the construction contract on 1 January 2016. In a similar manner
as discussed above, ABM should make a forex realisation loss as a result of FRE 4. The amount of
the loss should be approximately A$2,410,000, which is calculated as:
the final payment of US$10 million made by ABM, translated into A$ using the spot exchange rate
(of A$1=US$0.85) at the time when it makes the payment on 1 January 2016 (ie approximately
A$11,760,000); less
the proceeds of assuming the obligation to pay US$ worked out as at 1 January 2016, that is, the
A$ equivalent of the US$10 million final payment, translated using the spot exchange rate (of
A$1=US$1.07) as at 1 January 2014 (ie an amount of approximately A$9,350,000).
Provided that ABM makes a valid choice under s.775-80 to disregard the “short-term FX rules”, it
should be entitled to claim a deduction for the forex realisation loss of A$2,410,000 from FRE 4 on
1 January 2016. This deductible loss should offset the assessable TOFA gain of the same amount
that ABM makes on the same day as a result of the withdrawal of the US$10 million from its US$ bank
account. The matching FX positions should again result in tax-neutrality for ABM on that day.
12.3.8 The “cost” of the vessel for tax depreciation purposes
The tax cost of the vessel for the purposes of Division 40 should be approximately A$23,360,000.
This amount is the A$ equivalent of the US$25 million total purchase price, translated using the spot
exchange rate on 1 January 2014 (A$1=US$1.07): refer paragraph (a) in item 2 of the table in s.960-
50(6). This is on the basis that:
as discussed above, ABM begins to “hold” the vessel for Division 40 purposes on 1 January 2014
(when construction of the vessel starts);
as discussed above, ABM makes a valid choice under s.775-80 to disregard the “sort-term FX
rules”;
ABM incurs the obligations to pay the various instalments of the purchase price in return for its
starting to “hold” the vessel; and
those obligations are not satisfied before ABM begins to “hold” the vessel.
The assessable forex realisation gains made under Division 775 on the making of the progress
payment and the final payment (i.e. A$650,000 and A$2,410,000 respectively) would effectively
“capture” the movement in the spot exchange rate between 1 January 2014 (when the tax cost of the
vessel is set) and 1 January 2016 (when the final instalment is paid and the vessel is delivered).
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13 Case study 7: US$ borrowing to finance an offshore
equity investment
13.1 The facts
Abbott holds 100% of the voting shares in a wholly-owned US resident subsidiary (“US Co.”).
On 1 January 2014, Abbott borrows an amount of US$10 million from a bank for a 3-year term.
The spot exchange rate on 1 January 2014 is A$1=US$0.95.
On the same day, Abbott uses the US$10 million proceeds from the borrowing to subscribe for
additional share capital in US Co.
US Co is reasonably expected to pay dividends to Abbott over the next 3 years (subject to the
actual availability of profits, and the Board of Directors of US Co. making passing resolutions to
pay dividends).
Abbott repays the US$10 million principal amount of the loan on 1 January 2017.
The spot exchange rate on 1 January 2017 is A$1=US$1.
13.2 Financial arrangement
For the same reasons as discussed in Case Study 1, the US$ loan should be a TOFA financial
arrangement.
13.3 TOFA balancing adjustment gain
As a result of the repayment of the principal on the US$ loan on 1 January 2017, Abbott makes a
TOFA balancing adjustment gain of approximately A$0.5 million. This gain is calculated as the
excess of:
the A$ equivalent of the US$10 million loan proceeds, translated using the spot rate on 1 January
2014 when the loan was drawn-down (ie approximately A$10.5 million); over
the A$ equivalent of the US$10 million principal repayment, translated using the spot rate on 1
January 2017 when the loan is repaid (ie A$10 million).
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13.4 Nexus with NANE income
Abbott’s TOFA balancing adjustment gain of A$0.5 million on the repayment of the loan principal
should be NANE income pursuant to s.230-30(2)(b). This is because, if the gain had been a loss
instead, Abbott would have made it in gaining or producing NANE income, namely the dividends paid
by US Co. (which should be NANE income in the hands of Abbott by virtue of s.23AJ). The
hypothetical loss on the US$ loan would have a sufficient nexus with (in the sense of being “incidental
and relevant to”) the gaining or production of Abbott’s NANE dividend income.
This conclusion is supported by the ATO’s view of Example 3 in TR 2012/3 (refer paragraphs 32 to 36
of the Ruling).
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14 Case study 8: Hedging the FX risk on an offshore equity
investment
14.1 The facts
On 1 January 2014, Abbott borrows an amount of A$10.5 million from a bank for a 3-year term.
On the same day, Abbott enters into a “spot” transaction on the money market, whereby it
“purchases” US$10 million in consideration for the delivery of the A$10.5 million proceeds from its
borrowing (at the day’s spot exchange rate of A$1= US$0.95).
Also on the same day, Abbott uses the US$10 million proceeds that it obtains under the spot
transaction to subscribe for additional share capital in its wholly-owned US subsidiary, US Co.
Abbott expects to divest its interests in US Co. in 3 years. Accordingly, on the same day (ie
1 January 2014), in order to hedge against its exposure to US$ arising from its equity investment
in US Co., Abbott enters into a 3-year FX Forward contract with a bank. Under the contract,
Abbott agrees to take delivery of US$10 million on 1 January 2017 (the “forward date”) in
exchange for the payment of A$10 million. In other words, the agreed forward exchange rate is
A$1 = US$1.
US Co is reasonably expected to pay dividends to Abbott over the next 3 years (subject to the
actual availability of profits, and the Board of Directors of US Co. making passing resolutions to
pay dividends).
The treatment of a similar “spot” transaction is dealt with in Case Study 4 and will not be discussed
further here. Instead, the focus of this case study is on the potential nexus of a gain or loss arising
from the FX Forward with Abbott’s NANE income.
14.2 Financial arrangement
For the same reasons as discussed in Case Study 1, the A$ borrowing should be a TOFA financial
arrangement.
For the reasons discussed in Case Study 2, the FX Forward should also be a (separate) TOFA
financial arrangement.
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14.3 TOFA balancing adjustment gain
On 1 January 2017, when the FX Forward is closed-out, a balancing adjustment should occur for
Abbott. For the reasons discussed in Case Study 2, the TOFA balancing adjustment gain should be
approximately A$0.5 million.
14.4 Nexus with NANE income
Abbott’s economic position in this scenario is similar to its economic position in the scenario of Case
Study 7, the difference being that in Case Study 7 Abbott had an unhedged exposure to US$,
whereas in the present case study Abbott has sought to hedge its exposure to US$ via the FX
Forward.
Case Study 7 involved Abbott borrowing in US$ to finance its US$ equity investment in US Co, and
therefore, Abbott had an (unhedged) exposure to US$ in that scenario.
In the present scenario, Abbott has borrowed in A$ instead, it has converted the A$ into US$ in a spot
transaction, and it has used the US$ to fund its US$ equity investment in US Co. In this scenario,
Abbott has then entered into an FX Forward to hedge its US$ exposure arising from its US$ equity
investment.
In Case Study 7, Abbott’s TOFA gain in relation to FX movements arose in respect of Abbott’s US$
borrowing which was used to fund its equity investment in US Co. On the other hand, in the present
case study, Abbott’s TOFA gain in relation to FX movements arises on the FX Forward which has
been entered into to hedge Abbott’s FX exposure on the equity investment.
One could be forgiven for concluding that the result in both scenarios should be the same, ie that
Abbott’s TOFA gain of A$0.5 million on the close-out of the FX Forward should also be NANE income
pursuant to s.230-30(2)(b). This is on the basis that Abbott’s TOFA gain on the FX Forward has a
logical nexus with Abbott’s derivation of NANE dividend income from US Co.
However, in Example 6 of TR 2012/3, the Commissioner has surprisingly expressed the opposite
conclusion on very similar facts:
“49. If the gain had been a loss instead, this hypothetical loss would not have been made in
gaining or producing NANE income. The change in fair value of an investment held on an ongoing
basis does not affect the NANE income producing potential from that activity. The loss would not
be sufficiently proximate with the activities and processes that more directly produce NANE
dividends.
50. Consequently, the gain is not NANE income under subsection 230-30(2), and is included in
assessable income under subsection 230-15(1)...”
In reaching that conclusion, the Commissioner states:
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“125. The exposure being hedged in these circumstances is the risk that the capital committed to
the foreign investment will diminish in value over the life of the hedge. By investing in the foreign
company, Aussi Co encounters a foreign currency exposure. This exposure relates to the risk that
changes in currency exchange rates could reduce the value of the investment in Australian dollars
upon the realisation of the investment.
It appears that the Commissioner is attempting to draw a distinction between:
hedging against the FX risks relating to the initial US$ capital investment in the foreign subsidiary
(which would be subject to the CGT regime, albeit subject to a reduction under the “participation
exemption” in Subdivision 768-G); and
hedging against the FX risks relating to the US$ dividends expected to be received on that
investment (which are NANE income under s.23AJ).
In the authors’ view, the distinction is a dubious one, particularly given the similarity of Abbott’s
economic position in this scenario with its position in Case Study 7. It is not at all obvious that a Court
would reach the same conclusion as the Commissioner on these facts.
If the Commissioner’s view is accepted, then Abbott’s TOFA gain of A$0.5 million on the close-out of
the FX Forward should be included in Abbott’s assessable income under s.230-15(1) for the 2018
income year (ie the income year in which the close-out occurs).