Corporate Tax Masterclass

Transcription

1 -- 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, 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.

2 CONTENTS 1 Introduction Scope of Paper and overview Foreign exchange rate volatility Division 3B Background Continuing application of Division 3B the transitional rules Overview of Division 3B Operative provisions Eligible contract Currency exchange gain / currency exchange loss Translation rules Conversion (exchange) vs. translation Taxation Ruling TR 93/ The High Court s decision in ERA Withdrawal of TR 93/ Chief Tax Counsel s letter ostensible re-instatement of TR 93/ The Full Federal Court s recent decision in Messenger Press ATO s Decision Impact Statement on Messenger Press Division Background Continuing application of Division 775 the transitional rules Interaction with Division 3B Interaction with Division 230 (TOFA) Overview of Division Operative provisions of Division The most common FREs FRE 1: Disposal of foreign currency or right to receive foreign currency Mostafavi and Marston, Greenwoods & Freehills

3 3.5.2 FRE 2: Ceasing to have a right to receive foreign currency FRE 3: Ceasing to have an obligation to receive foreign currency FRE 4: Ceasing to have an obligation to pay foreign currency FRE 5: Ceasing to have a right to pay foreign currency Assistant Treasurer s Media Release Amendments to the foreign currency provisions Compliance cost saving measures The translation rules in Subdivisions 960-C and 960-D (and the associated Regulations) Subdivision 960-C Regulations Subdivision 960-D The TOFA regime (Division 230) Introduction Transitional rules Thresholds for the mandatory application of TOFA Financial arrangements Primary definition of financial arrangement Extended definition of financial arrangement Main exceptions from the application of TOFA Operative provisions of TOFA Tax-timing methods under TOFA Overview of the methods The default methods Foreign exchange retranslation method Fair value method Reliance on financial reports method Hedging financial arrangement method Case studies: Abbott Limited Mostafavi and Marston, Greenwoods & Freehills

4 7 Case study 1: US$ borrowing The facts The TOFA regime - general Financial arrangement Interest on the Notes Accruals method vs. realisation method Translation into A$ Running balancing adjustment Repayment of US$10 million principal Case study 2: FX Forward The facts Financial arrangement under TOFA No application of the accruals method Balancing adjustment Case study 3: Historic rate roll-over of FX Forward The facts Balancing adjustments Roll of FX Forward Final settlement of the FX Forward Case study 4: Cross-Currency Swap The facts Financial arrangement No application of the accruals method to the swap Disposal of US$ at the spot rate Balancing adjustment Case study 5: FX Option The facts Financial arrangement Mostafavi and Marston, Greenwoods & Freehills

5 11.3 Application of the tax-timing method(s) Balancing adjustment Case study 6: Acquisition of a depreciating asset The facts Whether the TOFA regime applies The construction contract for the vessel The US$ bank account The FX gains and losses recognised for income tax purposes The US$ bank account generally The payment of the US$5 million deposit on 1 January The withdrawal of US$10 million from the bank account on 1 December The making of the US$10 million progress payment on 1 December The withdrawal of US$10 million from the bank account on 1 January The payment of the final instalment of the purchase price on 1 January The cost of the vessel for tax depreciation purposes Case study 7: US$ borrowing to finance an offshore equity investment Financial arrangement TOFA balancing adjustment gain Nexus with NANE income Case study 8: Hedging the FX risk on an offshore equity investment Financial arrangement TOFA balancing adjustment gain Nexus with NANE income Mostafavi and Marston, Greenwoods & Freehills

6 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 Paper 1 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. Mostafavi and Marston, Greenwoods & Freehills

7 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 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: 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-themoney FX derivatives; and having foreign currency denominated liabilities, such as loans and out-of-the-money FX derivatives. Mostafavi and Marston, Greenwoods & Freehills

8 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 ) regime 3 was enacted with effect from 20 September 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 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 Refer s , which was essentially a currency translation rule. 5 Refer s Mostafavi and Marston, Greenwoods & Freehills

9 Division 775, Division 775 would potentially apply to the eligible contract from the applicable commencement date of Division 775. If: o 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 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 (3) and (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 regime 6, the TOFA regime would potentially apply to the preexisting 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 Mostafavi and Marston, Greenwoods & Freehills

10 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 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 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) (b) a contract entered into by the taxpayer on or after the commencing day, other than a hedging contract; or a hedging contract entered into by the taxpayer, on or after the commencing day, in relation to a contract to which Paragraph (a) applies. Mostafavi and Marston, Greenwoods & Freehills

11 Division 3B only applies to gains and losses to the extent that they are of a capital nature (having regard to the case law) 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 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 : 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 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. Mostafavi and Marston, Greenwoods & Freehills

12 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$ 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 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. Mostafavi and Marston, Greenwoods & Freehills

13 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 o the US$ issue proceeds of the Notes into A$ using the spot rate at the issue date of the Note; and 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 Mostafavi and Marston, Greenwoods & Freehills

14 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 ERA, op. cit. 96 ATC 4536, at Mostafavi and Marston, Greenwoods & Freehills

15 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 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. Mostafavi and Marston, Greenwoods & Freehills

16 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 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. Mostafavi and Marston, Greenwoods & Freehills

17 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 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: Mostafavi and Marston, Greenwoods & Freehills

18 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 FXdenominated 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 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. Mostafavi and Marston, Greenwoods & Freehills

19 3 Division 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 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 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 ). 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 For the vast majority of taxpayers, it is the first day of the 2004 income year (generally 1 July 2003). Mostafavi and Marston, Greenwoods & Freehills

20 775, and the taxpayer did not make the un-grandfathering election in s , then the taxpayer s right or obligation under that contract is grandfathered under Division 3B (refer ss (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 , 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 (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 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 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 (3) and (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 ). Division 775 was then switched on for ADIs and non-adi financial institutions from the commencement date of the TOFA regime 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 provides an anti-overlap rule which gives priority to TOFA. In particular, s (4) provides: Mostafavi and Marston, Greenwoods & Freehills

21 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 for the mandatory application of TOFA, and the taxpayer has not made an irrevocable election under s (7) to be subject to the TOFA regime on a voluntary basis. An arrangement that is not subject to TOFA because: o o it is not a financial arrangement within the primary definition of the term in s (eg an arrangement that is not cash settlable within the meaning of s (2)), nor within the secondary definition of the term in s (in relation to equity interests and rights or obligations in relation to equity interests); or 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 ), 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 ungrandfathering 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 applies. Broadly, s 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. Mostafavi and Marston, Greenwoods & Freehills

22 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 covers the following: o o Leasing arrangements (refer s (2)(b)). Therefore, if lease payments are denominated in a foreign currency, Division 775 may apply to the lease payments. A right or obligation that arises under a direct interest in a controlled foreign company ( CFC ) (refer s (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 and (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). Mostafavi and Marston, Greenwoods & Freehills

23 3.4 Operative provisions of Division 775 Section 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 (2) and in s The exceptions include situations where the forex realisation gain relates to deriving exempt or non-assessable non-exempt ( NANE ) income. Conversely, s 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 as follows: A currency exchange rate effect is: (a) any currency exchange rate fluctuations; or (b) a difference between: (i) (ii) an expressly or implicitly agreed currency exchange rate for a future date or time; and the applicable currency exchange rate at that date or time FRE 1: Disposal of foreign currency or right to receive foreign currency An FRE 1 happens if CGT event A1 (in s ) happens as a result of the taxpayer disposing of foreign currency or a right to receive foreign currency (refer s ). 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. Mostafavi and Marston, Greenwoods & Freehills

24 The typical example of FRE 1 is the assignment by the taxpayer of a foreign currency receivable to a third party 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 ). 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 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 ). A typical example of FRE 3 is the close-out of certain types of FX derivatives (eg certain FX options or FX swaps) 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 ). 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) 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 ). Mostafavi and Marston, Greenwoods & Freehills

25 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 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 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 10 th 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. Mostafavi and Marston, Greenwoods & Freehills

26 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 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. Mostafavi and Marston, Greenwoods & Freehills

27 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 provides for the translation of amounts into A$. Subsection (1) provides the general rule that: [f]or the purposes of this Act, an amount in a *foreign currency is to be translated into Australian currency The table in s (6) then provides certain specific translation rules. By way of example: Item 2 of the table provides that the cost of a depreciating asset under Division 40 must be translated into A$ 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. Mostafavi and Marston, Greenwoods & Freehills

28 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 and s 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 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 ). 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 ) or a capital loss under CGT event K11 (s ) (refer item 1 of the table in s (1) and s (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 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 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 of the Income Tax Assessment Regulations 1997 (the Regulations ) modifies the table in s (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: Mostafavi and Marston, Greenwoods & Freehills

29 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 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 (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. Mostafavi and Marston, Greenwoods & Freehills

30 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 , 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 Mostafavi and Marston, Greenwoods & Freehills

31 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 Transitional rules The transitional rules of the TOFA regime have been alluded to in sections 2.2 and 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 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. Mostafavi and Marston, Greenwoods & Freehills

32 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 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 (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 (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 (4)(b)); and the book value of the company s assets at the end of that income year is less than $300 million (s (4)(c)); and either: o o the relevant financial arrangement is not a qualifying security within the meaning of Division 16E of Part III of the ITAA 1936; or 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 (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). Mostafavi and Marston, Greenwoods & Freehills

33 5.4.1 Primary definition of financial arrangement The primary definition of financial arrangement is set out in s (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) (ii) the thing that you have the right to receive, or the obligation to provide, is not a financial benefit; or 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 (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: Mostafavi and Marston, Greenwoods & Freehills

34 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 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 (1)); a right to receive, and/or an obligation to provide, an equity interest (refer s (2)); foreign currency (refer s (1)); a non-equity share (refer s (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 (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 ), 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 (4)(e), (1), and (1)). Mostafavi and Marston, Greenwoods & Freehills

35 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 ). 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 (2)); certain interests in partnerships and trusts (refer s (3)); most insurance policies (refer s (5) and (6)); certain types of guarantees and indemnities (other than those given in relation to a financial arrangement): refer s (8); superannuation and pension benefits (refer s (11)); a right or obligation arising under a direct interest in a CFC (refer s (12)); earn-out arrangements (refer s (13)); registered emissions units (refer s ). There are certain other exceptions contained in ss to s 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 (1). Pursuant to s (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. Mostafavi and Marston, Greenwoods & Freehills

36 Section addresses the treatment of TOFA gains and losses that relate to the derivation of exempt income or NANE income. In this regard, s provides: (1) Despite section , 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 , 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 (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 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. Mostafavi and Marston, Greenwoods & Freehills

37 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 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 taxtiming methods is applicable to the financial arrangement. Generally, if an elective method applies, it has priority over the default methods (refer s (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 ). 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 ). 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. Mostafavi and Marston, Greenwoods & Freehills

38 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 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 ). 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 amendments 21, 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 (2)(c)). In other words, the particular gain or loss approach now takes priority and is the default approach. In this regard, s (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 ). Mostafavi and Marston, Greenwoods & Freehills

39 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 (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 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 (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 (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 (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. Mostafavi and Marston, Greenwoods & Freehills

40 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 FXdenominated transactions (which are generally taxed on a realisation basis) 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 (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 (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 (2). 24 Refer s (1). Mostafavi and Marston, Greenwoods & Freehills

41 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 ). 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 , 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 (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. Mostafavi and Marston, Greenwoods & Freehills

42 Subsection (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 ). 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 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 (2). If the taxpayer makes a valid election, then by virtue of s , the fair value method would generally apply to each TOFA financial arrangement of the taxpayer which: Mostafavi and Marston, Greenwoods & Freehills

43 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 , 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 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 (2)). However, the Commissioner does have a discretion to waive some of these conditions (refer s ). 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 ). The most critical restriction is contained in s (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 : Mostafavi and Marston, Greenwoods & Freehills

44 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 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 ). Mostafavi and Marston, Greenwoods & Freehills

45 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. Mostafavi and Marston, Greenwoods & Freehills

46 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 Abbott did not make the election to un-grandfather any of the financial arrangements that it started to have before 1 July 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. Mostafavi and Marston, Greenwoods & Freehills

47 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 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 (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 (2)). 7.3 Financial arrangement Each Note issued by Abbott should constitute a financial arrangement under the primary definition of the term in s for the following reasons: Mostafavi and Marston, Greenwoods & Freehills

48 under a Note, Abbott has: o o o a legal right to receive the issue proceeds of the Note; and a legal obligation to repay the principal amount of the Note on redemption; 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 (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 Interest on the Notes 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 (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 Mostafavi and Marston, Greenwoods & Freehills

49 s (3)). Each particular loss should be spread over the 6-month period to which it relates under the accruals method (refer s ). As discussed below, the amount that must be spread is the US$ amount of interest (without translation into A$). By virtue of s (2) and s , each loss must be spread using: compounding accruals; or a method whose results approximate those obtained using the accruals method (e.g. the effective interest method in AASB 139). It is assumed that, in Abbott s financial statements, the Notes will be measured at amortised cost using the effective interest method in AASB 139. The effect of this should be that Abbott s TOFA particular loss (in US$) 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 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 $2 million in the 2014 income year (on account of the 30 September 2013 interest payment) Translation into A$ 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 provides rules for the translation of amounts into Australian currency. In this regard, s (1) provides: For the purposes of this Act, an amount in a *foreign currency is to be translated into Australian currency. Relevantly, s (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)). Mostafavi and Marston, Greenwoods & Freehills

50 Subsection (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$21,917 each day using daily spot rates. This approach would seem to defeat the concept of translating a special accrual amount as a single amount, but it seems to be a consequence of applying the legislation literally. To mitigate the compliance burden, Abbott can choose to translate the accrued interest amounts using an average exchange rate for a period not exceeding 12 months, provided that the use of the average rate gives rise to a reasonable approximation of the actual result of translating the accrued amounts on a daily basis using daily spot exchange rates. In this regard, Reg (1) of Regulations inserts a new item (item 12) into the table in s (6). That item contains modifications to the way foreign currency is translated by using method in the rules in Schedule 2 to the Regulations. In particular, item 1.3 of Part 1 of Schedule 2 to the Regulations provides for the adoption of an average exchange rate. As an alternative, translation into A$ 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 (6) of the Act, as modified by Regulation (1), and item 1.1 of Part 1 of Schedul e 2 to the Income Tax Assessment Regulations Mostafavi and Marston, Greenwoods & Freehills

51 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 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 (3) or (4) may be relevant. Subsection (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$4 million actually paid on 1 October 2013, then, under s (3), Abbott is deemed to have made a TOFA gain on 1 October 2013 equal to the amount of the excess. Conversely, s (4) would apply to deem Abbott to have made a loss on a Note if the A$ 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 (1)(b)). Section 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 Mostafavi and Marston, Greenwoods & Freehills

52 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$1.40 million on the redemption of the Notes on 28 February This loss is calculated as: the A$ 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). Mostafavi and Marston, Greenwoods & Freehills

53 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$1=US$ Financial arrangement under TOFA The FX Forward should be a TOFA financial arrangement under the primary definition in s 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 (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. Mostafavi and Marston, Greenwoods & Freehills

54 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 (1)(b)). The step 1 amount in the method statement in s (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 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 (1) for the 2014 income year (ie the income year in which settlement occurs). Mostafavi and Marston, Greenwoods & Freehills

55 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 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$1 = US$ Balancing adjustments 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 (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 (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 (1) because: Mostafavi and Marston, Greenwoods & Freehills

56 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 (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 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' 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 (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 (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 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 (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. Mostafavi and Marston, Greenwoods & Freehills

57 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$520,000) would be the balancing adjustment amount, and it would be deemed under step 3 of the method statement to be a TOFA gain for Abbott on the historic rate rollover of the FX Forward. This gain would be included in Abbott s assessable income under s (1) for the 2014 income year (ie the income year in which historic rate roll-over occurs) Final settlement of the FX Forward On 30 September 2014, when Abbott s right to receive US$ 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 (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 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). Mostafavi and Marston, Greenwoods & Freehills

58 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 (1) to be a final TOFA gain on the FX Forward. This gain should be included in Abbott s assessable income under s (1) for the 2015 income year (in the income year in which final settlement occurs). Mostafavi and Marston, Greenwoods & Freehills

59 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$1 million principal on the loan Financial arrangement The US$ loan should be a financial arrangement under the primary definition in s 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 (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 Mostafavi and Marston, Greenwoods & Freehills

60 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) 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$1 million which Abbott will take delivery of on settlement (which will depend on the spot exchange rate at that time) will not be known with any degree of certainty until settlement. Accordingly, the accruals method in Subdivision 230-B should not apply to spread any gain or loss during the 6 month term of the swap Disposal of US$ 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 Balancing adjustment On the settlement of the cross-currency swap on 31 July 2014, Abbott will make a balancing adjustment under s (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 (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 Mostafavi and Marston, Greenwoods & Freehills

61 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 (1) to be Abbott s gain on the cross-currency swap. This gain should be included in Abbott s assessable income under s (1) in the 2015 income year (ie the income year in which the swap settles). Mostafavi and Marston, Greenwoods & Freehills

62 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$1=US$ Financial arrangement The FX option should constitute a financial arrangement under the primary definition in s 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 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 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 ). 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 Mostafavi and Marston, Greenwoods & Freehills

63 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 (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 (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 Refer s (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. Mostafavi and Marston, Greenwoods & Freehills

64 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 (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 (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 (2)(a) and the new s (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 (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 Refer item 33 of Schedule 33 to the 2013 Act. 29 Refer the comments and examples in the Explanatory Memorandum to the TOFA Act. Mostafavi and Marston, Greenwoods & Freehills

65 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 (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 (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 (1) to be a gain for Abbott on the FX option. This gain should be included in Abbott s assessable income under s (1) for the 2015 income year (ie the income year in which the option is exercised). Mostafavi and Marston, Greenwoods & Freehills

66 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 1/3 rd 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 o o a deposit of US$5 million is to be paid on execution of the contract; a progress payment of US$10 million is to be paid on 1 December 2014 (ie 11 months after execution of the contract); and 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). Mostafavi and Marston, Greenwoods & Freehills

67 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 for the TOFA regime Whether the TOFA regime applies The construction contract for the vessel Even if ABM exceeds the turnover/asset thresholds in s 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 (1)(d), (e) and (f)) 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 The FX gains and losses recognised for income tax purposes 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 each time that it withdraws an amount from the US$ bank account. Mostafavi and Marston, Greenwoods & Freehills

68 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 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) 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 (1) on 1 December 2014 (ie in the 2015 income year) 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 when it makes the progress payment of US$10 million to Susilo under the construction contract on 1 December This is because: at that time, ABM will cease to have an obligation to pay foreign currency (US$); 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). Mostafavi and Marston, Greenwoods & Freehills

69 As a result of FRE 4, ABM should make a forex realisation loss under s (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 (5)). According to item 5 of the table in s (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 There is a conceptual difficulty in applying the definition of proceeds of assuming the obligation in s 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 , 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 (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 Mostafavi and Marston, Greenwoods & Freehills

70 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 to disregard the short-term FX rules in s and s 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 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 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 , 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 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 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 (1) on 1 January 2016 (ie in the 2017 income year) 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 Mostafavi and Marston, Greenwoods & Freehills

71 the purchase price to Susilo under the construction contract on 1 January 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 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 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 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 (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 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). Mostafavi and Marston, Greenwoods & Freehills

72 Mostafavi and Marston, Greenwoods & Freehills

73 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 The spot exchange rate on 1 January 2017 is A$1=US$ Financial arrangement For the same reasons as discussed in Case Study 1, the US$ loan should be a TOFA financial arrangement 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). Mostafavi and Marston, Greenwoods & Freehills

74 13.4 Nexus with NANE income Abbott s TOFA balancing adjustment gain of A$0.5 million on the repayment of the loan principal should be NANE income pursuant to s (2)(b). This is because, if the gain had been a loss instead, Abbott would have made it in gaining or producing NANE income, namely the dividends paid by US Co. (which should be NANE income in the hands of Abbott by virtue of s.23aj). The hypothetical loss on the US$ 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). Mostafavi and Marston, Greenwoods & Freehills

75 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$1. US Co is reasonably expected to pay dividends to Abbott over the next 3 years (subject to the actual availability of profits, and the Board of Directors of US Co. making passing resolutions to pay dividends). The treatment of a similar spot transaction is dealt with in Case Study 4 and will not be discussed further here. Instead, the focus of this case study is on the potential nexus of a gain or loss arising from the FX Forward with Abbott s NANE income Financial arrangement For the same reasons as discussed in Case Study 1, the A$ 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. Mostafavi and Marston, Greenwoods & Freehills

76 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$0.5 million Nexus with NANE income Abbott s economic position in this scenario is similar to its economic position in the scenario of Case Study 7, the difference being that in Case Study 7 Abbott had an unhedged exposure to US$, 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 (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 (2), and is included in assessable income under subsection (1)... In reaching that conclusion, the Commissioner states: Mostafavi and Marston, Greenwoods & Freehills

77 125. 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 (1) for the 2018 income year (ie the income year in which the close-out occurs). Mostafavi and Marston, Greenwoods & Freehills