AUSTRALIA S NEW FOREX REGIME

Transcription

1 AUSTRALIA S NEW FOREX REGIME By Stephen Barkoczy * Australia has recently adopted a revolutionary new codified regime for dealing with the taxation treatment of transactions that occur in foreign currency. The new forex regime largely replaces various ad hoc statutory and common law rules that had been developed over the years for dealing with foreign currency transactions. Leaving aside a limited number of exceptions, the new rules will generally be relevant whenever transactions take place in foreign currency and are, therefore, clearly of great importance to all tax practitioners and tax scholars. The new forex regime comprises a set of rules for translating foreign currency into Australian currency and a set of rules for dealing with foreign currency exchange gains and losses. The new legislation introduces many new concepts and special terms, including the important notion of a forex realisation event. This article provides a conceptual and theoretical framework for analysing the new legislation. It examines the operation of the key provisions in the statute and it provides a number of illustrations of how some of the main rules work in a practical context. It also touches on various underlying policy issues relating to the scheme. 1. INTRODUCTION Without doubt, one of the most significant tax reforms that occurred in Australia last year was the introduction of the revolutionary new forex regime. 1 The forex regime consists of two * Associate Professor, Monash University and Consultant, Blake Dawson Waldron. 1 The forex regime was introduced pursuant to amendments contained in the New Business Tax System (Taxation of Financial Arrangements) Bill (No 1) 2003, which received assent on 17 December 2003 and became Act No 133 of JOURNAL OF AUSTRALIAN TAXATION

2 AUSTRALIA S NEW FOREX REGIME separate, although inter-related, sets of provisions. The first set of provisions, located in Div 775 of the Income Tax Assessment Act 1997 (Cth) ( ITAA97 ), deal with the tax treatment of foreign currency exchange gains and losses. The second set of provisions, located in Subdivs 960-C and 960-D of the ITAA97, contain rules for translating foreign currency into Australian currency. Together, these provisions represent a substantial body of new law and are of fundamental importance to the way in which transactions that occur in foreign currency are treated under the Australian income tax law. 1.1 The TOFA Reforms By way of background, the forex regime represents the second stage in the federal government s important taxation of financial arrangements ( TOFA ) reforms. These reforms were first mooted in the early 1990s. Since that time there has been an on-going consultative process between Treasury and the private sector with a view to developing an appropriate and consistent set of rules for taxing financial arrangements in Australia. Specific recommendations for reforming the way in which financial arrangements should be taxed were made in 1999 by the Review of Business Taxation in the Ralph Report. 2 These recommendations were accepted in principle by the government shortly after the report was handed down 3 and an agenda was then set for their implementation in four stages. The first stage of the TOFA reforms generally took effect from 1 July 2001, with the introduction of the controversial debt and equity regime. 4 The second stage of the reforms, namely the new forex rules, generally operate in relation to transactions entered into from 1 July The third and fourth 2 Review of Business Taxation, A Tax System Redesigned (1999) and Treasurer, Commonwealth of Australia, The New Business Tax System: Stage 2 Response, Press Release No 74 (November 1999) (Attachment N). 4 For a general discussion of this regime, see R Woellner, S Barkoczy, S Murphy and C Evans, Australian Taxation Law (2004) 1,134-1,146 and R Deutsch, M Friezer, I Fullerton, M Gibson, P Hanley and T Snape, Australian Tax Handbook (2004) (2004) 7(1) 7

3 S BARKOCZY stages of the reforms are now proposed to operate from no earlier than 1 July The third stage relates to the taxation of commodity hedges while the fourth stage relates to various tax timing issues and synthetic arrangements. 1.2 Aims of This Article This article focuses exclusively on the new forex rules. These rules are extremely technical in nature and introduce many new concepts, including eight different forex realisation events. As the forex regime is still new and many practitioners and scholars are therefore only just coming to grips with the way in which it operates, the main aim of this article is to provide readers with a general roadmap for navigating the complex web of provisions that make up the regime. In this regard, the article examines the operation of the key sections within the legislation (including the many important and lengthy tables that reside within these sections) and it provides a number of practical illustrations of how some of the main rules operate. The article also considers some of the policy aspects that underpin these rules and concludes with some broad observations about the regime. The remainder of this article is divided into the following parts: Part 2 examines the new foreign currency translation rules, which consist of a general translation rule and a functional currency translation rule ; Part 3 discusses the general nature of foreign currency exchange gains and losses and the circumstances in which they arise; Part 4 explains the way in which exchange gains and losses have been dealt with in the past under the income tax law; Part 5 outlines the general operation of the new foreign currency exchange gain and loss rules; Part 6 focuses on the eight different forex realisation events that arise under these rules; and 8 JOURNAL OF AUSTRALIAN TAXATION

4 AUSTRALIA S NEW FOREX REGIME Part 7 contains the writer s concluding comments on the new regime. 2. FOREIGN CURRENCY TRANSLATION RULES A fundamental principle that underpins the Australian income tax system is that a taxpayer s tax liability is required to be determined by reference to a constant unit of account. Not surprisingly, this unit of account is the Australian dollar ( A$ ). Accordingly, for transactions that occur in foreign currencies, it is necessary to have mechanisms for translating relevant amounts into equivalent A$ amounts. One of the main roles of the new forex regime is to provide the necessary legislative framework for doing this. Under the forex regime, the principal mechanism for translating foreign currency into A$ is contained in the general translation rule located in Subdiv 960-C ITAA97 (see 2.1). The general translation rule operates subject to special functional currency rules in Subdiv 960-D (see 2.2). These rules are superimposed upon the general provisions in the legislation and they work in conjunction with the specific foreign currency exchange gain and loss provisions located in Div 775 of the ITAA97 (see 5). Subject to various exceptions and transitional arrangements, Subdivs 960-C and 960-D generally apply to transactions entered into from the beginning of the 2003/04 income year. However, where a taxpayer has a substituted accounting period and the first day of its 2003/04 income year is earlier than 1 July 2003, the relevant commencement date is the first day of its 2004/05 income year. 5 The rules in Subdivs 960-C and 960-D replace a range of ad hoc currency translation rules that were previously scattered throughout the tax legislation. 6 The former rules, however, generally continue to operate in those circumstances where the new rules do not apply. Consequently, these rules will continue to operate in relation to 5 ITAA97, ss and (1). 6 See former ss 20, 102AAX and 391 of the Income Tax Assessment Act 1936 (Cth) ( ITAA36 ) and s of the ITAA97. (2004) 7(1) 9

5 S BARKOCZY transactions entered into before the commencement date of the forex regime. In addition, the former rules will also continue to be relevant to ADIs (eg banks) and non-adi financial institutions (eg finance companies). 7 This is because Subdiv 960-C and 960-D expressly do not apply to these entities by virtue of ss (3) and (5). 2.1 The General Translation Rule The general translation rule is contained in s (1). 8 This provision simply states that an amount in a foreign currency must be translated into Australian currency Application to Amounts Section (1) applies to amounts generally in other words, it applies to all amounts that are relevant for any income tax calculation purpose. 10 For example, it applies to an amount of ordinary income, an expense, an obligation, a liability, a receipt, a payment, consideration or a value. 11 Furthermore, it applies irrespective of whether such an amount is on revenue, capital or other account. 12 Amounts which are elements in the calculation of another amount are generally required to be translated prior to calculating the other amount The concepts of an ADI and a non-adi financial institution are defined in s 128A(1) of the ITAA36: ITAA97, s The general translation rule applies for both the purposes of the ITAA97 and the ITAA36. 9 In translating an amount into Australian currency, an entity must comply with the regulations which may, for instance, prescribe a particular translation method: ITAA97, s (8). 10 It does not, however, affect the operation of the provisions specified in s (10). 11 ITAA97, s (2). 12 ITAA97, s (3). 13 ITAA97, s (4). This rule does not, however, apply to another amount which is a special accrual amount. In other words, amounts taken into account in calculating a special accrual amount are not translated it is only the result of the calculations (ie the special accrual amount) which is translated: ITAA97, s (5). A special accrual amount is an amount that is included in assessable income or allowed as a deduction under one of the following Divisions: Div 42A in Sch 2E of 10 JOURNAL OF AUSTRALIAN TAXATION

6 AUSTRALIA S NEW FOREX REGIME Specific Translation Rules The most important feature of the general translation rule is that it contains a set of specific rules for determining the time at which particular amounts are translated into Australian currency. These rules are located in the table in s (6). The table sets out eleven specific translation rules, which operate subject to any modifications that may be made by the regulations. 14 The eleven rules may be conveniently summarised as follows: 1. The amount of certain obligations to pay foreign currency that have ceased in circumstances where forex realisation event 4 happens are translated at the exchange rate applicable at the tax recognition time under s (7) (see 6.4). 2. The cost of a depreciating asset is translated at the exchange rate applicable when the taxpayer began to hold the asset, or satisfied the liability to pay for it (whichever occurs first). 3. The value of trading stock on hand at the end of an income year which is valued at cost is translated at the exchange rate applicable at the time when the item became on hand. 4. The value of trading stock on hand at the end of an income year which is valued at market selling value or replacement value is translated at the exchange rate applicable at the end of the income year. 5. The amount of money, or the market value of property, relating to transactions or events under the CGT rules is the ITAA36; Div 240 of the ITAA97; Div 16D of Pt III of the ITAA36; and Div 16E of Pt III of the ITAA36: ITAA97; s ITAA97, s (7). For example, the regulations might allow an average rather than a spot rate to be used for translation purposes. (2004) 7(1) 11

7 S BARKOCZY translated at the exchange rate applicable at the time of the transaction or event. 6. The amount of ordinary income is translated at the exchange rate applicable at the time of its derivation or receipt (whichever occurs first). 7. The amount of statutory income (other than an amount included in assessable income under the CGT rules in Div 102 of the ITAA97) is translated at the exchange rate applicable at the time of receipt or at the time when the requirement first arose to include it in assessable income (whichever occurs first). 8. The amount of a deduction (other than a deduction arising under the capital allowance rules in Div 40 of the ITAA97) is translated at the exchange rate applicable at the time of payment or the time the amount becomes deductible (whichever occurs first). 9. The amount of something that is relevant to quantifying a company s expenditure on a film for the purposes of Div 376 of the ITAA97 is translated at the average exchange rate applicable to the period that starts at the earliest day on which principal photography or production of the animated images commenced and ends when the film is completed. 10. The amount required to be withheld from a payment under the PAYG provisions is translated at the exchange rate applicable at the time when the amount is required to be withheld. 11. The amount of any other payment or receipt is translated at the exchange rate applicable at the time of the receipt or payment. 12 JOURNAL OF AUSTRALIAN TAXATION

8 AUSTRALIA S NEW FOREX REGIME The following examples illustrate some of the above rules: Examples Item 2 X Co became the owner of a depreciating asset when it entered into a contract to purchase the asset from a United States company for US$1m on 1 July 2004 (when the exchange rate was A$1:US$0.50). X Co, however, only paid for the depreciating asset on 1 August 2004 (when the exchange rate was A$1:US$0.80). Pursuant to the table in s (1)(b) of the ITAA97, the cost of the depreciating asset is determined by reference to the amount paid for the asset (US$1m). Applying the special translation rule in s960-50(6) (item 2) to that amount, the cost of the asset for the purposes of Div 40 would be A$2m (US$1m x 1.00/0.50), rather than A$1.25m (US$1m x 1.00/0.80). Accordingly, any capital allowance that X Co claims in respect of the depreciating asset would need to be based on a cost of A$2m. Item 6 Y Co sells machinery to retailers in Europe and is ordinarily paid in Euro within three months of entering the contracts. On 1 June 2004, Y Co sold machinery to a German retailer for 6,000 (assume that at the time the exchange rate is A$1.00: 0.60). Y Co received payment on 1 September 2004 (assume that at the time the exchange rate is A$1.00: 0.90). As Y Co accounts for its income on an earnings basis, it derives income of 6,000 in the 2003/2004 income year. As the income is derived prior to payment being received, Y Co is required to translate the foreign currency denominated income into Australian dollars at the exchange rate applicable at the time of derivation. Y Co s income for the 2003/04 income year is therefore A$10,000 ( 6,000 x $1.00/0.60). (2004) 7(1) 13

9 S BARKOCZY It is important to be aware that the above transactions will also result in forex realisation events occurring under Div 775. These events and their consequences are discussed in detail below (see 5 and 6). 2.2 The Functional Currency Rules To reduce compliance costs associated with the general translation rule in Subdiv 960-C and to reflect commercial practice, Subdiv 960-D allows certain entities that keep their accounts solely or predominantly in a particular foreign currency to choose to work out their relevant tax calculations in that currency (the functional currency ) and then to simply translate the net figure into Australian dollars. 15 This overcomes the need to separately translate into A$ every single amount relevant to each transaction that is denominated in a foreign currency Entities That Can Choose to Use the Functional Currency Rules The particular entities that are able to choose to use the functional currency rules and the particular amounts that these rules apply to are set out in the table in s (1). There are five situations covered by the table: 1. An Australian resident required to prepare financial reports under s 292 of the Corporations Act 2001 (eg a public company under that Act) can choose to work out so much of its taxable income or tax loss as is not covered by any of the other choices outlined below according to the applicable functional currency. 2. An Australian resident carrying on an activity or business through an overseas permanent establishment and a foreign resident carrying on an activity or business through an Australian permanent establishment can choose to work out the taxable income or tax loss derived 15 ITAA97, ss and JOURNAL OF AUSTRALIAN TAXATION

10 AUSTRALIA S NEW FOREX REGIME from the activity or business carried on through the permanent establishment according to the applicable functional currency. 3. An offshore banking unit can work out its total assessable OB income and its total allowable OB deductions using the applicable functional currency. 4. An attributable taxpayer of a CFC can choose to work out the CFC s total attributable income using the applicable functional currency. 5. A transferor trust can choose to work out its attributable income using the applicable functional currency Applicable Functional Currency The applicable functional currency is the sole or predominant currency in which the accounts of the relevant entity, permanent establishment, offshore banking unit, CFC or transferor trust (as the case requires) are kept Choosing to Use the Applicable Functional Currency A choice to use the applicable functional currency must be made by the relevant entity in writing. 17 The fourth column in the table in s (1) specifies when the choice has effect from. Broadly, a choice generally has effect from the commencement of the following income year (or statutory accounting period) unless the choice is a backdated startup choice 18 in which case it generally has effect from the beginning of the income year (or statutory accounting period) in which the choice is made. A choice will continue to have effect until a withdrawal of the choice (which must also be made in writing) takes effect as determined in accordance with the table in s ITAA97, s ITAA97, s (2). 18 Defined in s of the ITAA ITAA97, s (3) to (4). (2004) 7(1) 15

11 S BARKOCZY Translating Amounts Using an Applicable Functional Currency The way in which amounts are translated using the applicable functional currency is set out in the table in s Different translation rules apply depending on the entity involved and the particular kind of tax calculation undertaken (eg calculation of taxable income, tax losses, attributable income etc). In general terms, the translation rules require all relevant amounts that are not in the applicable functional currency (including A$ amounts) to be translated into the applicable functional currency. The relevant tax liability is then calculated in the applicable functional currency. This amount is then finally translated into A$ Special Translation Rules for Amounts Attributable to Events That Straddle the Choice Special two-stage translation rules, contained in s , operate where: as a result of a choice (the current choice ) an entity is required to convert an amount to the applicable functional currency; and the amount is attributable to an event that happened, or a state of affairs that arose, at a time (the event time ) before the choice took effect. For example, these rules would operate to calculate the amount of a capital gain or capital loss in circumstances where an entity sells an asset after it has made a choice to use an applicable functional currency and the asset was acquired before that choice was made (eg when its cost was accounted for in A$ rather than foreign currency). According to the tables in s , where no previous choice was in effect at the event time, the amount is first translated into A$ at the exchange rate applicable at the event time and secondly to the applicable functional currency at the exchange rate applicable when the current choice took effect. The same process operates where a previous choice has been made, except the previously applicable 16 JOURNAL OF AUSTRALIAN TAXATION

12 AUSTRALIA S NEW FOREX REGIME functional currency is substituted for Australian currency. The double translation is designed to ensure that any unrealised gain or loss that exists at the time of the choice does not escape taxation simply because the choice is made NATURE OF FOREIGN CURRENCY EXCHANGE GAINS AND LOSSES The new currency translation rules discussed above operate in conjunction with the new foreign currency exchange gain and loss rules discussed below (see 5). However, before turning to examine these rules, it is appropriate to first discuss the general nature of foreign currency exchange gains and losses (3.1 to 3.2) and to outline the various regimes that have dealt with such gains and losses in the past (see 4). 3.1 Circumstances in Which Foreign Currency Exchange Gains and Losses Arise Foreign currency exchange gains and losses typically arise where taxpayers enter into contracts and the price is expressed in a foreign currency. If the exchange rate between the A$ and foreign currency fluctuates between the time the contract is entered into and the time the consideration is paid or received, the taxpayer will be required to pay, or will be entitled to receive, a different amount of A$ than the amount of A$ originally brought to account as assessable income or as a deduction under the currency translation rules. The difference in these amounts is the amount of the respective exchange gain or loss made by the taxpayer. 20 Explanatory Memorandum to the New Business Tax System (Taxation of Financial Arrangements) Bill (No 1) 2003, para (2004) 7(1) 17

13 S BARKOCZY Example Fred is a furniture exporter. On 1 June 2004 (when the exchange rate was A$1:US$0.80), Fred entered into a contract to supply furniture to a customer in the United States for US$100. Under the general translation rule (see 2.1), the US$100 is required to be translated into A$ at the time of derivation (ie on 1 June 2004). This results in Fred having to include A$125 (US$100 x 1.00/0.80) in his assessable income in the 2003/04 income year. Fred only received payment of the US$100 on 30 August 2004 (when the exchange rate was A$1:US$0.50). The value of the US$100 receipt at such time is therefore A$200 (US$100 x 1.00/0.50). In these circumstances, Fred has made a foreign currency exchange gain of A$75. The exchange gain has arisen because, while Fred only included an amount of A$125 in assessable income in the 2003/04 income year, he actually received an amount equivalent to A$200 in the 2004/05 income year. Accordingly, he is better off by A$ The Energy Resources Conversion Principle Under the common law, exchange gains and losses could only arise where amounts in one currency were actually converted into another currency. This principle is vividly illustrated by the decision in FC of T v Energy Resources of Australia Ltd. 21 This case concerned a taxpayer that had issued discounted euro notes in US dollars which it subsequently paid out in US dollars at face value. The High Court held that the taxpayer had not made any exchange gains or losses from the relevant transactions as only one currency ATC JOURNAL OF AUSTRALIAN TAXATION

14 AUSTRALIA S NEW FOREX REGIME was involved. In a joint judgment, Dawson, Toohey, Gaudron, McHugh and Kirby JJ stated: 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. 22 Their Honours then went on to state: The taxpayer received US dollars, paid in 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. 23 As a consequence of the introduction of the new currency translation rules, amounts relevant to tax calculations must now generally be translated into A$ irrespective of whether any actual conversion takes place. Accordingly, where these translation rules operate, exchange gains and losses can now arise even though no foreign currency has actually been converted into A$. In effect, this means that the outcome of Energy Resources would be different under the new rules. It is clear that in drafting the forex rules, the legislature specifically sought to address the Energy Resources principle. This policy intent is clearly expressed in the Explanatory Memorandum to the Bill which introduced the forex regime where it is stated: The forex provisions provide a statutory framework under which the gain or loss arising from these disparities is brought to account when it has been realised. This is the case even if the monetary elements of the transaction are not converted to A$. 22 Ibid Ibid (2004) 7(1) 19

15 S BARKOCZY Without such a framework, foreign currency gains and losses arising out of business transactions may fall outside the income tax net. This possibility is illustrated by FC of T v Energy Resources of Australia Ltd... The realisation rules, in conjunction with the core translation rule... confirm the policy intent behind the tax treatment of foreign currency denominated transactions. These rules ensure that foreign currency gains and losses, whether on revenue or capital account, are brought to account, regardless of whether there is an actual conversion to A$. This will generally occur when the gains and losses are realised PRE-FOREX REGIMES FOR DEALING WITH EXCHANGE GAINS AND LOSSES Prior to the introduction of the forex regime, foreign currency exchange gains and losses were dealt with under a number of different tax regimes. For the purposes of this article, these regimes may be conveniently referred to as the pre-forex regimes and they are briefly outlined at 4.1 to 4.3 below. 4.1 General Taxation Regime Initially, the only provisions that dealt with foreign currency exchange gains and losses under the Australian income tax law were the ordinary income and general deduction provisions contained in former s 25(1) and s 51(1) of the ITAA36 (now ss 6-5 and 8-1 of the ITAA97). To fall within these provisions it was necessary that the exchange gains and losses could be characterised as being of an income or revenue nature (as opposed to being of a capital nature). More specifically, the cases dealing with the former ss 25(1) and 51(1) established that exchange gains are assessable and exchange losses are deductible in so far as they are referable to discharging or providing for liabilities on revenue account (eg the purchase or sale 24 Explanatory Memorandum to the New Business Tax System (Taxation of Financial Arrangements) Bill (No 1) 2003, paras JOURNAL OF AUSTRALIAN TAXATION

16 AUSTRALIA S NEW FOREX REGIME of trading stock): Texas Co (Australasia) Ltd v FC of T; 25 International Nickel Australia Ltd v FC of T; 26 Armco (Australia) Pty Ltd v FC of T; 27 Caltex Ltd v FC of T, 28 Thiess Toyota Pty Ltd v FC of T, 29 and AVCO Financial Services Ltd v FC of T. 30 On the other hand, the cases also established that exchange gains and losses are capital in nature, and they were therefore not assessable or deductible under the ordinary income and general deduction provisions, where they are referable to expenditure incurred in strengthening a taxpayer s business structure or capital base: Commercial & General Acceptance Ltd v FC of T, 31 FC of T v Hunter Douglas Ltd Division 3B Division 3B of Pt III of the ITAA36 (s 82U to 82ZB) was introduced in the mid-1980s in order to bring certain exchange gains and losses that were of a capital nature (and which therefore did not fall within the ordinary income or general deduction provisions) within the tax system. Division 3B applied to currency exchange gains and currency exchange losses that arose under an eligible contract (ie basically a contract entered into after 18 February 1986 or a hedging contract in respect of such a contract). 33 The Division only applied to the extent to which the currency exchange gains and losses were of a capital nature 34 and only to the extent to which: 25 (1940) 63 CLR (1977) 137 CLR 347; 77 ATC (1948) 76 CLR (1960) 106 CLR ATC ATC ATC ATC ITAA36, s 82V(1). 34 ITAA36, s 82U(1). (2004) 7(1) 21

17 S BARKOCZY the currency exchange losses, assuming they were not of a capital nature, would have been deductible to the taxpayer under s 8-1; 35 and the currency exchange gains, assuming they were losses instead of gains and assuming they were not of a capital nature, would have been deductible to the taxpayer under s In other words, the Division was focused on currency exchange gains and losses that were of an income producing or business character, but which did not fall within the ordinary income and general deduction provisions simply because they were of a capital nature. The Division did not apply to currency exchange gains and losses that were of a private character. Where Div 3B applied, the following consequences flowed: the taxpayer was required to include in assessable income the amount of any currency exchange gain made during the year of income; 37 and 4.3 CGT Regime the taxpayer was (subject to certain limitations) entitled to a deduction for the amount of any currency exchange loss incurred during the year of income. 38 Since foreign currency and rights in respect of foreign currency constitute CGT assets, 39 exchange gains and losses made under contracts entered into after 19 September 1985 also potentially fell within the CGT regime. In practice, however, the CGT regime did not usually bring such gains and losses to account, since the gains and losses were usually already brought to account under either the 35 ITAA36, s 82U(2). 36 ITAA36, s 82U(3). 37 ITAA36, s 82Y. 38 ITAA36, s 82Z. 39 ITAA97, s JOURNAL OF AUSTRALIAN TAXATION

18 AUSTRALIA S NEW FOREX REGIME general taxation rules or the special rules in Div 3B. The CGT regime ordinarily provided relief against double taxation or double benefit in these circumstances GENERAL OPERATION OF DIVISION 775 The rules for dealing with currency exchange gains and losses under the new forex regime are contained in Div 775 of the ITAA97 (s to s ). The following discussion examines the general operation of this Division, which spans almost 50 pages of legislation. As mentioned previously, the rules in Div 775 work in conjunction with the foreign currency translation rules discussed above. 5.1 Application The forex regime generally applies to gains and losses on rights and obligations acquired or assumed under transactions entered into from the beginning of the 2003/04 income year. However, if the taxpayer has a substituted accounting period and the first day of its 2003/04 income year is earlier than 1 July 2003, the relevant commencement date is the first day of its 2004/05 income year. 41 While the forex regime generally applies prospectively (ie to gains and losses on transactions entered into from the commencement date), a transitional rule allows taxpayers to elect to have the forex rules apply to gains and losses made on transactions entered into before the commencement date, but realised after that date. 42 There is also a special rule which provides that the forex rules apply to rights and obligations relating to loans entered into before the commencement date that are extended after that date See, eg, ss and of the ITAA ITAA97, s ITAA97, ss and For most taxpayers this election had to be made by 16 January See further N Ward, (2004) 1 Tax Week ITAA97, s (2004) 7(1) 23

19 S BARKOCZY The forex regime has been designed to largely replace the former regimes dealing with exchange gains and losses. To the extent that any gains or losses fall within the forex regime, they are not also assessable or deductible under other provisions in the legislation (eg they do not fall within the ordinary income or general deduction provisions). 44 This ensures that the forex regime operates as the exclusive regime for dealing with exchange gains and losses and that no double taxation or double benefit arises. In addition, Div 3B of Pt III of the ITAA36 has been repealed from the commencement of the forex regime. A special transitional rule, however, maintains the operation of the Division (ie it is treated as if it had not been repealed) in relation to eligible contracts entered into before the commencement date. 45 The operation of the Division is also expressly maintained in relation to ADIs (eg banks) and non- ADI financial institutions (eg finance companies), which are expressly excluded from the forex regime pursuant to s Accordingly, while the forex regime now contains the principal rules for dealing with exchange gains and losses, it does not apply in all cases. In those circumstances where the forex regime does not apply, the pre-forex regimes (see 4) will generally continue to operate. 5.2 Aim of Div 775 Division 775 has been designed as a comprehensive taxation framework for dealing with currency exchange gains and losses. The principal aim of the Division is to include forex realisation gains in assessable income and to allow deductions for forex realisation losses. 44 ITAA97, ss (4) and (4). 45 New Business Tax System (Taxation of Financial Arrangements) Act (No 1) 2003, s 77(1)(a). 46 New Business Tax System (Taxation of Financial Arrangements) Act (No 1) 2003, s 77(1)(b). 24 JOURNAL OF AUSTRALIAN TAXATION

20 AUSTRALIA S NEW FOREX REGIME 5.3 Forex Realisation Events Forex realisation gains and forex realisation losses arise as a result of the happening of forex realisation events. There are five main kinds of forex realisation events: forex realisation event 1 ( FRE 1 ) happens when an entity disposes of foreign currency or a right to foreign currency to another entity (see 6.1); forex realisation event 2 ( FRE 2 ) happens when an entity ceases to have a right to receive foreign currency (see 6.2); forex realisation event 3 ( FRE 3 ) happens when an entity ceases to have an obligation to receive foreign currency (see 6.3); forex realisation event 4 ( FRE 4 ) happens when an entity ceases to have an obligation to pay foreign currency (see 6.4); and forex realisation event 5 ( FRE 5 ) happens when an entity ceases to have a right to pay foreign currency (see 6.5). In addition, there are three further kinds of forex realisation events which operate where certain choices have been made. Forex realisation event 6 ( FRE 6 ) and forex realisation event 7 ( FRE 7 ) relate to roll-over relief claimed in respect of a facility agreement under Subdiv 775-C (see 6.9). Forex realisation event 8 ( FRE 8 ) relates to the retranslation election in respect of a qualifying forex account under Subdiv 775-E (see 6.11). 5.4 The Basic Rules and Their Exceptions Underpinning the operation of Div 775 are two basic rules: The basic rule in s (1) provides that a taxpayer is required to include in assessable income, a forex realisation gain from a forex realisation event that happens during the year. (2004) 7(1) 25

21 S BARKOCZY The basic rule in s (1) provides that a taxpayer can deduct a forex realisation loss from a forex realisation event that happens during the year. These basic rules operate subject to the following exceptions: Private or domestic exceptions. Forex realisation gains that are of a private or domestic nature are not assessable income unless they would be taken into account under the CGT provisions 47 and they relate to: (i) the disposal of a CGT asset that is foreign currency or a right to foreign currency; (ii) the discharge of a right acquired in return for the realisation of another kind of CGT asset; or (iii) the discharge of an obligation incurred to acquire a CGT asset. 48 Furthermore, forex realisation losses that are of a private or domestic nature are not deductible unless they relate to: (i) the discharge of a right acquired in return for realising another kind of CGT asset; or (ii) the discharge of an obligation incurred to acquire a CGT asset. 49 Exempt income and non-assessable non-exempt income exceptions. Forex realisation gains are, respectively, exempt income or non-assessable non-exempt income to the extent that the gains, if they had been losses, would have been made in gaining or producing exempt income or non-assessable non-exempt income. 50 Also, forex realisation losses are not deductible to the extent that they are made as a result of: (i) FRE 1, FRE 2 or FRE 5 and are made in gaining or producing exempt income; or (ii) FRE 3, FRE 4 or FRE 6 and are made in gaining or producing exempt income or non-assessable non-exempt income 47 In other words, they would not be disregarded under any CGT exemptions such as the personal use asset exemption in s of the ITAA ITAA97, s (2). 49 ITAA97, s (2). 50 ITAA97, ss and JOURNAL OF AUSTRALIAN TAXATION

22 AUSTRALIA S NEW FOREX REGIME provided the relevant obligation does not give rise to a deduction. 51 Short-term forex realisation exceptions. Forex realisation gains are not assessable to the extent that they relate to short-term forex realisation gains as outlined in s (see 6.8). 52 Likewise, forex realisation losses are not deductible to the extent that they relate to short-term forex realisation losses as outlined in s (see 6.8). 53 To prevent double taxation of gains, s (4) provides that to the extent that a forex realisation gain would otherwise be included in assessable income under another provision (eg under s 6-5), the gain is only included in assessable income under s Similarly, to prevent double deductions for losses, s (4) provides that to the extent that a forex realisation loss would otherwise be deductible under another provision (eg under s 8-1), the loss is only deductible under s Calculating the Amount of a Forex Realisation Gain or Forex Realisation Loss The way in which a forex realisation gain or a forex realisation loss is calculated depends on the kind of forex realisation event involved. In general, the amount of the gain or loss is calculated according to one of the following two broad methods: Currency exchange rate effect method. Under the first method, the gain or loss is based on the currency exchange rate effect as defined in s Essentially, the currency exchange rate effect is the amount of the relevant currency fluctuation that has arisen under the event. This is usually the difference between the A$ cost of the foreign currency or right and the A$ proceeds for its 51 ITAA97, s ITAA97, s (3). 53 ITAA97, s (3). (2004) 7(1) 27

23 S BARKOCZY disposal. It can also be the difference between an agreed currency exchange rate for a future date or time and the actual currency exchange rate at the date or time. Alternative method. Under the second method, the gain or loss is based on the difference between the A$ cost of a right or obligation to receive or pay foreign currency at its tax recognition time and the A$ amount paid or received in satisfaction of that right or obligation. 54 The tax recognition time is generally the time that the right or obligation is first recognised under the tax system (eg as income, a deduction, a cost or disposal proceeds etc). In undertaking the above calculations, the new currency translation rules discussed above (see 2) are used to convert foreign currency amounts into A$. 6. FOREX REALISATION EVENTS AND OTHER SPECIAL RULES As mentioned above (see 5.3), forex realisation gains and losses arise as a result of the happening of one of the eight different kinds of forex realisation events. These events are, therefore, the trigger for the operation of the currency exchange gain and loss provisions in much the same way as CGT events are the trigger for the operation of the capital gain and loss provisions. 55 The following discussion (see 6.1 to 6.11) examines each of the specific forex 54 A constructive receipts and payments rule ensures that if an entity (the payer ) did not actually pay an amount to another entity (the recipient ), but the amount was applied or dealt with in any way on the recipient s behalf as the recipient directs, then the payer is taken to have paid and the recipient is taken to have received the relevant amount as soon as it is applied or dealt with: ITAA97, s The forex regime and the CGT regime also overlap in places. See, for instance, the overlap between FRE 1 and CGT event A1 (see 6.1). Note also the interaction between the short-term forex realisation gain and loss rules and CGT event K10 and CGT event K11 (see 6.8.2). 28 JOURNAL OF AUSTRALIAN TAXATION

24 AUSTRALIA S NEW FOREX REGIME realisation events as well as various special rules that apply in relation to these events. 6.1 Forex Realisation Event 1 (Disposal of Foreign Currency): s FRE 1 arises where CGT event A1 happens in relation to the disposal of foreign currency, or a right, or part of a right, to receive foreign currency. 56 The time of the forex realisation event is when the foreign currency, or right, or part of the right, to foreign currency is disposed of. 57 CGT event A1 happens where there is a change in the beneficial ownership of a CGT asset from one entity to another. 58 Thus, FRE 1 arises when there has been a change in the beneficial ownership of foreign currency or a right, or part of a right, to receive foreign currency from one entity to another entity. 59 For example, FRE 1 will occur where a taxpayer sells foreign currency, or assigns its rights under an option to acquire foreign currency, to another entity. It is particularly important to realise that every time foreign currency is paid to another entity (eg as consideration under a contract), the foreign currency will be disposed of and it will therefore be necessary to consider the application of FRE 1. This forex realisation event is therefore extremely common. 56 ITAA97, s (1). 57 ITAA97, s (3). 58 ITAA97, s Note that in applying FRE 1, certain modifications are made to the way in which the CGT provisions operate. In particular, there is a special rule which provides that if the capital proceeds from the event are more or less than the market value of the foreign currency, right, or part of the right, the capital proceeds are taken to be the market value: ITAA97, s (9). Special rules also require certain CGT provisions that would otherwise be relevant for the purposes of calculating capital gains and losses to be disregarded. The provisions that must be disregarded are: s (which reduces a capital gain by certain amounts that are otherwise assessable), Div 114 (which relates to indexation) and s (which disregards certain foreign currency hedging gains and losses): ITAA97 s (5), (7) and (8). 59 ITAA97, s (2). (2004) 7(1) 29

25 S BARKOCZY The circumstances in which an entity makes a forex realisation gain or forex realisation loss under FRE 1 are as follows: Forex realisation gain. An entity makes a forex realisation gain under FRE 1 if it makes a capital gain from CGT event A1 and some or all of that capital gain is attributable to a currency exchange rate effect. The amount of the forex realisation gain is that part of the capital gain (if any) which is attributable to a currency exchange rate effect. 60 Forex realisation loss. An entity makes a forex realisation loss under FRE 1 if it makes a capital loss from CGT event A1 and some or all of that capital loss is attributable to a currency exchange rate effect. The amount of the forex realisation loss is that part of the capital loss (if any) which is attributable to the currency exchange rate effect. 61 The following example illustrates the operation of FRE 1. Example In January 2004 (when the exchange rate was A$1:US$0.80), X Co acquired US$10m. In February 2004 (when the exchange rate was A$1:US$0.50), X Co used the US$10m to purchase shares listed on the NASDAQ stock exchange. The US$10m foreign currency is a CGT asset which has a cost base of A$12.5m (US$10m x 1.00/0.80). CGT event A1 happens when X Co disposed of the foreign currency to buy the shares. The capital proceeds from the disposal is A$20m (US$10m x 1.00/ 0.50), being the market value of the shares. Accordingly, pursuant to FRE 1, X Co has made a forex realisation gain of A$7.5m (A$20m A$12.5m) 60 ITAA97, s (4). 61 ITAA97, s (6). 30 JOURNAL OF AUSTRALIAN TAXATION

26 AUSTRALIA S NEW FOREX REGIME 6.2 Forex Realisation Event 2 (Ceasing to Have a Right to Receive Foreign Currency): s FRE 2 happens if the following three conditions specified in s (1) are fulfilled: (a) an entity ceases to have a right, or part of a right, to receive foreign currency; 62 (b) the right, or part of the right, is: a right, or part of a right, to receive, or that represents, ordinary income or statutory income (other than statutory income assessable under Div 775 or the CGT rules in Div 102); a right, or part of a right, created or acquired in return for ceasing to hold a depreciating asset; a right, or part of a right, created or acquired in return for paying or agreeing to pay Australian or foreign currency; or a right, or part of a right, created in return for a realisation event 63 happening in relation to a CGT asset not covered by the previous classes of right; and (c) the entity did not cease to have the right, or part of the right because it was disposed of. The time of the forex realisation event is when the entity ceases to have the right or part of the right to receive the foreign currency. 64 FRE 2 commonly occurs when a right to receive foreign currency is satisfied by the actual receipt of the foreign currency. It is 62 A right to receive foreign currency may be contingent and it includes a right to receive an amount of A$ that is calculated by reference to an exchange rate: ITAA97, s (1) and (2). 63 Defined in Div 977 of the ITAA ITAA97, (2). (2004) 7(1) 31

27 S BARKOCZY important to note that FRE 2 does not occur where the right to receive foreign currency is disposed of to another entity as, in such case, FRE 1 would apply. The circumstances in which an entity makes a forex realisation gain or forex realisation loss under FRE 2 are as follows: Forex realisation gain. An entity makes a forex realisation gain under FRE 2 if the amount the entity receives in respect of the event exceeds the forex cost base 65 of the right, or part of the right (worked out at the tax recognition time ) 66 and some or all of that excess is attributable to a currency exchange rate effect. The amount of the forex realisation gain is that part of the excess (if any) which is attributable to the currency exchange rate effect. 67 Forex realisation loss. An entity makes a forex realisation loss under FRE 2 if the amount received for the right, or part of the right, falls short of the forex cost base of the right, or part of the right (worked out at the tax recognition time ) and some or all of the shortfall is attributable to a currency exchange rate effect. The amount of the forex realisation loss is so much of the shortfall as is attributable to the currency exchange rate effect. 68 An entity also makes a forex realisation loss if the event happens because an option to buy foreign currency expires without having been exercised, or is cancelled, released or 65 The forex cost base of a right, or part of a right, to receive foreign currency is, broadly, the sum of the money paid and the market value of any non-cash benefit provided in respect of acquiring the right or part of the right reduced by any amounts that are deductible outside Div 775: ITAA97, s For the purposes of s , the tax recognition time is worked out according to the table in s (7). Essentially, it is the time that the right, or part of the right, is recognised under the tax law (eg where the right is ordinary income, it is the time when the ordinary income is derived). 67 ITAA97, s (3). 68 ITAA97, s (4). 32 JOURNAL OF AUSTRALIAN TAXATION

28 AUSTRALIA S NEW FOREX REGIME abandoned and the entity was capable of exercising the option immediately before the event. The amount of the forex realisation loss is the amount paid in return for the grant or acquisition of the option. 69 The following example illustrates the operation of FRE 2: Example Betty is a software exporter. On 1 April 2004 (when the exchange rate was A$1:US$0.80), she entered into a contract to supply products to a customer in the United States for US$1,000. As a consequence of entering into the contract, Betty has a right to receive foreign currency (ie US$1,000). The forex cost base of the right is determined at the tax recognition time, which is when the income is derived (ie 1 April 2004). The forex cost base of the right in A$ is therefore A$1,250 (US$1,000 x 1.00/0.80). Betty is required to include this amount in her assessable income for the 2003/04 income year under s 6-5. Betty s customer pays Betty the US$1,000 on 1 October 2004 (when the exchange rate was A$1:US$0.50). As a consequence of the payment, Betty ceases to have the right to receive the foreign currency as the debt is satisfied. This results in FRE 2 happening on 1 October The A$ amount that Betty receives in respect of the event is A$2,000 (US$1,000 x 1.00/ 0.50). As the amount Betty receives in respect of the event (A$2,000) is greater than the forex cost base of the right (A$1,250), Betty has made a forex realisation gain of $750. She must include this in her assessable income for the 2004/05 income year pursuant to s ITAA97, s (5). (2004) 7(1) 33