Taxation of Financial Arrangements
On Friday 16 December, the Government released the Exposure Draft and Explanatory Memorandum of additional provisions governing the taxation of financial arrangements, generally referred to in the industry as “TOFA Stages 3 and 4.” This Tax Brief outlines the main impacts that the Exposure Draft legislation will have if it is enacted in something like its current form.
No-one would disagree that the TOFA project has been long and difficult. Treasury’s first public step along this journey was the Consultative Document released in 1993. A further Issues Paper was released in 1996, and the Review of Business Taxation revisited the territory in 1999. This decade of ongoing consultation, drafting and re-drafting led to the debt-equity legislation (2001), the foreign exchange legislation (2003) and now to TOFA 3 and 4.
It is probably fair to say that, while industry has been keen to see reform of this difficult area of tax law, it has been less enthusiastic about the legislation which has emerged so far. The legislation has not proved easy to grasp or apply. For example, the meaning of key concepts in the debt-equity legislation is still being hotly debated between Treasury, the Australian Taxation Office (“ATO”), taxpayers and their advisors, and industry groups have lobbied the Government for the 2003 foreign exchange legislation to be redone in its entirety. In this environment, the next tranche of TOFA legislation was awaited with some hope, but also some hesitation.
Despite the long history, and extensive consultation with industry and practitioners, the Exposure Draft legislation just released is still clearly a work in progress – the form in which it was released indicates that this is still tentative drafting. However, the bare bones of the provisions are now evident, and three things are apparent:
- the regime will have very extensive coverage, extending well beyond what might be thought of as “financial” arrangements. The possibility of the unexpected application of these provisions to common transactions must be considered high;
- the regime will be far less detailed than has been typical of tax legislation drafted in recent years. The Exposure Draft has been prepared in a style which the drafters refer to as “coherent principles” drafting. Whether this will prove to be an unwelcome source of uncertainty, or the mechanism that allows a degree of flexibility and reasonableness in a difficult area is still an open question; and
- the Government has partially accepted pleas for closer alignment of the tax rules to the accounting treatment of financial arrangements, although there will still be discrepancies even after the reforms are enacted.
Subject to one possibility discussed below, this legislation, when completed and enacted, will conclude the Government’s announced TOFA agenda. We make some comments at the end of this Tax Brief about the unrecognised unfinished agenda that the Government could now embark upon to achieve a more satisfactory conclusion to the TOFA project.
The Draft contains provisions covering the treatment of financial arrangements, including hedging rules. However, according to the Press Release accompanying the Exposure Draft, details about the treatment of synthetic financial arrangements, the commencement date, managing transition to the new regime and the interaction with the rest of the income tax law “are being developed.”
Exposure Draft Legislation
The Exposure Draft legislation involves 4 discrete tax measures:
- the basic, and mandatory, regime for taxing financial arrangements, either on a yield-to-maturity basis or a realisation basis;
- an optional regime which allows certain financial instruments to be taxed on a fair value (i.e., a mark-to-market) basis;
- an optional regime which allows certain foreign currency denominated positions to be taxed on a retranslation basis; and
- an optional hedging regime.
The impact of the TOFA measures, when they apply, is in general terms to regulate either or both of:
- the character of amounts arising under the financial arrangement;
- the timing of the recognition of amounts arising under the financial arrangement.
The rules do not generally differentiate between the position of the issuer and the holder of a financial arrangement, although, as we will see, there are a few exceptions created for small taxpayers who hold financial arrangements.
The principal elements of the basic scheme
The basic rules, which apply to anything that meets the definition of a “financial arrangement”, create two outcomes:
- character: they require a taxpayer to account for amounts arising under the financial arrangement as income or a deduction (and not as a capital gain or loss); and
- timing: they will sometimes require the taxpayer to record these amounts during the life of the arrangement, rather than at the end of the arrangement, and independent of cash flows occurring under the arrangement
- Financial arrangement
a) Financial arrangement
The basic definition is a right or obligation “to provide something of economic value in the future.” This definition is said to capture the “principle” of a financial instrument, although there is nothing in the definition which expressly or by implication limits it to transactions with a financial flavour. Rather, the definition describes an incomplete transaction or an ongoing transaction. Any transaction which does not involve the simultaneous exchange and settlement of all rights and obligations is potentially a financial transaction, or contains a financial transaction embedded within it. The Explanatory Memorandum says that the 2 key elements of a financial arrangement are,
“entry into an arrangement now, with performance in the future [and a] right … to receive or obligation … to provide something of economic value in the future …”
The Bill takes two ideas that are undoubtedly inherent to a financial arrangement, and makes them sufficient to amount to a financial arrangement.
This definition will cover the kind of transactions one would expect to be within the scope of a regime directed to financial arrangements:
- secured and unsecured loans at interest,
- discounted and similar securities such as bills of exchange, promissory notes and zero-coupon bonds; and
- futures contracts, forwards, swaps and options.
Because of the breadth of the definition, a range of exemptions is then specified in the legislation. The exceptions operate in two ways. Some arrangements are defined not to be financial arrangements within the scope of the regime:
- financial arrangements lasting less than 12 months where there is a non-monetary component to the transaction;
- financial arrangements held by individuals or small businesses lasting less than 12 months – the exception applies only for the benefit of the individual or business, not necessarily the issuer;
- financial arrangements held by individuals or small businesses where the actual return from the arrangement is close to the implied compound interest rate (i.e., there is no significant deferral) – again, the exception applies only for the benefit of the individual or business, not necessarily the issuer;
- equity interests such as shares (unless the taxpayer is able, and chooses to, bring them into the regime and accounts for them using the fair value methodology);
- some interests in partnerships and trusts;
- a life insurance policy;
- a contract involving personal services – it is not clear whether this covers only employment relationships or whether it also extends to independent contractors including services provided by entities such as corporations;
- restrictive covenants;
- rights to compensation for personal injuries; and
- leases that are within some of the existing regimes that already deal with leases.
Secondly, some arrangements which are within the scope of the regime will, nevertheless, still give rise to capital gains and losses. This is discussed in more detail below.
It is important to note that although most of these exceptions appear to be permanent – i.e., the exception applies to the financial arrangement throughout its life – some can apply for some years and not apply for others during the life of the arrangement.
One can only speculate how these rules will apply to a range of other arrangements to which, it seems, they currently apply, and where an express exception has not yet been drafted, or where there is an exception but it might not apply. Examples include:
- some guarantees and indemnities;
- general insurance policies;
- purchased “add-on” warranties with a term longer than 12 months;
- pre-paid vouchers for goods or services with an indefinite term;
- sales of goods or services with embedded warranties longer than 12 months;
- finance leasing arrangements that are not within the listed exception;
- operating leases;
- sales of goods or real estate with no interest and an extended period for settlement;
- sales of goods or real estate with immediate settlement where the price is payable by instalments without interest;
- long-term supply contracts for goods;
- technology licensing agreements;
- leases of real estate; and
- interests in superannuation funds, deceased estates and some other trusts.
All of these instances can fall within the current definition of a financial arrangement because the arrangements all involve rights and obligation that are ongoing. Whether a particular exception will apply will often depend on the specific features of the arrangement – e.g., if lasts more than 12 months, some of the exceptions will not apply. However, some embedded financial arrangements with a term longer than 12 months can be ignored where “a substantial proportion” of the economic value will be paid or received within 12 months.
New Zealand, which has a similar financial arrangements regime but starting from a narrower definition, has had to revisit its provisions frequently to create an extended shopping list of exceptions. Australia will undoubtedly have a similar experience.
(b) Characterisation of gains and losses
Where the taxpayer has a financial arrangement, all gains or losses made while holding it, from selling it or redeeming it are made assessable as income and allowable as deductions. In other words, a principal objective of this regime is to put most gains and losses from holding, trading or investing in financial arrangements on revenue account.
The taxpayer is only entitled to deduct a loss where the loss is made in earning assessable income or in carrying on a business for the purpose of producing assessable income. (This requirement replicates the current test for the deductibility of interest expense under existing law.)
A loss from a financial arrangement can also be deducted if it is made in earning foreign source non-assessable non-exempt income connected to a debt interest issued by the taxpayer. (Again, this requirement replicates the current test for the deductibility of interest expense under existing law.)
By contrast, a loss on a financial arrangement made in gaining exempt income or non-assessable non-exempt income is not deductible. And a loss of a private or domestic nature is also not deductible. It is not clear whether the taxpayer will be allowed to recognise a capital loss in these circumstances.
This re-characterisation rule changes the current test for discounted instruments in Division 16E of the Income Tax Assessment Act 1936 (“ITAA 1936”) which presently operates merely as a timing rule. Premiums or discount which represent capital risk will now give rise to assessable income and allowable deductions for those taxpayers who previously treated them as involving capital amounts.
This re-characterisation rule is potentially very significant for those transactions which contain an embedded “financial arrangement” by virtue of the expansive definition, and which are not within the scope of an exception. For example, under the proposed rules, the sale of a capital asset with delayed settlement would generate for the vendor both a capital gain (or loss) from the sale of the asset, and statutory income (or a deduction) from the financial arrangement. Indeed, it may even generate unexpected combinations of outcomes such as a capital loss and statutory income. This will be significant for taxpayers which might otherwise benefit from a capital gains tax exemption or enjoy discount capital gains – the amount that is capital gain will presumably be smaller, and there will be an unexpected amount of statutory income. On the other side, the buyer will also have to disaggregate the price paid under the transaction into the consideration paid for the asset and the amount paid under the financial arrangement. There will also be changes to the time of recognition of the amounts in question for the seller and buyer – the capital gains tax accounting rules will not apply to the amounts attributable to the financial arrangement.
This will clearly be a significant issue wherever there is an embedded financial arrangement in a larger transaction – for example, the sale of goods with a 5 year warranty. Some of the price paid and received in the transaction will be for the element that isn’t a financial arrangement – the sale of the goods – and the remainder will be for the financial arrangement. At present, the Commissioner of Taxation requires the vendor to treat the entire proceeds of sale as assessable in the year of sale, and does not allow the vendor to defer some of the price pending performance or expiry of the warranty. Treating some of the price received as related to the financial arrangement would allow some of the price to be deferred after the time of sale. In fact, the Explanatory Memorandum takes the view that the de minimis exception could apply in this situation, although that outcome clearly depends on the view that the value of the warranty does not represent a substantial proportion of the price.
Finally, despite the general rule, the Exposure Draft retains some instances where a financial arrangement will still give rise only to capital gains and losses:
- gains and losses arising from the sale of derivatives over underlyings which are deliverable, such as commodities;
- losses (only) that arise from disposing of an interest-bearing security other than in the ordinary course of trading, or where the issuer was considered to be insolvent. (This mirrors the current exception in s. 70B(4) ITAA 1936).
(c ) Timing: Tax treatment while holding a financial arrangement
Where the taxpayer has issued or holds a financial arrangement the taxpayer must identify how much of its gains or losses are to be recognised as income and deductions each year.
In this respect, the legislation makes the taxpayer’s position turn on whether there is a reasonable likelihood of gain or loss having regard to the terms and conditions of the arrangement. The Explanatory Memorandum describes the test in this way:
"In the case where the terms and conditions of a financial arrangement are such that there is a contractual commitment (obligation) to return, at a future point in time, an amount which is more than the initial outlay, and there are no downside contingencies attaching, then, in terms of probabilities, it is taken to be certain that a gain (to the investor) will be made."
It then gives examples of instruments where there is and is not a reasonable likelihood of gain or loss:
- it is not reasonably likely that a taxpayer will make a gain or loss from holding an ordinary share (note that this is in addition to the general provision which excludes most shares from being financial arrangements);
- it is not reasonably likely that a taxpayer will make a gain or loss from an investment where the return is linked to the price of an ordinary share;
- the Draft leaves it unclear whether a gain or loss is reasonably likely if the return from an investment is linked to the price of a parcel of ordinary shares – e.g., the return is linked to movements in the Share Price Index;
- it is not reasonably likely that a taxpayer will make a gain or loss from an option or forward contract over ordinary shares;
- it is reasonably likely that a taxpayer will make a gain or loss from a fixed interest rate bond;
- it is reasonably likely that a taxpayer will make a gain or loss from an instrument which gives rise to a debt interest under the debt-equity tests in Division 974 of the Income Tax Assessment Act 1997 (“ITAA 1997”); and
it is reasonably likely that a taxpayer will make a gain or loss from a bond which gives a return linked to movements in the Consumer Price Index.
This test of reasonable likelihood (unlike the current Division 16E ITAA 1936) is not determined at a single point in time (e.g., the date of issue). Rather, the taxpayer is required to revisit the issue each income year and to consider the matter even for a “part of the income year.”
1) Financial arrangements which involve a reasonable likelihood of gain or loss.
If there is a reasonable likelihood of gain or loss, the taxpayer must recognise a portion of the gain and loss during each year of the term of the financial arrangement.
In a radical departure from tradition, the computation of the amount of gain or loss in each year is not prescribed in the legislation. Instead, the taxpayer is told to work out the gain or loss on a compounding accruals basis on rests not exceeding 12 months, and can even use a “reasonable approximation” of this method. The difference from current drafting practice is striking. Other laws in this area, including the proposals of the Review of Business Taxation, have always been highly prescriptive of the methodology for calculating the amount of income or deduction – obvious examples being Division 16E ITAA 1936 and the foreign exchange rules in Divisions 775 and 960 ITAA 1997.
One consequence where there is a reasonable likelihood of gain or loss – for example, the taxpayer holds or has issued a fixed interest bond – is that the actual cash flows occurring under the financial arrangement (the interest payments and receipts) are ignored.
In computing the amount of gain for each year, the legislation requires taxpayers to “take into account … the concept of compound interest …”. There are passages in the Explanatory Memorandum, however, which permit taxpayers to use simple interest and time apportionment for short-term financial arrangements.
Where a taxpayer has issued a discounted instrument, the taxpayer must accrue both the real interest and any discount or premium. This contrasts, for example, with the current law in Division 16E ITAA 1936 which allows a taxpayer to record interest income and expense under the ordinary timing rules, and accrue any discount or premium as a separate tax event under specific statutory rules.
2) Financial arrangements which do not involve a reasonable likelihood of gain or loss.
Where there is no reasonable likelihood of gain or loss, the taxpayer recognises income and deductions on the realisation of gains or losses under the financial arrangement.
The Exposure Draft refers to realising a gain or loss in the income year and says this occurs when you “receive” an amount, “provide” an amount, or when “the time for you to do so occurs.” This drafting suggests that the amounts under this kind of financial arrangement will no longer be accounted for when income is “derived” or expense “incurred.” The new test renders irrelevant in this context much current law on the time of recognising income and deductions.
(d) Tax treatment from winding up, or dealing in, a financial arrangement
In addition to recognising amounts during the term of the financial arrangement, a taxpayer will be obliged to recognise income or a deduction when it sells or redeems a financial arrangement – i.e., a kind of balancing adjustment.
The taxpayer will need to compare amounts (if any) taken into account while it held the financial arrangement with the amount of its actual gain or loss, and then record any surplus or deficiency as statutory income or allowable deduction. Again, the regime removes the possibility that some gains or losses made on the expiry or sale of financial arrangements will be capital gains or losses.
The optional fair value regime
Certain taxpayers have an option to replace the basic scheme with fair value (i.e. mark to market) accounting for some of their financial arrangements.
The fair value election is intended only to be available to taxpayers whose accounts have to be, and are, audited under the Corporations Act 2001 or a comparable foreign law.
If the fair value election is made, it is irrevocable and will apply to each financial arrangement which:
- is reported in that set of audited financial statements. Just how this requirement will work for consolidated groups where there is only one taxpayer but perhaps several sets of accounts, some of which may be audited, is not entirely clear; and
- must be accounted for in the entity’s profit and loss on a fair value basis in accordance with the Australian accounting standard AASB 139 or comparable foreign standard. The election is universal – it extends to every financial arrangement in the audited accounts that is or should be accounted for in this way.
Where the taxpayer has made the election, the Exposure Draft has taken the step of aligning the amount of income or deduction to the amount reported in the financial statements. It says the taxpayer’s assessable gain or deductible loss is,
"the gain or loss that the accounting standards, or [foreign] standards, … requires you to recognise for the income year …"
Retranslation of foreign exchange
Taxpayers have a further option to replace the basic scheme with a retranslation regime for some of their financial arrangements. This regime will allow certain taxpayers to re-state the amount of foreign currency denominated loans and borrowings at their Australian dollar value adjusting for the movement in exchange rates during the year. (Other effects which would be taken into account under a full fair value approach, such as movements in interest rates or changes to the creditworthiness of the borrower, are not taken into account under the retranslation regime).
The retranslation election is intended only to be available to taxpayers whose accounts have to be, and are, audited under the Corporations Act 2001 or a comparable foreign law.
If the retranslation election is made, it is irrevocable and will apply to each financial arrangement which:
- is reported in that set of audited financial statements; and
- generates an amount that is recorded as profit or loss in accordance with the Australian accounting standard AASB 121 or comparable foreign standard. The election is universal – it extends to every financial arrangement in the audited accounts that is or should be accounted for in this way.
Again, where the taxpayer has made the retranslation election, the Exposure Draft has taken the step of aligning the amount of income or deduction to the amount reported in the financial statements. It says the taxpayer’s assessable gain or deductible loss is,
"equal to the amount in profit or loss [under the accounting standard] for the income year …"
The hedging regime
Taxpayers have a further option to enter a hedging regime for some or all of their financial arrangements that have been put in place to hedge the risk on an underlying position. The hedging regime affects the time at which a taxpayer will derive gain or loss from the hedging financial arrangement. It will be most useful in the common situation where the taxpayer cannot put in place a single hedge and must instead protect its position by a series of rolling hedges.
The hedging election is only available to taxpayers whose accounts have to be, and are, audited under the Corporations Act 2001 or a comparable foreign law.
The taxpayer can only make the election for a “derivative financial arrangement.” This is defined to mean a financial arrangement where the value of the arrangement changes in response to changes in another variable.
Those accounts must record the financial arrangement as a hedging arrangement.
The financial arrangement must also satisfy the requirements of the local or foreign accounting standards (currently AASB 139 in Australia) to be effective as a hedging arrangement. (If the accounting standards treat the hedging arrangement as only partially effective as a hedge, the tax hedging regime can be applied just to the effective part of the financial arrangement.)
There is also a requirement that the taxpayer prepare a detailed document which describes the hedging arrangement and identifies how the gains or losses from the hedging financial arrangement will emerge.
While these eligibility requirements mostly deal with matters of form, there are also additional substantive requirements that:
- the hedging arrangement put in place “must be expected to be highly effective in reducing your exposure to changes in the market value of the hedged item or cash flows …”;
- the market values of the hedging arrangement and the hedged position can both be measured reliably; and
- the taxpayer continually assess the effectiveness of the hedging arrangement in reducing exposure to risk.
The Commissioner does have some discretion to relax certain of these requirements.
The taxpayer can make the election with respect to each derivative financial arrangement that it enters, acquires or applies for the purpose of hedging risk in relation to an asset, liability, current or future transaction.
(c ) Effect
Where a hedging election has been made, the time of any gain or loss made from holding or realising the hedging financial arrangement may be shifted to another year of income.
As was noted above, at the time that the hedging financial arrangement is entered into, the taxpayer must prepare a document which records just how it proposes to disclose the gain or loss that will emerge from the hedging financial arrangement. The proposal must be “objective” and “correspond with the basis on which you allocate your gains and losses from the hedged item or items …” In other words, the record must show that the time at which the gain or loss on the hedging arrangement is made matches the expected gains or losses on the underlying position.
Where everything happens as expected, the amount of income or deduction from the hedging arrangement will be allocated in accordance with the written record, subject to 2 limitations:
- the gain or loss from the hedging arrangement must emerge within 20 years if there is only one hedged item; and
- the gain or loss from the hedging arrangement must emerge within 5 years if there is more than one hedged item.
However, there are a variety of situations where the amount of gain or loss can be triggered at different times.
The Exposure Draft creates two different systems. One applies if, during the year of income:
- the taxpayer ceases to hold the hedged item or items – e.g., it sells out early;
- it becomes likely that a proposed transaction for which the hedge was put in place will now not happen; or
- the 5 or 20 year time limit expires.
In each of these cases, the taxpayer must record an amount of gain or loss in that year. Because there may not have been an actual realisation of the hedging financial arrangement, the taxpayer is deemed to have sold the hedging financial arrangement for its market value and then re-acquired it. This has the twin effects that (a) the gain or loss on the hedging arrangement is deemed to be realised and (b) the taxpayer has a cost in the financial arrangement so that the ordinary TOFA rules can apply to the arrangement thereafter.
The other set of rules applies if during the income year:
- the taxpayer revokes the hedging treatment which it formerly chose; or
- the financial arrangement put in place no longer qualifies as a hedging financial arrangement.
In these cases, the taxpayer still records its gain or loss according to the treatment proposed in the written record.
Closer alignment of tax and financial accounting – the Commissioner’s discretionDuring the last 14 years of consultation on the TOFA project, the banking industry has been arguing for a direct linkage between tax and financial accounts, provided the accounts are prepared in accordance with appropriate accounting standards and are audited. The Government has moved some way toward this position in two of the regimes in the Exposure Draft: (a) the time and amount of income and deductions where a taxpayer uses fair value accounting, and (b) the time and amount of income and deductions where a taxpayer makes a retranslation election.
In addition, the Exposure Draft contains a further regime which approximates a qualified alignment. The regime will be of most interest to banks and other financial institutions because of the access requirements.
Where the regime applies, the amount of gain or loss arising from a financial arrangement may be the same as the amount disclosed in the taxpayer’s financial accounts, rather than the (erroneous) amount of income or deduction reported.
However, this position can only come about where a number of conditions are satisfied:
- the taxpayer’s accounts must be, and are, audited in accordance with the Corporations Act 2001 or comparable foreign law for the relevant year of income;
- the taxpayer has made a fair value election and a retranslation election for those accounts;
- the taxpayer has made a hedging financial arrangement election for all its hedging arrangements for the year;
- the Commissioner is satisfied that the amount of the divergence between the financial accounts and the taxpayer’s assessable income “is not substantial”; and
- the Commissioner considers that the way in which the taxpayer prepared its return is “appropriate.”
Clearly this is not formal alignment, but it is a measure which allows – perhaps even encourages – a degree of flexibility on the part of the Commissioner.
Choices and electionsAs explained above, the TOFA regime contains three elections that taxpayers may make:
- the fair value election for various financial arrangements;
- the election to retranslate certain foreign currency positions; and
- the election to adopt hedging treatment for a hedging financial arrangement.
(a) Entitlement to elect
The elections can only be made by a taxpayer whose accounts are required to be and are audited in compliance with either Australian law or foreign law.
(b) Coverage of each election
The fair value election applies to all financial arrangements disclosed in its financial accounts where, under the accounting standards, the taxpayer must use fair value accounting for that arrangement. It seems that a single election is envisaged and that it will apply to all financial arrangements shown in those accounts.
The foreign currency retranslation election applies to all financial arrangements disclosed in its financial accounts where, under the accounting standards, the taxpayer must use retranslation for that arrangement. It seems that a single election is envisaged and that it will apply to all financial arrangements shown in those accounts.
It is not clear whether the taxpayer must make a new fair value and foreign currency retranslation election each year, or whether the election is ambulatory in effect and picks up each new financial arrangement which meets the qualifications in succeeding years.
The hedging financial arrangement election is made separately for each arrangement in a year. It seems unlikely, however, that this election is ambulatory in effect and so a new election might have to be made for each hedging financial arrangement in each succeeding year – the intended policy is not clear.
(c ) Time for making the election
The current drafting would seem to allow the election to be made at any time during the year of income, but not, for example, at the time that the taxpayer prepares and files its income tax return. Again, the intended policy is not clear.
(d) Manner of making and recording the election
There no rules yet about how the taxpayer indicates that it has made the fair value election or the foreign currency retranslation election. It may be that the taxpayer’s return will be treated as the evidence that the election was made.
The hedging regime contains specific and detailed requirements about the documentary evidence which must be generated recording that the arrangement is a hedging financial arrangement. Meeting these rules appears to be a precondition to effective access to the regime.
(e) Revocation of an election
Both the fair value and foreign currency retranslation elections are said to be irrevocable for the arrangements to which they apply. It seems, therefore, that a taxpayer cannot revert to the basic scheme for future years once it has elected fair value treatment for these financial arrangements shown in a set of financial accounts.
While both elections are said to be irrevocable, it is not entirely clear what this means. It seems clear that the position taken in the accounts will continue to apply while the taxpayer holds the financial arrangement. If the taxpayer must make a new election each year, then perhaps the taxpayer can in effect “revoke” the election by not electing again, but this will be effective only for new financial arrangement entered in succeeding years.
The hedging financial arrangement election is also said to be irrevocable, although there must be some doubt about what this means given that tax consequences are triggered when the taxpayer “revokes a hedging designation.”
Repeals and interactions
Part of the evidence that the Exposure Draft is still very much a work in progress can be seen in the list of issues that the legislation will need to, but doesn’t yet, address. Two important questions about which we still have no indications are:
- which of the multitude of existing provisions in the legislation that already deal with financial arrangements will be repealed as a result of the Exposure Draft; and
- for those provisions that remain, how will overlaps and inconsistencies be reconciled?
The Tax Acts currently contain provisions dealing with traditional securities (s. 26BB, s. 70B ITAA 1936), discounted securities (Division 16E ITAA 1936), various kinds of leasing arrangements (Division 16D ITAA 1936, Schedule 2E ITAA 1936, Division 240 ITAA 1997), hire purchase arrangements (Division 240 ITAA 1997), instalment sales (Division 240 ITAA 1997), and securities lending (s. 26BC ITAA 1936). Some of these regimes could be removed in light of the new regime, but it is not clear which ones will survive. Clearly, some will need to survive to deal with transactions that fall outside the proposed definition of financial arrangement because of the various exceptions to the definition.
Further, given that some if not all of the existing regimes will survive, the legislation will then need ordering rules to identify whether the new financial arrangements regime is an exhaustive regime, the primary provision with others still operating as a fall-back, or the fall-back regime when others do not appear to operate. A provision in the current Exposure Draft makes this regime an exclusive regime where it operates, but that masks the problem – if an arrangement would be taxed only at its expiry under these rules, does that offer immunity from the operation of other provisions in years prior to its expiry?
Transition to the new regime
Other evidence that the Exposure Draft is still very much a work in progress can be seen in the lack of any indication about how the transition to the new rules will be managed.
In 1999, the Review of Business Taxation proposed an option to bring existing financial arrangements into the new regime, but it is not clear whether this will be permitted under the Exposure Draft.
This legislation will clearly have wide impact when it is finalised, and so it is important to use this window of opportunity to make submissions to Treasury on the text of the Bill. Taxpayers have until 1 March 2006 to make their submissions.
We will be available to prepare or assist in the preparation of submissions and representations to Treasury on these difficult matters.
Some observations on the TOFA project
The evolution of TOFA policy
We noted above that this legislation appears to conclude the Government’s announced agenda on TOFA.
The last occasion that TOFA policy was comprehensively addressed was in the report of the Review of Business Taxation in 1999. It is clear that most of the recommendations of the Review of Business Taxation have now been acted upon, albeit with some modifications to elements of the policies that were originally announced.
Optional mark to market regime for financial arrangements
Included in Exposure Draft
Financial arrangements usually to be taxed using compounding accruals methodology
Included in Exposure Draft
Financial arrangements with uncertain returns to be taxed on realisation
Included in Exposure Draft
Option to use retranslation for foreign currency financial arrangements
Included in Exposure Draft
Taxpayers be allowed to use internal hedges
Appears to be abandoned
More extensive hedging regime included in Exposure Draft
Various transactions to be treated as equivalent to (and as not equivalent to) disposal, triggering tax adjustments
Included (albeit by implication) in Exposure Draft
Stripping interest or principal coupons to be treated as equivalent to disposal
Included (albeit by implication) in Exposure Draft
Wash sales and straddles (synthetic disposals) to be treated as equivalent to disposal
Status uncertain – according to the Press Release, rules are still “being developed.”
Transition to new financial arrangements rules to be prospective
Details of transitional arrangements yet to be announced
Option to include existing financial arrangements rules in new regime
Details of transitional arrangements yet to be announced
Material alteration to an existing financial arrangement after new regime commences will bring financial arrangement into new rules
Details of transitional arrangements yet to be announced
While the detail of some of the policies announced in the Review of Business Taxation has been modified in the 6 years since its Report was released, only the status of potential rules dealing with synthetic sales remain unclear.
We mentioned above that the Government should now consider other aspects of the TOFA project to achieve a more satisfactory conclusion to this work.
Two particular issues deserve mention.
First, even if the hedging regime in the Exposure Draft is enacted in full, it does not address character mismatching issues, only time mismatching issues. The Exposure Draft makes it quite clear that the proposed hedging regime is a “tax-timing hedging” regime only. A character matching problem would arise, for example, where the taxpayer has a primary position involving a capital asset or liability and has hedged that position with a derivative. While the hedging regime in the Exposure Draft will often allow the time for recognition of gain or loss on the derivative to be matched to the time of recognising loss or gain on the “underlying,” it does not deal with the fact that the character of the two items differs – the gain or loss on the primary position is on capital account, but the TOFA rules invariably make the loss or gain on the derivative position on revenue account. The same problem exists with the foreign exchange regime in Division 775 ITAA 1997.
Further, the banking industry has been arguing for some time that an election allowing direct alignment of tax results to financial accounting treatment in this area is both desirable and feasible, without challenging the integrity of the tax system. In the Press Release which accompanied the Exposure Draft legislation the Assistant Treasurer, Mr Brough said he was aware of this view and would welcome comments on the draft legislation. One can only assume his invitation extends to this aspect of the Exposure Draft legislation as well.
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