Revised financial arrangements tax measures released
On 3 January 2007, the Assistant Treasurer released a second Exposure Draft and Explanatory Memorandum (“2007 ED”) of the Taxation of Financial Arrangements (“TOFA”) legislation, generally referred to as “TOFA Stages 3 and 4.” The 2007 ED now addresses some of the issues raised during the extensive consultations that occurred in the year since the first Exposure Draft (“2005 ED”) was released in December 2005. (Details of 2005 ED are on our website http://www.gf.com.au/477_454.htm.) The 2007 ED was accompanied by a separate Consultation Paper on the interaction of the TOFA regime with current law.
This Tax Brief gives an overview of the key changes in the 2007 ED – we will be circulating a more considered Tax Brief later which examines the 2007 ED in detail.
The TOFA package comprises a bundle of 4 tax measures:
1. the basic, and mandatory, regime for taxing financial arrangements, either on a yield-to-maturity basis or a realisation basis;
2. an optional regime which allows certain financial instruments to be taxed on a mark-to-market basis;
3. an optional regime which allows certain foreign currency denominated positions to be taxed on a retranslation basis; and
4. an optional hedging regime which now extends to character matching, as well as timing matching.
But the 2007 ED is still not the complete package of TOFA measures. The 2007 ED does not yet contain:
1. the promised regime for addressing synthetic arrangements; and
2. details of the means for dealing with all of the overlaps and interactions with existing tax law covering similar territory.
1. Key changes from 2005 ED
Changed scope of TOFA regime. There has been some narrowing to the scope of the legislation. The regime applies to rights to receive (and obligations to pay) a financial benefit that has a monetary nature or that may be settled in money.
While there has been some narrowing, the legislation still remains comprehensive, extending beyond ordinary financial arrangements, necessitating a detailed list of exclusions. Among the exceptions are most shares, short term trade credit, various leasing arrangements, insurance, guarantees and indemnities, interests in superannuation funds and controlled foreign companies, and many financial arrangements of individuals and small businesses.
The 2007 ED also now extends the TOFA rules to foreign currency, shares that are re-classified as debt under the debt-equity rules and commodities held by traders.
Unfortunately, deciding whether an arrangement is a financial arrangement will not be a once-only decision. The 2007 ED makes it clear that transactions can become financial arrangements after they have been issued.
The demarcation between compounding accrual and realisation. The 2007 ED requires all financial arrangements to be taxed either by a compounding accrual method during the life of the arrangement, or upon realisation (unless one of the other regimes has been elected). The demarcation between arrangements subject to compounding accrual and those taxed at realisation will depend upon whether the return on the arrangement is “sufficiently certain,” meaning that there is a non-contingent entitlement to the amount and it is “fixed or determinable with reasonable accuracy.” This new formulation is regarded as a substantially clearer than the 2005 ED which made the distinction turn upon whether the arrangement involved a reasonable likelihood of gain or loss.
Compounding accruals calculation. The 2007 ED now contains some additional detail for calculating the amount of gain from holding a financial arrangement in each income year. Unless one of the other regimes has been elected, if the gain is sufficiently certain, the taxpayer must calculate its position using a compounding accrual calculation or a reasonable approximation of it. Unlike the current regime for qualifying securities, the details of calculating the compounding accrual amounts are not prescribed in the 2007 ED although the Explanatory Memorandum says it is “intended to reflect commercial accounting concepts.”
Character hedging. The 2007 ED retains the optional tax timing hedging regime proposed in the 2005 ED. The big news is the addition of a tax character hedging regime. While the timing hedging regime in the 2005 ED matched the recognition of gain or loss on a derivative to the time of recognising loss or gain on the “underlying,” it did not deal with the fact that the character of the two items could differ – the gain or loss on the primary position could be capital, but the TOFA rules would invariably make the loss or gain on the derivative position on revenue account. The 2007 ED proposes a “tax status hedging” regime. There are detailed pre-conditions and record keeping requirements limiting access to this election, and the Assistant Treasurer has said the Government will carefully monitor compliance with the regime to ensure it is not being used inappropriately.
Use of audited accounts. One of the common themes in the submissions made during the consultation on the 2005 ED was that certain taxpayers should be able to rely upon their audited accounts in reporting the tax consequences of their financial arrangements, instead of the legislated TOFA systems. The 2005 ED had proposed a curious compromise – that the Commissioner could accept the amounts shown in the taxpayer’s accounts if the taxpayer had made certain elections and the difference was insubstantial. The 2007 ED has gone to the next step: it allows certain taxpayers to make an irrevocable and universal election to report the amounts shown in their audited and unqualified financial accounts as the amount of gain or loss from their financial arrangements. There are, however, requirements that the amount of gain or loss appearing in the audited accounts must be the same as the amount determined under the TOFA methodology, and that any difference from a TOFA methodology is not substantial, both of which will tend to limit the usefulness of this election. (This formal alignment does not extend to hedges; the taxpayer must still comply with the stipulated TOFA rules in respect of hedging transactions.)
Commencement and transition. The 2007 ED proposes that the TOFA regime will apply to financial arrangements issued (or acquired) in years of income commencing on or after 1 July 2008, although taxpayers may elect to accelerate this date – to have the TOFA regime apply to financial arrangements issued (or acquired) in years of income commencing on or after 1 July 2007. There is also a separate election allowing taxpayers to bring existing financial arrangements (held at either commencement date) into the new system.
2. Unfinished agenda
Synthetic arrangements. The Assistant Treasurer’s Press Release accompanying the 2007 ED says that the final version of the legislation “will contain rules to address the tax treatment of synthetic financial arrangements.” Those rules have not yet been released.
Amendments to existing regimes. The 2007 ED was accompanied by a separate Consultation Paper on the interaction of the TOFA regime with current law. The Tax Acts currently contain provisions dealing with traditional securities, discounted securities, various kinds of leasing arrangements, hire purchase arrangements, instalment sales, and securities lending. The Consultation Paper gives some initial indications about how these and other overlaps and interactions with existing tax law might eventually be managed.
The 2007 ED has been released to solicit further submissions. The closing date for submissions is 28 February 2007.
For further information, please contact,
61 2 9225 5982
61 2 9225 5915
61 2 9225 5984