Tax Brief - TOFA - another announcement - another delay

The morass that is TOFA – the Taxation of Financial Arrangements – continues its descent into farce.  The 13 year gestation of this collection of disparate measures has been prolonged even further by an announcement from the new Assistant Treasurer, Mr Mal Brough, on 5 August 2004 (the “Announcement”). 

The Announcement:

• revises current proposals,
• proposes numerous (mostly welcome) amendments to recently-enacted legislation, and
• delays the implementation of the remaining stages of TOFA. 

Whether any of us will live long enough to see the full TOFA package completed looks unlikely.  Indeed, given the highly complex and over-engineered rules in the forex regime, many taxpayers may in fact be hoping that they have seen the last of TOFA.  Such taxpayers are likely to be disappointed.  It seems certain that more TOFA is coming: the challenge for the Government, aided by Treasury and the ATO, is to ensure that the remaining measures, which in fact represent the major component of the whole “TOFA package”, especially from the perspective of the banking industry, are drafted in a more user-friendly manner than the forex rules.

The measures loosely referred to as TOFA deal with three broad areas of tax law:

• the debt-equity distinction,
• the treatment of foreign exchange gains and losses, and
• the creation of a coherent tax regime to deal with a wide range of debt and financial derivative transactions, including some, very limited, rules dealing with hedging.

The TOFA saga began in 1991 with an initial two day meeting of interested parties, which was followed in 1992 by the first formal announcement of TOFA by the then (Labor) Government. A ‘Consultative Document’ was released in 1993, followed in 1996 by an ‘Issues Paper’ and the final report of the Ralph Committee in 1999. There were wild variations in the approaches and recommendations to TOFA contained in these various documents.

The legislation which has emerged so far was the debt-equity measures (2001) and the foreign exchange and currency translation rules (2003).  No legislation has yet been released to deal with debt and derivative transactions.

Not only was the consultation on the measures a prolonged ordeal, the execution of them has proved to be fraught with difficulties:

• The Government has repeatedly deferred the application of the debt-equity measures to at-call loans, especially in the small businesses sector – the first version of the legislation abandoned any application until 1 January 2003 (May 2001), the moratorium was later extended to 30 June 2004 (December 2002), Treasury issued a Discussion Paper revisiting the measures (April 2004), and a further extension of the moratorium until 30 June 2005 has now been announced (May 2004).
  
• The Government has also had to revisit the application of the debt-equity measures to banks.  The Government has announced that perpetual subordinated debt issued by banks would be classified as debt but has yet to introduce the necessary regulations (March 2003).
  
• The foreign exchange legislation, when finally introduced into Parliament, contained a specific exception from the entire measures for banks, substantially narrowing the scope of application of the legislation.
  
• The Government has repeatedly deferred the start of the remaining component of the TOFA regime after it was endorsed in September 1999 in the Report of the Ralph Committee:  first the Government announced that none of the TOFA measures would start before 1 July 2002 (March 2001); the Government then announced the deferral of the hedging measures to 1 July 2003 (May 2002);  they then announced another delay, this time to a date yet to be determined (November 2003).
  
• In a Treasury Paper (December 2003), the Government grappled with the problems caused for the consolidation regime by the various elections that individual members might have made for the forex regime prior to forming the consolidated group.  No legislation has yet emerged to announce the preferred conceptual position.

Mr Brough’s Announcement, and the more detailed 17 page Treasury paper which accompanies it, continue this procrastination in relation to the remaining elements of TOFA, although there are many welcome, if overdue, amendments to the existing measures.  There are three main elements to the Announcement:

• amendments to the recently enacted foreign exchange measures;
• changes to the debt-equity rules; and
• further deferral of other TOFA measures.

Forex amendments

The recently-enacted foreign exchange provisions (see our Tax Briefs dated 2 December and 19 December 2003) will be amended, with many amendments backdated to 1 July 2003.  For the most part, the proposed amendments will relieve taxpayers from some of the strictures of the provisions.  This relaxation is welcome – it is evident that, even with the explicit carve-out for banks, the accounting systems of many companies are simply unable to comply with the requirements of these rules.

The Announcement proposes to address a number of technical difficulties in the forex legislation and to modify some of the compliance requirements.  Among the most important proposals are:

• The exemption from the forex measures for banks will be extended to the entire consolidated group where a consolidated group has a bank as a subsidiary member, or the group includes a banking division.  (The extended exemption will still not apply to in-house finance subsidiaries.)
  
• Regulations, to be effective from 1 July 2003, will be developed to allow taxpayers to use foreign exchange rates and conversion methodologies which differ from those currently prescribed.  One purpose of the Announcement is to allow many taxpayers to continue to use rates and methods that were previously allowed under Taxation Ruling IT 2498 and to use the same exchange rates for tax and financial accounting purposes. The regulations will allow the use of average rates, including a weighted average approach.
  
• The ‘retranslation’ rules as currently enacted allow taxpayers to calculate their foreign exchange gains and losses annually under a slightly simplified methodology.  The concession is, however, limited only to accounts maintained with an approved deposit-taking institution.  The Announcement will extend this measure to, as yet unspecified, “other types of accounts”.
  
• The Act will be amended to align the forex rules with the tax base rules for convertible notes and other so-called ‘exchangeable interests.’  No capital gain or loss will usually arise from the conversion or exchange of these instruments.  Unfortunately, forex gains and losses can arise under current law.  Hence, the Announcement proposes that any forex gain or loss will be deferred until the final disposal of the share or other instrument into which the original instrument was converted or for which it was exchanged.
  
• The Act will be amended to clarify that bank accounts that existed at 1 July 2003 remain outside the forex regime unless the taxpayer makes an election to have the new rules apply.  That election will be irrevocable.

Other proposed forex amendments include the following:

• The current roll-over relief rules for loan agreements denominated in a single foreign currency will be extended to multi-currency facilities.
  
• New entities arising in the future (and not just those that came into existence within 90 days of the new regime) will be able to elect-out of the “short-term” forex realisation gain and loss rules.  The Announcement does not say just how long they will have after formation to make the election.
  
• Individual taxpayers will, in certain situations, now be deemed to be subject to the “limited balance” account rules.  These rules ignore forex gains and losses in defined situations, even if the relevant election was not made. Somewhat unreasonably, the backdating of this measure to 1 July 2003 may deny some (very prescient) individuals a deduction for realised forex losses already claimed.
  
• The accrued gain or loss on a qualifying account will now be recognised when an election is made to use the retranslation method – the rules as initially enacted were deficient in this regard.

A large number of other technical amendments to the forex regime are also proposed by the Announcement, including changes to the rules applying to exempt and non-assessable non-exempt forex gains and losses.

Debt-equity revisions

The Announcement revisits the application of the debt-equity measures to perpetual subordinated debt instruments issued by financial institutions.  The Announcement proposes:

• The regulation proposed in May 2003 for so-called “Upper Tier 2 capital instruments” issued by banks, will now extend to similar instruments issued by non-mutual building societies. The purpose of the regulation, which will have retrospective effect to 1 July 2001, is to ensure that qualifying transactions are treated as debt rather than as equity for tax purposes.
  
• Transitional measures, which preserved the treatment of “Upper Tier 2 capital instruments” on foot at 1 July 2001, will be extended to 1 July 2005 so that banks and building societies will have further time to adjust to any re-classification arising from the eventual promulgation of the regulation.

The Announcement also proposes to address a number of technical difficulties surrounding the debt-equity measures, many of them back-dated to 1 July 2001!  Again, many of the measures rectify technical deficiencies in the legislation.  Among the most important proposals are:

• The Announcement proposes removing the possibility that the issue of a non-equity share, such as a redeemable preference share that is treated as a debt interest for tax purposes, will give rise to a capital gain. This measure will be backdated to 1 July 2001.
  
• Payments of “non-share dividends” to non-residents will attract a withholding obligation, in a similar manner to traditional dividends. A non-share dividend is an income distribution on an equity interest in a company that is not a share, i.e. a non-share equity interest. Contentiously, this measure is also to be backdated to 1 July 2001. Backdating this measure may cause significant problems for Australian issuers of such instruments.
  
• Amendments will be made to cure some of the problems with the “non-share capital account” that companies are required to maintain for the purposes of these rules.

Again, there are more (and even more technical) amendments proposed.

Further deferrals

The last part of the Announcement foreshadows that the commencement of the remaining TOFA measures will be deferred from 1 July 2004 – a date that had already passed at the date of the Announcement. The Announcement states that such measures “will not commence prior to 1 January 2005”, although it is not at all clear when they will actually start.

The reason given for the delay is the need to co-ordinate TOFA with the commencement of the accounting standard on financial instruments: AASB 139 Financial Instruments: Recognition and Measurement.  The Announcement states that “appropriate”, but it appears not complete, alignment between the tax and accounting rules for financial transactions has the potential to provide substantial compliance and administrative benefits. 

According to the Announcement, the remaining measures which will be developed under the TOFA label include:

• revisions to the timing rules for financial instruments (currently enacted as Division 16E of the 1936 Act);
• a commodity hedging regime; and
• some measures termed “accruals/realisation, market value and retranslation rules.”

It is important to note that the remaining, now deferred, measures of TOFA are not just “left overs”. Among other matters, this part of the package will (hopefully) provide the first coherent set of Australian tax rules to deal with financial derivatives such as interest rate and currency swaps, including an election, eagerly sought by the banking industry, to allow the use of a mark-to-market methodology for tax purposes.

Ironically, it is this unfinished element of TOFA that was the main impetus for the banking industry to lobby for the introduction of TOFA in 1991. 

It is disappointing that the Announcement holds out no hope for any extension of rules to achieve an effective after-tax matching between losses and gains on a primary transaction and gains or losses made on related funding and or hedging transactions. Under current law, including the new forex regime, it is common for both “character” (revenue vs. capital vs. exempt) and timing mismatches to arise – that is, the tax treatment of the primary transaction and the related funding/hedging transaction are not brought into alignment.

The remaining stage of TOFA proposes only limited hedging rules to deal with timing mismatches arising on commodity hedges, and will apparently not comprehensively address the tax treatment of hedging transactions.

For further information, please contact,

Tony Frost
61 2 9225 5982
tony.frost@gf.com.au
www.gf.com.au