Further TOFA Developments
Our Tax Brief of 24 January 2007 (available at http://www.gf.com.au/477_524.htm) outlined the second Exposure Draft for the remaining stages of the taxation of financial arrangements (“TOFA”) reforms. In late May, Treasury released two further pieces of the TOFA jigsaw:
- details of the amendments that will be made to existing tax regimes in light of the introduction of TOFA; and
- proposed measures to address so-called “synthetic” financial arrangements.
This Tax Brief outlines the effects of these two developments.
The material released by Treasury in May does not contain any responses to the various submissions which were lodged on the January Exposure Draft.
1. Amendments to existing law
Current law already contains provisions dealing with many of the instruments and transactions to which TOFA will now apply: existing provisions address interest income and expense, bad debts, borrowing expenses, prepayments, debt forgiveness, annuities, traditional securities, discounted securities, leasing arrangements of various kinds, hire purchase, instalment sales, foreign exchange gains and losses, convertible instruments, and securities lending to name a few. Exactly what happens to these rules once TOFA is enacted is a difficult question; the January Exposure Draft contained some rules but the difficult questions were relegated to the accompanying Consultation Paper which offered a few tentative indications of the possible adjustments that would have to be made to current law in light of TOFA.
Some interactions could be inferred from the January draft. The TOFA regime is not universal, which means that many transactions will remain governed by existing law without any competition from a TOFA rule. The kinds of transactions which would stay outside the TOFA regime would arise in three different ways:
- Many financial transactions will not be “financial arrangements” as defined. For these transactions existing law obviously remains unaffected.
- Some short and long-term transactions which are financial arrangements will nevertheless be outside TOFA if they are held by individuals and small businesses. For these transactions existing law continues unaffected.
- Finally, special provisions within TOFA give priority to the existing regimes for luxury car leasing, hire purchase, equipment leasing and real estate rental arrangements.
The further measures released in May propose a series of adjustments to existing regimes where overlaps and inconsistencies with existing law are considered a problem. Ten pages of new rules propose specially-tailored and highly technical amendments to the rules dealing with, inter alia, pre-payments, scrip lending, short-term assignments of income streams, trading stock, capital gains, foreign exchange gains and losses, thin capitalisation, the debt-equity distinction and the calculation of pay-as-you-go instalments.
An issue which will be of particular interest and possible concern to the banking and finance sector is the proposal to “switch on” the forex tax regime (in Division 775) for banks and bank-like entities. These taxpayers have been specifically exempted from the highly complex forex regime since it was introduced in 2003. The new TOFA regime should generally override the forex regime, at least in most situations. However, it is not yet clear exactly what residual transactions may be subject only to the forex rules and not to the TOFA regime.
2. Synthetic arrangements
The final report of the Review of Business in 1999 (the Ralph Committee) proposed that some measures, including challenges under the general anti-avoidance rule, be developed to address so-called synthetic arrangements. A variety of situations were identified in the report:
- arrangements by which a loss was realised without an effective disposal of the underlying investment;
- arrangements by which no gain was recognised, even though there had been an effective disposal of the underlying investment;
- arrangements by which fixed returns from an investment were exchanged for a variable return (and vice versa) without disposing of the income-generating asset; and
- arrangements arising from multiple instruments with offsetting commercial effects that could be selectively realised.
It was expected that arrangements like debt defeasance arrangements, put-and-call options over assets, equity swaps, property swaps, interest rate and currency swaps, wash sales, straddle positions and a range of other transactions might all be affected by these rules. Unfortunately, the detail of the precise scope and the intended outcomes of the new measures was not elaborated in the report.
The proposal released in May provides some more detail. It does not deal with the various instruments by name but rather by generic descriptions and so, without the assistance of any explanatory material or examples, the intended scope is often still more than a little obscure. The proposal outlines three distinct situations:
- One set of rules is designed to trigger a deemed disposal of part of a specified type of financial arrangement. In general terms, it applies if the taxpayer enters into an arrangement for a term of more than 12 months, that is intended, and has the effect of removing all or most of the risks and benefits associated with part of the financial arrangement. This regime is, presumably, intended to apply to instruments such as debt defeasance arrangements, certain forwards and swaps, and to sold put and call options over an asset. Where the regime applies, the taxpayer is treated as having sold the affected rights and to have re-acquired them at their market value. The effect is to trigger a gain for the purposes of the TOFA rules. That is, any unrealised but “locked in” gain will be brought to tax. Interestingly, for the purposes of this rule (and the second set noted below) only certain financial arrangements are affected, and not all assets and liabilities. It appears that the rules may not apply, at least in many cases, to shares, other equity interests and real property transactions.
- A second set of rules, which broadly mirror the first, is designed to reverse the effect of triggering a loss from an actual disposal of part of a financial arrangement. In general terms, it applies if the taxpayer enters into an arrangement that would be a disposal, but the taxpayer is not relieved of all or most of the risks and benefits of the financial arrangement. This regime is, presumably, intended to apply to instruments such as wash sales and advancing forex losses on foreign currency borrowings, although the Ralph Committee report suggested, and subsequent case law has confirmed, that wash sales are susceptible to attack under the general anti-avoidance rule. Where the regime applies, the taxpayer is not entitled to deduct its loss on the actual disposal (and one is left wondering what happens next – there appears to be an omission from the drafting in this regard).
- The third set of rules have a different focus. They are designed to reverse the effect of swapping an uncertain return (that would not be subject to accrual under the TOFA rules) for a certain return (which would be subject to accrual under the TOFA rules). In general terms, they apply if the taxpayer enters into a supplementary arrangement for a term of more than 12 months, that is intended, and has the effect of providing the taxpayer with a certain return when the two arrangements are combined. This regime is, presumably, intended to apply to instruments such as certain swap and forward transactions. Where the regime applies, the taxpayer is required to apply the accrual methodology to its combined arrangement.
The final report of the Ralph Committee had suggested that certain aspects of the “anti-synthetics” rules would be handled by amendments to the general anti-avoidance rule in Part IVA. This is not now contemplated. Rather, there are a series of new, specific anti-avoidance rules. Of concern is the fact that the new rules have a purpose test which is based on a purpose other than an incidental purpose, rather than the “sole or dominant” purpose test which is generally used in Part IVA.
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