Bills Digest No. 51 2003-04
New Business Tax System (Taxation of Financial
Arrangements) Bill (No. 1)
2003
WARNING:
This Digest was prepared for debate. It reflects the legislation as
introduced and does not canvass subsequent amendments. This Digest
does not have any official legal status. Other sources should be
consulted to determine the subsequent official status of the
Bill.
CONTENTS
Passage History
Purpose and Commencement
Background
Main Provisions
Concluding Comments
Endnotes
Contact Officer & Copyright Details
Passage History
New
Business Tax System (Taxation of Financial
Arrangements) Bill (No. 1)
2003
Date Introduced:
29 May 2003
House: House of Representatives
Portfolio: Treasury
Purpose and Commencement
The bill proposes to remove the taxing point
at conversion or exchange of certain financial instruments. These
amendments will apply to the disposal or redemption of a
traditional security if the traditional security was issued after
7.30 pm, by legal time in the Australian Capital Territory, on 14
May 2002.
This bill also
includes measures to address a number of uncertainties and
anomalies relating to the tax treatment of foreign currency. These
amendments apply to:
all foreign currency gains and losses on transactions entered into
in or after the first income year commencing on or after 1 July
2003, and
at the option of the taxpayer, foreign currency gains and losses on
transactions entered into prior to the first income year commencing
after 1 July 2003 but realised after that time.
The A
Tax System Redesigned, (1)which was a report by a
committee chaired by Mr John
Ralph following a review of business taxation
in Australia (Ralph Review) included recommendations for the reform
of the taxation of financial arrangements (TOFA).
The Ralph Review accepted under Recommendation
9.7(a) that the disposal principle should determine the taxing
point. In other words, when a taxpayer ceases to hold a financial
asset or be subject to a financial liability whether by sale,
transfer, exchange, maturity or other alienation in whole or in
part there should be an adjustment for tax purposes. However, the
Review did accept that there should be certain exclusions to the
disposal principle. One of the exceptions to the disposal principle
recommended by the Ralph Review in Recommendation 9.7 (b) (i) was
when there is a conversion of a convertible or converting
instrument into shares. Such a conversion may create a potential
cash flow problem for the holder of the convertible or converting
instrument if the tax on any capital gains had to be paid.
The reasons for this recommendation were set
out in the Ralph Review as follows:
Taxing converting and convertible instruments on
conversion could create potential cash flow difficulties arising
from a gain on conversion being in the form of shares rather than
cash. Moreover, the point of conversion is not a taxing point in
the United States, Canada or the United Kingdom. Against these
considerations, the Review considers that the conversion of
converting and convertible instruments should not be a taxing point
for the holder.(2)
In announcing the second stage of the
Government s response to the recommendations of the Ralph Review on
12 November
1999(3), the Treasurer stated that a number of
important international issues will be subject to further review,
including a comprehensive review of the foreign source income
rules, and the redrafting and redesigning of the international tax
legislation. The Treasurer also announced that the Government will
be establishing a non-statutory Board of Taxation for a more
integrated and consultative approach to business tax.
The removal of the taxing point on conversion
or exchange of certain securities was announced by the Minister for
Revenue and Assistant Treasurer in a
press release of 14 May 2002 titled Maintaining the
Momentum of Business Tax Reform. The relevant extracts from that
Press Release are set out below for ease of reference.
Taxation of Financial Arrangements
The remaining reforms to the taxation of
financial arrangements (TOFA) will be implemented in stages over
the next 2 years (debt/equity reforms came into effect on 1 July
2001). These reforms were recommended by the Review of Business
Taxation and have previously received in-principle support from the
Government. The TOFA reforms are designed to remove anomalies,
distortions and gaps in existing laws, facilitate desirable
financial innovation, improve risk management and enhance the
efficient operation and competitiveness of Australia's business
sector.
The next stage of the TOFA reforms will
involve revamping the taxation laws relating to foreign currency
gains and losses. This will cover the resolution of tensions and
uncertainties within the existing law and will include implementing
recommendations included in the Review of Business Taxation.
Further consultations will be held over coming months (including
exposure draft legislation) with a view to introducing legislation
in the Spring Sittings.
Removal of Taxing Point at Conversion or Exchange of Certain
Financial Instruments
Under the current tax law, the point of
conversion or exchange of certain financial instruments represents
a taxing point for income tax purposes. This taxing point is to be
removed from the taxation law and will apply to traditional
securities that are issued after 7.30 pm EST 14 May 2002.
Relevant financial instruments issued before this announcement will
continue to be subject to the current tax law.
The effect of this announcement will be that
an investor who holds a relevant financial instrument through
conversion or exchange will not be subject to tax until it is
ultimately sold. Furthermore, where the gain or loss on disposal is
of a capital nature, the investor will be able to qualify for
capital gains treatment for the period before, and after,
conversion or exchange.
This proposal was announced by the Minister
for Revenue and Assistant Treasurer on 14 May 2002. An
exposure draft covering both proposals was released for public
comment on 17 December 2002.
Referring to the proposal for the removal of
uncertainties and anomalies on the tax treatment of foreign
currency, the Minister for Revenue and Assistant Treasurer stated
as follows in a
press release of 17 December 2002.
Taxation measures addressing foreign currency
gains and losses are the second stage of reforms to the taxation of
financial arrangements (TOFA) recommended by the Ralph report of
the Review of Business Taxation. The first stage, dealing with
reforms to the borderline between debt and equity for taxation
purposes, was implemented in July 2001.
"These reforms remove uncertainties and anomalies
in the current law governing the taxation of foreign currency gains
and losses," Senator Coonan said.
"They also clarify some aspects of the taxation of
foreign currency gains and losses by improving the interaction with
the uniform capital allowance and capital gains tax provisions. In
addition, the elective functional currency rules will generally
reduce compliance costs for businesses which conduct a significant
part of their activities in a foreign currency."
This Digest highlights the main provisions
below. The attention of the reader is drawn to the Explanatory
Memorandum paragraphs 1.4 to 1.61 for a detailed explanation
of the proposed changes.
A traditional security as defined in
subsection 26BB(1) of the Income Tax assessment Act 1936
(ITAA 1936) is broadly a security that is not issued at a deep
discount, does not bear a significant deferred interest element and
is not capital indexed. Examples of traditional securities are
bonds, debentures, deposits with a financial institution or a
secured or unsecured loan.
Proposed section 130-100 to
the Income Tax Assessment Act 1997 (ITAA 1997) to be
inserted by Item 15 of Schedule 1
defines exchangeable interest. Broadly, an exchangeable interest is
an interest that is a traditional security which is issued on the
basis that it will or may exchange into shares in a company which
is neither the issuer of the exchangeable interest nor a connected
entity of the issuer.
Under current law a
taxing point arises under section 26BB of the ITAA 1936
when a traditional security is disposed of or redeemed. Any gain is
included in assessable income under subsection 26BB (2) and any
loss is allowed as a deduction under subsection 70B (2) of the ITAA
1936.
Under proposed subsection
26BB(4) to be inserted by Item 2 of
Schedule 1, no gain will be included in assessable
income from the conversion of a traditional security that converts
into ordinary shares of the issuer. In addition under,
proposed subsection 26BB(5) no gain will be
included in assessable income where the redemption of a traditional
security is in exchange for ordinary shares of a company other than
the issuer or a connected entity of the issuing
company. Likewise, no loss will be allowed as a
deduction under proposed subsections 70B(2B) and
70B(2C) to be inserted by Item 3
of Schedule 1 when such conversions or exchanges
give rise to a loss.
Any capital gain or loss from the disposal of
an exchangeable interest to the issuer of the interest or to a
connected entity of the issuer or from its redemption will be
disregarded under proposed subsection 130-105(4)
to the Income Tax Assessment Act 1997(ITAA 1997) to be
inserted by Item 15 of Schedule
1.
There are also rules for modifying the cost
base and reduced cost base included in proposed Subdivision
130-E to the ITAA 1997 to be inserted by Item
15 of Schedule 1.
The attention of the reader is invited to
paragraphs 1.20 to 1.37 of the Explanatory Memorandum to
the Bill for a detailed explanation of these rules illustrated with
examples of its application.
Australian income tax liability is calculated
in terms of Australian currency. For foreign currency amounts to be
taken into account in determining Australian income tax liability,
there is a need for rules which translate these foreign currency
denominated amounts into Australian dollars (A$).
The applicable rules are contained in
proposed Division 775 to be inserted into the ITAA
1997 by Item 58 of Schedule 4 as
well as proposed Subdivision 960-C and
proposed Subdivision 960-D to be inserted into the
ITAA 1997 by Item 59 of Schedule
4.
The core translation rule in proposed
section 960-50 provides that for the purposes of the ITAA
1997 and ITAA 1936, an item of foreign currency is to be translated
into, or expressed in, Australian currency. Foreign currency as
defined in proposed subsection 995-1(1) inserted
by Item 65 of Schedule 4 as a
currency other than Australian currency.
The rule applies to
amounts generally, and is intended to be interpreted broadly.
Examples of an amount include:
-
an amount of ordinary income
-
an amount of an expense
-
an amount of an obligation
-
an amount of a liability
-
an amount of a receipt
-
an amount of a payment
-
an amount of consideration, and
-
a value.
Some entities or parts of entities are able to
choose to account for their activities in a currency other than A$
for income tax purposes, as an intermediate step prior to
translating a net amount from those activities into A$. The
functional currency rules allow those entities which make a valid
choice to account for individual transactions using a unit of
account other than A$. Nevertheless, the net amount from those
transactions, generally the taxable income, must be converted into
A$.
Proposed subdivision 960-D
lists out those entities that may use a functional currency as an
intermediate step. These are:
-
residents who are required to prepare financial reports under
section 292 of the Corporations Act 2001 (i.e. all
disclosing entities, public companies, large proprietary companies,
registered schemes and certain small proprietary companies)
-
residents carrying on a business through an overseas PE
(permanent establishment)
-
non-residents carrying on a business through an
Australian PE
-
OBUs (offshore banking units)
-
attributable taxpayers of a CFC (controlled foreign company),
and
-
transferor trusts.
Proposed Division 775
inserted by Item 58 of Schedule 4
provides that the assessable income includes a foreign exchange
(forex) gain as a result of a forex realisation event. Likewise it
provides that a forex realisation loss as a result of a forex
realisation account can be deducted from assessable income.
There are 5 main
types of forex realisation events, all of which may give rise to a
forex realisation gain or loss:
-
forex realisation event 1, which happens when an entity
disposes of foreign currency or a right to it to another entity
-
forex realisation event 2, which happens when an entity
stops having a right to foreign currency
-
forex realisation event 3, which happens when an entity
ceases to have an obligation to receive foreign currency
-
forex realisation event 4, which happens when an entity
stops having an obligation to pay foreign currency, and
-
forex realisation event 5, which happens when an entity
stops having a right to pay foreign currency.
However, proposed subsection
775-15(2) provides that the assessable income does not
include a forex realisation gain to the extent that it:
(a)
is a gain of a private and domestic nature, and
(b) is
not covered by an item in table attached to proposed
subsection 775-15(2).
Likewise, proposed subsection
775-30(2) provides that a taxpayer cannot deduct a forex
realisation loss to the extent that it:
(a)
is a loss of a private or domestic nature, and
(b) is
not covered by an item in the table attached to proposed
subsection 775-30(2).
The attention of the reader is invited to
paragraphs 2.1 to 3.101 of the Explanatory Memorandum to
the Bill for a detailed explanation of these rules illustrated with
examples of its application.
The measures in this bill implement Stage 2 of
the reforms of the taxation of financial arrangements (TOFA)
outlined by the Minister for Revenue and Assistant Treasurer in the
Press Release of 14 May 2002. These measures were recommended in
the Review of Business Taxation.
This Bill was passed by the House of
Representatives on 23 June 2003 and introduced into the Senate on
24 June 2003. On 25 June 2003 the Senate referred the Bill to the
Senate Economics Legislation Committee for report as recommended by
the Selection of Bills Committee.
The Selection of Bills Committee report No. 7
of 2003, whilst noting that the removal of the taxing point on
conversion or exchange of certain traditional securities provides
for the deferral of tax liabilities and facilitate capital raising
for some companies, indicated that it may establish a precedent for
other instruments which would be for the purpose of deferring tax
rather than raising capital.
The report(4) of the Senate
Economics Legislation Committee was tabled in the Senate on 13
August 2003. The majority report merely notes at paragraph 3.1 that
although the Selection of Bills Committee highlighted for attention
to Schedules 1 to 3 of the Bill which deals with the taxing point
on conversion or exchange of certain traditional securities, no
submission addressed these schedules. The minority report had two
outstanding issues which in its view needed clarification:
1.
the revenue effects in the medium to long term, and
2.
the reasons for removing the taxing point on exchange of financial
instruments where the exchange for ordinary shares are in a company
which is neither the issuer or a related company.
On issue 1, the minority report recommended
that Treasury give further consideration to the medium and
long-term revenue implications of these measures and report on them
before the Bill is further dealt with by the Senate.
On issue 2, the minority report recommended
that Treasury consider possible integrity measures to confine the
removal of the taxing point on exchange of certain financial
instruments so that these cannot be used for the primary purpose of
deferring capital gains tax.
The majority report considered the amendments
in Schedule 4 which outlines the measures to address a number of
uncertainties and anomalies relating to the tax treatment of
foreign currency. It noted that during the course of the hearing
Treasury indicated that further consideration of a number of
technical issues was warranted. In its concluding paragraph 3.26,
it noted that the Committee is of the view that responses to the
issues raised should be available before consideration of the Bill
commences in the Senate.
-
A Tax System Redesigned, the Report of the Review of
Business Taxation (the Ralph Review) (July 1999).
-
ibid., p. 354.
-
The New Business Tax System: Stage 2 Response; Press Release of
the Treasurer No. 074 of 12 December 1999.
-
New Business Tax System (Taxation of Financial Agreements) Bill
(No. 1) 2003 (August 2003) Report of the Senate Economics
Legislation Committee:
http://www.aph.gov.au/Senate/committee/economics_ctte/nbts_no3/report/report.pdf
Bernard Pulle
13 October 2003
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ISSN 1328-8091
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