Bills Digest no. 73 2008–09
Tax Laws Amendment (Taxation of Financial Arrangements)
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
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House: House of
Commencement: All provisions commence on Royal Assent, except
those in Part 4 of Schedule 1, which commenced retrospectively on 7
December 2003 (being immediately after the commencement of the
New Business Tax System (Taxation of Financial Arrangements)
Act (No. 1) 2003).
latter Act applied 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.
The amendments contained in the Bill will apply to income years
commencing on or after 1 July 2010 unless a taxpayer elects to
apply the amendments to income years commencing on or after 1 July
Links: The relevant links to
the Bill, Explanatory Memorandum and second reading speech can be
accessed via BillsNet, which is at http://www.aph.gov.au/bills/.
When Bills have been passed they can be found at ComLaw, which is
This Bill principally amends the Income
Tax Assessment Act 1997 (ITAA 1997) so that the taxation of
various financial arrangements occurs by an appropriate method.
Further, this Bill makes consequential amendments to:
- Income Tax Assessment Act 1936
- Income Tax (Transitional Provisions) Act 1997
- Taxation Administration Act 1953, and
- New Business Tax System (Taxation of Financial
Arrangements) Act (No. 1) 2003.
This Bill inserts new Division
230 into the ITAA 1997. The proposed Division defines the
term ‘financial arrangement’ and sets out six
alternative methods for the profits and loss from transactions
involving financial arrangements to be assessed for taxation
The taxation of financial arrangements (TOFA)
has been a long standing issue for the Australian Parliament.
Changes in the taxation of income derived from this source was
first announced in the 1992 Commonwealth Budget. Then, the Review of Business
Taxation (Ralph Review) recommended that the taxation of financial
arrangements be changed in 1999. Stages one and two
of these reforms were implemented by legislation in 2001 and 2003
respectively. This current Bill implements Stages three and
This particular Bill has been the subject of
extensive consultation. Its general proposals were first put to
Parliament in the Tax Laws Amendment (Taxation of Financial
Arrangements) Bill 2007. That Bill lapsed upon the calling of the
2007 election. In
2008, Treasury issued a further consultation paper in June
legislation and explanatory material were issued to the public in
September 2008. Extensive comment was received in response to this
The current Bill is the product of this consultation process.
For the purposes of this Bill, a
‘financial arrangement’ is a right to receive or an
obligation to provide a benefit that is:
- monetary in nature
- non-monetary in nature and may be settled by money or a money
- in substance and effect monetary in nature.
short, these obligations are ‘cash settlable’. Further,
it does not matter that the value of the arrangement, or its
existence is contingent on some event or other matter occurring.
Rather, it is enough for these rights and obligations to exist
formally and be capable of execution.
The above definition seeks to cover the
elements common to a wide range of financial instruments, such as
futures and options, credit swaps, forward agreements and other
financial products. The definition also covers more traditional
financial arrangements such as loans, promissory notes and
The pace at which new financial products have
been devised and used, by both business and industry, has been
rapid in the past two decades. The use of futures and options,
forward contracts and hybrid debt/equity securities (to name a few)
has increased as business has sought to protect itself from
financial risks in an increasingly global environment.
The Explanatory Memorandum argues that
government responses to the use of these new financial instruments
has been ad hoc and piecemeal in nature and that taxation law lacks
an overarching framework for the tax assessment of these
The result of this approach is that the legal
form, not the economic substance, of a transaction has been the
basis for the taxation of these arrangements. This has led to
inconsistent treatment of arrangements with similar economic
outcomes but of different legal forms, uncertainties in the
application of the law and a mismatch between the point at which
the gains or losses arising from these arrangements are realised
and the point at which they are taxed. Ideally, the realisation of
the gains and losses, and the tax treatment of those events, should
occur at the same time.
These difficulties have favoured the use of
some types of financial arrangement over others, due to more
favourable tax treatment. Thus tax law is said to impact adversely
on pricing, risk management and the efficient allocation of
The proposed changes are based on a single,
comprehensive definition of a ‘financial arrangement’.
The proposed new Division contains six methods under which the
gains and losses from these transactions are assessed for taxation
purposes. The difference between capital and revenue is largely
removed. Most losses and gains are recorded on an entity’s
revenue account. Generally, losses are tax deductible, and gains
are tax assessable.
A particular feature of the proposed changes
is that the recognition of gains and losses may be closely aligned
with the relevant Australian Accounting Standards, should the
taxpayer choose to do so.
In the context of the
proposed Division 230, the most
relevant accounting standards are:
- Australian Accounting Standard AASB 139 Financial
Instruments: Recognition and Measurement — which covers
recognition and measurement of financial assets and
- Australian Accounting Standard AASB 121 The Effects of
Changes in Foreign Exchange Rates — which covers certain
gains and losses attributable to changes in foreign exchange rates;
- Australian Accounting Standard AASB 127 Consolidated and
Separate Financial Statements — which covers the
preparation and presentation of consolidated financial statements
for a group of entities under the control of a parent.
Other Australian accounting standards have
also had a significant impact on the development of the provisions
of this Bill.
As noted above, proposed
Division 230 allows six alternative methods for
bringing gains and losses arising from financial arrangements to
account for tax purposes. These methods are divided into either
elective methods or non-elective methods.
The non-elective methods apply if the taxpayer
does not choose an elective method. The non-elective methods
- the accruals method, or
- the realisation method.
The taxpayer chooses which non-elective method
is appropriate for their particular circumstances.
If neither of the above methods is suitable,
the taxpayer has the option to choose from the following
- elective hedging
- elective financial reports
- elective fair value, or
- elective foreign exchange retranslation.
A balancing adjustment may be applied, if
appropriate, when using any of the above methods. Further
information on these methods is in the Main Provisions sections
The tax integrity of this new approach is
protected by the requirement to constantly use one of the above
methods over the life of a particular financial arrangement,
provisions to prevent value shifting and a requirement to act on an
arm’s length basis. Further details of these integrity
provisions are given below.
The Government’s intention to adopt a
number of the recommendations of the Review of Business Taxation
(i.e. the Ralph Review) was first announced in the then
Treasurer’s press release of 11 November 1999. The current
Government’s intention to proceed with TOFA amendments Stages
three and four was announced in the Assistant Treasurer and
Minister for Competition Policy and Consumer Affairs’ media
release of 13 May 2008. This decision was confirmed in that Minister’s
media releases of 1 October and 4 December respectively.
The Bill was referred to the Senate Standing
Committee on Economics on 4 December 2008. This committee is due to complete its
report on this Bill by 20 February 2009.
Generally, industry organisations supported
the introduction of this particular legislation to Parliament.
However, most industry groups stressed that additional changes
needed to be made to the draft legislation to overcome various
problems. Further, additional guidance would be needed on how
various sections of the proposed legislation interact. Other industry groups
simply requested that the draft legislation be further altered
before its introduction to Parliament.
After the Bill was introduced to Parliament
some commentators noted that various issues raised in the
consultation phase had been addressed. Further, many aspects of the
new regime are a significant advance on current practice and
contain significant advantages to business in terms of reduction in
compliance costs. One commentator noted that the Bill introduced to
Parliament was ‘well developed’.
Press reaction to the introduction of the Bill
was generally favourable. However, some commentators noted that the Bill, if
passed, may create extra work for ‘non-financial
business’. This latter comment referred to the exposure draft
legislation and it is not clear whether the current Bill has
addressed this issue.
The proposed changes will provide a greater
degree of certainty in the taxation of financial arrangements. The
proposal to align the proposed changes closely with the prevailing
Australian Accounting Standards will reduce business and industry
compliance costs. Further, if successful, these changes will reduce
the influence of tax considerations on the choice of a financial
arrangement, thus encouraging the use of the most appropriate
arrangement in any particular situation.
However, in view of the problems identified in
the consultation process it may be the case that this particular
Bill needs further refinement in consultation with industry before
its passage through Parliament.
To date, non-government parties have not
publicly responded to the introduction of this Bill. Given that
broadly similar proposals were introduced to Parliament in 2007
under the previous government, it may be the case that Coalition
members and senators may support this Bill.
The Explanatory Memorandum notes that the
financial implications of the proposed changes are
The proposed changes are complex and far
reaching. Accordingly, the main issue is whether the proposed
changes have been sufficiently refined to avoid major issues
arising in their implementation.
It is worth noting that the Government intends
to monitor the legislation’s implementation and would
consider the need for any refinements.
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The majority of the proposed changes in this
Bill are contained in Part 1 of Schedule
1 to this Bill.
Item 1 of Schedule
1 inserts Division 230 into the ITAA
1997. This Division specifies the tax treatment of gains and losses
from financial arrangements.
230-5 specifies that the new Division 230
does not apply to:
- an individual
- a superannuation entity, managed investment scheme or an entity
similar to a managed investment scheme under a foreign law with
assets of less than $100 million
- an Authorised Deposit-taking Institution (ADI) or other
financial sector entity with a total annual turnover of less than
$20 million, or
- another entity with
- an annual turnover of less than $100 million, and
- financial assets of less than $100 million, and
- other assets of less than $300 million
if the financial arrangement is to last less
than 12 months, or is not a ‘qualifying security’.
The term ‘qualifying security’ is
used numerous times in the ITAA 1997 but currently is only defined
by reference to the meaning of that term in Division 16E of Part
III of the Income Tax Assessment Act 1936 (ITAA 1936).
There a ‘qualifying security’ is defined in
subsection 159GP(1). Broadly, it is a security
which, at the time of issue, is reasonably likely to result in the
sum of the payments (excluding periodic interest as defined in
subsection 159GP(6) of the ITAA 1936) exceeding
the statutorily established formula in subsection
159GP(1) of the ITAA 1936.
Item 22 of Part
1 of Schedule 1 inserts a definition of
‘qualifying security’ into subsection
995-1(1) of the ITAA 1997 (the definitions section of that
Act), by reference to the above definition in the ITAA 1936.
230-5(2)(b) also exempts financial arrangements from the
scope of the new Division that are equity interests as defined by
proposed section 230-50 if
- a fair value election
- a hedging financial arrangement election, nor
- an election to rely on financial reports
to the particular arrangement (see below for further discussion of
Equity interests will include such securities
as shares, but will also include a wider range of securities and
arrangements such as convertible notes or arrangements that are
linked to the level of a particular equity index (e.g. the
Australian Stock Exchange All Ordinaries Index). It also includes
arrangements where the parties have the right to receive, or an
obligation to provide, equity interests in settlement of a
Technically, an equity interest has the
meaning given by:
- in the case of a company Subdivision 974-C of
the ITAA 1997, and
- in the case of a partnership or trust section 820-930 [which
modifies the definition of ‘equity interest’ in
subdivision 974-C to make it relevant to trusts
The Explanatory Memorandum also notes that
proposed Division 230 will not
apply to a wide variety of other arrangements, amongst which
- leasing arrangements
- a financial arrangement that is given in exchange for property
- general and life insurance policies
- certain workers compensation arrangements
- personal arrangements such as payment for personal
services, deceased estates, gifts by deed, maintenance payments and
payment for injury
- interests in foreign investments and foreign life insurance
policies or a controlled foreign company
- proceeds from the sale of certain business
- infrastructure borrowings and farm management deposits
- retirement village residence contracts, retirement village
services contracts, contracts for the provision of residential or
- forestry managed investment schemes, and
- forgiveness of commercial debts and payment of franked
Some of these arrangements are specifically
exempted from the application of proposed Division
230 by proposed Subdivision 230-H.
230-35 exempts borrowings and other financial arrangements
used for private or domestic purposes from assessment under
proposed Division 230.
230-40(1) specifies the six methods for taking a gain or
loss into account arising from a financial arrangements. These
- accruals or realisation (see proposed subdivision
- elective fair value (see proposed subdivision
- elective foreign exchange retranslation (see proposed
- elective hedging (see proposed subdivision
- elective reliance on financial reports (see proposed
The balancing adjustment method
230-G) is also used in conjunction with
most of the above methods when an estimated gain or loss needs to
be adjusted in the light of an actual outcome or change in
circumstances, or when a financial arrangement ends. These
balancing adjustments bring to account unrealised losses and gains
in various circumstances.
Generally, the accruals and realisation methods will apply unless
the taxpayer elects to use another method, as circumstances
require. Proposed subsection 230-40(4) enables
such an election to be made.
Proposed sections 230-20 and
230-25 ensure that gains and losses assessed under
proposed Division 230 are only
recognised once for taxation purposes. For example a loss
deducted from income under proposed
Division 230 cannot be a deduction under any other
part of the tax legislation.
Proposed section 230-45 precisely
defines the term ‘financial arrangement’. Briefly, a
financial arrangement exists where an entity has, under an
arrangement, an equitable or legal right to receive or and
obligation to provide a financial benefit that is settlable by the
payment or receipt of cash including a combination of or one or
more such rights or obligations.
However, under this particular section an
arrangement is not a ‘financial arrangement’ where:
- the thing that is to be received or provided is not a
financial benefit, and
- the obligations and rights involved are not cash settlable,
these non-financial or non-cash benefits are
not an ‘insignificant’ part of the arrangement.
230-50 includes equity interests in the definition of
financial arrangement. However, equity interests will not be
subject to all of proposed Division
230 provisions. Specifically, equity interests will
not be assessed using:
- accruals and realisation methods
- foreign exchange retranslation methods, or
- generally, a hedging financial arrangement election.
proposed section 230-60 a
financial arrangement exists even where the entity that either
provides or receives a financial benefit is not a formal party to
230-530 also specifies that Division 230 also applies
- foreign currency as if the currency were a right that
constituted a financial arrangement
- non-equity shares as if they were a right that constitutes a
- commodities held by traders, and
- offsetting commodity contracts held by traders.
Proposed section 230-80 requires
that once an assessment method is chosen, it must be used for the
life of the financial arrangement. Further, where an entity has a
two or more similar arrangements, and has chosen a particular
method to assess the gains and losses from these arrangements for
tax purposes, it must be applied in the same manner consistently to
all these arrangements.
also contains provisions for the assessment of balancing
adjustments made in non-arms length situations in
proposed sections 230-510 and
230-515. Briefly these proposed sections require
that balancing adjustments made between related parties are
included in assessable gains and loss of the taxpayer under
proposed Division 230.
Proposed section 230-520 also
guards against gains and losses not being assessed as a result of
‘value shifting’. Broadly, the value shifting rules prevent
inappropriate tax consequences where, under a scheme, value is
shifted from equity or loan interests. Gains which are reduced, or
losses which are increased, in this manner are to be disregarded
under Division 230 in determining tax outcomes for financial
The accruals method, in the context of the
taxation of financial arrangements, refers to the allocation or
spreading of gains or losses over time, where the gain or loss is
calculated by reference to known or estimated future amounts
(represented by the financial benefits under the arrangement) and
on the assumption that the entity will continue to have the
arrangement for its remaining term.
The period over which the sufficiently certain
gains or losses are intended to be spread is the period to which
the gains or losses relate. The intended basis of allocation of the
relevant gain or loss under the accruals (spreading) principle
reflects the financial concept of interest on interest, or compound
Proposed Subdivision 230-B
contains provisions for the use of either the accruals or
realisation methods for assessing taxable gains and losses. As
noted above, the accruals and realisation methods are the default
methods for such assessments under proposed
Division 230 if no other assessment method is
The application of the accruals method depends
on the returns or payments arising from a financial arrangement
being sufficiently certain. The Explanatory Memorandum notes that
financial arrangements having the following characteristics may
give rise to sufficiently certain returns:
- periodic returns under the arrangement are determined and set
in advance of the period to which they relate and are paid in
- the initial outlay will be returned at maturity, and
- if there are cash flows (financial benefits) that are not known
at the start of the arrangement, those cash flows will not have the
effect of reducing the estimated overall gain or loss arising from
Comments provided in relation to the exposure
draft legislation sought additional guidance and clarity on what is
meant by the term ‘sufficiently certain’. It appears that
the Government has well responded to this comment.
Proposed section 230-100
requires the accruals method to be used when the gain or loss from
the financial arrangement is sufficiently certain. In all other
circumstances the realisation method is to apply (unless an
election is made to use another method).
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230-105 notes that a sufficiently certain gain or loss
from a financial arrangement occurs when a gain or loss is
- a particular amount, or
- at least a particular amount,
assuming that the entity continues to have the
financial arrangement for the rest of its life.
230-115(2) provides that the payment or reception of a
financial benefit is sufficiently certain only if:
- it is ‘reasonably expected’ that these payments or
receipts will occur, and
- at least some of the amount or value of the financial benefit,
at that time, is fixed or determined with ‘reasonable
The meaning of the term ‘reasonably
expected’ is not further defined in tax legislation. After
consideration of the various tax cases the Explanatory Memorandum
notes that there must be quite a firm expectation that the
financial benefits will be paid and received.
230-115(3) requires that this expectation take account
- the terms and conditions of the financial
- accepted pricing and valuation techniques applying to that
- the economic or commercial substance and effect of that
- the contingencies that attach to other financial benefits that
are to be provided or received under that arrangement
treating the financial benefit in question as
not being contingent (if it is appropriate to do so).
230-115(4) provides that when determining whether some
amount or value of the financial benefit arising from the financial
arrangement can be determined with reasonable accuracy (see
proposed paragraph 230-115(2)(b))
the factors in proposed subsection 230-115(3) must
be taken into account, as well as:
- an interest rate, or
- a rate that solely or primarily reflect the time value of
- a rate that reflects the Consumer Price Index, or
- a rate that reflects an index prescribed by regulations for the
purposes of this particular paragraph,
where the financial benefit depends on one of
these four variables.
sections 230-130 to
230-170 contain provisions for the application of
the accruals method and the treatment of fees arising from a
230-175 deals with the making of a running balancing
adjustment when the gains or losses from the financial arrangement
assessed under the accruals method have been mistakenly
The realisation method allocates gains and
losses to income years when they occur, which will generally be
when the relevant financial benefit representing the gain or loss
is due to be provided or received, as the case may be at the end of
230-180 to 230-200 allow for a
re-estimation of gains or losses from a financial arrangement
assessed using the accruals method when there is a material change
to terms and conditions of the financial arrangement or a material
change to the circumstances that affect that arrangement. Such
material changes may include the disposal of part of the assets
involved in a particular financial arrangement, a change in
relevant market conditions affecting that arrangement or a change
in the expected cash flows involved in that arrangement,
The elective fair value method is a tax-timing
methodology that measures gain or loss for tax purposes as the
change in the value of a financial arrangement between two points
in time. Under fair value tax accounting the gain or loss from a
financial arrangement for a particular period is the increase or
decrease in its fair value between the beginning and end of the
period, adjusted for amounts paid or received during the
The term fair value is defined in Australian
Accounting Standard AASB 139 Financial Instruments: Recognition
and Measurement as:
The amount for which an asset could be
exchanged or a liability settled, between knowledgeable, willing
parties in arm’s length transactions.
The valuation methods used for the elective
fair value method ought to generally be the same as those used for
the fair value valuation in relevant accounting standards.
Eligibility to apply the fair value method
(and all other elective methods under proposed Division
230) for tax assessment purposes depends on the entity
preparing financial reports in accordance with accepted accounting
standards. The Corporations Act 2001 and Australian
accounting standards (e.g. Australian Accounting Standard AASB 101
Presentation of Financial Statements) set out what is
meant by the term ‘financial report’. A financial
- a balance sheet
- an income statement (profit or loss statement)
- a statement of changes in equity showing either
- all changes in equity; or
- changes in equity other than those arising from transactions
with equity holders acting in their capacity as equity
- a cash flow statement
- notes, comprising a summary of significant accounting policies
and other explanatory notes, and
- a director’s declaration that the financial statements
are a true and fair representation of the entity’s
As readers would be aware, financial reports
must be prepared by entities regulated by the Corporations Act
2001. Since 1 January 2005, Australia has adopted the
International Financial Reporting Standards (IFRS) as the basis for
its own accounting standards. With the wide spread adoption of the
IFRS by first world countries, many foreign accounting and auditing
standards will contain the same standards as those used in
230-210 provides that an entity is eligible to elect to
use the fair value method if:
- the entity prepares financial reports in accordance with
the relevant accounting standards of Australia or comparable
accounting standards of another country, and
- the entity’s financial reports are audited in accordance
with the relevant Australian, or comparable foreign, auditing
As noted above, an entity must meet this basic
qualification to be able to use any of the elective methods to
assess their financial arrangements for tax purposes.
230-210(3) states that once this election is made it is
irrevocable - save in the circumstances set out in
proposed section 230-240.
230-240 specifies when a fair value election ceases to
apply. Briefly, it ceases to apply from the start of a new income
year if the entity ceases to be eligible to choose that election
under proposed subsection 230-210
- that is, ceasing to prepare financial reports in
accordance with the accepted accounting standards and having them
audited under accepted Australian, or comparable foreign, auditing
230-245 allows for a balancing adjustment to be made to
the gains or losses arising from a financial arrangement assessed
under the fair value method if:
- the fair value election ceases to have effect, or
- when the arrangement is disposed.
Similar requirements for the making of
balancing adjustments apply to all of the elective methods.
The retranslation method measures the gain or
loss that arises from translating a given number of units of one
currency into another currency, which is due to different
prevailing exchange rates at different points in time. The
retranslation tax-timing method will only be relevant to those
taxpayers with arrangements denominated in, or determined by
reference to, a foreign currency or, in the case of taxpayers who
have made an election under subdivision 960-D ITAA
1997, a non-functional currency.
Where the foreign exchange retranslation
method applies to the financial arrangement, the accruals or
realisation methods will also apply to determine any gains or
losses from the financial arrangement, to the extent they are not
attributable to currency exchange movements. This is made clear in
the objects provision of subdivision 230-D
(proposed section 230-250).
There are two retranslation elections
specified in proposed section 230-255, the general
election and the qualifying foreign exchange accounts election.
section 230-255 an entity may make a foreign
exchange retranslation election if it prepares financial reports in
accordance with the relevant accounting standards and the financial
reports have been audited under the appropriate auditing
230-255 applies the general election method to financial
arrangements that are recognised in financial reports that the
relevant Australian or foreign accounting standard requires to be
recognised in financial reports.
230-255(3) allows these elections to be made in relation
to a ‘qualifying forex account’ if no other
retranslation election has been made in relation to that
A qualifying forex account is an account that
is denominated in a foreign currency; held in Australia or overseas
in an ADI (or similar financial institution) and which either has
the primary purpose of facilitating transactions, or is a credit
card account according to subsection 995(1) ITAA
230-255(5) states that the election to use the foreign
exchange retranslation method is irrevocable – save where the
provisions of proposed section
230-285 provides that the foreign exchange retranslation
method ceases to apply when the entity ceases to prepare financial
reports in accordance with accepted accounting standards or have
them audited in accorded with accepted auditing standards (see
proposed section 230-255
In respect of a general foreign exchange
retranslation method nothing stops the entity from making a new
general election at a later date if it again becomes eligible to do
so. However, under proposed subsection
230-285(6) once the eligibility to make a qualifying forex
account election has been lost, the entity cannot again make such
an election in relation to that particular account at a later
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The term ‘hedging financial
arrangement’ is to be inserted into subsection
995-1(1) ITAA 1997 (the dictionary provision) of
Part 1 of Schedule 1 to the Bill.
It is to be defined by reference to proposed subsections
230-335 (1) to (9) and proposed
sections 230-340 and 230-345 (see below).
Proposed section 230-335 defines
this term as either:
- a ‘derivative financial arrangement’, or
- a ‘foreign currency hedge’.
The term ‘derivative financial
arrangement’ is defined in proposed subsection
230-350(1) as a financial arrangement where its value
changes in response to changes in specific variables (such as
interest rates) and there is no requirement for a net investment
for the full value of the underlying commodities or financial
instrument to be made.
The term ‘foreign currency hedge’
is to be inserted into subsection 995-1(1) ITAA
1997 by item 16 of Schedule 1 to
the Bill. It is defined by reference to proposed subsection
230-350(2) which provides that a ‘foreign currency
hedge’ is a financial arrangement where its value changes in
response to specific variables (such as an interest rate or foreign
currency exchange rate) but (unlike a ‘derivative financial
arrangement’) there is a requirement for a net investment of
the full value of the currency concerned. Further, the arrangement
must hedge (i.e. offset) a risk in relation to the movements in
currency exchange rates (proposed paragraph
This proposed section also specifies that, for
the purposes of proposed Division 230 a hedging
financial arrangement is also:
- it is created for the purposes of offsetting risks (i.e.
hedging) associated with holding a ‘hedged item’
- the arrangement is recorded as a hedging instrument in the
taxpayers’ financial reports and other documents on which
these reports are based.
A taxpayer may hold a parcel of
Commonwealth bonds. However, these bonds will lose value if their
interest rate rises. To guard against these losses, the taxpayer
may sell the appropriate number of futures contracts covering the
parcel of Commonwealth bonds. The selling of theses futures contracts is a
hedging financial arrangement.
Normally, when selling futures contracts, the
seller receives an amount equal to a set percentage of the value of
the actual Commonwealth bonds covered, usually five per cent of the
value at the time the investment was made. Those buying such
arrangements generally commit an amount equal to about five per
cent (but may be lower) of the value of the Commonwealth bonds
covered by this arrangement. Thus the net amount of the investment
is far less than the actual value of the Commonwealth bonds in
Generally, an entity buys or sells different
amounts of a foreign currency to hedge (or guard against adverse
currency movements) their exposure to adverse foreign currency
movements. The full value of the currency in question is paid. Thus
there is a requirement for the full amount to be invested in a
foreign currency hedge.
Hedging financial arrangements apply to
‘hedged items’. In the above example the Commonwealth
bonds held by the taxpayer is a hedged item. Under
proposed subsection 230-335(10)
hedged items are not limited to parcels of financial assets (such
as Commonwealth bonds or foreign currencies) but can include:
- an asset (in full or in part)
- the firm expectation of receiving payments (such as a
- interest rates that are to apply to a proposed arrangement,
- other highly probable forecast transactions.
230-300 allows the taxpayer to choose to use the elective
hedging method to calculate gains and losses arising from a
financial arrangement if none of the other methods for assessing a
financial arrangement in proposed Division
230 are chosen.
230-305 lists the rules for allocating gains and losses
over specific periods if various events happen. It expands on the
provisions of proposed subsection
230-310 aligns the tax treatment of the gains or losses
from the hedging financial arrangement with the tax treatment of
the hedged item.
The important point here is that gains or
losses arising from the hedging financial arrangement are not
automatically brought into the taxpayer’s revenue account.
Rather, they are included in either the taxpayer’s revenue or
capital accounts, according to the account where the gains or
losses arising from the hedged item finally end up.
section 230-315 an entity is eligible to elect to
use the elective hedging method if its financial reports are
prepared according to accepted accounting standards and audited
according to accepted auditing standards.
An election to use this method is irrevocable,
save where the provisions of proposed sections
230-385 or 230-370 apply.
230-370 specifies that a hedging financial arrangement
ceases to apply if the entity ceases to meet the requirements of
proposed subsection 230-315(2).
Briefly, this refers to the requirement for the taxpayer to prepare
financial reports in accordance with accepted accounting standards
and have them audited in accordance with accepted auditing
section 230-385 the Commissioner for Taxation may
determine that a hedging financial arrangement election ceases to
apply if the taxpayer is unlikely or unable to meet:
- the requirements of proposed section
230-335, (which deals with of hedging financial
arrangements and hedged items), or
- the requirements of proposed section
230-360 (which sets out the need for a taxpayer to
determine basis for allocating gains or losses from a hedging
An election to use the elective financial
hedging method will not, under proposed
section 230-330, apply to equity interests as
defined in proposed section 230-50 or individuals;
amongst other specified entities.
section 230-345, the Commissioner for Taxation has
the option to treat a derivative financial arrangement or a foreign
currency hedge as a hedging financial arrangement for the purposes
of this Division, if the Commissioner considers that an honest or
inadvertent mistake has been made in setting up the arrangement and
it does not meet the necessary requirements in
proposed paragraphs 230-335(1)(b)
or (c). For the Commissioner to exercise this
option he or she may have regard to the taxpayer having kept
appropriate records and followed internal appropriate governance
procedures including having taken steps to correct the mistake.
230-355 requires those choosing to use the elective
hedging method to compile appropriate records of each hedging
financial arrangement in their financial reports.
230-365 requires that the hedging financial arrangement
must be expected to be highly effective (within the meaning of the
appropriate accounting standards).
section 230-380 the Commissioner for Taxation may
determine that a financial arrangement meets the requirements to be
treated as hedging financial arrangement despite all the
requirements of proposed sections
230-355 to 230-365 not having been
subdivision 230-F a taxpayer may elect to rely on
their annual financial reports.
section 230-395 allows the taxpayer to elect to
rely on their financial reports for the tax assessment of their
gains and losses arising from financial arrangements, providing the
- are compiled in accordance with the appropriate accounting
standards (including comparable foreign accounting standards where
- are audited according to the appropriate auditing standard
- have not been qualified by the auditor in the last five
financial years (including the current year), and
- has reliable accounting systems, controls and internal
The main financial report used for these
purposes is the profit and loss statement
must also be no adverse assessment of the taxpayer’s
accounting system in relation to the taxation treatment of
financial arrangements in any recent audit or review
(proposed paragraphs 230-395(2)(c),(d) and
auditor’s qualification on a set of accounts is a serious
matter. It means that some or all of the information in the
accounts is, to some extent unreliable, or unable to be
election to rely on financial reports is irrevocable
(proposed subsection 230-395(4)). However, this
election may cease to apply under the provisions of
proposed section 230-425.
230-405 allows the Commissioner for Taxation to waive the
requirements of proposed paragraphs 230-395(2)(c)
and (e). Proposed subsection 230-405(2) sets out
matters ton which the Commissioner must have regard in deciding to
waive the audit requirements, Such matters include the reasons for
non-compliance and any remedial action taken to avoid
non-compliance with applicable accounting or auditing standards in
subparagraphs 230-410(1)(e) and
(f) also require that there be a reasonable
expectation that the overall gain and loss shown in the annual
financial reports will be the same as or not be substantially
different from, the gains and losses that would have been
calculated under this Division if the election to rely or financial
records did not apply.
section 230-425, an election to use financial
records ceases to apply if the taxpayer ceases to be eligible to
elect to use its financial reports under proposed
section 230-395. In these circumstances, a
balancing adjustment is required to be made under
proposed section 230-430.
230-G provides additional rules for the calculation of a
balancing adjustment to a taxpayer’s gains and losses from
financial arrangements where the taxpayer disposes of the financial
arrangement. Generally, all balancing adjustments in relation to
the various methods of assessment in proposed
Division 230 are to be made by following this
particular subdivision’s rules where the taxpayer ceases to
have financial arrangements.
For the purposes of proposed
subdivision 230-G a balancing adjustment is an additional
amount of gain or loss brought to account on the disposal of a
financial arrangement to ensure the correct amount of gain or loss
is brought to account.
230-440 lists circumstances where a balancing adjustment
under proposed subdivision 230-G
is not made:
- where the financial arrangement is an equity interest and
neither the fair value or elective financial reports assessment
methods apply, or
- where a hedging financial arrangements election applies,
- where a financial arrangement is written off as a bad debt,
- where a derivative financial arrangement is settled or closed
out for margining purposes, and
- where a traditional security (such as, say a debt instrument)
is converted into ordinary shares.
Items 31 to
101 make proposed amendments to the ITAA 1936, the
ITAA 1997, the Income Tax (Transitional Provisions) Act
1997 and the Tax Administration Act 1953 that are
consequential upon the insertion of proposed Division
230 into the ITAA 1997.
Item 103 specifies that the
Bill’s amendments take effect for tax income years that
commence on or after 1 July 2010. However any taxpayer may elect to
apply these provisions to their tax affairs for their tax income
year that starts on or after 1 July 2009.
Item 104 specifies that the
proposed amendments apply to all financial arrangements entered
into after these amendments take effect (on or after 1 July 2010,
or 1 July 2009 as the case may be).
A taxpayer may elect to apply the proposed
amendments to existing financial arrangements (sub-item
The foregoing comments provide an introduction
to a very complex set of amendments to the ITAA 1997.
The viability and/or workability of the
arrangements set out in proposed Division 230 will
only be established when the division becomes operational. However,
at this stage the proposals have been welcomed by the professional
taxation industry and seem, at least in principle, to have
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For example Institute of Chartered Accountants
TOFA 3&4 - Exposure Draft Legislation and Explanatory
Material, submission to Treasury, 17 October 2008.
16 January 2009
Bills Digest Service
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