2. Taxation of Financial Arrangements (TOFA)
Briefing
Sydney
24 January 2007

3. Outline Presentations by: William Potts, Treasury
Tony Frost, Greenwoods & Freehills
Andrew White, Greenwoods & Freehills
Q&A session

4. William Potts Business Tax Division Treasury
Taxation of Financial Arrangements (TOFA) Stages 3 and 4 Exposure Draft Legislation (2nd ED - released January 2007)
William Potts
Business Tax Division
Treasury

5. Background
Objective
What will the draft legislation do?
What are the major changes from the 1st exposure draft?
Scope of the TOFA 3 & 4 proposals
Tax timing methods
Commencement and transitional issues
Consultation

6. Background Financial innovation
Inappropriate and uncertain tax treatment of financial arrangements
swaps
discount
option premiums
Development of financial accounting treatment of financial instruments

7. Objective
Minimise the extent to which the tax treatment of financial arrangements distorts trading, financing, investment and risk management decisions, by
Aligning tax more closely with the commercial recognition of gains and losses
Appropriately allocating gains and losses throughout the term of the arrangement
Generally, recognising gains and losses on revenue account; and
Appropriately taking account of and minimising compliance costs

8. What will the draft legislation do?
Will insert a new division (Division 230) into the 1997 Income Tax Assessment Act which will:
define ‘financial arrangement’
bring to tax gains and losses on most financial arrangements (and some other arrangements)
generally treat gains and losses on revenue account
determine the amount of gains and losses attributable to an income year by one (or more) tax-timing methods

9. Major issues and changes
Major changes
Second Exposure Draft
Consultation
and Review
First Exposure Draft
Major issues and changes
Definition of financial arrangement
Accruals / realisation borderline
Hedging - tax status matching
Individuals and small business carve-out
Commencement and transitional rules

10. Scope The scope of the draft legislation is determined by:
The definition of financial arrangement
Specific exceptions
Additional operation

11. Financial Arrangement
Primary test
Right to receive and/or obligation to provide financial benefit(s) of a monetary nature (only)
Secondary test
Right to receive or obligation to provide a financial benefit of a non monetary nature where the taxpayer:
has a practice, or intention of satisfying such arrangements by paying money; or
deals in such arrangements for profit making
does not have the sole or dominant purpose of entering, receiving or delivering a financial benefit that is convertible to money/money equivalent as part of an expected purchase, sale or usage requirement
Equity interest
Not all tax timing methods apply to equity interests

12. Specific exceptions
Short term (not more than 12 months) ‘non money’ arrangements, e.g. trade receivables and payables
Small businesses (less than $20m turnover) and individuals
Qualifying securities
Election
Leases and licenses other than finance leases
Interest in partnerships and trusts with only one class of interest, or where interest is an equity interest

13. Specific exceptions (cont)
Personal services, deceased estates, gifts under deed, maintenance payments
Superannuation and pension income
Interest in a CFC or FIF
Proceeds from the sale of a business where payment is contingent on the performance of the business (‘earn outs’)
Retirement village arrangements
Certain insurance policies

14. Additional Operation Foreign currency Non equity shares
Commodities held by traders

15. The tax timing methods Balancing Adjustment Default methods
Realisation
Accruals
Retranslation
Fair Value
Elective methods
Financial Reports
Hedging

16. Accruals and realisation tax timing methods
Sufficiently certain gains and losses accrued
Sufficiently certain gain or loss:
may be:
An overall gain or loss; or
A particular gain or loss
require sufficiently certain financial benefits:
Effectively non contingent right or obligation; and
Fixed or determinable with reasonable accuracy

17. Accruals and realisation tax timing methods (cont)
Gains and losses that:
are not sufficiently certain; and
are not subject to one of the elective tax timing methods
are brought to account on a realisation basis

18. Fair value tax timing method
Elective
Must have audited financial accounts prepared in accordance with the accounting and auditing Standards
Irrevocable
May cease to apply if requirements are not satisfied
Applies to financial arrangements:
which are fair valued for financial accounting purposes; and
which are first held in the income year in which the election is made or in a later income year

19. Retranslation tax timing method
There are 2 separate elections:
1st election – foreign exchange retranslation election
Must have audited financial accounts prepared in accordance with the accounting and auditing Standards
Irrevocable
May cease to apply if requirements are not satisfied
Applies to financial arrangements
which are retranslated for financial accounting purposes; and
which are first held in the income year in which the election is made or in a later income year

20. Retranslation tax timing method (cont)
2nd election – applies to qualifying forex accounts
Irrevocable
May cease to apply if requirements are not satisfied
Applies to financial arrangements which are qualifying forex accounts, as elected by the taxpayer (not one-in, all-in)

21. Hedging tax timing & tax status method
Elective
Must have audited financial accounts prepared in accordance with the accounting and auditing Standards
Irrevocable
Applies to
financial arrangements with purpose of hedging risk
Requirements
Must be a derivative or a foreign currency hedge
Satisfy documentation requirements
Subject to Commissioner’s discretion, must qualify as a ‘hedging instrument’ under accounting standards and be recorded in the accounts as a hedge
Effectiveness tests must be met

22. Hedging tax timing & tax status method (cont)
Determines:
Timing: that is, determines when the gain or loss is brought to account (including when the election ceases to apply to the hedging financial arrangement); and
Status: that is, determines the character of the gain or loss (for example, capital, revenue, assessable or exempt) from the hedging financial arrangement by reference to gain or loss of the underlying arrangement

23. Financial reports tax timing method
Elective
Must have audited financial accounts prepared in accordance with the accounting and auditing Standards
Irrevocable
May cease to apply if requirements are not met
Applies to
Financial arrangements which are first held
in the income year in which the election is made or
in a later income year

24. Financial reports tax timing method (cont)
Requirements include:
Financial accounts must not be relevantly qualified in the current or previous 4 years
The overall gain or loss from the arrangement must be brought to account
May cease to apply if requirements are not satisfied

25. Balancing adjustment A balancing adjustment: is made when:
all (or in some circumstances when some) of the rights and obligations under a financial arrangement cease or are transferred; or
the fair value election, retranslation election or election to rely on financial reports ceases to apply to the financial arrangement (in these cases it is assumed the arrangement is disposed of and re-acquired for its fair value at this time)

26. Balancing adjustment (cont)
Gain or loss is the difference between:
the net of the financial benefits provided and received under the financial arrangement (including any amounts on the cessation or transfer); and
The amounts that have been (or would have been) brought to account from the financial arrangement

27. Commencement and transitional rules
Applies to income years commencing on or after 1 July 2008 unless taxpayer elects to have rules apply to income years commencing on or after 1 July 2007
Applies to financial arrangements first held after rules first apply
Taxpayer may elect to have rules apply to existing financial arrangements
Balancing adjustment

28. The consultation process
The exposure draft legislation and explanatory material is available on tofa.treasury.gov.au
Consequential and interaction amendments
Comments on the exposure draft are due by 28 February 2007
Consultation meetings with industry and professional groups

29. Greenwoods & Freehills, Sydney
Tony Frost
Director
Greenwoods & Freehills, Sydney
Revenue Account
Override rule – Div 230 supreme

30. Outline Overall comments What is a “financial arrangement” (“FA”)?
How do the timing elections work?
Fair value election
Retranslation election (for forex)
Reliance on financial accounts election
Interactions and consequential amendments
Commencement and transitional rules

31. Some questions … What is broken in the law and needs fixing?
What are/were the various ways to fix the current tax rules for financial transactions?
Is the latest TOFA Exposure Draft the best way to fix things?
What changes need to be made to the ED to achieve the best reform outcomes?
WIIFM: What is the impact of the ED on my organisation and what do I do now?

32. Yes, Minister …
“Mr Dutton said, ‘The Government believes that these substantial reforms to the taxation of financial arrangements will reduce uncertainties and distortions. The reforms will lead to lower costs for financial activities conducted by business and result in improved competitiveness and greater efficiency in the general operation of Australia’s financial markets.’ ”

33. What’s new – headline issues
“Coherent Principles” jargon abandoned
Commencement dates and transitional rules
Revised (narrower) definition of a FA
Treatment of finance leases
Hedging rules
character/tax status rules for the first time
abolition of 5/20 year time limits
forex borrowings can be hedges and not just derivatives

34. What’s new – headline issues
Accruals vs realisation borderline
Use of financial accounts election
Disposal rules and balancing adjustments
Some initial guidance on interactions and consequential amendments
But wait … there’s more … including: “proposed synthetic rules and any additional integrity rules …”

35. “Financial arrangement”
Primary test
directed mainly at rights/obligations of a monetary nature
contains important exceptions
Secondary test
includes some rights/obligations not of a monetary nature
Other inclusions
equity interests; non-equity shares; FX; some commodities
Aggregation/disaggregation of transactions
Exceptions
This definition is so important it has to be said twice – at and (OPC can’t help themselves in their drafting style even when given principles based approach).
The concept or right and/or obligation covers rights, obligations as well as arrangements that may be a combination of rights and obligations.
Further it is possible that a number of rights may actually constitute a single financial arrangement. The EM and notes in the legislation give examples of convertible notes, stapled securities.
The EM goes further and explains that the concept of “financial arrangement” is cast by reference to those things that characterise both the provision of finance and the shifting or allocation of risk. Those things are futurity and rights or obligations to provide something of economic value. The EM adds “irrespective of whether the value or existence of the right or obligation is contingent on some event or other thing.”
There are 2 things to observe about this definition:
It is not clear from the words of the section that something that is contingent as to its existence is truly captured by the definition.
More importantly, the definition doesn’t include “financial” or the provision of finance as part of the concept. Rather, it focuses on incomplete or ongoing transactions. The only thing not covered by the definition is a transaction where all rights and obligations are simultaneously satisfied.
We will look at the carve outs in a moment.
It should be noted that NZ has a similar regime with a narrower definition but has had to continually extend its shopping list of exceptions.

36. FA: Primary test
First limb: rights/obligations re financial benefits of a monetary nature
financial benefit: … anything of economic value
monetary nature: money or money equivalent
money equivalent: something whose value is set/limited by money or can be settled in money
Examples
standard loans; interest bearing and discounted bonds; bills; promissory notes; interest rate swaps
ED: a right to receive $100 worth of oil in 12 months
This definition is so important it has to be said twice – at and (OPC can’t help themselves in their drafting style even when given principles based approach).
The concept or right and/or obligation covers rights, obligations as well as arrangements that may be a combination of rights and obligations.
Further it is possible that a number of rights may actually constitute a single financial arrangement. The EM and notes in the legislation give examples of convertible notes, stapled securities.
The EM goes further and explains that the concept of “financial arrangement” is cast by reference to those things that characterise both the provision of finance and the shifting or allocation of risk. Those things are futurity and rights or obligations to provide something of economic value. The EM adds “irrespective of whether the value or existence of the right or obligation is contingent on some event or other thing.”
There are 2 things to observe about this definition:
It is not clear from the words of the section that something that is contingent as to its existence is truly captured by the definition.
More importantly, the definition doesn’t include “financial” or the provision of finance as part of the concept. Rather, it focuses on incomplete or ongoing transactions. The only thing not covered by the definition is a transaction where all rights and obligations are simultaneously satisfied.
We will look at the carve outs in a moment.
It should be noted that NZ has a similar regime with a narrower definition but has had to continually extend its shopping list of exceptions.

37. FA: Primary test
Second limb: rights/obligations re financial benefits of a non-monetary nature that may be settled by:
paying money or providing money equivalent; or
transferring, entering into or exchanging another FA
Example (from EM)
optional cash settlement: forward contract to deliver corn in one year where there is a choice, under the contract, to deliver the corn or settle in cash
This definition is so important it has to be said twice – at and (OPC can’t help themselves in their drafting style even when given principles based approach).
The concept or right and/or obligation covers rights, obligations as well as arrangements that may be a combination of rights and obligations.
Further it is possible that a number of rights may actually constitute a single financial arrangement. The EM and notes in the legislation give examples of convertible notes, stapled securities.
The EM goes further and explains that the concept of “financial arrangement” is cast by reference to those things that characterise both the provision of finance and the shifting or allocation of risk. Those things are futurity and rights or obligations to provide something of economic value. The EM adds “irrespective of whether the value or existence of the right or obligation is contingent on some event or other thing.”
There are 2 things to observe about this definition:
It is not clear from the words of the section that something that is contingent as to its existence is truly captured by the definition.
More importantly, the definition doesn’t include “financial” or the provision of finance as part of the concept. Rather, it focuses on incomplete or ongoing transactions. The only thing not covered by the definition is a transaction where all rights and obligations are simultaneously satisfied.
We will look at the carve outs in a moment.
It should be noted that NZ has a similar regime with a narrower definition but has had to continually extend its shopping list of exceptions.

38. FA: Primary test – Exception 1
No FA if … (s (6)):
there are also rights/obligations of a non-monetary nature in the arrangement; and
such rights/obligations are not insignificant compared to those of a monetary nature
Examples
Note to ED: derivatives that can only be settled by delivery of something other than money/money equivalent
EM: sale of land (terms not specified)
Others (not in ED): all sorts of things, including most leases, whether operating or finance (?)
This definition is so important it has to be said twice – at and (OPC can’t help themselves in their drafting style even when given principles based approach).
The concept or right and/or obligation covers rights, obligations as well as arrangements that may be a combination of rights and obligations.
Further it is possible that a number of rights may actually constitute a single financial arrangement. The EM and notes in the legislation give examples of convertible notes, stapled securities.
The EM goes further and explains that the concept of “financial arrangement” is cast by reference to those things that characterise both the provision of finance and the shifting or allocation of risk. Those things are futurity and rights or obligations to provide something of economic value. The EM adds “irrespective of whether the value or existence of the right or obligation is contingent on some event or other thing.”
There are 2 things to observe about this definition:
It is not clear from the words of the section that something that is contingent as to its existence is truly captured by the definition.
More importantly, the definition doesn’t include “financial” or the provision of finance as part of the concept. Rather, it focuses on incomplete or ongoing transactions. The only thing not covered by the definition is a transaction where all rights and obligations are simultaneously satisfied.
We will look at the carve outs in a moment.
It should be noted that NZ has a similar regime with a narrower definition but has had to continually extend its shopping list of exceptions.

39. FA: Primary test – Exception 2
Right/obligation of a monetary nature does not include … (s (8)):
a right/obligation to receive/provide property, goods or services
Example: Note to ED
Note to ED: “This subsection means that making a prepayment for property or goods (other than money or a money equivalent) or services does not give rise to a financial arrangement”
Does this cover deferred purchase agreements?
This definition is so important it has to be said twice – at and (OPC can’t help themselves in their drafting style even when given principles based approach).
The concept or right and/or obligation covers rights, obligations as well as arrangements that may be a combination of rights and obligations.
Further it is possible that a number of rights may actually constitute a single financial arrangement. The EM and notes in the legislation give examples of convertible notes, stapled securities.
The EM goes further and explains that the concept of “financial arrangement” is cast by reference to those things that characterise both the provision of finance and the shifting or allocation of risk. Those things are futurity and rights or obligations to provide something of economic value. The EM adds “irrespective of whether the value or existence of the right or obligation is contingent on some event or other thing.”
There are 2 things to observe about this definition:
It is not clear from the words of the section that something that is contingent as to its existence is truly captured by the definition.
More importantly, the definition doesn’t include “financial” or the provision of finance as part of the concept. Rather, it focuses on incomplete or ongoing transactions. The only thing not covered by the definition is a transaction where all rights and obligations are simultaneously satisfied.
We will look at the carve outs in a moment.
It should be noted that NZ has a similar regime with a narrower definition but has had to continually extend its shopping list of exceptions.

40. FA: Secondary test
Applies if primary test failed due to lack of rights/obligations of a monetary nature, and:
practice or intention exists to settle by money, money equiv. or transfer of another FA;
there is a dealing of rights/obligations for profit making; or
(s (6)): the financial benefit is readily convertible into money and no sole/dominant purpose exists to receive/deliver the benefit as part of expected purchase, sale or usage requirements
This definition is so important it has to be said twice – at and (OPC can’t help themselves in their drafting style even when given principles based approach).
The concept or right and/or obligation covers rights, obligations as well as arrangements that may be a combination of rights and obligations.
Further it is possible that a number of rights may actually constitute a single financial arrangement. The EM and notes in the legislation give examples of convertible notes, stapled securities.
The EM goes further and explains that the concept of “financial arrangement” is cast by reference to those things that characterise both the provision of finance and the shifting or allocation of risk. Those things are futurity and rights or obligations to provide something of economic value. The EM adds “irrespective of whether the value or existence of the right or obligation is contingent on some event or other thing.”
There are 2 things to observe about this definition:
It is not clear from the words of the section that something that is contingent as to its existence is truly captured by the definition.
More importantly, the definition doesn’t include “financial” or the provision of finance as part of the concept. Rather, it focuses on incomplete or ongoing transactions. The only thing not covered by the definition is a transaction where all rights and obligations are simultaneously satisfied.
We will look at the carve outs in a moment.
It should be noted that NZ has a similar regime with a narrower definition but has had to continually extend its shopping list of exceptions.

41. FA: Secondary test - Examples
EM: Nickel futures contract
delivery required but the practice is to cash settle
EM: Commodities dealer
dealing for profit from buy/sell margins
Deferred purchase agreement (not in EM)
Buyer pays $100 today to receive BHP shares in year 5 – the value of the shares received depends on the movement in a share price index or some other variable
does the FA status depend on the taxpayer’s purpose (ignoring other exceptions for individuals etc)?
This definition is so important it has to be said twice – at and (OPC can’t help themselves in their drafting style even when given principles based approach).
The concept or right and/or obligation covers rights, obligations as well as arrangements that may be a combination of rights and obligations.
Further it is possible that a number of rights may actually constitute a single financial arrangement. The EM and notes in the legislation give examples of convertible notes, stapled securities.
The EM goes further and explains that the concept of “financial arrangement” is cast by reference to those things that characterise both the provision of finance and the shifting or allocation of risk. Those things are futurity and rights or obligations to provide something of economic value. The EM adds “irrespective of whether the value or existence of the right or obligation is contingent on some event or other thing.”
There are 2 things to observe about this definition:
It is not clear from the words of the section that something that is contingent as to its existence is truly captured by the definition.
More importantly, the definition doesn’t include “financial” or the provision of finance as part of the concept. Rather, it focuses on incomplete or ongoing transactions. The only thing not covered by the definition is a transaction where all rights and obligations are simultaneously satisfied.
We will look at the carve outs in a moment.
It should be noted that NZ has a similar regime with a narrower definition but has had to continually extend its shopping list of exceptions.

42. FA: Testing time EM: “generally” at time arrangement starts
EM: may need to re-assess during life
Example (EM)
SCO agrees to acquire a train from BCO for $1m
Delivery and payment both stated to occur in 12 months
However, on delivery in 12 months, SCO and BCO agree to defer payment for a further 3 years
“After delivery the only rights/obligations that remain are those of a monetary nature. At this time, a financial arrangement will come into existence”.
Equity interests and fair value election – TONY will discuss
short term non-monetary arrangements:
- not a derivative financial arrangement,
- the relevant right or obligation and/or the consideration are not money or money equivalent
- the period between the time the consideration is to be received or given and the things of economic value are to be provided or received is less than 12 months [i.e. the particular financial arrangement subsists for less than 12 months]
- the fair value election doesn’t apply
- e.g. Manufacturer Co sells widgets to Retailer Co on 90 day terms. That is, Retailer Co has 90 days after delivery of the widgets to pay for them. Manufacturer Co does not recognise gains and losses from these contracts on the basis of fair value through profit and loss under AASB 139.
For the 90 day period, Manufacturer Co is financing Retailer Co’s purchase of the widgets. However, because the consideration for the right to payment is in a non-monetary form (widgets), the period between delivery and the time for payment is not more than 12 months, and the contracts are not subject to a fair value election under
proposed section Therefore, they are not covered by proposed Division 230.
e.g.sale of truck with 1 week delivery and 3 year warranty – not subject to fair value election; note the EM refers to right to repairs under the warranty are things other than money or a money equivalent the financial arrangement is excluded from proposed Division 230 as a substantial proportion of the things of economic value which the are to be received not more than 12 months from the time the consideration (the $50,000 cost) was paid.
[BACK TO 3 & 4 ABOVE – incl CTP Custodian – is there ever a single class?]

43. FAs – other issues Rights/obligations: can be legal or equitable
FA definition: wider than AASBs 132/139
Aggregation/disaggregation of transactions
EM: “typically” a contract is the taxable item, but ED allows aggregation or disaggregation as a question of fact
Note to ED: a “typical” convertible note is not split up
Exception for “earn-outs”
why limited to proceeds from sale of a business?
why not also cover sale of interests in entities that hold a business?
Equity interests and fair value election – TONY will discuss
short term non-monetary arrangements:
- not a derivative financial arrangement,
- the relevant right or obligation and/or the consideration are not money or money equivalent
- the period between the time the consideration is to be received or given and the things of economic value are to be provided or received is less than 12 months [i.e. the particular financial arrangement subsists for less than 12 months]
- the fair value election doesn’t apply
- e.g. Manufacturer Co sells widgets to Retailer Co on 90 day terms. That is, Retailer Co has 90 days after delivery of the widgets to pay for them. Manufacturer Co does not recognise gains and losses from these contracts on the basis of fair value through profit and loss under AASB 139.
For the 90 day period, Manufacturer Co is financing Retailer Co’s purchase of the widgets. However, because the consideration for the right to payment is in a non-monetary form (widgets), the period between delivery and the time for payment is not more than 12 months, and the contracts are not subject to a fair value election under
proposed section Therefore, they are not covered by proposed Division 230.
e.g.sale of truck with 1 week delivery and 3 year warranty – not subject to fair value election; note the EM refers to right to repairs under the warranty are things other than money or a money equivalent the financial arrangement is excluded from proposed Division 230 as a substantial proportion of the things of economic value which the are to be received not more than 12 months from the time the consideration (the $50,000 cost) was paid.
[BACK TO 3 & 4 ABOVE – incl CTP Custodian – is there ever a single class?]

44. Finance leases (FL) Intention seems to be …
Lessors: always treat a FL as FA. Therefore, treat as a loan and split rent into principal and interest – no depreciation
Corporate/big lessees: treated as owner, can claim depreciation and interest component of rentals
Small lessees: just deduct lease payments
Not clear why finance leases don’t satisfy the exception from FA primary test
Lots of “history” and more lobbying to come
Darrel Nolan (1989); BIE Report (1991); Ralph RBT (1999)
Equity interests and fair value election – TONY will discuss
short term non-monetary arrangements:
- not a derivative financial arrangement,
- the relevant right or obligation and/or the consideration are not money or money equivalent
- the period between the time the consideration is to be received or given and the things of economic value are to be provided or received is less than 12 months [i.e. the particular financial arrangement subsists for less than 12 months]
- the fair value election doesn’t apply
- e.g. Manufacturer Co sells widgets to Retailer Co on 90 day terms. That is, Retailer Co has 90 days after delivery of the widgets to pay for them. Manufacturer Co does not recognise gains and losses from these contracts on the basis of fair value through profit and loss under AASB 139.
For the 90 day period, Manufacturer Co is financing Retailer Co’s purchase of the widgets. However, because the consideration for the right to payment is in a non-monetary form (widgets), the period between delivery and the time for payment is not more than 12 months, and the contracts are not subject to a fair value election under
proposed section Therefore, they are not covered by proposed Division 230.
e.g.sale of truck with 1 week delivery and 3 year warranty – not subject to fair value election; note the EM refers to right to repairs under the warranty are things other than money or a money equivalent the financial arrangement is excluded from proposed Division 230 as a substantial proportion of the things of economic value which the are to be received not more than 12 months from the time the consideration (the $50,000 cost) was paid.
[BACK TO 3 & 4 ABOVE – incl CTP Custodian – is there ever a single class?]

45. Elections: TCG vs individual entities
$64 question: How do the fair value, retranslation and financial reports elections apply?
Tax Consolidated group (TCG)

46. Fair value & forex elections
Gain/loss for tax = gain/loss that accounting standards “require” at FV through P&L
i.e. not necessarily what is actually shown in the taxpayer’s accounts. No tax definition of “fair value”
No particular accounting standards listed
FV: no longer limited to AASB 139 (unlike 2005 ED)
seems to allow materiality standard (AASB 1031) to be respected
What happens if a share trader also holds longer term (capital account) shares?
if FV is elected and all shares are FV for financial accounts, is the capital status of the investments lost for tax?

47. Election to use financial reports
This was suggested in 1991 …
Only some taxpayers will want this
2005 ED: Commissioner discretion rather than an election
2007 ED: can only elect if:
specified requirements are met; and
the election is “reasonable and appropriate” having regard to 6 other matters

48. Election to use financial reports
Requirements and matters include:
difference in TOFA and financial accounting methods “would reasonably be expected not to be substantial”
cost of compliance comparison with/without the election
costs of preparing financial reported and having it audited
comparison of overall tax outcomes with/without the election
nature of business; standard of accounting systems/controls and internal governance; accounting standard compliance

49. Interactions & consequential amendments
29 page Consultation Paper
very high level only
What happens to (amongst others):
Div.775 (forex) regime
Div.16E (qualifying securities)
ss.26BB/70B (traditional securities)

50. Commencement & transitional
Is 1 July 2007 (elective) realistic?
Need to avoid the Forex (Div.775) approach
legislation enacted in December 2003, with effect from 1 July 2003
Election to include all pre-TOFA transactions
4 year spread of initial balancing adjustment – in line with Ralph RBT recommendation
EM: can assume elections would have been made
will need to take “short cuts” with the method statement
no revenue/capital (hedging) re-characterisation

51. Concluding comments Overall, this ED is an advance on 2005
hedging regime is a major step forward
enough alignment to financial accounts?
Will still be a debate on the overall approach and necessity for some/all of the rules
Practicality and compliance costs will be issues for many taxpayers
do some “road testing”
have your voice heard

52. Recognition methods, disposals and hedging
Andrew White
Senior Associate
Greenwoods & Freehills, Sydney

53. Overview Basic recognition methods Disposals of FAs
Elective tax hedging method

54. Definition of FA
Property Council lobbying in relation to ED 2005 definition
Non-monetary exception should apply to most property transactions
Property financing transactions still caught
Query whether financing elements need to be disaggregated
Refer to accounting opinion that L-T lease over a retirement village can be a finance lease
Also refer to whether a LTCC needs to be disaggregated between financing elements and non-financing

55. Accruals method
Applies where elections are not made to apply other methods
Can apply to:
a sufficiently certain overall gain or loss from an FA
a particular sufficiently certain gain or loss
A particular sufficiently certain gain or loss can arise during the term of the FA
Gain or loss is net amount arising from financial benefits provided and received.

56. Sufficiently certain Financial benefits are sufficiently certain if:
effectively non-contingent; and
fixed or determinable with reasonable accuracy
Certain variables fixed at current value (eg interest rates and CPI)
Power to make Regulations

57. Spreading gain or loss
The gain or loss is to be spread on a compounding accruals basis:
taking into account actual net gain or loss likely to make
use a compounding period that does not exceed 12 months
assume you hold it until it ends
Can instead use reasonable approximation
Consider how compounding accrual may apply where no net investment

58. Simple example Subscribe $100 for a bond that provides for:
$100 payment at the end of year 4; and
$10 payment at the end of year 2
IRR is 2.53% p.a. and $10 is spread over 4 years as follows:
$2.53 in year 1, $2.59 in year 2, $2.41 in year 3 (after having received $10) and $2.47 in year 4

59. More complex example Example 4.3 in EM
Subscribe $10,000 for a 10 year bond that provides for:
$12,000 payment in year 10; and
discretionary interest payments
Overall gain from FA of $2,000 on Day 1
During term of the bond Issuer decides in advance to make an interest payment:
particular sufficiently certain gain or loss
accruals method applies

60. Running balance adjustments
Financial benefits estimated at commencement of FA
Difference between estimated and actual financial benefit gives rise to a gain or loss
Brought to account in the year the financial benefit is provided or received
Assessment required for each financial benefit

61. Requirement to re-assess
Relevant for applying accruals method
Must make a “fresh assessment” when there is a material change to the circumstances affecting estimate
terms & conditions
contingencies
terms of credit
impaired loans
Not clear from the legislation what happens at the time of re-assessment – does not appear to be any balancing adjustments

62. Requirement to re-estimate
Only relevant for accruals method
Must re-estimate when there is a material change to the circumstances affecting estimate
Two options:
maintain IRR and adjust amounts
adjust IRR and maintain amounts
Balancing adjustment under Option 1
First choice governs all future re-estimations

63. Realisation method If elections and accruals method don’t apply
The gain or loss is the difference between financial benefits provided and financial benefits received (net concept)
Made in the year the gain or loss occurs

64. Realisation method - examples
Vanilla option and forward contracts because not probable to conclude that sufficiently certain that a gain or loss will be made
Index linked security
compare/contrast CPI vs SPI
some SPI may be fixed and determinable
Option gain or loss realised at the time the rights under the option cease (eg being disposed, exercised or expiring).

65. “Disposal” of FAs
Balancing adjustment arises on cessation or transfer of FAs (assets and liabilities) in whole or part
The term “disposal” not generally used in ED, but used extensively in the EM
Method statement to determine gain or loss
“ensures that the entity’s overall gain or loss ... is recognised”
Gain or loss arises in year in which cessation or transfer occurs

66. “Disposal” of FAs Special rules for: Examples in the EM:
“historic rate rollover” type situations
conversion or exchange
margining
Examples in the EM:
sale of a fixed interest bond
assignments of interests stream (rule is similar to s.159GZ re stripped securities, and not s.102CA)
in substance/economic defeasance of a liability
legal defeasance of a liability

67. Things to do for each FA Outset
Sufficiently certain overall gain or loss
Sufficiently certain particular gain or loss
During life of FA (continuous)
Re-assess whether a particular gain or loss arises
Re-assess whether accruals method is appropriate
Re-estimates where material change
Running balance adjustments
Disposal
Balancing adjustments

68. Elective hedging rules
Note the “objects” of the rule
“to facilitate the efficient management of financial risk by reducing after-tax mismatches …where hedging takes place”
“to minimise tax deferral …”
no reference to tax/accounts alignment
Election is irrevocable
available even if other elections are made (to ensure access to character matching)
Relevant to all taxpayers – excluded from all other elections ie can elect in to take advantage of character matching

69. Elective hedging rules
Election applies to all “hedging financial arrangements” (HFA)
HFA is a “derivative financial arrangement” or “foreign currency hedge” where:
acquired etc for purpose of hedging risk/s re an asset, liability, current or future transaction
DFA satisfies hedge status under accounting stds
financial accounts are audited and show the DFA as a hedging instrument
ATO discretion: if all requirements not met
5/20 year time limits removed

70. Record keeping requirements
Requirements to make election:
recording details of the hedge
determine/record basis of allocation of hedge gains/losses to years of income on an “objective” basis, so as to match hedged item
expectation that hedge will be “highly effective” and assessed on an “ongoing basis”
ATO discretion to allow if not all requirements met (EM refers to macro hedging/risk management)
“highly effective” expected that if accounting requirements are satisfied then this will be satisfied

71. Elective hedging rules
A taxpayer can be excluded from Division if:
one of the previous requirements ceases to be met
deliberate failure of requirement
Commissioner can determine that the taxpayer is allowed back in

72. Elective hedging rules
Consequences of hedge accounting applying:
generally recognise gains/losses per taxpayer allocation
character matching! (refer later slide)
revocation/redesignation of hedging designation
ceasing to meet hedge requirements
ceasing to have hedged item(s) or they never come into existence

73. Elective hedging rules
2 examples in the EM:
forward FX contract hedging forward purchase of depreciable plant/equipment
hedging future minerals production via futures
eg 1 – allocates gain or loss that enables it to be incorporated into cost of machinery
eg2 futures contracts for shorter period than the projected sale date, still can be allocated to the year in which sale is made

74. Character matching
Character matching only available where tax hedge criteria are met (incl. record keeping)
Specified items (eg)
Hedged item
Treatment of hedge gain / loss
NANE income
NANE / non-deductible
Capital asset
Capital gain / loss
Foreign sourced income
Foreign sourced

75. Character matching Examples in EM cross currency interest rate swap
Possible outcomes
Australian sourced hedge of foreign income
CC swap – PCA submission
Foreign sourced income hedged by swap taken out in Aus, character matching deems source of swap gain to be foreign, no withholding when distributed to non-resident

76. What to do now Scope – take “inventory” of FAs
Lobbying action – 28 February
Elections
Cash flow, P/L and Investor impact
Planning opportunities?
Compliance systems?

77. William Potts, Treasury
Q & A
Panel
William Potts, Treasury
Tony Frost, G&F
Andrew White, G&F