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

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Presentation on theme: "Taxation of Financial Arrangements (TOFA) Briefing Sydney 24 January 2007."— Presentation transcript:

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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 Taxation of Financial Arrangements (TOFA) Stages 3 and 4 Exposure Draft Legislation (2 nd 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 changes Major issues and changes Second Exposure Draft Consultation and Review First Exposure Draft 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 Default methods Elective methods Balancing Adjustment Financial Reports Accruals Fair Value Realisation Retranslation Hedging

16 Accruals and realisation tax timing methods Accruals 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) Realisation 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: 1 st 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) 2 nd 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 Tony Frost Director Greenwoods & Freehills, Sydney

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

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

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

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 (?)

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?

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

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)?

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”.

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?

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)

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

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

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

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

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

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: – “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)

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

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)

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

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

75 Character matching Examples in EM – cross currency interest rate swap Possible outcomes – Australian sourced hedge of foreign income

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

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