The revised TOFA regime
Greenwoods & Freehills recently hosted a seminar on TOFA. For a copy of the presentation, click here.
Summary
• The Assistant Treasurer has released a second Exposure Draft of legislation for the taxation of financial arrangements. The new version fills in some of the gaps evident in the last version and changes some of the policy and legislative detail.• A start date of 1 July 2007 (on an elective basis) has been proposed.
• While there has been some narrowing, the scope of the legislation remains comprehensive, extending beyond ordinary financial arrangements, necessitating a detailed list of exclusions.
• These rules will affect, and in many situations alter, the timing and character of amounts arising under almost all transactions that qualify as “financial arrangements.” In some instances the rules can also change the timing and character of non-financial transactions by requiring the taxpayer to isolate and assess a deemed finance component.
• The new draft modifies some of the proposed measures in the former version, particularly those dealing with hedging, retranslation of amounts in foreign currency and the ability to rely on audited financial accounts. The inclusion in the latest draft of hedging character matching rules is a major and welcome advance in the TOFA project.
• The new rules will require the continuous oversight of financial arrangements, both to ascertain whether past predictions have been borne out and to reassess whether predictions of the future remain valid.
• Despite its length, the new version is still not the entire package of measures. Further measures are expected dealing with synthetic arrangements and the interaction between the TOFA rules and existing regimes.
• TOFA represents a significant change for most taxpayers, not just banks and financial institutions. Taxpayers need to inform themselves about its impacts and the opportunities it presents in order to make a number of important decisions that may need to be taken over the next few months.
Further detail regarding TOFA below.
1. The background, and some preliminary observations
2. Revised scope of the measures
3. Treatment of gains and losses from financial arrangements
4. Basic accruals and realisation regime
6. Retranslation of foreign currency positions
8. Alignment of tax and financial accounting
9. Application to consolidated regimes
10. Interaction between TOFA and other measures
11. Commencement and transition
13. What you need to consider now
1. The background, and some preliminary observations
On 3 January 2007, the Assistant Treasurer released a second Exposure Draft (“2007 ED”) and Explanatory Material (“2007 EM”) of legislation for the reform of the taxation of financial arrangements (“TOFA”), referred to as “TOFA Stages 3 and 4.” (TOFA Stage 1 comprised the debt and equity regime in 2001, while TOFA Stage 2 was the 2003 revision of the tax rules for foreign currency denominated transactions.) Our Tax Brief on the 2005 version of these rules and our Tax Brief contrasting the major differences between the 2005 and 2007 EDs are both at our website: http://www.gf.com.au/.
The 2007 ED contains the accumulated outcome of extensive consultations that occurred in the year since the first Exposure Draft (“2005 ED”) was released in December 2005. As a result, the 2007 documents are much more detailed with many of the gaps now filled in and with some significant changes of policy.
In our 2005 Tax Brief, we noted that TOFA has been a long and difficult process – from its first public appearance in 1993, to the 1996 Issues Paper, the 1999 Review of Business Taxation, and then the 2005 ED. During 2006, industry made extensive submissions – 28 public written submissions are listed on the Treasury’s consultation website – and Treasury released several additional confidential discussion papers responding to various issues identified in those consultations and submissions. We are all now one year older, but the 2007 ED brings us one large step closer to concluding this substantial tax reform project – seemingly the longest running in this country’s history.
A few general comments can be made about the package presented in the 2007 ED and 2007 EM:
• this regime will have extensive coverage, governing almost all aspects of financial arrangements and, as a result, supplanting much established law and practice in a wide variety of areas;
• where these rules apply, they will constitute a code for the treatment of gains and losses made on the instrument, excluding much current law. Where these rules do not apply – most especially for certain types of excluded financial arrangements, and for financial arrangements held or issued by individuals and small businesses – current law will remain unaffected. Australia will thus have parallel sets of rules for computing the income and deductions from many financial transactions;
• there is a reduced, but not insignificant, risk that the regime will have application beyond what would be thought of as “financial” arrangements, generating unexpected consequences for taxpayers;
• it was always hoped that the consultation process would address difficulties seen in the 2005 ED, but it was also recognised that industry would not manage to persuade Government on every position. Both predictions have been borne out. There are a number of areas where there has been significant movement in Government policy, including the hedging rules; and
• there has been some movement towards formal alignment of the tax rules to the accounting treatment of financial arrangements, but the ability to rely upon financial accounts is so severely constrained that it is probably not a realistic option for many taxpayers.
The 2005 package was expressed to be drafted using a “coherent principles” approach. By contrast, the 2007 EM simply refers to a “principle based” approach – specific references to “coherency” have been dropped.
The elements of the TOFA package have now grown to a bundle of four key tax measures:
1. the basic, and mandatory, regime for taxing financial arrangements, either on a compounding accruals or realisation basis;
2. an optional regime which allows certain financial instruments to be taxed on a fair value (i.e., a mark-to-market) basis;
3. an optional regime which allows certain foreign currency denominated positions and “qualifying forex accounts” to be taxed on a retranslation basis; and
4. an optional hedging regime, which is subject to a number of significant “gateway” tests.
Triggering these rules can affect:
• character: they generally require a taxpayer to account for amounts arising under the financial arrangement as assessable income or an allowable deduction (and not as a capital gain or loss), unless the hedging regime would provide to the contrary; and
• timing: they will sometimes require the taxpayer to record these amounts during the life of the arrangement, rather than at the end of the transaction, and independent of cash flows occurring under the arrangement.
The rules do not generally distinguish between the position of the issuer and the holder of a financial arrangement, although exceptions exist for individuals and small business taxpayers who hold financial arrangements. In these cases, and where parties to a single transaction make different elections, there will often be circumstances where the parties to a single instrument will adopt different character and timing positions.
In theory at least, the new regime could start as early as 1 July 2007 (or the next tax year starting after 1 July) for those who elect into it. For those who do not elect into it, the regime will commence on 1 July 2008 (or next tax year starting after 1 July). While this timetable is ambitious, one must assume that the Government is serious about this timetable and prepare accordingly. (See further comments on the timetable, and possible action, at the end of this Tax Brief.)
While the 2007 ED advances matters substantially, there is still a large unfinished agenda. Two important matters still in abeyance are:
• a regime for “synthetic” arrangements – essentially anti-avoidance measures, as foreshadowed in the 1999 Report of the Review of Business Taxation. The Assistant Treasurer’s Press Release accompanying the 2007 ED says that the final version of the legislation “will contain rules to address the tax treatment of synthetic financial arrangements” but those rules have not yet been released; and
• the rules for managing overlaps with existing regimes. The 2007 ED was accompanied by a separate Consultation Paper on the interaction of the TOFA regime with current law, but it provides only tentative indications about how overlaps and interactions with existing tax law might eventually be managed.
Our Tax Brief follows the division of the subject matter adopted in the 2007 ED. The main focus of each section is our explanation of the 2007 ED and 2007 EM – what they say, and what they seem to mean. We integrate at each stage a discussion of how the 2007 documents differ from the 2005 versions and identify new measures in the 2007 ED that fill some of the gaps that existed in the 2005 version.
2. Revised scope of the measures
2.1 “Financial arrangement”
The core definition for TOFA is “financial arrangement” – the scope and operation of the regime depend critically on this term. The definition in the 2005 ED was criticised in almost every submission made to Treasury and so it was expected that there would be significant modifications to the definition. One suggestion made in some of those submissions – that the definition be based on the accounting standards – has been explicitly rejected. However, the 2007 EM states that “it is expected that all financial instruments covered by the scope of financial accounting standards AASB 132 and AASB 139 will fall within the scope of financial arrangements treated within the tax timing methods of the exposure draft.” Even if this is the case, the issue which will arise is just how much wider the TOFA rules are than the accounting standards.
The new test for a financial arrangement now refers to four types of arrangements:
1. a right to receive, or an obligation to provide, a “financial benefit” that has a monetary nature, including amounts denominated in foreign currency, as well as foreign currency itself;
2. an arrangement which is likely or intended to be satisfied by paying an amount of money or readily marketable assets;
3. equity interests (for example shares, options and some types of participating loans) and non-equity shares (such as certain kinds of redeemable preference shares); and
4. commodities held by commodity traders.
Rights and obligations to money. The first leg of the definition, described in the legislation as the “primary test” for a financial arrangement, will cover the kind of transactions one would expect to be within the scope of a regime directed to financial arrangements: secured and unsecured loans at interest, discounted and similar securities such as bills of exchange, promissory notes and zero-coupon bonds, together with some derivatives such as interest rate swaps.
We noted in our Tax Brief on the 2005 ED that the original version of the test expressed the idea of an incomplete transaction, not a financial transaction. The amended definition in the 2007 ED is narrower than the 2005 ED in the important respect that it now refers to rights to something which has a “monetary nature,” which is defined to mean money or a “money equivalent” (also a defined term).
Those who remember the development of the “debt test” in the debt equity rules will have a sense of déjà vu – those rules had to be amended to include a reference to the “finance” idea underlying debt. The primary test also includes transactions which have the option of being settled by delivery of a money equivalent or the transfer of another financial arrangement.
Transactions likely or intended to be satisfied in money or readily marketable assets. This part of the definition, the “secondary test,” is intended to capture arrangements where one leg of the arrangement involves goods, property and services, rather than money. Such arrangements will usually fall outside the primary test.
The secondary test is very widely drafted and includes as a financial arrangement a transaction where a taxpayer:
• in practice settles transactions of the relevant type in money, money equivalent or by way of transfer of another financial arrangement;
• intends to settle a transaction in money, money equivalent or by way of transfer of another financial arrangement;
• sells or deals with its rights or obligations under the contract for profit making purposes; or
• is to receive or provide a financial benefit which is “readily convertible” into money or a money equivalent and the taxpayer does not have the sole or dominant purpose of actually receiving or delivering the benefit as part of their expected “purchase, sale or usage requirements.”
This provision is intended to mean that the TOFA regime will apply to contracts and a wide range of derivatives (e.g. forwards, futures, swaps and options) for the purchase or sale of assets, but the assets are not to be delivered. Examples would include forward sales or purchases of commodities, where the taxpayer’s practice is to settle the contract by a cash payment, not by delivery of the underlying commodity. It may have some significance for other arrangements (such as deferred purchase agreements) which are not always settled by delivery, or if, they are, are settled by the delivery of readily marketable securities.
This leg of the definition, which relies upon one party’s intention, nicely demonstrates another point – it highlights that the question whether a financial arrangement exists is to be answered separately for each party to it. It is possible for an arrangement to be a financial arrangement for one side and not a financial arrangement for the other.
Shares. The inclusion of equity interests and shares that are re-characterised as debt is an unexpected and interesting development in the 2007 ED. It necessitates specific provisions to remove the consequences that would otherwise follow for shareholders – they could be required to accrue “guaranteed” dividend flows and even unrealised gains on shares in certain circumstances, as well as deeming all gains made on shares to be revenue rather than capital in nature. The apparent intention of the inclusion is much more restricted – it is to allow but not require the fair value election to be made; for example, to allow banks to record unrealised changes to the value of a “trading” share portfolio as income and deductions.
But including shares as financial arrangements requires many additional adjustments. The legislation is already littered with special provisions designed to prevent the issuer of shares from treating the shares as financial arrangements (to prevent it claiming deductions for committed future dividend payments or premiums payable on a planned share redemption or buy-back). Including equity interests as financial arrangements appears to open some other unintended outcomes, which may necessitate further amendments, if not revisiting the policy in its entirety.
Commodities. The 2007 ED provides that commodities held by dealers in commodities are also to be treated as financial arrangements. This complements the prior provision which includes as financial arrangements the contracts of a taxpayer who “deals with” commodities contracts for the purpose of generating a profit. This expansion will have special significance for taxpayers in mining, oil and natural resources industries.
2.2 Exceptions
Despite the narrowing of the definition, “financial arrangement” is still an expansive notion which has to be surrounded by an extensive list of exceptions.
Perhaps the most significant exception appears in the primary test for a financial arrangement. A new provision excludes the entire agreement if one leg of it involves goods, property or services. In fact, that leg need only involve a “not insignificant” amount of property, goods or services. It will not be a financial arrangement for either party to the arrangement. (Note however, that this exception only applies to the primary test; it does not apply to arrangements, under the secondary test, which are likely or intended to be settled in cash, rather than by delivery, or by the delivery of readily marketable property.)
This exception has some important consequences for a host of transactions where there might be thought to be an embedded finance element involved in the contract – for example, a sale of goods with 90 days interest-free credit, sales of goods or real estate where the price is payable by instalments without interest, sales of goods or real estate with no interest and an extended period for payment, construction contracts with deferred payments, and long term supply contracts with progress payments at stipulated intervals other than delivery. It also is intended to eliminate prepayments for goods or services.
Finance leases. As presently drafted, this exception would also appear to remove finance leases from the scope of “financial arrangements.” This is presumably not the policy intention; it is understood that finance leases are meant to be within the TOFA rules, at least so far as the lessor is concerned. (The effect of this inclusion would mean that lessors under all finance leases – not just those of luxury cars or those characterised as hire purchase arrangements for tax purposes – would be re-characterised as involving a notional sale and loan by the lessor.)
Additional exceptions are explicitly created for:
• amounts dealt with under the existing statutory regimes for leases of luxury cars and hire purchase arrangements;
• amounts arising under equipment leases (unless classified as a finance lease) and licences;
• amounts arising from leases and licenses of real estate;
• rights arising from holding most interests in a partnership, trust, offshore controlled foreign company or foreign investment fund;
• most life and general insurance policies;
• rights under guarantees or indemnities (unless the taxpayer elects otherwise or the arrangement amounts to a derivative);
• rights to a variety of payments involving individuals – such as payments for personal services, including services as the trustee of a deceased estate, payments for restrictive covenants, obligations to pay alimony or maintenance, compensation for personal injuries, rights to superannuation benefits and pensions, and obligations to pay amounts under agreements with retirement village operators;
• rights to amounts under an “earn-out” arrangement on the sale of a business (but not, it appears, the sale of shares and other interests in a company or other entity that owns a business); and
• amounts arising under trade credit on sales of goods or services lasting less than 12 months.
Two special exceptions exist for financial arrangements held by individuals or small businesses:
• financial arrangements lasting less than 12 months; and
• financial arrangements lasting longer than 12 months provided there is no significant component of the return on the arrangement that is not periodic interest (i.e., there is no significant deferral arising from a premium or deferred interest).
These two exceptions apply only for the benefit of the individual or small business, not typically the issuer of the arrangement.
2.3 Some other characterisation questions
Dissection and aggregation. Our 2005 Tax Brief noted that one of the areas that was likely to prove contentious was the requirement to dissect an arrangement into monetary and non-monetary components – it would be difficult to know whether to apply one of the many express exceptions in the TOFA regime to an entire transaction, or whether to apply the rule which requires dissecting a transaction so as to create sub-transactions, one or more of which might be a financial arrangement. Difficulties may also arise with knowing when to aggregate seemingly separate contracts into the one “arrangement.”
The drafting of the 2007 ED, when read with the 2007 EM, is said to express a more conservative approach, not generally requiring dissection or aggregation. Having said that, it is clear from the 2007 ED that there will be situations which will require the dissection of what a taxpayer may regard as one contract or arrangement into various legs so that a “financial” element can be disclosed and dealt with under the TOFA regime. Similarly, aggregation will be necessary in some situations, i.e. even before considering the promised rules on “synthetics.”
Ongoing characterisation and re-characterisation. The 2007 EM says that the characterisation of an arrangement as a financial arrangement (or as falling into one of the exceptions) can in most cases be made once at the time the arrangement is entered into. However, the 2007 ED insists that, because an arrangement can change its character during its term, the characterisation of an arrangement will require constant monitoring. The reasonableness and practicality of this proposal will need to be addressed by business in the consultation on the 2007 ED.
Areas of uncertain application. We noted in our Tax Brief on the 2005 ED that the original definition would create a large number of unexpected “financial arrangements.” Some – for example, guarantees and indemnities, general insurance policies, operating leases, interests in superannuation funds and some other trusts – have now been resolved in the 2007 text.
Further, the exception mentioned above for agreements involving goods, property or services significantly narrows the scope for some of these problems, especially if the requirement to dissect transactions to disclose an embedded financial arrangement is of limited application. However, the “fine print” surrounding some of the exceptions will need careful attention and a few areas will remain as surprises – for example, purchased “add-on” warranties where the manufacturer has the option to repair the item or refund the price.
3. Treatment of gains and losses from financial arrangements
3.1 TOFA rules take precedence
The TOFA regime applies to every transaction which involves a financial arrangement. The principal effect of holding an instrument that is within the TOFA regime is that, in general terms, all amounts (in excess of any issue price) which arise from the financial arrangement are taxed either on an accruals (yield-to-maturity) basis or a realisation basis, unless the taxpayer elects to adopt one of the other permitted methods.
The practical effect of the TOFA regime is that it will operate as an exclusive statement of the tax consequences for the transactions to which it applies; the regime excludes any other provisions from operating for amounts that are assessed or deducted under the TOFA regime. But because the TOFA regime is not universal some existing law will remain in play. The fact that the TOFA regime will not be an exhaustive set of rules for all financial transactions is likely to give rise to a number of uncertainties and unintended consequences.
The new regime effectively switches off the existing rules which might otherwise operate to make amounts assessable or deductible, but only where a TOFA rule in fact applies. Because of this impact, the 2007 ED re-states many of the current rules about whether interest, discounts, premiums, bad debts, debt forgiveness, prepayments and the embedded finance in other transactions are assessable as income or allowable as deductions, and if so when. The 2007 ED applies to all amounts “you make from a financial arrangement” which is presumably intended to mean amounts arising from issuing, holding, trading in, redeeming or cancelling financial arrangements.
3.2 Characterisation of gains and losses arising under a financial arrangement
Gains. The 2007 ED provides that gains arising from a financial arrangement will now almost always be deemed to be assessable income (the main exceptions being for some hedging situations and some arrangements held by individuals and small businesses, discussed below). This is the rule which now makes interest assessable, for example. Interest income will no longer be assessable because it represents ordinary income; it will instead be assessable because it represents “a gain … from a financial arrangement.” This wholesale supplanting of a sizeable body of existing law will almost inevitably raise difficult and unforseen consequential issues.
This characterisation rule – gains made from financial arrangements are included in assessable income – changes the current tests for a variety of instruments such as discounted instruments or certain foreign currency transactions where some amounts are treated as involving capital receipts or outgoings, or are absorbed into the cost of assets.
Losses. The 2007 ED provides that losses from a financial arrangement will be deductible if the loss is made in earning assessable income or in carrying on a business for the purpose of producing assessable income (once again subject to the possible application of the elective hedging rules). This qualification replicates the current test for the deductibility of losses and outgoings under existing law, but, as there is no exclusion for losses that are “capital or of a capital nature,” losses on financial arrangements will now almost always be deductible.
This formulation would, for example, re-write the law established in some of the numerous cases, over many decades, in which the Commissioner has sought to deny interest deductions. It explicitly puts in focus the question whether interest might be non-deductible because it is “of a capital nature” – the 2007 ED would seem to eradicate this problem – or whether interest might be non-deductible because it is insufficiently connected to earning income or carrying on a business – which the 2007 ED would not change.
A loss from a financial arrangement can also be deducted if it is made in earning foreign source non-assessable non-exempt dividend income and arises from a debt interest issued by the taxpayer. Again, this requirement replicates the current test for the deductibility of interest expense under existing law.
By contrast, a loss on a financial arrangement made in gaining exempt income or other kinds of non-assessable non-exempt income is not deductible. Again, this reproduces the test under current law.
A loss made on a financial arrangement used to raise finance for a private or domestic purpose is similarly not deductible.
While the 2007 ED is careful to re-state the limits on deducting expenses that currently exist, it has not inserted all of the entitlements to deductions that current law offers. For example, the 2007 ED makes no provision to allow a company to deduct dividends paid on shares that are re-characterised as debt under the debt-equity rules even though such shares are deemed to be a financial arrangement. Whether existing law, which allows a deduction for dividends on debt-like shares, is meant to remain operative requires clarification.
Limitations. Despite the general re-characterisation of gains and losses, the 2007 ED retains the rule that losses (only) that arise from disposing of an interest-bearing security other than in the ordinary course of trading, where the issuer was considered to be insolvent, are to be treated as giving rise to a capital loss only. (This mirrors the current exception.)
Of course, gains and losses on arrangements that are not defined as financial arrangements – for example, indemnity payments, recoveries under insurance policies, earn-outs from the sale of a business – remain to be characterised under the tests expressed in existing law.
3.3 Hierarchy of tax timing methods and elections
The discussion which follows in sections 4 – 7 of this Tax Brief describes the basic accruals and realisation rules for instruments within the TOFA rules and the four alternative timing elections open to some taxpayers – the fair value regime, the retranslation regime for foreign currency positions, the hedging rules and the financial reports election.
This multiplicity of rules requires ordering. In many cases, there can be no overlap because the election operates for particular classes of arrangements that are recorded in a particular way in the taxpayer’s accounts. However, for those cases where there might be conflict, the 2007 ED provides a hierarchy of rules:
• any of the four elective regimes will take priority over the basic accruals or realisation regime;
• so far as any conflict between the four elective regimes is concerned,
• the election to adopt the hedging regime will take priority over any of the other elections;
• the election to adopt financial reports will take priority over any of the remaining elections; and
• making the fair value election will defeat the foreign currency retranslation election.
3.4 Other issues
Absorption costing. One important addition to the 2007 ED is an “absorption costing” type rule. This rule requires taxpayers to treat an amount paid to, or received from, a third party as forming part of the gain or loss arising from their financial arrangement if the amount “plays an integral role” in determining whether there is a gain or loss from the arrangement. Obvious examples would be valuation fees paid to external valuers. Whether this would extend to fees paid to advisers such as investment bankers or tax advisers will depend upon whether their fees play “an integral role” in determining the profitability of the arrangement.
The existence of this provision begs the question whether fees paid between the parties to the arrangement (such as loan establishment fees, internal valuation fees or fees for credit reference checks) should also be treated as forming part of the proceeds of the arrangement in order to have the TOFA rules applied to them, as is suggested in the 2007 EM. At present, many of these fees would be recorded as discrete amounts of income or deducted by the borrower under special timing rules.
Consistency. The 2007 ED provides a rule to ensure that a taxpayer applies the various timing methods on a consistent basis (across similar arrange-ments, and across income years) so as to prevent “inappropriate tax benefits.”
4. Basic accruals and realisation regime
4.1 Timing: Arrangements taxed on an accruals basis
Where a taxpayer has issued or holds a financial arrangement, the taxpayer must identify how much of its gains or losses are to be recognised as income and deductions each year. The 2007 ED makes the taxpayer’s position turn on whether there is a gain or loss that is “sufficiently certain” at the time that the arrangement commences, or becomes “sufficiently certain” during its term. Where the gain or loss is or becomes sufficiently certain, the taxpayer must allocate a portion of the gain or loss to individual income years over the life of the arrangement using the compounding accruals calculation; if not, the taxpayer allocates the entire gain or loss to the period when it is realised.
(a) Sufficient certainty
The definition of when a gain or loss is “sufficiently certain” has two elements:
• the gain or loss must be “effectively non-contingent” (one element in the test currently used to distinguish a debt instrument from equity); and
• the amount of the gain or loss must be “fixed or determinable with reasonable accuracy.” (This phrase replaces the test used in the 2005 ED which referred to there being “a reasonable likelihood of gain or loss.” The “reasonable likelihood” test was the subject of many comments in the industry submissions. The new formulation, which derives from the accounting standard, is regarded as clearer than the test expressed in 2005 ED.)
Just how this double-barrelled test is to be applied will undoubtedly require careful judgments in many cases. The operation in some situations will be obvious: it is almost axiomatic that there is a sufficiently certain gain or loss under a fixed interest loan involving a creditworthy borrower, but there is not sufficiently certain gain or loss where the taxpayer holds an ordinary share. The 2007 ED contains a provision which requires an assumption to be made that certain rates or indexes will continue at their current rate, which may facilitate the judgment that an amount is sufficiently certain. It is understood that under this provision, the return from a CPI-indexed bond would be regarded as sufficiently certain. However, the return under a standard share price indexed bond is apparently not meant to be regarded as sufficiently certain.
(b) Compounding accruals methodology
If there is a sufficiently certain overall or particular gain or loss at the time that a financial arrangement starts, the taxpayer must recognise a portion of the gain or loss during each year of the term of the arrangement. The computation of the amount of gain or loss in each year is not fully prescribed in the legislation. Instead, the taxpayer is given the basic contours – work out the gain or loss on a compounding accruals basis on rests not exceeding 12 months. The taxpayer can also use an “approximation” of this method, which, the 2007 EM suggests, will mean that in some instances a taxpayer will be able to adopt a straight-line accrual or simple pro-rating of the gain or loss between periods.
One consequence of the new regime will be that the actual cash flows occurring under a financial arrangement (e.g. interest payments and receipts) are ignored. Hence, for example, the deduction for interest charged on an overdraft facility is not the interest expense when paid, but rather the amount which emerges from using the TOFA compound interest computation.
(c) Predicting the future; monitoring the past
Three provisions in the 2007 ED will require the ongoing monitoring of financial arrangements – to re-examine both the border between the accruals and realisation dichotomy, and the computation of the amounts being accrued.
First, the 2007 ED requires a taxpayer to commence compounding accruals accounting where amounts become sufficiently certain during the term of an arrangement. If, after the arrangement has commenced, an amount becomes sufficiently certain because of a material change to the circumstances surrounding the financial arrangement, the 2007 ED requires the taxpayer to apply accruals accounting to that amount from the start of the current income year. Once again, the reasonableness and practicality of this proposal in some situations will need to be addressed by business in consultation on the 2007 ED.
Secondly, the 2007 ED requires taxpayers to re-estimate the amount to be accrued in the future where circumstances that affect the amount of gain or loss change. It is understood the kind of situations intended to be within this rule include changes to the inflation rate for a CPI-linked bond.
Thirdly, as the legislation requires a taxpayer to accrue gains or losses which need only be “sufficiently certain,” there is the possibility that past predictions will not have been borne out. Hence, there is an additional requirement to make periodic adjustments if the amount of gain or loss when actually received or provided turns out to be different from the amount previously estimated.
4.2 Timing: Arrangements taxed on a realisation basis
Where a gain or loss is not sufficiently certain, the taxpayer will recognise income and deductions on the realisation of any gain or loss under the financial arrangement.
Current law prescribes that gains or losses that are ordinary income are recognised in the year when the income is “derived” or the loss or outgoing “incurred.” The 2007 ED says that the realisation of a gain or loss on a financial arrangement is recognised in the year in which the gain or loss “occurs.” The 2007 EM seems to imply that “occurs” will have the same meaning as the current tests (which distinguish between “cash” and “earnings based” taxpayers), despite the different wording. Unless the 2007 EM is correct, the new term would render irrelevant much current law on the time of recognising income and deductions.
This term will also replace the many different terms that are currently used to dictate when gains or losses that are statutory income are recognised. Other amounts might be recognised when “written off,” or when a particular “CGT event occurs,” when there is a “disposal” or “redemption” or when a debt is “forgiven.”
4.3 Tax consequences of selling or winding up a financial arrangement
In addition to recognising amounts during the term of a financial arrangement, a taxpayer will be obliged to recognise income or a deduction when the financial arrangement is sold or otherwise ceases. These rules, which are relevant for all financial arrangements (e.g. whether they constitute assets, liabilities or derivatives in the hands of the taxpayer) apply where the taxpayer deals with the whole or merely part of the financial arrangement.
The events which triggers these rules are the transfer of all or part of a financial arrangement to another person, or the cessation of the arrangement by satisfaction, expiry or negotiated early termination. The rules are not generally triggered on the cessation of a hedging arrangement (the gain or loss from the hedge will be recognised at the time chosen under the special procedures for hedges), writing off a bad debt, or the conversion of a convertible debt instrument into shares. There is no special rule, however, to prevent recognition of losses on a debt-for-equity swap.
When a relevant event occurs, a balancing adjustment process is legislated in the 2007 ED. The taxpayer will need to compare amounts (if any) taken into account while the financial arrangement was on foot with the amount of its actual gain or loss, and then record any surplus or deficiency as income or allowable deduction. Again, the object of the regime is to remove the possibility that some gains or losses made on the expiry or sale of financial arrangements will be capital gains or losses, and to ensure that any amounts which have not been recognised during the term of the arrangement are finally included.
The amount of any resulting gain or loss is recorded in the year that the relevant event occurs.
5. Fair value regime
The 2007 ED retains the elective regime set out in the 2005 ED which allows certain financial arrangements to be taxed on a fair value (i.e., a mark-to-market) basis. Certain taxpayers will have an option to replace the basic accruals or realisation scheme with fair value accounting for some of their financial arrangements.
5.1 Eligibility
The fair value election is only available to taxpayers which prepare accounts in accordance with Australian or foreign accounting standards and whose accounts are required by law to be audited. The banking and finance industry pushed for the availability of this election, but the regime is not limited to entities in that sector. Individuals and small businesses will only be able to make this election if they meet those requirements and elect to enter the TOFA regime in its entirety.
5.2 Scope
If the fair value election is made, it will apply to each financial arrangement which:
• is reported in that set of audited financial statements; and
• must be classified in the entity’s accounts as at fair value through profit and loss.
The election does not apply to the issuer of an equity interest.
The election is universal – it extends to every financial arrangement in the audited accounts that is or should be accounted for in this way. (This may raise interesting issues where the relevant assets – e.g., shares – would otherwise have been held on capital account for tax purposes.) The election is irrevocable, although it can cease to have effect if the taxpayer or the arrangement no longer qualifies.
5.3 Effect
Broadly speaking, where the taxpayer has made the election, the 2007 ED aligns the amount of income or deduction to the amount required to be reported in the taxpayer’s financial statements. If the taxpayer or an arrangement no longer qualifies for this treatment, the 2007 ED requires a balancing adjustment computation to be made. Thereafter, presumably the basic compound accruals or realisation regime will apply.
The 2007 ED caters for the situation where a financial accounting standard splits a transaction into two parts, only one of which is fair valued.
6. Retranslation of foreign currency positions
The 2007 ED retains an elective regime which allows certain foreign currency denominated positions to be taxed on a “retranslation” basis. The 2007 ED elaborates on the 2005 version by offering an additional and more limited election applicable just to a taxpayer’s “qualifying forex accounts.”
The retranslation regime allows certain taxpayers to re-state the amount of foreign currency denominated loans and borrowings (i.e. assets and liabilities) at their Australian dollar value adjusting for the movement in exchange rates during the year. (Other effects which would be taken into account under a fair value approach, such as movements in interest rates or changes to the creditworthiness of the borrower, are not taken into account under the retranslation regime.)
6.1 Eligibility
The retranslation election is only available to taxpayers who prepare accounts in accordance with Australian or foreign accounting standards, and whose accounts are required by law to be audited. Individuals and small businesses will only be able to make this election if they meet those requirements and elect to enter the TOFA regime in its entirety.
6.2 Scope
Two retranslation elections are possible. One applies to each financial arrangement which:
• is reported in that set of audited financial statements; and
• generates an amount that is recorded as profit or loss in accordance with the Australian accounting standard AASB 121 or comparable foreign standard.
This election (directed, but not limited, to banks and other financial institutions) extends to every financial arrangement in the accounts that is or should be accounted for in this way.
The second election (which may be of some interest to certain non-bank taxpayers) is more narrow – it extends just to a taxpayer’s “qualifying forex accounts.” This is an account denominated in foreign currency held for the primary purpose of facilitating transactions.
Both elections are irrevocable, although they can cease to have effect if the taxpayer or the arrangement no longer qualifies.
6.3 Effect
Again, where the taxpayer has made either retranslation election, the 2007 ED aligns the amount of income or deduction to the amount required to be reported in the taxpayer’s financial statements. If the taxpayer or the arrangement no longer qualifies for this treatment, the 2007 ED requires a balancing adjustment computation to be made. Thereafter, presumably the basic compound accruals or realisation regime will apply.
7. Revised hedging rules
The 2007 ED retains the optional tax timing hedging regime proposed in the 2005 ED. The big news in the 2007 ED, and perhaps the most significant development since the original 1993 TOFA Consultation Document, is the addition of a tax character hedging regime.
7.1 Proposed hedging rules – the timing and character dimensions
The 2007 ED retains an elective hedging regime to defer gains or losses arising from financial arrangements put in place to hedge the risk on an underlying position. This aspect of the hedging regime will be most useful in the common situation where a taxpayer cannot put in place a single hedge that it will realise when it realises the hedged item, and must instead protect its position by a series of rolling hedges. Under the 2005 ED, the usefulness of the election was subject to two time limitations: the gain or loss from the hedging arrangement had to be recognised within 20 years if there was only one hedged item, or within five years if there was more than one hedged item. Both of these limits have now been removed and it seems taxpayers can defer gains and losses on a hedging arrangement without an arbitrary time limit.
The hedging regime in the 2005 ED contained no rules about character matching. Character matching problems arise, for example, where the taxpayer has a primary position involving a capital asset or liability and has hedged that position with a derivative. While the hedging regime in the 2005 ED would have often allowed the time for recognition of any gain or loss on the derivative to be matched to the time of recognising loss or gain on the underlying item, it did not deal with the fact that the character of the two items differs – the gain or loss on the primary position would be on capital account, but current law and the TOFA rules would typically make the loss or gain on the derivative position on revenue account. The 2007 ED now contains measures to align the character of the gain or loss on the hedge to the character of the gain or loss made on the underlying item. This character matching can apply in a wide range of situations (including, for example, changing the source of income from a hedge), and not just to potential revenue or capital mismatches.
7.2 Eligibility
Because of obvious nervousness about possible abuse of this regime, access to it is circumscribed by a detailed list of conditions. (The Press Release accompanying the 2007 ED states that the Government will monitor the implementation of the hedging rules to ensure that they are used as intended and not “exploited.”)
The hedging election is available to taxpayers who prepare accounts in accordance with Australian or foreign accounting standards, and whose accounts are required by law to be audited.
The taxpayer can make the relevant election for a financial arrangement that is either a “derivative financial arrangement” or a “foreign currency hedge” (e.g. a foreign currency borrowing used to acquire foreign assets).
The hedging arrangement must be entered into in order to hedge risk in relation to an underlying asset, liability or transaction. The arrangement must be designated in the taxpayer’s financial accounts as a hedging arrangement, and must satisfy the requirements of the local or foreign accounting standards (currently AASB 139 in Australia) to be classified as a hedging arrangement. There is a requirement that the hedge “must be expected to be highly effective …” in reducing risk and be regularly reviewed. Finally, other detailed records must be prepared and maintained. The 2007 ED insists that the taxpayer prepare a record which describes the hedging transaction in precise detail – the hedge, the hedged item, the risk against which the hedge protects, how the effectiveness of the hedge will be assessed – and, just as importantly, sets out the basis for determining when the gains and losses from the hedging transaction will be brought to account for tax purposes. The Commissioner does have some discretion to disregard failure to meet strict compliance with some requirements.
7.3 Scope
The election extends to every hedge that the taxpayer has or puts in place and which satisfies the relevant requirements. The election is irrevocable.
7.4 Effects
Timing. Where a hedging election has been made, the time of any gain or loss made from holding or realising the hedging financial arrangement will be shifted to another year of income – the year(s) identified in the records which the taxpayer was obliged to prepare detailing the hedging strategy and the hedging arrangement.
The taxpayer is required to allocate the hedge gains and losses on an objective basis so as to fairly and reasonably correspond with the basis on which gains and losses will be recognised on the underlying hedged assets. In order for the hedging election to be useful, it will be necessary that a taxpayer be able to specify an indeterminate future year, e.g. “the year in which a [specified] capital asset may be eventually sold.” The 2007 ED needs to be amended so that this style of indeterminate allocation is clearly permitted.
The original timeframe designated by the taxpayer for the recognition of hedge gains or losses will continue to apply notwithstanding that the taxpayer:
• revokes the hedging designation;
• “redesignates” the hedging financial arrangement; or
• ceases to meet the “effectiveness” requirement in relation to the hedge.
A different outcome applies where –
• the taxpayer ceases to hold the underlying hedged item or items – e.g., it sells out early; or
• it becomes likely that a proposed transaction for which the hedge was put in place will now not happen.
In each of these cases, the taxpayer must record an amount of gain or loss on the hedge in the year in which such an event occurs. Because there may not have been an actual realisation of the hedging financial arrangement, the taxpayer is deemed to have sold the hedging financial arrangement for its market value and then re-acquired it. This has the twin effects that the gain or loss on the hedging arrangement is deemed to be realised and the taxpayer has a cost in the financial arrangement so that the ordinary TOFA rules can apply to the arrangement thereafter.
Character issues. Where a hedging election has been made, the character of gains or losses made from holding or realising the hedging financial arrangement will be re-classified to match the character of the hedged item. This requires stipulating both character and Australian or foreign source. For example, if the hedging arrangement is put in place to hedge the currency risk for an expected amount of foreign source assessable income, a gain or loss made on the hedging arrangement is also treated as assessable foreign source income or a loss incurred in earning foreign income. If the underlying hedged item is anticipated to be an amount of non assessable non exempt income (e.g. certain foreign dividends) or a capital gain which may not be recognised under the foreign active asset exemption, then the hedge gain or loss can take the same character.
For many taxpayers, the hedge character matching rules will be of profound importance and may lead to significant changes in their tax positions, and in the way that they actually undertake hedges (e.g. some hedges will no longer need to be “grossed-up” to achieve a de facto character match).
8. Alignment of tax and financial accounting
One common theme to the submissions made by some industry sectors (especially the banking and finance industry) since the inception of the TOFA project, has been the desire to see direct linkage between tax and financial accounts, where accounts are prepared in accordance with appropriate accounting standards and are audited. The Government moved some way toward this position in the 2005 ED in the fair value accounting regime and the retranslation election. The 2005 ED also proposed a curious compromise – that the Commissioner could accept the amounts shown in the taxpayer’s accounts if the taxpayer had made certain elections and the difference was insubstantial. Industry continued its lobbying for more direct alignment of tax and financial accounting during the consultation on the 2005 ED.
At first glance, the 2007 ED appears to accept the industry submissions without reservation: it offers certain taxpayers an irrevocable and universal election to report the amounts shown in their audited and unqualified financial accounts as the amount of gain or loss from their financial arrangements. In reality, the fine print shows that the 2007 ED has gone only one half-step further.
There are many conditions which seriously limit access to this election. One is the requirement that the overall amount of gain or loss appearing in the audited accounts from financial arrangements “must be the same as the amount of those overall gains or losses as determined by applying [the TOFA methodology] …” A second condition is that any difference from a TOFA methodology is “reasonably expected not to be substantial …” A third condition is that making the election must be “reasonable and appropriate” because it saves compliance costs.
These conditions effectively mean that taxpayers in some situations may need to go to the effort of computing gains and losses using the TOFA methodology to see if there are differences individually and in aggregate, and whether they are “substantial.” They will also need to be mindful of the fact that their financial accounts will have been prepared with the benefit of a materiality threshold.
This election for formal alignment does not extend to hedges; the taxpayer must still apply the stipulated TOFA rules in respect of hedging transactions instead of the positions appearing in their audited financial accounts. (The rationale for this approach is that, unlike tax law, financial accounts do not have differential character outcomes for gains and losses.)
9. Application to consolidated groups
One constant issue in any income tax reform these days is how it applies to a tax consolidated group. For TOFA, a key consolidation-related issue is how the fair value, retranslation, hedging and financial accounts elections will apply within consolidated groups. In the 2005 ED, the policy was apparently to allow consolidated groups to make these elections but with differential effect – for example, to allow a subsidiary member not to be bound by the fair value election made by the head entity. Certainly, industry groups have lobbied very strongly and persistently for such an outcome.
It is understood that this policy remains unchanged in the 2007 ED, although the provisions permitting this are perhaps less clear than in the 2005 ED. The provisions refer to a person making the election and it is conceivable that if this person were the head entity of a consolidated group, the election would operate for all of the subsidiary members of the group. It is to be hoped that any residual doubts can be removed by the time the final version of the legislation is enacted.
10. Interaction between TOFA and other measures
The 2007 ED was accompanied by a separate Consultation Paper on the interaction of the TOFA regime with current law. The issue of how TOFA meshes with the multitude of existing provisions in the legislation is not easy. The tax legislation contains provisions dealing with bad debts, borrowing expenses, debt forgiveness, annuities, traditional securities, discounted securities, leasing arrangements of various kinds, hire purchase, instalment sales, foreign exchange gains and losses, convertible instruments, and securities lending to name a few. Some of these regimes could be removed in light of the new regime, some will clearly have to amended, but it is not clear which ones will survive nor how extensive the amendments will be. Further, there will need to be ordering rules where an existing regime survives and covers the same territory as the TOFA rule.
Unfortunately, the Consultation Paper on the interaction of the TOFA regime with current law does not clearly explain what is intended, but a degree of informed guesswork suggests some possibilities.
First, the current drafting of the 2007 ED makes it clear that the intention of the drafters is for the TOFA regime to have priority where it applies, to the exclusion of other possible regimes. Having said that, it is clear the existing debt forgiveness rules will have priority over TOFA; the 2007 ED triggers the TOFA rules only for any balance after the debt forgiveness rules have been worked through.
Secondly, it is clear that some of these regimes will survive the enactment of TOFA in order to deal with transactions that fall outside the proposed definition of financial arrangement because of the various exceptions to the definition. The rules dealing with luxury car leases and hire purchase are possible examples.
Thirdly, existing regimes will need to remain in place for the financial arrangements of individuals and small businesses that qualify for exclusion. For example, it is understood that finance leases of equipment will be dealt with under the TOFA rules so far as the lessor is concerned, but under existing law for lessees who are individuals or small businesses. The much criticised existing foreign exchange gains and loss rules will seemingly need to remain in place for them as well, and may, as a result, have residual application in some situations to other taxpayers.
11. Commencement and transition
11.1 Start date
The 2007 ED proposes that the TOFA regime will apply to financial arrangements issued (or acquired) in years of income commencing on or after 1 July 2008.
Taxpayers may elect to accelerate this date – to have the TOFA regime apply to financial arrangements issued (or acquired) in years of income commencing on or after 1 July 2007. The election must be made by the date upon which the taxpayer’s first tax return after 1 July 2007 is lodged – this will mean in many cases, by the time of lodging the return for the 2006-07 income year. The 2007 ED does not indicate how this election is to be made, nor whether it must be communicated to the Commissioner.
11.2 Existing financial arrangements at start date
Whichever start date is chosen, financial arrangements existing on that date will prima facie not be within the scope of the measures. (At present, there are no rules that would bring existing financial arrangements into the new regime if a “material variation” were made to an existing financial arrangement.)
This means that taxpayers would need to operate two systems – existing law for existing arrangements until they expire or are sold, and the new law for arrangements issued or acquired after the start date. However, presumably in order to remove the need for two systems, there is an election which allows taxpayers to bring existing financial arrangements held at either commencement date into the new system. The election extends to all financial arrangements existing at the start date.
The election must be made by the date upon which the taxpayer’s first tax return is lodged after the start of the first year to which the TOFA regime applies (not the later date being the lodgement of the first tax return affected by the TOFA measures). The 2007 ED does not indicate how this election is to be made, but it must be communicated to the Commissioner.
Where a taxpayer elects to bring existing arrangements into the new law, the 2007 ED requires the taxpayer to undertake a complex “balancing adjustment” computation. This adjustment is designed to capture amounts arising under an instrument that weren’t recognised in prior years and will not be recognised in future years if the TOFA methodology were adopted (and to eliminate amounts already recognised that would be recognised again if the TOFA methodology were adopted). It recognises the adjustment amount in equal portions over four years, to “smooth” the impact.
12. Unfinished business
The 2007 ED represents a substantial advance in the development of a comprehensive regime, but despite the nearly 80 pages of draft legislation and 200 pages of explanatory material, there is still more to come.
Synthetic arrangements. The Assistant Treasurer’s Press Release accompanying the 2007 ED says that the final version of the legislation “will contain rules to address the tax treatment of synthetic financial arrangements.” Those rules have not yet been released.
Interaction with existing regimes. The 2007 ED was accompanied by a separate Consultation Paper on the interaction of the TOFA regime with current law. The Tax Acts currently contain provisions dealing with annuities, traditional securities, discounted securities, various kinds of leasing arrangements, hire purchase arrangements, instalment sales, convertible instruments, debt forgiveness, borrowing expenses and securities lending. The Consultation Paper gives some initial indications about how these and other overlaps and interactions with existing tax law might eventually be managed.
13. What you need to consider now
An important initial issue for each organisation to consider is what level of organisational effort and resources to devote to TOFA, and when. There is no “one size fits all” way to deal with this issue.
Given the 15 year history of TOFA, and the various proposals over that period, it has always been difficult to know when “things are getting serious” and require close attention. For the first time, the Government has released implementation dates, and each organisation will need to determine, based upon the extent and complexity of its own financial arrangements, just how long it can afford to delay dealing with TOFA. In particular, some organisations may benefit from early adoption of TOFA (e.g. from 1 July 2007).
There will probably be further amendments to the 2007 ED. However, it is not yet clear whether this will cause delays to the proposed start dates. Having said this, given the work still evidently required on the interaction and consequential amendment rules, we regard the stated timetable as highly ambitious and further slippage is possible.
Nonetheless, if the 2007 ED were to be enacted as it stands, how would it affect your organisation? For organisations that wish to answer this question, the following tasks would assist:
1. Scope. Undertake a high level “inventory” of the organisation’s financial arrangements, as defined in the 2007 ED. This will include a wide range of debt, equity, hybrid and derivative transactions, whether denominated in AUD or foreign currency.
2. Tax law impact and lobbying. Identify possible changes proposed by the 2007 ED to existing tax treatments, with particular attention being focussed on the hedging rules, which may impact not just on tax timing outcomes but on the tax status of transactions. Part of this exercise should compare the TOFA outcomes to the financial accounting rules applicable to the organisation’s financial transactions. Where appropriate, lobby for changes to the 2007 ED by the due date of 28 February 2007, either directly or via industry and professional associations.
3. Elections. Consider whether the organisation may benefit from each of the various elections in the 2007 ED, including the elections dealing with early adoption and the inclusion of pre-existing transactions.
4. Cash flow and profit and loss impact. Determine the likely impact of TOFA not only on cash flow but on P&L, especially in light of the hedging rules.
5. Planning, treasury and operational impact. Assess whether the organisation should change the way it enters into financial arrangements (either now or post-TOFA) so as to optimise the impact of TOFA on the organisation.
6. Compliance systems impact. Conduct a high level analysis of what would be required to implement TOFA in the organisation. How big a project would be required and how would it be managed? When would the organisation need to start, and who needs to be involved? How long will it take and how much will it cost?
For further information, please contact:
Tony Frost
61 2 9225 5982
tony.frost@gf.com.au
Jane Michie
61 2 9225 5915
jane.michie@gf.com.au
Andrew White
61 2 9225 5984
andrew.white@gf.com.au
These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions.