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

Taxation of Financial Arrangements (TOFA)

Briefing

Sydney

24 January 2007

Outline

• Presentations by:– William Potts, Treasury– Tony Frost, Greenwoods & Freehills– Andrew White, Greenwoods & Freehills

• Q&A session

Taxation of Financial Arrangements

(TOFA)Stages 3 and 4

Exposure Draft Legislation(2nd ED - released January 2007)

William Potts

Business Tax Division

Treasury

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

Background

Financial innovation

Inappropriate and uncertain tax treatment of financial arrangements– swaps

– discount

– option premiums

Development of financial accounting treatment of financial instruments

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

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

Major changes

Major issues and changes

Second Exposure

Draft

Consultationand 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

Scope

The scope of the draft legislation is

determined by:

– The definition of financial arrangement

– Specific exceptions

– Additional operation

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

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

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

Additional Operation

Foreign currency

Non equity shares

Commodities held by traders

The tax timing methods

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Balancing Adjustment

Financial Reports

Accruals

Fair Value

Realisation

Retranslation

Hedging

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

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

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

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

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)

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

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

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

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

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)

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

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

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

Tony Frost

Director

Greenwoods & Freehills, Sydney

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

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?

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.’ ”

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

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 …”

“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

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

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

FA: Primary test – Exception 1

• No FA if … (s.230-40(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 (?)

FA: Primary test – Exception 2

• Right/obligation of a monetary nature does not include … (s.230-40(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?

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.230-45(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

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)?

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”.

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?

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)

Elections: TCG vs individual entities$64 question: How do the fair value, retranslation and financial reports elections apply?

Bank/ADI(Head Co)

Insurance sub Other subs

Tax Consolidated group (TCG)

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?

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

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

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)

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

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

Recognition methods, disposals and hedging

Andrew White

Senior Associate

Greenwoods & Freehills, Sydney

Overview

• Basic recognition methods

• Disposals of FAs

• Elective tax hedging method

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

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

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

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

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

More complex exampleExample 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

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

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

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

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

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

“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

“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

Things to do for each FAOutset

• 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

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)

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

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)

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

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

Elective hedging rules

• 2 examples in the EM: – forward FX contract hedging forward purchase of

depreciable plant/equipment – hedging future minerals production via futures

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

Character matching

• Examples in EM– cross currency interest rate swap

• Possible outcomes– Australian sourced hedge of foreign

income

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?

Q & APanel

William Potts, Treasury

Tony Frost, G&F

Andrew White, G&F

www.gf.com.au