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Financial arrangements tax corporates

The expression 'buyer beware' aptly applies to the proposed measures, released by the previous government, dealing with the taxation of 'financial arrangements'. The rules are contained in the Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2007.

While the proposed changes are generally positive (especially in respect to the taxation of foreign currency hedges), taxpayers will need to take care when choosing to apply the various elections contained in the Bill. It is also noted at the outset that although this Bill has lapsed, it is expected to be reintroduced by the new government.

The object is to more closely align the tax and commercial (e.g. accounting) treatment of gains / losses from financial arrangements and to minimise compliance costs. It seeks to do this by incorporating concepts from the accounting standards into the framework and providing flexibility in relation to the calculation of taxable gains or losses from financial arrangements. However, the Bill contains both opportunities and traps that will need to be managed.

The range of transactions, agreements, instruments, rights or obligations caught by the new rules are extremely broad. Therefore, it should not be assumed that the rules will only apply to hedging transactions.

The new rules apply from income years commencing on or after 1 July 2009 (the 2010 income year for entities with a 30 June year-end). However, taxpayers can elect for the rules to apply to them from 1 July 2008.

When the proposed law applies, taxpayers may elect to apply the rules to arrangements entered into before the relevant start date (with the gains / losses generally spread over four years). Therefore, it may be worth structuring arrangements in anticipation that an election may be made to apply the proposed legislation to them.

Also be aware that arrangements / agreements entered into before the applicable commencing date may, due to certain events or variations, give rise to a new financial arrangement. Accordingly, it should not be assumed that all agreements entered into before the commencing date will not be affected by the Bill.

The government's rationale

There is currently no one set of rules that apply to all financial arrangements. Taxpayers need to rely on different areas of the law, which include amendments that have been introduced in an ad hoc manner and have tended to be piecemeal in nature. Accordingly, there is, at times, no certainty for taxpayers as to whether their interpretation of the relevant tax rules will be accepted by the tax commissioner.

There is also a need to align the accounting and tax treatment of financial arrangements. This will reduce the need to do multiple calculations to meet both needs and improve communication between the financial accounting, tax and treasury departments. To this end, the Bill incorporates certain accounting concepts into the framework, which means that tax personnel will need to understand the relevant accounting standards relied upon by the Bill.

Entities most affected

Entities that enter into hedging transactions, whether for speculative or risk management purposes. This will include:

• investment funds that use capital and income hedges to manage the foreign currency exposures of their overseas investments
• entities that enter into foreign currency denominated transactions
• share traders
• financial institutions and entities that issue, hold, invest or trade in financial instruments (including debt securities)

Normal transactions not involving derivates or foreign currency could also be caught by the proposed rules. These include, among other things, deferred settlements for property purchases, prepayments and earnouts not based on economic performance.

The general framework

The legislation is a principle-based framework. In other words, taxpayers will not find a subdivision in the Bill that deals solely with, say, cross-currency swaps or forward contracts. Instead, the Bill in general, sets out the principles and rules that should apply to all financial arrangements.

The Bill, with some exceptions, generally taxes gains / losses from financial arrangement on a revenue basis (as opposed to taxing them as capital gains). Herein lies the first trap. If a gain is taxed on revenue account, then taxpayers lose certain capital gains tax concessions, such as the capital gains tax general 50 per cent discount. Also, the taxpayer will not be able to apply its carried forward capital losses against the revenue gains.

To calculate the gains or losses, there are certain elective methods that may be used. These methods generally follow the treatment of the gains / losses under the accounting standards. If the elective methods are not used, then taxpayers will need to, by default, apply either the 'accruals method' or the 'realisation method', as relevant.

Which transactions are caught?

The most important aspect of the Bill for a CFO / CEO to comprehend is: which transactions are caught by the new rules? This will enable the officer to understand whether a particular venture, agreement or acquisition / disposal transaction is affected by the proposed rules and to negotiate the terms accordingly.

Financial arrangements caught by the proposed rules

A transaction / scheme is caught by the proposed legislation if it satisfies the definition of a financial arrangement.

In broad terms, a financial arrangement exists if there is (either actual or in substance) a right or obligation to receive / pay money.

The reader will note that this definition is very broad. It is not difficult to run down one's own balance sheet and find numerous items that will meet this definition. The table below, lists some of the rights or obligations that will satisfy the above definition (but note exclusions below).

The saving grace is, where under an arrangement, either party has a right to receive or an obligation to provide something other than money, the arrangement will not give rise to a financial arrangement.

Example:
Bill Co enters into an agreement on 1 July 2006 to sell land to Jim Co for $100,000. At the time of the agreement, Bill Co has a right to receive a financial benefit of  $100,000 and an obligation to provide a non-monetary benefit (title to the land). As Bill Co's obligation to provide the land is not insignificant when compared to its right to receive payment from Jim Co, the entire arrangement will not constitute a financial arrangement.

The Bill is relevant to retirement village operators. It also specifically clarified that the example of Bill Co would apply equally to rights and obligations under a retirement residence / services contract. The same should apply to time-charters of vessels and aircrafts.

An equity interest is a financial arrangement

An equity interest is specifically treated as a financial arrangement. The definition of an equity interest is contained in the Income Tax Assessment Act 1997 and would include ordinary shares in a company. (The rules in relation to the equity / debt dichotomy were introduced in 2001 as part of Stage 1 of the TOFA reforms.)

Furthermore, a right or obligation to receive or provide an equity interest will also be an equity financial arrangement. An example would be a call option on the shares in a company or a unit in a unit trust.

While an equity interest constitutes a financial arrangement, the rules, in effect provide that the existing taxation treatment (e.g. taxation under the CGT provisions, imputation rules, taxation of dividends, etc.) will continue to apply, provided that the relevant elective methods are not chosen to apply with respect to the equity interests.

Therefore, where a taxpayer (or its unit holders, if the taxpayer is a flow-through unit trust), is relying on CGT concessions, then the taxpayer should exercise caution when deciding whether or not to apply the elective methods under the Bill. This is because, if the investments are caught under the proposed legislation, they may be taxed on revenue account. Accordingly, the taxpayer risks losing the benefit of CGT concessions or not being able to apply capital losses against the gains.

Exclusions from the proposed rules

To reduce the compliance burden for certain entities and to address the fact that certain arrangements are already adequately dealt with by existing tax provisions, the Bill allows certain arrangements to be excluded from the operation of the proposed legislation.

Excluded entities

Certain entities do not need to apply the new rules provided that the relevant conditions are satisfied. These include individuals, certain financial sector entities (with less than $20m turnover) and any other entity with less than $100m turnover.

Also, most importantly, to the relief of Australian investment / property funds with foreign investments, the proposed regime can be disregarded when calculating assessable income under certain foreign source income anti-tax deferral regimes.

Excluded arrangements

As previously noted, the definition of a financial arrangement is very broad.

The proposed rules address this by excluding certain arrangements from the ambit of the proposed rules. The key exceptions include:

• Amounts receivable or payable for acquisition or supply of goods, property or services, where the time between the payment of the consideration and the provision of the supply is less than 12 months.
• Payments in relation to certain guarantees and indemnities. (This should include payments/receipts for breach of a warranty or indemnity clause under an asset / share purchase agreement.)
• Earn-out payments in relation to an asset or share sale where the consideration is contingent only on the economic performance after the sale. (Be careful if the contingency is not solely limited to economic performance.)
• Luxury car leases and hire purchase agreements (which are treated as a notional sale and loan transaction for tax purposes).
• Licences and leases over goods, real property and intellectual property. This will include operating leases.

Some of the exceptions may be lost if the relevant elective method is chosen to apply. Accordingly, when deciding whether or not an elective method should be used, taxpayers should also consider the impact of making the relevant election on the exception provisions.

Tax Timing Methodologies (TTM)

Once a taxpayer has determined that a particular arrangement is caught by the new rules, the next step is to decide on the TTM to be used to calculate the gain / loss. The table below sets out the TTM that may be applied:

This table is set in the order of priority. For example, the fair value method does not apply if the hedging or financial report method is elected. If an elective method is used for the relevant financial arrangement, then the default methods do not apply.

As well as applying these tax methods, a balancing adjustment generally needs to be calculated when a taxpayer ceases to have a financial arrangement.

The proposed rules will affect a wide range of taxpayers and a broad range of transactions. They will need to be taken into account when structuring financial arrangements.

These are the steps that organisations can take now:

1. Prepare a database of transactions / arrangements caught by the new rules. Agreements entered into before the start date should be analysed to determine whether they will give rise to new financial arrangements after the start date (and therefore be subject to the proposed measures).
2. Calculate the tax impact if an election is made for the new rules to apply to arrangements entered into before the start date. Calculations will be required to be done under the proposed regime going back to the beginning of the arrangement and compared with income and deductions already included or claimed in the tax return. Any overall difference will give rise to assessable income or deductions spread over four years starting with the first year (e.g. 2010 income year unless an election is made to apply the rules from the 2009 income year).
3. Assess whether the early adoption of the proposed measures will yield any benefits and determine whether your organisation has the capability to apply those measures effectively.
4. Project the impact of the new legislation on financial arrangements proposed to be entered into by your organisation. If necessary, refer to the financial forecasts documentation and speak to your treasury department in relation to planned hedging transactions. A comparison should be made between the application of the elective method(s) versus the applicable default method.
5. Consider systems and procedures required to comply with the new regime. This will require coordination between the financial accounting, tax and treasury teams.
6. Implement (or update) a policies and procedures manual with respect to financial arrangements once the above steps have been taken.

The proposed legislation and accompanying explanatory memorandum have 549 pages. In addition, the rules are highly complex. Accordingly, it is vital to prepare and commence the analysis early.

Also, it is noted that due to the calling of the federal election, the Bill lapsed. However, this should not have any practical consequence given that the Labor Government is likely to revive and pass the Bill substantively in its current form.

Also, it is hoped the government will expedite the reintroduction of the Bill to provide a reasonable lead time for taxpayers to prepare for early adoption of the proposed law.

Daren Yeoh is tax partner with Moore Stephens.

Reference: March 2008, volume 78:02, p. 55-57

Page last updated: Tuesday, 16 September 2008