A new tax Bill reforms the taxation of financial arrangements. It allows for a number of methods to calculate taxable gains or losses, says Daren Yeoh.
A new arrangement
It has long been pointed out that Australian tax rules have failed to adequately keep up with financial innovation. To address this, the previous government released a tax Bill (which is expected to be reintroduced by the new government) to reform the taxation of financial arrangements (TOFA).
In my previous article ('Financial arrangements tax corporates', March INTHEBLACK), I discussed the transitional considerations and the scope of the proposed measures. This article will explain the various methodologies available to calculate the taxable gain / loss arising from eligible arrangements.
Although there are certain traps and issues that will need to be managed, the proposed rules should be commended. The measures reduce compliance costs and mitigate the inefficiencies and distortional effects on decision making resulting from accounting versus tax treatment of financial arrangements.
It is anticipated that investment funds investing into or out of Australia and multinational groups will make the election to adopt the proposed rules early (provided that this ability is not removed by the new government). Therefore, it is important that such entities commence their implementation project early to achieve a smooth transition into the new framework. The diagram below broadly depicts some suggested project implementation steps. It is noted that the proposed rules make references to the Australian equivalents to the International Financial Reporting Standards (AIFRS). As the AIFRS are generally identical to the International Accounting Standards (IAS), I will be referring to the IASs in this article.
Tax timing methodologies (TTM) In general, where an entity has a financial arrangement that falls within the ambit of the proposed regime, it can elect to apply certain TTMs to calculate the gain / loss from the arrangement for tax purposes. The aim of the elective TTMs are to more closely align the tax and commercial (i.e. accounting) treatment of gains / losses from financial arrangements. Where the relevant elective method is not chosen to apply, then the relevant default calculation method must be used.
There are four elective TTMs and two default TTMs that may apply to a particular financial arrangement. See Table 1, which is set in the order of priority. For example, the fair value method does not apply if either the hedging method or the financial report method is elected.
Also, for all the methods above, there is a requirement to perform a balancing adjustment calculation on the occurrence of certain events.
There are three salient points in relation to the TTMs. Firstly, a common feature of the elective methods is that the entity must generally prepare its financial statements in accordance with the accounting standards and the accounts must be audited.
Secondly, the elective methods are optional but once made, they are irrevocable. However, the relevant method may cease to apply if the relevant conditions are no longer satisfied (for example, the accounts are no longer audited or prepared in accordance with the accounting standards).
Finally, the new rules represent a rather unique challenge for tax managers. This is because, to apply some of the TTMs, the tax manager will need to have a sound understanding of the relevant accounting standards (including the very complex IAS 39 dealing with financial instruments) and some aspects of business finance.
Table 1
Elective
Default
Elective hedging
Compounding accruals
Elective financial report
Realisation
Elective fair value
Elective retranslation
Table 2: Who should use this method:entities that enter into hedging transactions
Advantages
Disadvantages
Compliance cost savings
Hedging documentation required
Practical
Losses not deductible if exemption applies to hedged items
Auditors can understand
Compliance cost will be incurred to monitor differences between the proposed tax rules and the accounting standard.
Less difference between accounting and taxable income
Match treatment of hedgeding instrument and hedged item
Hedge gains may benefit from exemptions for hedged items
Elective hedging methodology Hedging activity is used frequently by investment funds, multinational groups and / or foreign investors to manage risk associated with the value of an asset, foreign exchange variations or financial exposures created from an anticipated transaction (the 'hedged item').
Derivatives are often used to manage the risk. These include swaps, forward contracts, options and futures (the 'hedging financial arrangement / hedging instrument'). Non-derivatives can also be used. For example, an Australian tax resident may apply a natural hedge strategy by borrowing in US dollars to fund a US dollar denominated investment.
Currently, there is a mismatch between the tax and accounting treatment of hedges. A mismatch also exists between and the tax treatment of the hedging instrument and the underlying hedged item. For example, the realised gain on a hedging instrument (where it is a cash flow hedge that qualifies for hedge accounting) may not be recognised in the accounting profit and loss but will represent assessable income for tax purposes.
The elective hedging methodology seeks to bring the hedge accounting concept espoused in IAS 39 within the taxation framework. In particular, the rules governing this TTM mirrors and / or relies on certain definitions and requirements contained in IAS 39.
There are similarities between the two. Both apply to derivatives with the exception of foreign currency risks, where non-derivatives can also be used. Both have the same documentation requirements (except that the proposed tax rules have additional documentation requirements relating to the allocation and tax characterisation of the tax gains or losses from a hedging arrangement). Thirdly, both require the hedge to be highly effective. In this regard, the proposed rules apply the conditions / test contained in IAS 39.
Broadly speaking, if the hedging instrument qualifies for hedge accounting, it will also be eligible for hedge tax treatment. As a result of the similarities between the proposed rules and IAS 39, tax managers would be able to rely on the work of the finance / treasury team in determining whether the hedging election can be made with respect to the hedging instrument.
But in limited circumstances the proposed rules allow entities to adopt hedge tax treatment for certain arrangements even when they do not meet the accounting standard hedge requirements. Another difference is that the proposed rules contain tax character matching, which is irrelevant in the context of IAS 39. Such differences will need to be borne in mind when performing the relevant tax calculations.
To apply the elective hedging method, the taxpayer accounts must comply with the accounting standards (in particular IAS 39) and the accounts must be audited. Once the election is made, it will apply to all eligible hedging arrangements. That is, one in all in.
Calculating taxable gain / loss under hedging If the TTM is applied, an entity can generally allocate gains and losses from a hedging financial arrangement on an objective, fair and reasonable basis. The allocation of the gains / losses from the hedging instrument should reasonably correspond with the basis on which the gains / losses from the hedged item are allocated.
The tax classification of the gain or loss will also depend on the hedged item. For instance, if the hedging instrument is used to hedge a capital asset, then the gain / loss from the hedging instrument will be treated as a capital gain / loss. If the gain / loss on the sale of the hedged items is exempt from capital gains tax, then the gain / loss on the hedging instrument will generally also be exempt from tax.
When determining how the taxable gain / loss from the hedging instrument can be allocated and the tax character of the gain / loss, the entity may consider the following steps:
Step 1: Identify the hedging instrument and the underlying hedged item.
Step 2: Determine the accounting treatment of the hedging instrument. Note: With respect to the hedging instrument, IAS 39 differentiates between three kinds of hedges.
Fair value hedge whereby:
The entity hedges a change in fair value of a recognised asset or liability or firm commitment
The change in fair values of both the hedging instrument and hedged item are recognised in the profit and loss when they occur.
Cash flow hedge whereby:
The entity hedges changes in the future cash flows relating to a recognised asset or liability or a probable forecast transaction
The change in the fair value of the instrument is recognised directly in equity until such time as those future cash flows occur, in which case the amount in equity is transferred to the profit and loss.
Hedge of a net investment in a foreign operation:
A foreign operation is defined to be an entity that is a subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity.
A hedge of a net investment in a foreign operation is treated as a cash flow hedge.
Step 3: Determine the tax treatment of the hedged item.
Step 4: Determine the tax character and allocation of the gain / loss from the hedging instrument. This should reasonably correspond with the manner in which the gain / loss on the hedged item is taxed.
Step 5: When computing the taxable income of the entity, compare the results of Step 4 with Step 2 and make the necessary tax reconciliation adjustment as required.
Elective financial report The advantages and disadvantages of this TTM are similar to that of the elective fair value method in Table 3.
Where the relevant conditions are satisfied, the entity can make an irrevocable election to rely on the financial reports. This means that the taxable gain or loss on the eligible financial arrangement will be the amount recognised in the profit and loss of the entity.
However, it is cautioned that the election is only available if the overall gain / loss and the gain / loss calculated from year to year using the financial report election will not be substantially different to that calculated under other TTMs that would otherwise apply. Given that Australia operates under a self-assessment system, this condition should be verified on an ongoing basis.
Importantly, not all gain or loss in the profit and loss will be taxed under the new rules. For instance, dividend income will continue to be taxed under the current rules. That is, a franking offset will continue to be available for franking credits attaching to franked dividends received.
Also, where relevant, the entity may still prefer to make the hedging election even if the financial report election is made. This is because the latter does not apply to gains / losses recognised in equity. Also, the financial report method does not match the character of the gains / losses of the hedging instrument to the hedged item.
Entities will need to evaluate whether the compliance benefits of this elective method will outweigh the issues associated with unrealised gains being subject to tax. For example, the taxable component of distributions from a property or investment trust will be higher when the trust, having made this election, has to include significant unrealised gains in its assessable income.
Elective fair value method For accounting purposes, certain financial assets and liabilities are fair valued through the profit and loss ('fair value accounting'). This means that the change in the fair value of the relevant asset / liability between two periods of time is recognised as an income or expense in the profit and loss.
Broadly, IAS 39 allows fair value accounting for the following financial assets and financial liabilities:
financial assets and liabilities held for trading including those held for short-term profit taking
certain financial asset and liabilities that the entity can designate to be measured at fair value through the profit and loss
derivative assets and liabilities not held for hedging purposes
Under the current rules, changes in fair values are considered unrealised. Therefore, the gain / loss is not taxed until the gain / loss is realised (which occurs when the asset is disposed or the liability settled). It is noted, however, that where the portfolio is held as trading stock, a revaluation of the closing stock (for tax purposes) would effectively subject the value increase to taxation. Although the deferral of taxation of unrealised gains is a tax timing advantage, it does create a mismatch between the accounting and tax treatment of the investment. It also requires tracking of the original costs of the financial asset or liability to correctly calculate the total gain or loss from the arrangement.
When the relevant conditions are satisfied, an entity can make an irrevocable fair value election to be taxed on the changes in the fair values recognised in the profit and loss account, adjusted for amounts paid and received during the period. The gains or losses will be taxed on revenue account.
The increased correlation between the accounting and tax treatment of the trading portfolio should reduce compliance costs and achieve economies in record keeping and data management.
When there is volatility in the market prices, the entity may face a similar volatility in the tax payable and may also be subject to tax on significant unrealised gains. Accordingly, this election must be supported by a strong cash management process.
Table 3: Elective fair value method
Who should use this method: entities that hold trading portfolios.
Advantages
Disadvantages
Compliance cost savings
Unrealised gains are subject to tax
Practical
Cash flow impact arising for siginficant unrealised gains
Auditors can understand
Less difference between accounting and taxable income
Deduction for unrealised losses
Less of a need to track original costs
Elective foreign exchange retranslation method Currently, foreign exchange (forex) gains and losses are taxable only when they are realised. The exchange rate required to be used to calculate the forex gains or losses for accounting and tax purposes may differ. This means that tax practitioners may be required to verify the veracity of the allocation between realised and unrealised forex gain / loss recorded for accounting purposes. This may be time consuming and result in significant compliance costs.
Under the proposed rules, taxpayers can elect to use the accounting forex gain / loss calculation figures for tax purposes. This election only applies to forex movements and will apply in conjunction with other TTMs. The election applies in two circumstances. The first is forex movements of all arrangements that are required by IAS 21 to be recognised in the profit and loss (the 'general retranslation election'), and the second is certain foreign currency-denominated bank and credit card accounts (the 'qualifying forex account election').
When taxpayers do not want to make the general retranslation election, they may still make the qualifying forex account election.
The election cannot apply to forex gains or losses recognised in equity (for example, a reserve account) and amounts recognised in the profit and loss after having been recognised in equity earlier.
The default: compounding accruals method and realisation method All affected financial arrangements will have gains / losses worked out using these default methods unless the arrangement is an equity interest or an elective method applies to the arrangement. An exception to the second exception is when the elective foreign currency retranslation method (where that method applies to determine the foreign currency gain or loss from the arrangement) is applicable. In this case, the accruals or realisation treatment may still apply to determine the non-foreign currency gain or loss component of the financial arrangement.
Broadly, the compounding accruals method must be applied if there is sufficient certainty that the relevant gain / loss from the arrangement will be obtained. The proposed measures provide guidance in determining whether the 'sufficient certainty' test is satisfied.
The compounding accruals method allocates / spreads gains and losses from a financial arrangement to income years according to its internal rate of return on the assumption that the arrangement will be held for its remaining term.
When the compounding accruals method is not applicable, then the realisation method applies. The realisation method allocates gains and losses to income years when they occur, which will generally be when the relevant financial benefit representing the gain / loss is due to be provided / received.
It is possible for both the compounding accruals method and the realisation method to apply to gains / losses arising from a single financial arrangement. This may occur because some of the financial benefits under the financial arrangement are sufficiently certain and others are not.
Interaction with other measures In the case of a tax-consolidated group or a multiple entry consolidated (MEC) group, elections are made by the head company of the group. Generally, the election will apply to all the relevant transactions of all members of the tax-consolidated group or MEC group.
In the case of tax-effect accounting, the application of the default methods will simplify the accounting for income taxes. As accounting / commercial and tax are more closely aligned, the deferred tax balances will be smaller if the relevant elective TTM is applied.
What it all means The proposed rules are generally set to apply from 1 July 2009. However, entities can make an election to apply the rules from 1 July 2008, provided that this election is not removed by the current government. There may be advantages to be gained from the early adoption of the rules. It is recommended that entities commence their TOFA implementation project to achieve a smooth transition to the new rules.
Steps to consider
identification of affected business units and stakeholders and the formation of a project team
assess resource requirements and organise training and workshops as required
information identification, collation and compliation
establishment of financial arrangements an dissues database
analysis of the information including performing computations and comparing the results under the ulternative TTMs
Documentation of risks, issues and opportunities. The reasons for adopting the applicable TTM should be documented. Also steps to manage the risk (for example cash flow risk) resulting from the election should be listed.
Prepare documentation to evidence the elections made and identify systems and controls required to support the election.
