Legislation to implement the third and fourth stages of the Taxation of Financial Arrangements (TOFA) reforms was introduced into Parliament on 20 September 2007 as the Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2007.
The measures in the Bill complete a program which has already seen the introduction of:
- tests to distinguish debt from equity for various purposes in the tax law (Stage 1), and
- rules which treat foreign currency (forex) gains and losses on revenue account, and deal with currency conversion (Stage 2).
In this edition of TaxTalk, the PricewaterhouseCoopers’ specialists who have been engaged in the confidential TOFA consultation process provide insights on the tax timing methodologies for financial arrangements contained in the Bill. Their particular focus is on TOFA preparation and the implementation strategy developed as a result of TOFA assignments carried out by the Firm to date.
The impact of the Federal Election
The looming Federal Election raises the strong prospect that Parliament will be prorogued, and the Bill lapse, before it is able to complete its passage. The next Parliament sitting dates are scheduled to run from 15 to 25 October 2007, and most commentators expect the election to be called before then.
However, we expect the Bill to be reintroduced by the incoming Government, whatever the outcome at the polls.
Although some might be tempted to regard the election as another reason to delay consideration of the impact of TOFA, the legislation is not expected to change markedly on reintroduction to Parliament. “TOFA time” has well and truly arrived and business taxpayers need to start considering the ramifications.
To quote President John F Kennedy: “Change is the law of life. And those who look only to the past or present are certain to miss the future”.
Commencement
The proposed rules (in Division 230 of the Income Tax Assessment Act 1997) will apply to all financial arrangements acquired on or after the first day of the first income year commencing on or after 1 July 2009.
However, taxpayers can elect to ‘go early’ and have the measures apply to financial arrangements acquired on or after the first day of the first income year commencing on or after 1 July 2008.
Pre-existing financial arrangements can be brought into the new regime
Taxpayers may also elect to apply the rules to all financial arrangements existing at the relevant start date.
However, it is worth noting that this election may give rise to a transitional “balancing amount” (ie an assessable or deductible amount) which will be spread over four years. Where the arrangement first started prior to the commencement of the new rules (ie in proposed Division 230), this transitional election will not extend to the tax character treatment for gains and losses from hedging financial arrangements subject to the elective hedging method (see below).
| Main features of TOFA
The main features of the legislation are as foreshadowed in the January 2007 exposure draft, albeit with some significant changes to the detail.
The rules apply to ‘financial arrangements’, which, very broadly, are defined as cash settlable rights/obligations to receive/provide a financial benefit.
Gains and losses from financial arrangements will, subject to various exclusions, be treated as assessable or deductible.
There is a general exclusion from the rules for individuals, finance entities with turnover less than $20 million and other entities with turnover less than $100 million, but with an option to elect in.
The rules apply on a prospective basis only, but with the option of being applied to pre-existing arrangements, in which case a balancing adjustment may be required. Such an adjustment would be spread over four years.
There is a menu of optional and default methods of bringing gains and losses to account, supported by a balancing adjustment methodology to true up the final result.
The default methods are:
- accruals, where there is a sufficiently certain gain or loss, and
- realisation, for other gains or losses.
The optional (elective) methods are, subject to various eligibility criteria:
- fair value
- foreign exchange retranslation – general or account specific
- hedging, and
- financial reports.
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Should you ‘go early’?
All entities affected by the new TOFA measures should conduct an initial scoping exercise to decide if there are compelling reasons to ‘go early’ from 1 July 2008.
If there are no compelling reasons supporting early adoption, taxpayers should commence the process of project managing the transition to TOFA so that they are ready by the general start date on or after 1 July 2009. It is expected that the Australian Taxation Office (ATO) and relevant professional and industry bodies will be working on public rulings and guidelines during the implementation phase. Those that enter the regime at the general start date will benefit most from the additional guidance.
There are possible compelling reasons to ‘go early’, however. These include:
- gaining the compliance cost savings associated with TOFA sooner rather than later (eg less adjustments from book to tax if the elective financial reports method suits the tax and accounting profile of the business)
- high levels of confidence due to an analysis of existing financial instruments used in the business, well-functioning accounting systems, and favourable tax and accounting advice (indicating that early adoption will be a relatively smooth process)
- early access to the hedging rules, particularly the character matching hedging provisions. As noted earlier, character matching cannot be obtained for pre-commencement date hedging transactions even if a transitional election is made. Access to the hedging rules could be particularly useful where your business anticipates a significant overseas acquisition during 2008–2009, and
- impact on the timing and amount of income tax payments. The management of the franking account balance and shareholder expectations relating to franked dividends will be a factor for Australian companies.
‘Carve-outs’
Not all taxpayers and not all financial arrangements are subject to the new TOFA rules. The main ‘carve-outs’ are summarised in Table 1. Given the benefits available under TOFA, there is a facility for excluded taxpayers to opt into TOFA. It is recommended that professional advice be obtained prior to making an ‘opt-in’ decision.
What has changed compared to the January 2007 exposure draft?
The Department of Treasury (Treasury) has taken on board many of the submission points made in respect of the January 2007 exposure draft and a later, confidential, draft. Some of the changes include:
- the optional and mandatory start dates have been moved back a year
- there has been a significant bulking up of both the law and explanatory material
- the turnover threshold for entities other than finance entities to remain outside the rules has been raised from $20 million to $100 million
- eligibility criteria for the various elective methods have been relaxed a little and the hedging rules made available for pre-existing arrangements (but for tax timing only, not tax character) provided these are brought into the regime, and
- the carve-out for leases has been extended to include finance leases.
| Particular taxpayer exclusions
Exclusions apply to:
- individuals
- financial entities with an annual aggregated turnover less than $20 million, and
- other entities with an annual aggregated turnover less than $100 million,
but not in respect of financial arrangements that are “qualifying securities” with a remaining term of more than 12 months at the time the taxpayer started to hold them.
However, it is possible for these taxpayers to opt into the TOFA rules by making an irrevocable election that the new rules apply to all their financial arrangements that they start to have in the income year in which the election is made and for subsequent income years
Particular financial arrangements
Exclusions include:
- short-term arrangements where non-monetary amounts are involved for goods, property or services (ie short-term trade credit arrangements, where the period between delivery and the time for payment is not more than 12 months and various other conditions are satisfied)
- leasing or property transactions, including:
a luxury car lease falling within specific provisions of the income tax law
a deemed sale and loan transaction (hire purchase) under the income tax law
licences or leases over goods or personal chattels (other than money or a money equivalent), real property or intellectual property
- an interest in a partnership or trust if there is only one class of interest in the partnership or trust or the interest is an equity interest in the partnership or trust (except if elective fair value tax timing method or reliance on financial reports method applies – see below)
- a right or obligation under certain life or general insurance policies
- a right or obligation under a guarantee or indemnity, subject to certain exceptions
- rights and obligations under specified types of personal arrangements (including the provision of personal services) and personal injury rights
- a right to receive or an obligation to provide financial benefits arising from membership of a superannuation or pension scheme
- a right to receive or an obligation that arises from an interest in a controlled foreign company a foreign investment fund or a foreign life assurance policy
- a right to receive, or an obligation to provide, financial benefits arising from the sale of a business, or shares in a company or interests in a trust that operates a business, if the amounts or the value of the financial benefits are contingent only on the economic performance of the business after the sale (earn-outs)
- rights and obligations arising in respect of infrastructure borrowing investments, farm management deposits or forestry managed investment schemes, and
- rights and obligations arising under a retirement village residence or services contract or arrangement for the provision of residential or flexible care.
There is also a regulation-making power to expand the range of exceptions.
Adjustment mechanisms
Although not expressed as exceptions, there are also adjustment provisions which, in broad terms:
- prevent losses from being allowed as revenue losses as a result of the disposal or redemption of a financial arrangement, where it can be objectively concluded that a reason for the disposal or redemption was an apprehension or belief that the issuer would be unable or unwilling to discharge its obligations to make payments under the financial arrangement, and
- ensure that gains made from the release, waiver or extinguishment of a debt under a financial arrangement continue to be subject to the commercial debt forgiveness provisions in the income tax law.
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TOFA tax timing methods in a nutshell
Tables 2 and 3 on pages 5 and 6 of this edition of TaxTalk highlight the key attributes and eligibility criteria for each TOFA tax timing method, with the exception of:
- the elective financial reports method, and
- the account specific foreign exchange retranslation election,
both of which are discussed below.
It should be noted that the relevant law relating to the summary in Tables 2 and 3, particularly for the elective methods, is complex. Advice should be obtained on the detailed operation of the law.
The elective financial reports method
For those taxpayers looking for close to full alignment of their tax and accounts, the elective financial reports method provides an important opportunity. The election is, however, irrevocable once made, so careful evaluation is required.
The election applies to all financial arrangements first held in the income year in which the election is made and all future income years.
The election does not apply to a financial arrangement that is an equity interest that is:
- not classified or designated as at fair value through profit or loss, or
- issued by the taxpayer.
Notwithstanding the election, specific adjustments for franked dividends and amounts arising on the impairment of debts are to be made to the amount of the gain or loss that is recognised for tax purposes.
Eligibility
The main requirements that a taxpayer must satisfy in order to make an election to rely on financial reports are:
- the financial reports must be prepared and audited in accordance with relevant accounting and auditing standards, and
- there must be no qualification relevant to the tax treatment of financial arrangements in those financial reports in the current year or in any of the previous four financial years.
Robust accounting systems
The degree of integrity of a taxpayer’s accounting systems and controls is relevant for those seeking to use the financial reports method. Unfavourable opinions expressed by an external auditor or a regulatory agency on the quality of the taxpayer’s accounting systems will impact on a taxpayer’s entitlement to use this method, subject to an overriding discretion vested in the Commissioner of Taxation.
Trumps every method other than elective hedging method
Where the financial reports election is made, this methodology will determine the tax treatment of relevant financial arrangements except where the elective hedging method applies. Hedging is excluded because the tax characterisation of gains and losses on hedges (see Table 3) cannot be ascertained from the taxpayer’s financial reports.
The reasonably proximate outcome requirement
Opting into the financial reporting method is not the end of the story. The new TOFA legislation contains a requirement that, despite discussions during the consultative process, continues to be of some concern. Continued use of the financial reports method depends on whether it is reasonably expected that:
- the overall gain or loss made on the financial arrangement is the same using the financial reports method as it would have been had the gain or loss been calculated under the TOFA provisions (with the exception of the financial reports method), and
- the gain or loss will be recognised at approximately the same time as it would have been recognised had the financial reports method not applied.
The concerns raised during the consultative process broadly relate to a taxpayer’s potential exposure, and the potential for costly disputation between accounting experts called as expert witnesses where an ATO investigation concludes (with the benefit of hindsight) that the proximate outcome requirement was breached.
If, however, this requirement is breached by a particular financial arrangement, only that arrangement will be denied the benefit of the election.
Table 2: The Default Tax Timing Methods
 | Compound accruals method | Realisation method |
When is it used? | Where there is sufficient certainty at the time of having the financial arrangement that a gain or loss from the financial arrangement will occur.
In applying the sufficient certainty test, assume that the arrangement will be held to maturity. | Where none of the other methods apply – it is the default method for determining the tax treatment of gains and losses arising from financial arrangements.
Specifically, if a taxpayer does not elect to use any of the elective methods, it will apply where gains or losses are not sufficiently certain. |
When is it not used? | Equity interests. | Equity interests. |
How do you calculate the gain or loss? | The gain or loss is the difference between the value of financial benefits received (proceeds) and the financial benefits provided (cost).
The method of allocating the gain or loss will be:
a compounding accruals method, or
a method whose results approximate that outcome.
The gain or loss is spread over a relevant period, typically over the life of the financial arrangement, or over the period to which a particular gain or loss from a financial benefit relates. | The gain or loss is the difference between the value of financial benefits received (proceeds) and the financial benefits provided (cost).
The gain or loss is calculated at the time when the last of the financial benefits which are to be taken into account are provided or due to be provided (or in the case of bad debts, when the debt is written off as bad). |
Table 3: The Elective Tax Timing Methods (excluding elective financial reports method)
| Fair value method | Foreign exchange retranslation election – general | Hedging election |
| When is it used? | Audited financial reports prepared in accordance with accounting standards (or comparable foreign equivalent).1
Irrevocable election made.
All financial arrangements which start to be held in the income year that the election is made (and all subsequent years), and are recognised in financial reports as required by accounting standards to be classified or designated as at fair value through profit and loss. | Audited financial reports prepared in accordance with accounting standards (or comparable foreign equivalent).1
Irrevocable election made.
All financial arrangements which start to be held in the income year that the election is made (and all subsequent years), and for which AASB 121 (or its foreign equivalent) requires amounts to be recognised in the profit or loss that are attributable to changes in currency exchange rates. | Audited financial reports prepared in accordance with accounting standards (or comparable foreign equivalent).1
Irrevocable election made.
All “derivative financial arrangements” or “foreign currency hedges” which:
start to be held in the income year that the election is made (and all subsequent years), and
satisfy the requirements of accounting standards (AASB 139) to be a hedging instrument, and
are designated and recorded as such in the relevant financial reports for the income year in which the right/obligation is created or acquired or applied.
Note this can apply to a limited number of specific hedging financial arrangements that do not meet the financial accounting standard hedge requirements.
Other criteria will need to be satisfied, including:
a record made of the hedging arrangement, including the basis upon which gains or losses will be allocated over income years and the basis on which any hedge gain or loss will be dealt with (ie tax character matching), and
the hedge must meet effectiveness tests. |
| When is it not used? | financial arrangements covered by the elective hedging or financial reports methods
financial arrangements which are fair valued through equity for financial reporting purposes
franked distributions
equity interests issued by the taxpayer
see Note 2
where requirements for the election are no longer satisfied.3 | financial arrangements covered by the elective fair value, hedging or financial reports methods
equity interests
see Note 2
where requirements for the election are no longer satisfied.3 | equity interests (other than where the interest is a foreign currency hedge issued by the taxpayer)
see Note 2
where requirements for the election are no longer satisfied.3 |
| How do you calculate the gain or loss? | The gain or loss that the relevant accounting standards (eg AASB 139) require to be recognised for the income year on the relevant financial arrangement. | The gain or loss that is required to be recognised in the profit and loss account under AASB 121 (or comparable foreign accounting standard). | The gain or loss is equal to the overall gain or loss and is allocated over income years according to an objective, fair and reasonable basis that corresponds with the basis on which gains/losses from the hedged item(s) are allocated and which has been recorded by the taxpayer.
The tax character of the hedging financial arrangement is matched to that of the underlying hedged item eg a hedge gain or loss may be treated on capital account where the hedged item is a capital investment. |
The qualifying forex accounts retranslation election (no need for audited financial reports)
There is only one tax-timing election which can be made regardless of whether the taxpayer has audited financial reports – the qualifying forex retranslation election.
In broad terms, this election replicates the existing foreign exchange retranslation election in the forex gain and loss provisions of the existing tax law, but it applies in much broader circumstances.
A qualifying forex account is an account denominated in foreign currency and which either:
- has the primary purpose of facilitating transactions, or
- is a credit card account.
It is no longer a requirement that the account be held with a financial institution. This means that this election could be applied to inter-company accounts which are commonly used by multinationals to meet foreign currency denominated transactions.
This irrevocable election can be made at any time and can apply to specifically identified qualifying forex accounts, including pre-existing accounts, subject to the general retranslation election not applying to the account. The election will apply from the start of the income year in which the election is made (balancing adjustments may be required for pre-existing qualifying forex accounts).
The gain or loss to be brought to account under this method will reflect the amount that would be recognised in accordance with the relevant accounting standard (eg AASB 121).
Balancing adjustment on ceasing to have a financial arrangement
The proposed TOFA provisions acknowledge that the tax timing methods may not produce the correct tax outcome when the total gain or loss on a financial arrangement is viewed after the instrument is disposed of (either wholly or partially), or ceases to exist.
Accordingly, a “sweeper” mechanism will apply in the income year when a taxpayer’s rights and/or obligations under a financial arrangement cease to be held, so that:
- a gain or loss may be brought to account at that time, and
- this gain or loss calculation takes into account amounts which have already been assessed or deducted during the life of the arrangement.
The balancing adjustment provisions are distinguishable from the realisation method (see Table 2). Under the balancing adjustment rules, a gain or loss is recognised only where the taxpayer transfers some or all of the rights or obligations under the arrangement to another person, or all of the rights or obligations under the arrangement otherwise cease.
On the other hand, the realisation method applies where a financial benefit under the financial arrangement is paid, or received, or the time comes for it to be paid or received.
How does Division 230 fit in with existing law?
The TOFA Bill proposes a number of amendments to existing provisions in the tax law to ensure that appropriate interactions and consequential issues are dealt with.
The consequential and interaction amendments generally fall into the following categories:
- ordering rules – which generally provide that the TOFA rules of Division 230 will take precedence
- value setting rules – for the capital allowance and capital gains tax provisions, and in dealing with gains or losses up until the time an entity joins or leaves a tax consolidated group, and for foreign currency conversion purposes
- recognition of gains and losses – for offshore banking units and foreign bank branches, on change in residency and for Pay As You Go (PAYG) instalment purposes, and
- definition and referencing changes.
In addition, the Bill makes retrospective amendments with effect from 1 July 2003 to ensure that securitisation vehicles and special purpose vehicles are excluded from the existing foreign exchange rules in Division 775 of the Income Tax Assessment Act 1997 (ITAA 1997) and related foreign currency conversion provisions in Division 960 of the ITAA 1997, at least until the Division 230 rules commence. Once the retranslation and hedging regimes under the TOFA framework commence, Authorised Deposit Taking Institutions (ADIs), non-ADI financial institutions and securitisation vehicles that had been excluded from Division 775 and the foreign currency conversion rules will become subject to those provisions.
Other changes are made in relation to the existing forex retranslation election.
More TOFA legislation to come – consolidation measures and (possibly) synthetic arrangements
The latter stages of the confidential consultation process on the TOFA Stages 3 and 4 involved a consideration of measures which do not appear in the Bill as introduced into Parliament.
The Bill does not include any rules to deal with synthetically constructed financial arrangements and to synthetically created disposal and non-disposal events. These measures (contained in a separate consultation exposure draft released in May 2007) were subject to heavy criticism, mainly because of the potential breadth of their application. The Minister for Revenue, Mr Dutton, noted these concerns in a press release relating to the current Bill and indicated that further consultation would be undertaken regarding the need for any TOFA-specific synthetic integrity rules.
Also absent from the Bill are provisions dealing with the interaction of TOFA and the cost setting provisions of the tax consolidation rules. These additional measures are expected to be introduced into Parliament prior to 1 July 2008, following further consultation with professional and industry bodies.
The Bill introduced to Parliament should therefore be regarded as the first module of legislative change, though it does represent the overwhelming proportion of the new law. Assuming the Federal Election is called before the current Bill is passed, an amended, expanded Bill may be introduced by the incoming Government. Alternatively, a second TOFA Bill may be introduced containing additional TOFA-related measures.
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