During the 1980s, there were significant economic and legal developments such as the deregulation of the Australian financial sector and floating of the Australian dollar, as well as technological changes. These developments highlighted the deficiencies in existing tax legislation, which did not keep pace with financial innovation.
Before the TOFA reforms, the income tax law emphasised legal form rather than economic substance in the context of financial arrangements. The legislation recognised basic forms of financial arrangements, but did not satisfactorily apply to more complex instruments.
This led to inconsistencies in the tax treatment of transactions with similar economic substance. In addition, income and deductions from financial arrangements were often dealt with on a realisation basis, which was not in line with accounting practice and the economic substance of financial arrangements. The inability of these form-based rules to keep pace with financial innovation created opportunities for tax deferral and tax arbitrage.
Furthermore, the way tax law applied to financial arrangements resulted in tax-timing and tax-classification mismatches. The law did not address the tax-timing treatment of emerging hybrid instruments or new structured products, including those with fixed and contingent returns.
The ad hoc manner in which amendments were made to address new tax products or problems created considerable uncertainty for entities.