House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon Wayne Swan MP)

Chapter 1 Background and framework

Outline of chapter

1.1 Division 230 contains new rules for the taxation treatment of financial arrangements.

1.2 This chapter:

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explains why reform of the taxation of financial arrangements (TOFA) is necessary;

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explains the framework of Division 230; and

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provides an outline of how the Division applies.

Context of amendments

Why is the existing law inadequate?

1.3 Over recent decades the development of new financial arrangements to provide finance and allocate risk has had broad ranging impacts on the operation of capital markets. The income tax law has not kept pace with this financial innovation.

1.4 Where the tax law has been amended to address new product developments, the amendments have been largely in response to specific pressures and have tended to be of a limited, ad hoc and piecemeal nature. What has been lacking is an overarching framework which seeks to systematically address the functional purposes of different financial arrangements and the ways in which they are used. As a consequence, current tax laws, which have continued to rely significantly on legal form, represent an increasingly complex amalgam of both general and specific provisions.

1.5 Under the current law, accruals rules, which spread gains and losses from financial arrangements over time, have been narrowly focused. Outside their purview, tax treatments do not adequately take into account the time value of money or provide for an appropriate allocation of economic income over time.

1.6 Current tax laws have resulted in tax-based timing and character mismatches and lack the tax design architecture needed to facilitate efficient hedging activity and market-making. In a number of areas, gaps have appeared in the law, determinacy has been lacking, tax anomalies and distortions have emerged, neutrality has not been achieved, and uncertainty has developed about the appropriate treatment of some basic financial arrangements. The current tax law does not adequately address the tax-timing treatment of emerging hybrid instruments, or newer structured products, including those with both fixed and contingent returns. As a consequence, the existing tax system impacts adversely on pricing, risk management and allocative efficiency.

1.7 The current income tax law has often placed greater emphasis on the form rather than the substance of financial arrangements. This has resulted in inconsistencies in the tax treatment of transactions with similar economic substance which has impeded commercial decision-making, created difficulties in addressing financial innovation, and facilitated tax deferral and tax arbitrage.

Division 230 and earlier reforms to the taxation of financial arrangements

1.8 Building on earlier consultative papers and extensive consultations, recommended reforms to TOFA were set out in the Review of Business Taxation: A Tax System Redesigned (July 1999). Division 230 represents the combined third and fourth stages of TOFA reforms emanating from the previous government's in-principle support for those earlier TOFA recommendations.

1.9 In 2001, in conjunction with the introduction of thin capitalisation measures and in response to the failure of the legal form-based tax system to cope with the creation of new financing products, growing mischaracterisation of debt and equity interests and general uncertainty over appropriate tax treatments, the previous government introduced Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997).

1.10 Division 974 of the ITAA 1997 reformed the debt/equity tax borderline and represented Stage 1 of the TOFA reforms. Under that reform, the test for distinguishing debt interests from equity interests focuses on a single organising principle - debt is evident where an issuer has an effective obligation to return to the investor an amount at least equal to the amount invested.

1.11 In 2003, in response to uncertainty over the taxation of foreign currency gains and losses, the previous government introduced Division 775 and Subdivisions 960-C and 960-D of the ITAA 1997. Those amendments addressed anomalies and provided certainty as to how foreign currency gains and losses are brought to account for tax purposes. At the same time, reforms aimed at removing the taxing point at conversion or exchange of certain financial instruments were introduced in sections 26BB and 70B of the Income Tax Assessment Act 1936 (ITAA 1936). Together, these reforms represented Stage 2 of the TOFA reforms.

1.12 Division 230 contains provisions which cover both the tax treatment of hedges (Stage 3) and tax-timing treatments in respect of arrangements other than hedges (Stage 4). The provisions address:

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the final stages of the TOFA reforms recommended by the Review of Business Taxation (Ralph Review);

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the previous government's announcement in the 2005-06 Budget to extend the tax-timing hedge treatment for hedges of commodities - proposed by the Ralph Review - to hedging transactions generally; and

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the addition of tax status hedge rules which provide for matching of the tax classification or status (capital, revenue, assessable, exempt, non-assessable non-exempt) of the gain or loss from the hedging financial arrangement with the tax classification or status of the underlying.

Objectives of Division 230

1.13 The two overarching objectives underpinning Division 230 are greater efficiency and the lowering of compliance costs.

1.14 Greater efficiency, in this context, means minimising the extent to which the taxation of financial arrangements (by providing inappropriate impediments or stimulation) distorts a taxpayer's trading, financing, investment, pricing, risk taking and risk management decisions. Such distortions impact adversely on the allocation of investment activity both within the financial sector and between the financial and non-financial sectors and also reduce the general efficiency, effectiveness and competitiveness of capital markets. Removing such distortions involves the development of an enhanced and more comprehensive and coherent tax law framework.

1.15 Greater efficiency will result from:

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providing tax treatments that cover all financial arrangements coherently and consistently;

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closer alignment of tax and commercial recognition of gains and losses from financial arrangements;

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facilitating the appropriate allocation over time of the gains and losses from financial arrangements for tax purposes;

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general recognition of gains and losses on revenue account;

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reducing tax-timing and tax-status mismatches;

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increasing reliance on economic substance over legal form; and

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reducing opportunities for tax deferral and tax arbitrage.

1.16 The lowering of compliance costs necessarily involves greater regard being given to the commercial context within which financial arrangements are traded and exchanged. Lower compliance costs are achieved through:

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reliance on the gains and losses required to be included in commercial financial reports as the basis for taxation where appropriate;

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otherwise incorporating the concepts and methods used in financial accounting standards, where appropriate, as the basis for tax treatments;

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reducing complexity and taxpayer uncertainty while increasing clarity of the law; and

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increasing alignment of tax treatments with the functional purposes that commercial parties have when entering particular financial arrangements.

1.17 The Division 230 tax framework explicitly takes into account a number of Australian accounting standards. These standards reflect the adoption of the international financial reporting standards in Australia, with effect from 1 January 2005. However, Division 230 does not mandate that taxpayers use accounting standards as the basis for taxation. Such an approach could impose unfair compliance costs on certain taxpayers and could also lead to volatility in tax liabilities. Volatility in taxation could arise, for instance, from mandatory application of fair value treatment. Rather, the closer alignment with accounting standards and taxation is achieved through two basic mechanisms. The first involves a specific election to rely on gains and losses determined by relevant accounting standards for tax purposes where certain specified requirements are met. Outside the operation of that specific election, Division 230 achieves, through the operation of a range of other provisions, a substantial level of consistency with the concepts and treatments used in accounting standards. This close alignment is most evident in respect of the methods used for accruals purposes and the concepts, methods and measurements available under the fair value election, the retranslation election and the hedging election.

1.18 In developing this framework, particular regard was given to the following Australian versions of the international accounting standards: Australian Accounting Standard AASB 132 Financial Instruments: Disclosure and Presentation (AASB 132) and Australian Accounting Standard AASB 139 Financial Instruments: Recognition and Measurement (AASB 139). The framework also takes into account other accounting standards such as Australian Accounting Standard AASB 7 Financial Instruments: Disclosures (AASB 7), Australian Accounting Standard AASB 101 Presentation of Financial Statements (AASB 101), Australian Accounting Standard AASB 118 Revenue (AASB 118), Australian Accounting Standard AASB 121 The Effects of Changes in Foreign Exchange Rates (AASB 121), Australian Accounting Standard AASB 127 Consolidated and Separate Financial Statements (AASB 127) and Australian Accounting Standard AASB 137 Provisions, Contingent Liabilities and Contingent Assets (AASB 137).

Summary of new law

1.19 This legislation is built on a principle-based framework for the taxation of gains and losses from financial arrangements. Gains from financial arrangements are assessable and losses are deductible. A set of principles and rules within the framework tells taxpayers how to work out gains and losses each income year.

1.20 The legislation generally applies to all 'financial arrangements' as defined in Subdivision 230-A or included by the additional operation of Subdivision 230-J. However, certain financial arrangements are effectively subject to an exception under Subdivision 230-H.

1.21 Division 230 provides a range of elective methods for determining gains and losses, including the elective fair value method, the elective retranslation method, the elective hedging method and the elective financial reports method. Where these elective methods are not, or cannot be, adopted the tax treatment defaults to either the accruals or realisation method.

1.22 This legislation does not apply to:

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financial arrangements of individuals except where the arrangement is a qualifying security and its remaining life after acquisition is more than 12 months or where the taxpayer elects to have Division 230 apply to all of its financial arrangements;

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financial arrangements of superannuation funds (both regulated and self managed), approved deposit funds, pooled superannuation funds or an entity that is a managed investment scheme for the purposes of the Corporations Act 2001 where the value of the entity's assets are less than $100 million except where the arrangement is a qualifying security and its remaining life after acquisition is more than 12 months or where the taxpayer elects to have Division 230 apply to all of its financial arrangements;

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financial arrangements of authorised deposit-taking institutions (ADIs), securitisation vehicles and financial sector entities with an aggregated annual turnover of less than $20 million per year except where the arrangement is a qualifying security and its remaining life after acquisition is more than 12 months or where the taxpayer elects to have Division 230 apply to all of its financial arrangements; or

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financial arrangements of other entities:

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with an aggregated annual turnover of less than $100 million;

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where the value of the entity's financial assets are less than $100 million; and

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where the value of the entity's assets is less than $300 million,

except where the arrangement is a qualifying security and its remaining life after acquisition is more than 12 months or where the taxpayer elects to have Division 230 apply to all of its financial arrangements.

Comparison of key features of new law and current law

Detailed explanation of new law

Approach to tax reforms for financial arrangements

1.23 Achieving the optimal set of tax reforms for financial arrangements requires the balancing of the objectives of greater efficiency and lower compliance costs with rules to ensure the integrity of the tax system within a complex financial environment. This part of the chapter discusses the manner in which the reforms to tax treatments have been approached with these factors in mind.

1.24 The Division 230 framework more closely aligns the recognition of gains and losses on financial arrangements with commercial norms.

1.25 Regard to that commercial context is given effect by:

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incorporating financial accounting concepts and methods and hedging rules into the framework;

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providing an election to rely on financial reports;

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incorporating some flexibility in the tax-timing treatments for financial arrangements; and

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placing many financial arrangements on revenue account.

Financial accounting concepts and methods

1.26 The default approach for Division 230 is accruals treatment of gains and losses. Where gains or losses are not sufficiently certain a realisation basis is used. In addition, Division 230 incorporates four elective tax methods: an election to rely on financial reports, elective fair value, elective retranslation and elective hedging. The fair value, retranslation, hedging and the financial reports methodologies are not recognised, to any significant extent, under the current income tax law. Their adoption as part of these reforms reflects the different methods found in financial accounting standards and practice. That is, the so-called 'mixed model' approach in financial accounting is an inherent feature of the Division 230 framework.

1.27 The mixed model approach in turn reflects alternative functional applications and the different ways in which financial arrangements are used for commercial purposes (ie, trading, investing/financing and hedging).

1.28 While financial accounting standards may provide important information for investors, they may not be an appropriate basis for taxation. The reason for this is that the standards aim to give investors information upon which they can make financial decisions, including making assessments about the stewardship of the entity in question during a particular accounting period.

1.29 Financial accounting standards covering the measurement of gains and losses from financial arrangements have adopted fair value accounting as a default treatment to better reflect commercial realities and to expose the potential risks in using derivatives. The mandatory use of the fair value treatment in a tax context could result in taxpayers being required to pay tax on large, unsystematic, unrealised gains which do not eventuate, potentially causing cash flow difficulties.

1.30 However, allowing taxpayers to access fair value tax treatment through an elective regime may facilitate price-making in relation to market-making portfolios of financial arrangements typically held by financial institutions. It could also provide overall compliance cost savings for taxpayers who prepare financial reports in accordance with the new financial accounting standards.

1.31 Division 230 provides an elective regime for the recognition of gains and losses on a fair value basis for income tax purposes in respect of those financial arrangements which are fair valued through the profit or loss statement. Chapter 6 explains the operation of this election.

1.32 Similarly, Division 230 allows elective tax treatment for retranslation and hedging (see Chapters 7 and 8 respectively).

1.33 This legislation also includes an election for taxpayers to rely on their financial reports for taxation purposes in respect of their financial arrangements, subject to specified conditions (see Chapter 9).

1.34 Appropriate safeguards are required to ensure that the use of the elective regimes does not lead to adverse selection opportunities or other inappropriate tax outcomes. The safeguards are explained in the relevant chapters of this explanatory memorandum. Chapter 5 discusses the general requirements common to all elective Subdivisions. Additional specific requirements relevant to each election are outlined in the specific chapters (ie, Chapters 6 to 9) covering the elective tax treatments.

Flexibility in tax-timing treatments

1.35 Substantial flexibility exists in the application of tax-timing methods. For example:

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there is no prescriptive basis for valuation under the fair value and retranslation tax elections, other than the proper application of the financial accounting standard on which these elections are based;

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if the compounding accruals basis is required for a financial arrangement, any compounding interval that is not longer than 12 months can be used. A reasonable approximation of this basis may also be adopted. The effective interest method used in accounting standards is generally permissible; and

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there is flexibility as to the allocation period under the hedging method, provided certain safeguards are met.

1.36 To prevent this flexibility from being exploited for income tax purposes, the legislative framework requires that a particular manner of allocating gains and losses has to be applied consistently. [ Schedule 1, item 1, section 230-80 ]

1.37 Reliance on broad, clearly enunciated principles where appropriate, rather than highly prescriptive rules, should provide greater stability to the tax framework, allowing it to better cope with financial innovation and the flexibility of financial arrangements themselves.

Placing many financial arrangements on revenue account

1.38 With some exceptions, gains and losses from financial arrangements are generally to be taxed on revenue account (see Chapter 3 for more detail) [ Schedule 1, item 1, section 230-15 ]. This removes the complex capital/revenue distinction for many financial arrangements.

The legislative approach

1.39 Division 230 tells a taxpayer how to work out the amount of gain or loss in an income year using the following steps:

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identify a financial arrangement (step 1);

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determine whether an exclusion from the Division applies to gains and losses from the financial arrangement (step 2);

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determine which tax method will apply to the financial arrangement and, using relevant tax-timing treatments, work out the gains and losses from the financial arrangement for each income year (step 3); and

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determine whether the gains or losses from the financial arrangement are assessable or deductible (step 4).

Identification of a financial arrangement

1.40 A financial arrangement is the core unit upon which a tax liability is determined under Division 230.

1.41 Subdivision 230-A provides the test for determining whether an arrangement is a financial arrangement [ Schedule 1, item 1, section 230-45 ]. In this context an arrangement consists of all the rights and obligations (including contingent rights or obligations [ Schedule 1, item 1, section 230-85 ]), that are appropriately considered to be part of the same arrangement. Section 230-55 sets out the factors to be considered when determining what rights or obligations comprise an arrangement or two or more separate arrangements [ Schedule 1, item 1, section 230-55 ]. Importantly, whether there is one or more arrangements takes into account normal commercial understandings.

1.42 Under this test, relevant rights and obligations under an arrangement comprise a financial arrangement to the extent they are 'cash settlable' legal or equitable rights or obligations to receive or provide financial benefits, or combinations thereof, and the arrangement does not consist of any other subsisting non-insignificant rights or obligations [ Schedule 1, item 1, subsections 230-5(1) and 230-45(1 )]. The meaning of the term 'cash settlable', and its relationship to money or money equivalence, and to intentions, purposes and commercial practices, is defined by this test, and explained in Chapter 2 [ Schedule 1, item 1, subsection 230-45(2 )].

1.43 Some common examples of financial arrangements are:

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debt-type arrangements, including loans, bonds, promissory notes and debentures; and

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risk-shifting derivatives, including swaps, forwards and options.

1.44 An equity interest (such as an ordinary share) is also a financial arrangement [ Schedule 1, item 1, paragraph 230-5(2)(b) and section 230-50 ], but not all tax-timing methods will apply to equity interests (for instance, an equity interest will not be subject to the accruals or realisation tax-timing methods) [ Schedule 1, item 1, paragraph 230-40(4)(e )].

1.45 A simple delayed settlement is a financial arrangement, where the payment occurs some time after the relevant thing is delivered. This is because from the time of delivery the only subsisting rights and obligations under such an arrangement are cash settlable. However, where the period between delivery and the time for payment is 12 months or less, gains and losses from the financial arrangement are excluded from Division 230 [ Schedule 1, item 1, section 230-450 ]. More complex financial arrangements include hybrid financial arrangements.

1.46 Arrangements which are not 'financial arrangements' under the definition include arrangements for the purchase of property (except property that is itself a financial arrangement), goods or services and arrangements, where payment is made on entering into the arrangement but delivery of the property, goods or services is deferred (usually referred to as prepayments). This is because such arrangements have non-insignificant non-cash settlable rights and obligations throughout the life of the arrangement. This fact, together with the exclusion for deferred payments of less than 12 months (discussed above), means that most construction contracts, contracts for the provision of services and arrangements known as farm-out arrangements will generally be excluded from the operation of Division 230.

1.47 A number of things that do not satisfy the definition of 'financial arrangement' are specifically included in the scope of Division 230 by virtue of Subdivision 230-J. These are:

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foreign currency;

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non-equity shares; and

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commodities and offsetting commodity contracts held by traders.

[ Schedule 1, item 1, Subdivision 230-J ]

1.48 Chapter 2 explains what arrangements meet the definition of a 'financial arrangement' or are otherwise treated as financial arrangements.

Determine whether an exclusion applies to the arrangement

1.49 A number of financial arrangements have gains and losses from them excluded from the provisions of Division 230. The main categories of excluded arrangements are:

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financial arrangements held by individuals that are not qualifying securities, and qualifying securities held by individuals which have a remaining life at the time of acquisition of 12 months or less [ Schedule 1, item 1, paragraph 230-5(2)(a) and section 230-455 ];

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financial arrangements held by entities whose business is essentially financial in nature with less than $100 million in assets or $20 million aggregated annual turnover;

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or other entities (other than individuals) with:

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less than $100 million aggregated annual turnover;

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less than $100 million in financial assets; and

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less than $300 million in assets;

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which are not qualifying securities, and qualifying securities held by such entities which have a remaining life at the time of acquisition of 12 months or less [ Schedule 1, item 1, paragraph 230-5(2)(a) and section 230-455 ];

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short-term financial arrangements where a non-monetary amount (property, goods or services) is involved [ Schedule 1, item 1, section 230-450 ]; and

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gains on the forgiveness of commercial debts [ Schedule 1, item 1, section 230-470 ].

1.50 Other particular arrangements have gains and losses excluded from the Division to the extent to which they arise from specific rights and obligations that are leasing or licensing arrangements over real and intellectual property, certain interests in partnerships or trusts, certain insurance policies, certain rights or obligations under a workers' compensation scheme, certain guarantees or indemnities, personal arrangements and personal injury, certain superannuation and pension income arrangements, interests in a controlled foreign company, interests in a foreign investment fund, retirement village residence and services contracts, arrangements under which residential care or flexible care is provided, proceeds from certain 'earn-out' business sales, arrangements to which Division 16L of the ITAA 1936 applies, arrangements to which section 121EK of the ITAA 1936 applies, a right to receive (or obligation to provide) a farm management deposit where the taxpayer is the owner of that deposit and interests in forestry-managed investment schemes which are deductible under Division 394 of the ITAA 1997. The list of specific exclusions may be added to by regulation. [ Schedule 1, item 1, section 230-460 and subsections 230-475(3) and (4 )]

1.51 If an arrangement is excluded, other provisions of the tax law may apply to the arrangement.

1.52 Chapter 2 explains what financial arrangements have their gains and losses excluded from Division 230.

Apply the appropriate tax method to work out the gain or loss for the income year

1.53 One or more of the following tax methods applies to every financial arrangement that is subject to Division 230:

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Non-elective methods:

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compounding accruals [ Schedule 1, item 1, Subdivision 230-B ];

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realisation [ Schedule 1, item 1, Subdivision 230-B ]; and/or

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balancing adjustment [ Schedule 1, item 1, Subdivision 230-G ];

and/or;

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Elective methods:

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elective fair value [ Schedule 1, item 1, Subdivision 230-C ];

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elective retranslation [ Schedule 1, item 1, Subdivision 230-D ];

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elective hedging [ Schedule 1, item 1, Subdivision 230-E ]; and

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elective financial reports [ Schedule 1, item 1, Subdivision 230-F ].

1.54 Use of any of the elective methods requires that the taxpayer have financial reports prepared and audited in accordance with relevant financial accounting and auditing standards.

Diagram 1: Hierarchy of tax treatments (excluding balancing adjustments)

1.55 As well as the above tax methods, a balancing adjustment is generally required to be calculated when a taxpayer ceases to have a financial arrangement, or transfers part of a financial arrangement to someone else [ Schedule 1, item 1, Subdivision 230-G ]. A separate balancing adjustment may also arise where an election ceases to apply to a financial arrangement [ Schedule 1, item 1, sections 230-245, 230-290 and 230-430 ].

1.56 The tax methods determine the basis for calculating what amounts are assessable or deductible in each income year. [ Schedule 1, item 1, section 230-40 ]

Elective fair value method

1.57 The elective fair value method allocates gains and losses from a financial arrangement to each income year in accordance with changes in the fair value. If elected, the method applies to all financial arrangements acquired in the income year in which the election is made, or in a later income year, that are classified or designated as at fair value through profit or loss for the purposes of relevant accounting standards, where they are reported in financial reports prepared and audited in accordance with relevant accounting and auditing standards. This method is elective, but once a taxpayer elects to apply it to arrangements reported in its financial reports, the election generally applies to those arrangements for all future income years. An election will cease to apply to a financial arrangement where relevant criteria are no longer satisfied [ Schedule 1, item 1, Subdivision 230-C ]. A balancing adjustment must be made if the fair value election ceases [ Schedule 1, item 1, section 230-245 ].

1.58 Chapter 6 explains the fair value method in more detail.

Elective foreign exchange retranslation method

1.59 The elective retranslation method allocates gains and losses from changes in the value of foreign currency to the income year in which the change occurs. The elective foreign exchange retranslation method may apply to:

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all relevant arrangements that are, subject to retranslation treatment under a relevant accounting standard, are reported in a relevant financial report prepared and audited in accordance with relevant accounting and auditing standards [ Schedule 1, item 1, Subdivision 230-D ], and which are acquired in the year in which the election is made or later years; or

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designated qualifying foreign exchange accounts [ Schedule 1, item 1, Subdivision 230-D ].

1.60 The effect of applying this Subdivision is that, for tax-timing purposes, the taxpayer will generally recognise gains and losses from the foreign currency component independently of gains and losses from the rest of the arrangement. Accordingly, this method may apply in addition to other tax-timing methods.

1.61 The foreign exchange retranslation method only applies where the taxpayer elects to apply it.

1.62 An entity can make a foreign currency retranslation election in respect of a qualifying foreign exchange account after it starts to have the account. In such cases, a balancing adjustment is required to bring to account any unrealised foreign currency gains or losses on the account. Like the fair value election, the foreign exchange retranslation election will cease to apply where relevant criteria are no longer satisfied and a balancing adjustment will be necessary when the foreign currency retranslation election ceases to have effect [ Schedule 1, item 1, section 230-290 ]. It should be noted that the balancing adjustment in relation to the cessation of the foreign currency retranslation election captures only the foreign currency component of the relevant financial arrangement.

1.63 Chapter 7 explains the elective foreign exchange retranslation method in detail. For taxpayers subject to Division 230, foreign currency denominated arrangements excluded from the operation of Division 230 can be retranslated under the retranslation provisions in Division 775 of the ITAA 1997.

Elective hedging method

1.64 The elective hedging method allocates gains and losses from a hedging financial arrangement on a basis that corresponds with the gains and losses from the relevant hedged item. The hedging rules provide for both tax-timing and tax classification (ie, capital, revenue, assessable, exempt, non-assessable non-exempt) matching. The scope of the hedging treatment is determined by the coverage of 'hedging financial arrangements' defined for accounting standards purposes but can include certain other financial arrangements. To use the elective hedging method the taxpayer must have financial reports prepared and audited in accordance with relevant financial accounting and auditing standards [ Schedule 1, item 1, Subdivision 230-E ], and must meet certain other requirements, including record-keeping and hedge effectiveness criteria.

1.65 The balancing adjustment required under Subdivision 230-G is not required in relation to a financial arrangement that is covered by the hedging financial arrangement election. [ Schedule 1, item 1, subsection 230-440(2 )]

1.66 Chapter 8 explains the elective hedging method in detail.

Election to rely on financial reports

1.67 The election to rely on financial reports determines gains and losses from financial arrangements by reference to relevant accounting standards. This election effectively aligns the tax treatment of relevant arrangements to the accounting treatment.

1.68 To make this election the taxpayer needs to have financial reports which are prepared and audited in accordance with relevant accounting and auditing standards. Other requirements include that the relevant auditor's report must be unqualified, and meeting certain standards in relation to accounting systems and controls.

1.69 Further, the election can only apply to a financial arrangement if it is reasonably expected that the difference between the amount of the overall gain or loss (and its allocation over time derived from using the accounting reports) and that which would be determined under the other provisions of Division 230 would reasonably be expected not to be substantial. [ Schedule 1, item 1, Subdivision 230-F ]

1.70 A balancing adjustment is required when the election to rely on financial reports ceases to apply. [ Schedule 1, item 1, section 230-430 ]

1.71 Chapter 9 explains the financial reports election in detail.

Compounding accruals and realisation methods

1.72 All financial arrangements within the scope of Division 230 (after taking into account any exceptions or additions) will have gains and losses worked out using the accruals or realisation methods unless:

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an elective method applies to the arrangement. However, in the case of the elective foreign currency retranslation method (where that method applies to determine the foreign currency gain or loss from the arrangement) the accruals or realisation treatment may still apply to determine the non-foreign currency gain or loss component of the financial arrangement; or

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the arrangement is an equity interest or is a right to receive or an obligation to provide an equity interest and that right or obligation is not 'cash settlable'.

Compounding accruals method

1.73 The compounding accruals method allocates gains and losses from a financial arrangement to income years according to an implicit rate of return. This rate of return is commercially known as the 'internal rate of return' or the 'effective interest rate'. The compounding accruals method applies when an overall, or a particular, gain or loss from a financial arrangement is sufficiently certain. An amount or value is 'sufficiently certain' if it is 'fixed or determinable with reasonable accuracy'. [ Schedule 1, item 1, sections 230-100, 230-105, 230-115 and 230-135 ]

1.74 Where material changes are made to terms or conditions or circumstances that affect arrangements, taxpayers are required to make fresh assessments of gains and losses subject to accruals treatment. In certain circumstances they may need to re-estimate relevant gains and losses. [ Schedule 1, item 1, sections 230-185 and 230-190 ]

1.75 These are special accruals rules in respect of premiums, discounts and fees associated with certain financial arrangements where the arrangements are part of a portfolio of similar financial arrangements where the net amount of the premium, discount of fees is not significant. [ Schedule 1, item 1, sections 230-150, 230-160 and 230-165 ]

1.76 A running balancing adjustment is made to correct for any underestimation or overestimation resulting from application of the accruals method. [ Schedule 1, item 1, section 230-175 ]

1.77 Chapter 4 explains the compounding accruals method in more detail.

Realisation method

1.78 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 or loss is due to be provided or received, as the case may be. This method applies to the extent that the compounding accruals method or the elective methods do not apply. [ Schedule 1, item 1, subsections 230-40(4) and 230-100(5) and section 230-180 ]

1.79 Chapter 4 explains the realisation method in more detail.

Available choices among the tax treatments

1.80 Gains and losses a taxpayer makes when they cease to hold a financial arrangement (including if they transfer part of a financial arrangement) other than a hedging financial arrangement are recognised using the balancing adjustment provisions, and not under any of the other methods (see Chapter 10). [ Schedule 1, item 1, subsection 230-40(1), Subdivision 230-G ]

1.81 However, while a taxpayer holds a financial arrangement, gains and losses they make from that arrangement can be calculated under the accruals or realisation methods or any of the elective methods (subject to the relevant criteria being satisfied). [ Schedule 1, item 1, subsection 230-40(1 )]

1.82 Amongst the elective methods, the elective hedging method, to the extent that it is applicable, takes priority over the other elective methods. Subject to this, if an election to rely on financial reports is made, gains and losses from all relevant financial arrangements are determined using this method. [ Schedule 1, item 1, subsections 230-40(2) and (7 )]

1.83 Where the fair value treatment applies to the whole of a financial arrangement, the taxpayer does not have to consider other tax-timing methods (except to the extent to which the elective hedging method or the election to rely on financial reports applies to the financial arrangement). [ Schedule 1, item 1, subsection 230-40(5 )]

1.84 However, if the fair value treatment applies to only a part of a financial arrangement then the other part is deemed to be a separate financial arrangement and must be subject to another tax-timing treatment. [ Schedule 1, item 1, section 230-235 ]

1.85 The foreign exchange retranslation method may apply to determine the foreign currency component of gains or losses from a financial arrangement only if none of the other elective methods apply to that arrangement [ Schedule 1, item 1, subsection 230-40(6 )]. If the retranslation method and other elective methods do not apply, the foreign currency gain or loss may be taxed on a realisation basis.

1.86 If the financial arrangement is subject to one of the elective methods (other than the retranslation method), the accruals and realisation methods will not apply. Where the foreign exchange retranslation method applies to the financial arrangement, the accruals or realisation methods will also apply to determine any gains or losses from the financial arrangement, to the extent they are not attributable to currency exchange movements. [ Schedule 1, item 1, subsection 230-40(4 )]

1.87 Neither the accruals, realisation, nor retranslation methods will apply to a financial arrangement that is an equity interest, or to other 'equity' financial arrangements within the meaning of subsection 230-50(2). The hedging method will only apply to a financial arrangement that is an equity interest if it is a foreign currency hedge and is issued by the taxpayer. [ Schedule 1, item 1, paragraph 230-40(4)(e) and sections 230-270 and 230-330 ]

1.88 Finally, the realisation method will apply to a gain or loss from a financial arrangement only where the accruals method does not apply. [ Schedule 1, item 1, subsection 230-100(5 )]

If the year is the final holding year, work out any gain or loss from ceasing to have the financial arrangement

1.89 In the last year that a taxpayer holds a financial arrangement, the taxpayer needs to work out the gain or loss it makes from ceasing to hold the financial arrangement. This is to ensure that the total gain assessable, or the total loss deductible, on the arrangement reflects the actual gain or loss [ Schedule 1, item 1, section 230-435 and subsection 230-40(1 )]. Chapter 10 addresses the treatment of gains and losses from ceasing to hold a financial arrangement.

Integrity rules

Consistency

1.90 Gains and losses must be worked out consistently for each financial arrangement through time. This means that the methods used should be used consistently both from year to year for a particular financial arrangement (subject to a particular method ceasing to apply, for example where the requirements for its application are no longer met), and where the taxpayer is entitled to choose to apply a method in a particular manner they must use the same manner for all financial arrangements that are of a similar nature. [ Schedule 1, item 1, section 230-80 ]

Value shifting

1.91 Broadly, the value shifting rules prevent inappropriate tax consequences where, under a scheme, value is shifted from equity or loan interests. Gains which are reduced, or losses which are increased, in this manner are to be disregarded under Division 230 in determining tax outcomes for financial arrangements. [ Schedule 1, item 1, section 230-520 ]

Arm's length rules

1.92 Broadly, Division 230 will incorporate arm's length rules that are consistent with those that apply to arrangements not covered by the Division. [ Schedule 1, item 1, sections 230-510 and 230-515 ]

Application and transitional provisions

1.93 The rules will apply to financial arrangements acquired on or after the first day of the first income year starting on or after 1 July 2010. A taxpayer may also elect to apply the rules to financial arrangements acquired on or after the first day of the first income year starting on or after 1 July 2009.

1.94 A taxpayer may elect to apply the rules contained in Division 230 to existing arrangements (ie, to those financial arrangements which the taxpayer acquired before the start of the first applicable income year but still held at that time). Such an election may give rise to an amount in the nature of a transitional 'balancing adjustment' if the amount taken into account under the ITAA 1936 and the ITAA 1997 prior to the application of Division 230 differs from the amount that would have been taken into account under Division 230 if it had applied from the commencement of the arrangement. There are also special transitional balancing adjustment rules for arrangements subject to Subdivision 775-F (see Chapters 7 and 13). The transitional balancing adjustment is to be spread over the first applicable income year and the next three income years [ Schedule 1, Part 3, items 102 to 105 ]. The election to apply Division 230 to existing arrangements does not extend to the alignment of tax classification treatment for gains and losses from hedging financial arrangements under Subdivision 230-E where the taxpayer first started to hold the arrangement prior to the commencement of Division 230 [ Schedule 1, Part 3, subitem 104(10 )]. Chapter 13 explains the application and transitional provisions in more detail.