House of Representatives

Explanatory Memorandum

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

Chapter 10 Balancing adjustment on disposing of financial arrangements

Outline of chapter

10.1 This chapter explains when a financial arrangement (or part of a financial arrangement) is transferred or otherwise ceases to be held, and the consequences following these events.

10.2 For convenience, the expression 'disposal' is used to refer to a financial arrangement (or part of a financial arrangement), ceasing to be held or being transferred.

Overview of balancing adjustments on disposal

A balancing adjustment

10.3 A balancing adjustment is an additional amount of gain or loss brought to account on the disposal of a financial arrangement to ensure the correct amount of gain or loss is brought to account from holding and disposing of the financial arrangement. Amounts recognised prior to disposal are taken into account in working out any gain or loss on disposal. This corrects any previous under-allocation or over-allocation of a gain or loss before disposal.

Gains and losses from disposal of a financial arrangement

10.4 Gains and losses from disposing of a financial arrangement (or a part of it) may arise from a transfer to another person of relevant rights and/or obligations under the arrangement. Gains and losses from disposing of a financial arrangement can also be made when all the rights and/or obligations which exist under the arrangement cease. Both gains and losses from either transfer or cessation require a balancing adjustment.

Disposal of a financial arrangement

General rule - disposal of all rights and obligations

10.5 The general rule is that disposal of a whole financial arrangement, that is, a disposal of all the rights and/or obligations under the financial arrangement, occurs if those rights and/or obligations end or are transferred to another entity.

10.6 The ending of the relevant rights and/or obligations can occur in different ways, for example, through their discharge (of obligations) or satisfaction, expiry, close out, forfeiture or maturity.

10.7 A transfer of a right or obligation (which is a form of a right or obligation ceasing) can also occur in different ways, for example, as a result of a sale, under a legal defeasance of obligations, or an assignment of rights.

10.8 Where a financial arrangement is an asset, a transfer is effectively taken not to have occurred unless the effect of the transfer is to transfer substantially all the risks and rewards of ownership of the asset to another entity.

Partial disposal

10.9 A partial disposal of a financial arrangement can occur only if there is a transfer of one of the following types:

•

a proportionate share of all the rights and/or obligations under the financial arrangement;

•

a right or obligation under the financial arrangement to a specifically identified financial benefit; or

•

a proportionate share of a right or obligation under the financial arrangement to a specifically identified financial benefit.

Special rules or exceptions to the general rule

10.10 The general rules outlined above are overridden by special rules and exceptions dealing with equity interests, hedging, margining, historical rate roll-over, conversion or exchange and commercial debt forgiveness.

Equity interests

10.11 A balancing adjustment is not made if the financial arrangement is an equity financial arrangement and neither the fair value method nor the elective financial reports method applies to it. Such a financial arrangement will be outside the scope of Division 230; rather any disposal may be subject to the capital gains tax (CGT) measures (where the asset is not held on revenue account).

Hedging

10.12 The tax hedging provisions provide tax matching between the hedging financial arrangement and the hedged item or items. To allow this matching, it may be necessary to defer a gain or loss on the hedging financial arrangement past the time of its disposal.

Bad debts

10.13 The writing off of a bad debt is taken not to be a disposal of a financial arrangement. Therefore, a balancing adjustment is not made when a financial arrangement is written off as a bad debt.

Margining

10.14 A balancing adjustment is not required for exchange traded derivatives that are subject to margining.

Historic rate roll-over

10.15 A specific rule provides that an historic rate roll-over of a derivative financial arrangement is taken to be a disposal of all the rights and/or obligations under the arrangement. Accordingly, a balancing adjustment may be required on disposal.

10.16 However, this will be subject to the operation of the tax hedging rules. Accordingly, the gain or loss on disposal of an historic rate roll-over derivative contract (used in a hedging context) may be deferred and matched to the timing and treatment of the gain or loss on a hedged item for tax purposes.

Conversion or exchange

10.17 A balancing adjustment will not be required by a conversion or exchange of a traditional security into ordinary shares if it was issued on the basis that it will, or may:

•

convert into ordinary shares of the issuer or a connected entity of the issuer, and the ceasing of the rights or obligations under the financial arrangement that is the security, is because it is converted into such shares; or

•

exchange into the ordinary shares of an entity other than the issuer or a connected entity of the issuer, and:

-

it is exchanged for such shares; and

-

if the ceasing of the rights or obligations occurs because of a disposal, the disposal is to the issuer or a connected entity of the issuer.

Subsidiary member leaving a consolidated group

10.18 A balancing adjustment is not made in relation to the financial arrangement of a subsidiary member which ceases to be a member of a consolidated group, or a multiple entry consolidated group as a result of ceasing to be a member of that group.

Commercial debt forgiveness

10.19 A cancellation or other discharge of obligations under a financial arrangement which qualifies as commercial debt forgiveness will be subject to the commercial debt forgiveness provisions. The gain which would be subject to Division 230 is reduced to the extent that the gain is covered by the commercial debt forgiveness provisions. Accordingly, to the extent that the commercial debt forgiveness provisions apply no balancing adjustment is required.

What amount is recognised as a result of the disposal?

10.20 The amount to be recognised as a result of a disposal (ie, the disposal balancing adjustment amount), is that amount which ensures that the entity's overall gain or loss from having the financial arrangement (or the relevant part of it) is recognised.

10.21 To ensure this outcome amounts recognised prior to the disposal are taken into account in working out the amount of any disposal gain or loss.

10.22 In order to work out the gain or loss, relevant costs must be taken into account. So, the gain or loss in respect of the disposal of rights and/or obligations comprising the whole or part of a financial arrangement must factor in the costs (if any) in respect of the arrangement or the relevant part of the arrangement, at the time of disposal.

Complete cessation or transfer

10.23 In broad terms, the balancing adjustment on disposal of a whole financial arrangement is worked out as (a + b + c) - (d + e + f) where:

a = the total of the financial benefits received;

b = the total of amounts that have been allowed as deductions and would have been allowable deductions before the disposal;

c = the total of amounts that will be allowed as deductions (such as deductions due to the transitional balancing adjustment);

d = the total of all financial benefits provided;

e = the total of amounts that would have been included in assessable income and have been included in assessable income before the disposal; and

f = the total of amounts that will be included in assessable income (such as income due to the transitional balancing adjustment).

10.24 If the disposal balancing adjustment is positive (ie, the sum of a, b and c exceeds the sum of d, e and f) the amount is a gain made from the financial arrangement and is included in assessable income. Conversely, if the disposal balancing adjustment is negative, the amount is a loss made from the arrangement and may be an allowable deduction.

10.25 If a balancing adjustment is required for a partial disposal in certain circumstances the variables in the balancing adjustment formula are adjusted to take into account the nature of the partial disposal.

Disposal balancing adjustment made in year of disposal

10.26 The gain or loss produced by the disposal balancing adjustment is made in the year in which the disposal occurs.

Context of amendments

10.27 Under the current income tax law, there are several provisions dealing with the tax consequences of disposing of financial arrangements which would qualify as financial arrangements under Division 230. They include both general and specific provisions such as:

•

sections 26BB and 70B of the Income Tax Assessment Act 1936 (ITAA 1936);

•

section 159GS of the ITAA 1936;

•

sections 6-5 and 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997); and

•

Part 3-1 of the ITAA 1997.

10.28 These provisions apply in different circumstances and in different ways. For example:

•

sections 26BB and 70B of the ITAA 1936 generally operate when an 'arrangement' is 'redeemed' or 'disposed of'. While 'redeemed' is not defined, 'dispose' is defined in subsections 26BB(1) and 70B(1);

•

section 159GS of the ITAA 1936 operates when an arrangement is 'transferred'. The definition of 'transfer' (in subsection 159GP(1) of the ITAA 1936) is similar to, but not the same as, the definition of 'dispose' in subsections 26BB(1) and 70B(1);

•

sections 6-5 and 8-1 of the ITAA 1997 generally rely on the concept of realisation to bring to account gains and losses on disposal; and

•

Part 3-1 of the ITAA 1997 relies on the concept of CGT events.

10.29 Thus, there is an amalgam of general and specific provisions without any common or uniform treatment applicable to the disposal of financial arrangements. There is no express framework for considering what is disposed of, when it is disposed of, and how to quantify the amount to be recognised for tax purposes as a result of the disposal.

10.30 More specifically, the current law does not contain a comprehensive provision dealing with the tax consequences of disposing of financial arrangements that are liabilities in a non-forgiveness context. This means, for example, that it is not clear whether the tax treatment of the defeasance of debt instruments falls under the general deduction and income provisions, under the CGT provisions or under a specific provision. In addition, it is not clear to what extent gains and losses on such defeasances are recognised under the current income tax law.

10.31 In specifying how much gain or loss is to be brought to account at the time of disposal, it is necessary to determine how much has already been brought to account, in respect of the financial arrangement or relevant part of it. Any allocation of gain or loss from the financial arrangement prior to that time (eg, under the accruals provisions), is taken into account to ensure that only the actual net gain or loss from the whole, or part, of the financial arrangement is recognised for income tax purposes. That is, an adjustment calculation is made at the time of the disposal to take account of any previous under-allocation or over-allocation. This calculation is referred to as a 'balancing adjustment'.

Summary of new law

10.32 Subdivision 230-G provides that a balancing adjustment is made when all the rights and/or obligations under a financial arrangement cease or are transferred to another person. In certain circumstances, a balancing adjustment is also made when there is a partial transfer.

10.33 In broad terms, the balancing adjustment gain or loss is calculated by netting the financial benefits received and provided under the arrangement - including the consideration received or provided in relation to the cessation or transfer - and any amounts that have been (or would have been) brought to account for income tax purposes from the arrangement until the cessation or transfer.

10.34 This balancing adjustment gain or loss is made in the income year in which the cessation or transfer occurs.

Comparison of key features of new law and current law

Detailed explanation of new law

10.35 In broad terms, gains and losses from financial arrangements can be made in one of two ways:

•

having a financial arrangement; or

•

disposing of a financial arrangement.

10.36 Gains from having a financial arrangement can flow from, for example, the right to receive interest or an amount represented by discount, while losses from having a financial arrangement can flow from, for example, the obligation to provide interest or an amount represented by discount. The interest is paid or received under the arrangement in question. Guidance on how the taxpayer should treat these gains and losses is not addressed in this chapter. Relevant guidance on these gains and losses, and other gains and losses which arise from the expiry or performance of rights and/or obligations while the financial arrangement continues in operation, is set out in other Subdivisions of Division 230 and in other relevant chapters of this explanatory memorandum.

10.37 Gains and losses from disposing of a financial arrangement (or a part of it) may, however, arise from a transfer to another person of relevant rights and/or obligations under the arrangement. Gains and losses from disposing of a financial arrangement can also be made when all the rights and/or obligations which exist under the arrangement cease. Both of these types of gains and losses (ie, from transfer or disposal) are the gains and losses that Subdivision 230-G apply to.

10.38 The design of the disposal provisions in Subdivision 230-G takes into account the derecognition criteria adopted by Accounting Standard AASB 139 Financial Instruments: Recognition and Measurement .

What constitutes a disposal?

General rule

10.39 The general rule is that a disposal of a whole financial arrangement, that is, a disposal of all the rights and/or obligations under the financial arrangement, occurs if those rights and/or obligations cease or are transferred to another person. [ Schedule 1, item 1, paragraphs 230-435(1)(a) and (b )]

10.40 A cessation of the relevant rights and/or obligations can occur in different ways, for example, through their discharge of obligations or satisfaction, expiry, close out, forfeiture or maturity.

10.41 A transfer of a right or obligation (which is a form of cessation) can itself occur in different ways, for example, as a result of a sale, under a legal defeasance of obligations, or an assignment of rights. If a financial arrangement is an asset, however, a transfer is effectively taken not to have occurred unless its effect is to transfer to another entity substantially all the risks and rewards of ownership of the asset [ Schedule 1, item 1, subsection 230-435(3 )]. For example, the security subject of the 'repo' in Example 2.5 would be treated as having not been transferred for Subdivision 230-G purposes.

10.42 A partial disposal of a financial arrangement can occur only if there is a transfer of one of the following types:

•

a proportionate share of all the rights and/or obligations under the financial arrangement [ Schedule 1, item 1, subparagraph 230-435(1)(c)(i )];

•

a right or obligation under the financial arrangement to a specifically identified financial benefit [ Schedule 1, item 1, subparagraph 230-435(1)(c)(ii )]; or

•

a proportionate share of a right or obligation under the financial arrangement to a specifically identified financial benefit [ Schedule 1, item 1, subparagraph 230-435(1)(c)(iii )].

Special rules or exceptions

10.43 The general rules outlined above are overridden by special rules and exceptions dealing with equity interests, hedging, margining, historical rate roll-over, conversion or exchange and commercial debt forgiveness.

Equity interests

10.44 A balancing adjustment is not made if the financial arrangement is an equity financial arrangement (as described in Chapter 2) - and neither Subdivision 230-C nor Subdivision 230-F apply to the financial arrangement [ Schedule 1, item 1, subsection 230-440(1 )]. The effect of this is that, unless the elective fair value method or the election to rely on financial reports applies to an equity financial arrangement, the disposal gain or loss in respect of that equity financial arrangement will not be calculated under Subdivision 230-G, but rather will be determined by provisions outside of Division 230.

Hedging

10.45 As explained in Chapter 8, the tax hedging provisions are designed to provide appropriate tax matching between the hedging financial arrangement and the hedged item or items. To establish this matching, it may be necessary to defer a gain or loss on the hedging financial arrangement past the time at which it would otherwise be recognised for income tax purposes, due to its disposal. In addition, an equity interest which is designated as a hedging financial arrangement may have that part of the gain or loss which is attributable to a currency exchange rate effect calculated under the hedging provisions. Hence, the balancing adjustments otherwise required by Subdivision 230-G operates subject to the tax hedging provisions in Subdivision 230-E.

Bad debts

10.46 Although the writing off of a bad debt would not constitute a transfer or cessation of a financial arrangement, Subdivision 230-G makes it clear that a balancing adjustment is not made when a financial arrangement, in part or whole, is written off as a bad debt [ Schedule 1, item 1, paragraph 230-440(3)(a )]. Specific rules for bad debt deductions are included in the accruals method and realisation method. To permit the ongoing operation of the bad debt provision in section 25-35 of the ITAA 1997, there is an exception to the anti-overlap rule in section 230-25 [ Schedule 1, item 1, subsection 230-25(3 )].

Margining

10.47 Exchange traded derivatives typically are subject to margining requirements. Thus, on a daily basis, the party carrying a loss on the contract is required to settle it by making a payment. It is arguable that the settlement of the contract means that the rights and obligations under it come to an end because they are satisfied and that there is therefore a disposal.

10.48 It appears that upon payment (under the margining requirements) a new contract equivalent to the settled contract (other than as to price) is created to replace the settled contract. The effect, therefore, is that the parties to the contract are in the same economic position as before the settlement but for the margin payment and the new price.

10.49 Except for the margining requirement, there would not have been a settlement of the old contract. In these circumstances, it is appropriate for the settlement of the exchange traded derivative, due to any margining requirements, not to give rise to a balancing adjustment. This is what paragraph 230-440(3)(b) gives effect to, although the provision is not limited to exchange traded derivatives. This exclusion from having the balancing adjustment apply extends to any financial arrangement that is a derivative financial arrangement that is settled or closed out for margining purposes.

10.50 As explained in Chapter 8, derivative financial arrangements are financial arrangements that:

•

change in value in response to a change in a specified variable or variables; and

•

require little or no net investment, in that the net investment is smaller than that required for other types of financial arrangements - that is, other than derivative financial arrangements - which would be expected to have similar results to changes in market factors.

[ Schedule 1, item 1, subsection 230-350(1 )]

10.51 It should be noted that the margining process is different to the process which occurs when an entity does not wish to maintain its exposure under the derivative contract. In this case, under clearing house rules there is a close-out, but no creation of an equivalent contract (but for price). A close-out in this situation, which is not for margining purposes, would constitute a disposal because the rights and obligations under the contract are extinguished and there is no exception which provides otherwise.

Historic rate roll-over

10.52 The term of a derivative financial arrangement may be able to be extended or 'rolled over' at a non-market or 'off market' rate which reflects the original or 'historic' rate at which the financial arrangement was entered into, and the extension of credit by the party that has a gain in relation to the financial arrangement, at that time, to the other party. This is commonly referred to as an 'historic rate roll-over'.

10.53 In substance, at the roll-over date, there is a cessation by way of expiry of the rights and/or obligations under the derivative financial arrangement. Whether there is an expiry as a matter of contract law is unclear. Accordingly, to avoid doubt, there is a specific rule in Subdivision 230-G to provide that an historic rate roll-over of a derivative financial arrangement is taken to be a ceasing of all the rights and/or obligations under the arrangement. [ Schedule 1, item 1, subsection 230-435(5 )]

10.54 As mentioned above, this and other disposal situations are subject to the operation of the tax hedging rules in Subdivision 230-E. Accordingly, the gain or loss on disposal of an historic rate roll-over derivative contract (used in a hedging context) may be able to be deferred and matched to the timing and treatment of the gain or loss on a hedged item for tax purposes. This depends on the application of the tax hedging rules (see Chapter 8).

Conversion or exchange

10.55 A balancing adjustment will not arise by virtue of the conversion or exchange, as the case may be, of a traditional security into ordinary shares if it was issued on the basis that it will, or may:

•

convert into ordinary shares of the issuer of the security or a connected entity of the issuer, and the ceasing of the rights or obligations under the financial arrangement that is the security, is because it is converted into such shares [ Schedule 1, item 1, paragraph 230-440(3)(c )]; and

•

exchange into the ordinary shares of an entity other than the issuer of the security or a connected entity; and

•

it is exchanged for such shares; and

•

if the ceasing of the rights or obligations occurs because of a disposal, the disposal is to the issuer of the traditional security or a connected entity of the issuer [ Schedule 1, item 1, paragraph 230-440(3)(d )].

Commercial debt forgiveness

10.56 A cancellation, or other discharge of obligations under a financial arrangement, which qualifies as commercial debt forgiveness is considered under Division 245 of Schedule 2C to the ITAA 1936. The gain which would be subject to Division 230 is reduced to the extent that the gain is captured by Division 245 (see discussion in Chapter 2 also). [ Schedule 1, item 1, section 230-470 ]

What amount is recognised for income tax purposes as a result of the disposal?

10.57 The amount to be recognised for income tax purposes, as a result of a disposal (ie, the disposal balancing adjustment), is that amount which ensures that the entity's overall gain or loss from having the financial arrangement (or the relevant part of it) is recognised.

10.58 Thus, amounts recognised prior to the disposal are taken into account in working out the amount of any disposal gain or loss. This process corrects for any under-allocation or over-allocation prior to the disposal point.

10.59 As explained in Chapter 3, which deals with gains and losses from financial arrangements, the concept of a gain or loss is a net concept. In order to work out the gain or loss, relevant costs must be taken into account. So, the gain or loss in respect of the disposal of rights and/or obligations comprising the whole or part of a financial arrangement must factor in the costs (if any) in respect of the arrangement or the relevant part of the arrangement, at the time of disposal.

Complete cessation or transfer

10.60 In broad terms, the way in which the balancing adjustment for cessation or transfer of the whole financial arrangement is worked out for a financial arrangement can be summarised in a formula, thus:

Disposal balancing adjustment = (a + b + c) - (d + e + f) where:

10.61 The notes to step 1(a) and step 2(a) of the method statement for balancing adjustments at section 230-445 make clear that financial benefits that are taken to be provided or received under the financial arrangement (because of the operation of section 230-65) are to be included in the balancing adjustment calculation. These are financial benefits that play an integral role in determining whether a gain or loss (or the amount) is made from the financial arrangement within the meaning of paragraphs 230-60(1)(c) and 230-60(2)(c). To illustrate the application of this rule in the context of the balancing adjustment , consider a loan between two parties. If the amount owed under the loan is 'waived' by the creditor then it could be said that the debtor has received a benefit in the form a 'waiver' being the release from payment under the loan. However, in applying the balancing adjustment calculation to this simple example the 'waiver' benefit itself would not be considered integral (in the context of section 230-60) to working out whether the debtor has made a gain or loss on the financial arrangement. The amount included in the balancing adjustment calculation in this situation would be the actual loan proceeds received by the debtor which is compared to any amounts provided by the debtor which in this example would be nil.

10.62 It is intended that, where running balancing adjustments (generally relevant for gains or losses subject to the accruals method) have been made over the period before disposal, these adjustments are taken into consideration when calculating the disposal balancing adjustment under the method statement for the disposal balancing adjustment. [ Schedule 1, item 1, subsection 230-445(1), steps 1(b) and (c) and 2(b) and (c) in the method statement ]

10.63 If the disposal balancing adjustment is positive (ie, when the total of the step 1 amount exceeds the step 2 amount), the amount is a gain made from the financial arrangement. If the disposal balancing adjustment is negative (ie, when the total of the step 2 amount exceeds the step 1 amount), the amount is a loss made from the arrangement. [ Schedule 1, item 1, subsection 230-445(1), step 3 in the method statement ]

Example 10.1 : Sale of a fixed interest bond

Investor Co buys a five-year bond carrying a fixed annual coupon of 10 per cent per annum. The bond is bought for $1,000 and is to be redeemed for $1,000 in five years.

Assume that, after receiving two $100 coupons that were included in its assessable income $200, Investor Co sells the bond for $1,050.

Investor Co's overall gain from having the bond is:

$250 = $1,050 + (2 x $100) - $1,000

Given that $200 has already been included in Investor Co's assessable income, only $50 has to be included as a disposal gain.

Under the balancing adjustment formula, (a + b + c) less (d + e + f), set out in paragraph 10.60 (though c and f are not relevant in this circumstance), the gain or loss is determined as follows:

($1,250 (per section 230-65, the $1,050 received on disposal is taken to have been received under the financial arrangement that is the bond) + $0 + $0) = $1,250

less

($1,000 (per section 230-60, the $1,000 is taken to have been provided under the financial arrangement that is the bond) + $200 + $0) = $1,200

= $50 gain on disposal.

Partial transfer

10.64 As mentioned in paragraph 10.9, there are circumstances where a balancing adjustment arises in respect of a partial disposal in certain circumstances. In these circumstances, the variables in the above formula are adjusted to take into account the nature of the partial disposal, as discussed in the following paragraphs.

10.65 Where there is a disposal of a proportionate share of all the rights and/or obligations under a financial arrangement, all the variables are reduced by that proportion. [ Schedule 1, item 1, subsection 230-445(2 )]

10.66 Where there is a disposal of a right or obligation under a financial arrangement of a specifically identified financial benefit, it is necessary to determine what has happened in relation to that right or obligation - for example, in terms of the cost already allocated - in order to determine the gain or loss to be brought to account as a balancing adjustment. This is done by determining, in relation to the particular variable, what is reasonably attributable to the right or obligation. [ Schedule 1, item 1, subsection 230-445(3 )]

10.67 The attribution of a right to receive or obligation to provide, or a proportion of such a right or obligation, a financial benefit to a particular financial benefit, must reflect appropriate and commercially accepted valuation principles. These principles must take into account the nature of the rights and obligations under the financial arrangement, the risks associated with each of the financial benefits, rights and obligations under the arrangement, and the time value of money. [ Schedule 1, item 1, subsection 230-445(5 )]

10.68 Where there is a disposal of a proportionate share of a right to receive or obligation to provide to a financial benefit under the financial arrangement, to a specifically identified financial benefit, the two types of adjustment discussed above both apply. That is, the starting point for each of the variables in the formula is the amount reasonably attributable to the particular right or obligation. These amounts are then reduced, by the disposal proportion, to arrive at the amounts actually used for the variables in the formula [ Schedule 1, item 1, subsection 230-445(4 )]. This attribution must reflect the valuation principles discussed in paragraph 10.67 [ Schedule 1, item 1, subsection 230-445(5 )].

Example 10.2 : Assignment of rights to future amounts

Assignor Co makes a 10-year loan of $5 million to Borrower Co. The loan pays a fixed annual coupon. The rate is 8 per cent per annum. Assume that this is also the prevailing market interest rate.

Assignor Co immediately assigns the right to all the interest payments to Assignee Co for $2,684,033. This payment is the present value of the future interest payments discounted at 8 per cent per annum.

While the assigned payments are equal in amount to the interest on the loan, the assignment gives rise to a partial disposal of the asset, being the right to a stream of future payments. In Assignee Co's hands, economically, each payment is equivalent to 'principal' and 'interest' (ie, each payment economically has a portion of Assignor Co's $5 million cost attributed to it - see discussion in Chapter 3). The rules in section 230-70 requiring no attribution of a cost to interest payments, do not apply for the purpose of Subdivision 230-G.

To calculate the gain or loss on the partial disposal of the loan, it is necessary to determine the cost of assigned interest payments at that time. Commercially, this is done by allocating an amount, sometimes referred to as the 'carrying amount', to the part which is disposed of. The partial disposal is done by allocating the carrying amount of the whole financial arrangement between the part disposed of, and the part retained, on the basis of the fair value of the part disposed of, relative to the fair value of the whole thing.

The fair value, at the time of the partial disposal, of the part disposed of is $2,684,033 and the fair value of the whole loan, is $5 million. The carrying amount of the whole loan is $5 million.

Therefore, the carrying amount of the part disposed of is $2,684,033, which is the cost of the right to the 10 future annual payments of $400,000. Since $2,684,033 is also the amount of proceeds from the assignment, there is no gain or loss.

Under the balancing adjustment formula, (a + b + c) less

(d + e + f) (though b, c, e and f are not relevant in this circumstance), set out in paragraph 10.60, this is determined as follows:

($2,684,033 (per section 230-65, this amount received on disposal is taken to have been received under the financial arrangement that is the loan, and it is entirely attributable to the portion of the arrangement, the interest income stream, disposed of) + $0 + $0) = $2,684,033

less

($2,684,033 (per section 230-65, the $5 million lent is taken to be an amount Assignor Co had an obligation to provide, and did provide under its financial arrangement, and $2,684,033 of this cost is attributable to its right to receive interest payments that were disposed of) + $0 + $0) = $2,684,033

= $0 gain or loss on disposal.

Alternatively, if, for example, Assignor Co assigns these payments for $3 million, it would make a gain of $315,967 (step 1(a) in the above calculation would be $3 million).

When does the disposal occur?

10.69 The gain or loss produced by the disposal discussed in this chapter is made in the year in which the relevant cessation or transfer occurs. [ Schedule 1, item 1, subsection 230-445(6 )]

10.70 So, for example, if there is a disposal because of an assignment of certain rights under a financial arrangement, the gain or loss is made under the balancing adjustment when the assignment occurs.

10.71 In another case, when a financial arrangement is sold, a disposal occurs (and the balancing adjustment gain or loss is made) when the relevant rights and obligations are given up or transferred.

Arm's length value adjustment for financial benefits received or provided where the parties are not dealing at arm's length

10.72 To preserve the integrity of Division 230, the amount of a financial benefit received or provided under certain non-arm's length financial arrangement dealings is to be substituted for the amount of the financial benefit that would reasonably be expected to be received or provided had the parties been dealing at arm's length. Without such a rule, parties not dealing at arm's length could, as a result of those dealings, obtain inappropriate tax advantages.

10.73 Under various provisions of the ITAA 1936 and the ITAA 1997, where a financial asset or liability ceases to be held as a result of a non-arm's length dealing those provisions generally require the Commissioner of Taxation to substitute an arm's length value if the amounts provided for the acquisition, transfer or cessation are not at arm's length. Examples include:

•

subsections 26BB(3) and 70B(3) of the ITAA 1936 dealing with gains and losses arising from the disposal or redemption of traditional securities; and

•

section 775-120 of the ITAA 1997 dealing with the calculation of foreign exchange gains and losses.

10.74 In addition, there are a number of provisions in the ITAA 1936 and the ITAA 1997 that either reduce the holding costs of a financial arrangement (eg, excessive interest payments claimed as a deduction) where the parties are not dealing at arm's length or, alternatively, require the substitution of a market value regardless of whether or not the parties are dealing at arm's length. Examples include:

•

section 52A of the ITAA 1936, which limits a deduction to the arm's length amount on monies borrowed and used to acquire 'prescribed property' where the parties are not dealing at arm's length;

•

subsection 73B(31) of the ITAA 1936 which limits excessive interest payments associated with research and development activities to their arm's length amount where there is a non-arm's length dealing;

•

subsection 159GZZZQ(2) of Division 16K of the ITAA 1936 which deems the market value to have been received for the disposal of a share in an off-market share buy-back arrangement;

•

section 775-40 of the ITAA 1997 which deems a market value where the proceeds from the disposal of foreign currency is more or less than market value; and

•

subsection 245-65(2) of Subdivision 245-C, Schedule 2C to the ITAA 1936 which substitutes the market value as the consideration provided by a debtor in respect of debt forgiveness where no consideration is provided or the consideration (in whole or part) cannot be valued.

10.75 To ensure that the intention of the above mentioned provisions is preserved, Division 230 contains corresponding integrity measures. Ensuring symmetry in the operation of these integrity measures between arrangements subject to Division 230 and those not subject to Division 230 would also operate to prevent inappropriate tax arbitrage opportunities.

10.76 The paragraphs below set out the situations when the non-arm's length dealing rule in Division 230 will apply to financial arrangements.

Non-arm's length dealings in relation to the complete or partial transfer, cessation or from starting to have a financial arrangement

10.77 Consistent with the existing tax rules dealing with the disposal or redemption of traditional securities contained in sections 26BB and 70B of the ITAA 1936, the intent of section 230-510 is to ensure that, upon the cessation or transfer of a financial arrangement, arm's length values are used to calculate the balancing adjustment if there has been a non-arm's length dealing in relation to the cessation or transfer, or the starting to hold the arrangement, or the holding of the arrangement. This prevents the creation of a loss, a greater loss or reduction of a gain as a result of the parties not dealing at arm's length.

10.78 Also consistent with the application of the existing tax law dealing with the taxation of traditional securities, section 230-510 does not apply to non-arm's length cessations or non-arm's length dealings that arose prior to the cessation of loan-like financial arrangements (eg, when the taxpayer started to hold the financial arrangement). This prevents a time-value-of-money financial benefit (eg, interest) being deemed to have been received or provided as a result of those dealings. [ Schedule 1, item 1, paragraph 230-510(1)(b )]

10.79 Accordingly, subject to the exception discussed below, the non-arm's length dealing rule would apply where:

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a balancing adjustment is made under section 230-435 in respect of the financial arrangement;

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the parties to the financial arrangement did not deal at arm's length in relation to the cessation or complete or partial transfer of the financial arrangement, or in relation to an earlier time (including starting to have the financial arrangement); and

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the amount of the financial benefit received or provided under the financial arrangement at any time from (and including) starting to hold the financial arrangement until (and including) a complete or partial transfer or cessation is more or less than the financial benefit that might be reasonably expected to have been received or provided if the parties were dealing at arm's length.

10.80 In such circumstances, unless a specific exception applies (see below), the amount of the financial benefit received or provided (including where it is nil) is taken, for the purposes of Division 230, to be the amount of the financial benefit that would have been received or provided if the parties were dealing at arm's length. [ Schedule 1, item 1, section 230-510 ]

Example 10.3 : Non-arm's length dealing

Hamish Co and Lucky Co entered into a financial arrangement on 1 July 2010 whereby Hamish Co agreed to provide Lucky Co with a financial benefit of $100 in return for Lucky Co providing periodic financial benefits based on arm's length rates of interest of 10 per cent per annum and a repayment of the original $100 financial benefit in five years from the date the financial benefit was provided. Hamish Co disposes of the rights to receive the financial benefits under the financial arrangement to a related entity, Bert Co, for $90 when its arm's length value is $100.

Having regard to the relationship between the parties to the transfer and the fact that Hamish Co transferred the financial arrangement to Bert Co, a related entity, for a non-arm's length amount, it would be concluded that Hamish Co and Bert Co are not dealing at arm's length in relation to the transfer.

In these circumstances, Hamish Co would be taken to have received a financial benefit equal to the arm's length value of $100 as a result of the disposal.

Bert Co will be taken to have acquired the financial arrangement for $100.

Exception for non-arm's length dealings arising from the cessation of financial arrangements that are debt interests or loans

10.81 In certain circumstances, applying an arm's length rule as a result of a cessation event may give rise to inappropriate tax outcomes and impute a time-value-of-money financial benefit where no financial benefit is to be paid. Therefore the measures exclude from the operation of the arm's length rule, non-arm's length dealings arising in respect of debt interests and loans (whether they are loans in legal form or economic substance) that cease to be held other than by transfer (eg, by repayment). This outcome is achieved, in part, by excluding non-arm's length dealings in respect of commencing to hold or the cessation of a 'debt interest' as defined for the purposes of the debt/equity rules in Division 974 of the ITAA 1997 and other financial arrangements that are loans. Financial arrangements that are loans would include, for the purposes of Division 230, those financial arrangements that would normally be considered to have debt-like features such as the existence of debtor and creditor relationship. One such example would be an interest-free loan with a term greater than 10 years.

10.82 Without such an exclusion, a cessation event in relation to a debt interest or loan would result in the imputing of a gain to the lender and a loss to the issuer because the financial benefit amount repaid by a related party borrower would be less than the arm's length value (which would be the loan amount and the time-value-of-money as compensation for use of funds).

Example 10.4 : Acquisition and cessation of a non-arm's length dealing financial arrangement

Hamish Co and a related entity, Lucky Co, entered into an arrangement on 1 July 2010 whereby, Hamish Co agreed to provide Lucky Co with a financial benefit of $100 (interest-free) repayable in full in 15 years from the date the financial benefit was provided. On 1 July 2010 the market value of the right to receive the $100 financial benefit in 15 years time is $70.

On entering into the arrangement Hamish Co has a financial arrangement being the right to receive a cash settlable financial benefit of $100 in 15 years time. Lucky Co also has a financial arrangement being the obligation to provide a cash settlable financial benefit of $100 in 15 years time.

Having regard to the relationship between the parties to the financial arrangement and the fact that, had Hamish Co provided the financial benefit of $100 to a non-related entity the financial benefits or benefits that Hamish Co would have been entitled to would have included a financial benefit or benefits calculated by reference to the 15 years that the $100 cash has been provided for, it would be concluded that the parties are not dealing at arm's length.

The financial arrangement would be treated as a loan for the purposes of Division 230 given that there is an obligation to repay the amount after 15 years.

If the non-arm's length rule applied to this situation, Hamish Co would make a $30 gain on the cessation of the financial arrangement which would have had the effect of imputing or deeming a time-value-of-money gain on the financial arrangement. Paragraph 230-510(1)(b) operates so as to prevent the application of the arm's length rule to these circumstances and hence no gain or loss arising from the non-arm's length dealing would be bought to account.

From Lucky Co's perspective, when it commences to hold the non-arm's length financial arrangement its market value would be $70, which, if it had been substituted for the actual amount received, would have resulted in a loss on providing the financial benefit for Lucky Co at the end of the term of the financial arrangement (because Lucky Co is required to provide $100 at the end of the term of the financial arrangement). Consistent with the tax treatment of Hamish Co, the loss from the related party non-arm's length dealing would not be recognised by not requiring the arm's length value to be substituted in the calculation of Lucky Co's balancing adjustment. On cessation of the loan, Lucky Co's financial benefits provided would be taken to be $100 rather than the market value of $70.

Exception for the transfer of non-arm's length debt interests or loan-like arrangements

10.83 In certain circumstances, the measures operate where there is a complete or partial transfer of a debt interest or loan and a loss, or gain, arises under the method statement as set out in subsection 230-445(1). In such a case, the loss or the gain is adjusted by the difference between the amount of any financial benefits provided under the financial arrangement and the amount that would have been provided if the parties were dealing at arm's length. That is, the loss or the gain is adjusted only to the extent that it is attributable to the non-arm's length dealing as distinct from other factors.

Example 10.5 : Transfer of a non-arm's length financial arrangement

Tony Co enters into an arrangement with related entity Teresa Co on 1 July 2012 whereby Tony Co agrees to provide Teresa Co with a financial benefit of $100. Teresa Co is required to repay the $100 in five years time. At the time the arrangement is entered into, market interest rates are at 6 per cent per annum resulting in arm's length value for the arrangement of $74.73.

On 1 July 2013, Tony Co transfers the right to receive the financial benefit of $100 in three years' time (being five years from the original date of the arrangement) for its market value of $72 (interest rates have risen).

On entering into the arrangement, Tony Co has a financial arrangement, being the right to receive a cash settlable financial benefit of $100 in five years' time. Teresa Co also has a financial arrangement, being the obligation to provide a cash settlable financial benefit of $100 in five years' time. The financial arrangement is a debt interest as defined in Division 974 of the ITAA 1997.

Having regard to the relationship between the parties to the financial arrangement and the fact that, had Tony Co provided the financial benefit of $100 to a non-related entity the financial benefits that would have been received by Tony Co would have included a financial benefit or a series of financial benefits for the use of the $100 cash provided for a term of five years, it would be concluded that the parties are not dealing at arm's length.

Upon transfer of the financial arrangement, a loss of $25.27 would ordinarily arise under the balancing adjustment method statement contained in subsection 230-445(1) (total of all financial benefits received under the financial arrangement of $74.73 less the total of all financial benefits provided under the financial arrangement of $100).

However, had the parties been dealing at arm's length in relation to the original acquisition, the loss would have been limited to $2.73 (the difference between $74.73 and $72). Subsection 230-510(3) operates to reduce the loss on transfer of the financial arrangement to this amount.

Arm's length dealings in relation to certain financial arrangements

10.84 As mentioned above, in certain circumstances the existing tax law under the ITAA 1936 or the ITAA 1997 operates to:

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substitute an arm's length amount where the parties are not dealing with each other at arm's length and excessive deductions are claimed under a financial arrangement to amounts; or

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substitute a market value for the relevant financial benefit where the parties are dealing with each other at arm's length but the relevant financial benefit is not at market value.

10.85 To ensure symmetry and prevent opportunities for tax arbitrage between those provisions in the ITAA 1936 and the ITAA 1997 that require the use of an arm's length or market value rule, the Division 230 arm's length rules will, where the circumstances specified in the relevant provisions apply, operate to substitute an arm's length value or market value for the relevant financial benefit. The provisions in subsection 230-442(2) are provisions in the income tax law that effectively provide a market value substitution rule irrespective of whether or not the relevant transaction is at arm's length, namely:

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section 52A of the ITAA 1936;

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section 73B of the ITAA 1936;

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Division 16J of the ITAA 1936;

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Division 16K of the ITAA 1936;

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subsection 245-65(2) of Subdivision 245-C, Schedule 2C to the ITAA 1936; and

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section 775-40 of the ITAA 1997.

10.86 In certain circumstances, both the arm's length dealing rules in section 230-510 and section 230-442 can have application in respect of a financial arrangement. In such cases, section 230-510 will operate to specify the amount of the financial benefit that is to be substituted for the purposes of Division 230 in a non-arm's length dealing.