House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP)

Chapter 3 - Taxation of financial arrangements and pay as you go instalments

Outline of chapter

3.1 Schedule 3 to this Bill amends Division 45 of Part 2-10 of Schedule 1 to the Taxation Administration Act 1953 (TAA 1953) to ensure that, for taxpayers who apply Division 230 of the Income Tax Assessment Act 1997 (ITAA 1997) to their financial arrangements, the interaction between the taxation of financial arrangements (TOFA) provisions and the pay as you go instalments (PAYGI) provisions does not impose significant compliance costs.

Context of amendments

3.2 The PAYGI provisions contained in Division 45 of Part 2-10 of Schedule 1 to the TAA 1953 ensure the efficient collection of, among other things, income tax. In general, the PAYGI provisions operate so that as taxpayers earn instalment income, they pay instalments after the end of each instalment quarter worked out on the basis of their instalment income for that quarter.

3.3 Generally, under the PAYGI provisions, instalment income for a period includes ordinary income derived during the period, but only to the extent that it is assessable income of the income year that is or includes that period. For certain types of entities it may also include statutory income. As stated in subsection 6-5(1) of the ITAA 1997, ordinary income is income according to ordinary concepts. This generally means gross income before taking expenses into account.

3.4 The TOFA provisions were inserted by the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 which commenced on 26 March 2009. The TOFA provisions apply mandatorily for income years commencing on or after 1 July 2010, unless a taxpayer elects to apply the TOFA provisions for income years commencing on or after 1 July 2009. The TOFA provisions generally only apply in relation to gains and losses from financial arrangements held by certain taxpayers who do not satisfy certain asset or turnover threshold tests.

3.5 For a taxpayer who is required or elects to apply the TOFA provisions in relation to gains and losses from their financial arrangements (TOFA entities), the gains and losses from their financial arrangements are taken into account in determining their taxable income. That is, their assessable income includes a gain they make from a Division 230 financial arrangement and their allowable deductions include a loss they make from a Division 230 financial arrangement. Gains and losses from Division 230 financial arrangements may constitute either or both ordinary income and statutory income.

Summary of new law

3.6 These amendments extend the definition of 'instalment income' in section 45-120 to also include net gains (to the extent the gains equal or exceed the losses) from Division 230 financial arrangements. For TOFA entities (excluding individuals, or those entities that only have qualifying securities), this enables their instalment income from Division 230 financial arrangements to be worked out more easily from gains and losses worked out under the TOFA provisions.

3.7 These amendments also ensure that to the extent an amount of statutory or ordinary income is included in working out a gain or loss from Division 230 financial arrangements under the extended definition; that amount of statutory or ordinary income is excluded from other categories of instalment income.

3.8 The extension of the 'instalment income' definition commences from the first quarter of an income year following a TOFA entity's (other than individuals, or entities where the entity's only financial arrangements are qualifying securities) first base assessment that applied the TOFA provisions to their Division 230 financial arrangements. The income year to which the first base assessment relates must generally commence on or after 1 July 2010.

3.9 Under certain circumstances, taxpayers may elect to commence the extended 'instalment income' definition earlier.

Comparison of key features of new law and current law

Detailed explanation of new law

Instalment income extended to include a net TOFA gain

3.10 This Schedule extends the definition of 'instalment income' in section 45-120 of Schedule 1 to the TAA 1953 so that a TOFA entity's instalment income for an instalment period includes the difference between:

•

gains from financial arrangements that are assessable under Division 230 of the ITAA 1997 and reasonably attributable to the instalment period; and

•

losses from financial arrangements that are allowable deductions under Division 230 of the ITAA 1997 and reasonably attributable to the instalment period, but only to the extent that the losses do not exceed the gains [Schedule 3, item 1, subsection 45-120(2C)] .

3.11 Financial arrangement has the meaning given by sections 230-45 and 230-50 of the ITAA 1997. Broadly, financial arrangements are arrangements where the rights and obligations under the arrangement are cash settlable, subject to certain add-ons and exceptions. A financial arrangement is a Division 230 financial arrangement if Division 230 of the ITAA 1997 applies in relation to gains and losses from the arrangement.

3.12 The extended definition allows TOFA entities to include net gains from their Division 230 financial arrangements in their instalment income calculations for an instalment period, as opposed to ordinary income derived from their financial arrangements. Net gains from Division 230 financial arrangements (net TOFA gains) equal total assessable gains from their Division 230 financial arrangements for an instalment period (TOFA gains) reduced by deductible losses from their Division 230 financial arrangements for that period (TOFA losses), but only to the extent that the TOFA losses do not exceed the TOFA gains.

3.13 Without the extension, for TOFA entities to work out their instalment income from the TOFA gains and losses, the taxpayer would generally be required to add back expenses to work out the gross income amount and then subtract any statutory income amounts. This process would increase compliance costs for taxpayers.

3.14 With respect to derivatives which are generally fair valued for financial accounting purposes, the current 'instalment income' definition may not include fair value gains as they are unlikely to be ordinary income and also it may be very difficult to work out the gross income amount because expenses are generally not readily identifiable.

3.15 The words reasonably attributable are intended to have their ordinary meaning. TOFA gains and TOFA losses that accrue over more than one instalment period should be apportioned to one or more instalment period(s) on a reasonable basis. [Schedule 3, item 1, subparagraphs 45-120(2C)(a)(ii) and 45-120(2C)(b)(ii)]

3.16 For some TOFA entities, TOFA gains and losses from certain financial arrangements may be taken into account for income tax purposes under an elective tax-timing method where TOFA gains and losses are spread in an un-systematic way, for example the fair value tax-timing method. Under this tax-timing method, the gain or loss from a financial arrangement for a particular period is the increase or decrease in its fair value (broadly, the market value) between the beginning and end of the period. In such situations, instalment income should include the net fair value changes of a financial arrangement for an instalment period where the fair value changes are readily ascertainable; for example, where the financial arrangement is quoted in an active market or where reliable valuation methodologies can be used.

3.17 Where fair value changes of a financial arrangement for an instalment period are not readily ascertainable, it is reasonable for the fair value changes to be included in instalment income for an instalment period in which the fair value of the financial arrangement is required to be determined for financial accounting or commercial purposes.

Example 3.10

CFD Co is a TOFA taxpayer that has made a valid election to apply the fair value tax-timing method to its financial arrangements that are classified or designated as at fair value through profit or loss for financial accounting purposes.

CFD Co has two portfolios of listed securities (financial arrangements) during the instalment period from 1 July 2013 to 30 September 2013 - listed shares in Company A and listed units in Property Trust B - that are being classified as at fair value through profit or loss for financial accounting purposes.

At the beginning of 1 July 2013, the listed shares portfolio has a market value of $65 million and the listed units portfolio has a market value of $10 million. At the end of 30 September 2013, the listed shares portfolio has a market value of $70 million and the listed units portfolio has a market value of $8 million. For the instalment period, CFD Co has a fair value gain of $5 million from the listed shares portfolio and a fair value loss of $2 million from the listed units portfolio. CFD Co's instalment income for the period includes the net TOFA gain of $3 million from its financial arrangements.

3.18 To reduce complexities, the extended 'instalment income' definition does not apply to TOFA entities who are individuals, or only apply Division 230 of the ITAA 1997 in relation to amounts from their qualifying securities. [Schedule 3, item 1, subsection 45-120(2D)]

3.19 'Qualifying security' is defined in Division 16E of Part III of the Income Tax Assessment Act 1936 (ITAA 1936). Generally, qualifying securities are long-term (more than 12 months), discounted and deferred interest securities with tax deferral characteristics.

3.20 To ensure no double counting of an ordinary or statutory income amount in instalment income calculations for any instalment period; where an amount of ordinary or statutory income is taken into account in working out a net TOFA gain for an instalment period, it is not taken into account again in the instalment income calculations for any instalment period. [Schedule 3, item 1, subsection 45-120(2E)]

3.21 Even where the net TOFA gain is a nil amount, due to the TOFA losses equalling or exceeding the TOFA gains, the ordinary or statutory income amounts used in working out the TOFA gains should not be included again as instalment income for any instalment period. Where such an amount has already been included in an earlier instalment period, the amount should be subtracted from the instalment income calculations for the current period.

Example 3.11

Charter Co has $100 interest income (TOFA gains) and $200 interest expense (TOFA losses) from its Division 230 financial arrangements for the instalment period from 1 July 2013 to 30 September 2013. As Charter Co's TOFA losses are greater than its TOFA gains for the instalment period, no amount in relation to its Division 230 financial arrangements is included in its instalment income for the period.

While the $100 interest income is an amount of ordinary income which would otherwise have been included in Charter Co's instalment income for the instalment period under subsection 45-120(1) of Schedule 1 to the TAA 1953, this amount is not to be taken into account in calculating instalment income for any instalment period because it has been taken into account in working out the nil amount of net TOFA gains for the purposes of calculating instalment income for the instalment period from 1 July 2013 to 30 September 2013.

Application of the extended 'instalment income' definition

Definition

3.22 The instalment income definition as extended is defined as the amended instalment income definition . [Schedule 3, item 2 ]

3.23 A taxpayer's first TOFA year is defined as the first income year commencing on or after 1 July 2010 where the taxpayer has an assessable gain or deductible loss from its Division 230 financial arrangements (other than a qualifying security). [Schedule 3, item 2 ]

Main rule

3.24 Subject to the early opt-in provisions (explained below), a taxpayer applies the amended instalment income definition when:

•

the Commissioner of Taxation (Commissioner) issues an instalment rate under section 45-15 of Schedule 1 to the TAA 1953 after this Bill receives Royal Assent and in the first quarter of a taxpayer's income year; and

•

the base year that applies in working out the instalment rate is the taxpayer's first TOFA year or a later year.

[Schedule 3, subitems 3(1) and (2)]

3.25 Under the PAYGI provisions, the Commissioner is required to use the taxpayer's base assessment instalment income to work out the instalment rate. Base assessment instalment income is defined in subsection 45-320(2) of Schedule 1 to the TAA 1953 to mean so much of the taxpayer's assessable income, as worked out for the purposes of the base assessment, as the Commissioner determines is instalment income for the base year. Base year is the income year to which the base assessment relates. Broadly, the base assessment is the latest assessment for the taxpayer's most recent income year for which an assessment has been made.

3.26 The main application rule operates so that taxpayers, who use the instalment rate method to work out their PAYGI amounts, only start to apply the amended instalment income definition from the instalment period in which the Commissioner issued an instalment rate that is worked out by using the amended instalment income definition in calculating the base assessment instalment income. This is to ensure that the Commissioner has sufficient TOFA-related information to issue a TOFA-related instalment rate.

3.27 The amended instalment income definition will only have an effect where a taxpayer has gains or losses calculated under Division 230 of the ITAA 1997. In other words, applying the amended instalment income definition to any periods prior to a taxpayer's first TOFA year gives the same instalment income amounts as applying the existing instalment income definition.

3.28 To reduce complexities of the law in terms of the various amendments to the PAYGI provisions that would be required consequential to starting the amended instalment income definition part way through an income year, the amended instalment income definition commences in the first instalment quarter of a taxpayer's income year.

Example 3.12

Heyward Ltd is a full self-assessment taxpayer with an income year ending on 30 June. The TOFA provisions mandatorily apply to Heyward Ltd for income years commencing on or after 1 July 2010 (that is, from the 2010-11 income year). Heyward Ltd's first TOFA year is 2010-11 income year.

In compliance with its tax agent's lodgment program it lodges its income tax return for the 2010-11 income year through its tax agent on 15 January 2012. Assuming a similar lodgment due date applies in subsequent years, the 2010-11 income year is the base year for the third and fourth instalment periods of the 2011-12 income year and the first and second instalment periods of the 2012-13 income year.

As per the diagram below, the Commissioner issues Heyward Ltd with:

•

an instalment rate based on the base assessment instalment income worked out using the existing instalment income definition in Heyward Ltd's third instalment period (that is, Q3 - 1 January 2012 to 31 March 2012) of the 2011-12 income year (in line with current practice for non-TOFA entities); and

•

another instalment rate based on the base assessment instalment income worked out using the amended instalment income definition in Heyward Ltd's first instalment period (that is, Q1 - 1 July 2012 to 30 September 2012) of the 2012-13 income year.

In this situation, Heyward Ltd continues to use the existing instalment income definition to work out its instalment income for the third and the fourth instalment periods of the 2011-12 income year. Heyward Ltd starts to use the amended instalment income definition to work out its instalment income from the first quarter of the 2012-13 income year.

Example 3.13

Long Ltd is a full self-assessment taxpayer with an income year ending on 30 June. It is required to apply the TOFA provisions to its financial arrangements from the 2011-12 income year due to the breach of the asset threshold tests in the TOFA provisions in the 2010-11 income year. Long Ltd's first TOFA year is the 2011-12 income year.

In compliance with its tax agent's lodgment program it lodges its income tax return for the 2011-12 income year through its tax agent on 15 January 2013. Assuming a similar lodgment due date applies in subsequent years, the 2011-12 income year is the base year for the third and fourth instalment periods of the 2012-13 income year and the first and second instalment periods of the 2013-14 income year.

As per the diagram below the Commissioner issues Long Ltd with:

•

an instalment rate based on the base assessment instalment income worked out using the existing instalment income definition in Long Ltd's third instalment period (that is, Q3 - 1 January 2013 to 31 March 2013) of the 2012-13 income year (in line with current practice); and

•

another instalment rate based on the base assessment instalment income worked out using the amended instalment income definition in Long Ltd's first instalment period (that is, Q1 - 1 July 2013 to 30 September 2013) of the 2013-14 income year.

In this situation, Long Ltd continues to use the existing instalment income definition to work out its instalment income for the third and fourth instalment periods for the 2012-13 income year. Long Ltd starts to use the amended instalment income definition from the first instalment period (Q1) for its 2013-14 income year.

Application - Partnerships and trusts

3.29 Under sections 45-260 (partnerships) and 45-280 (trusts) of Schedule 1 to the TAA 1953, a partner of a partnership's or a beneficiary of a trust's instalment income for an instalment period includes their share of the partnership's or trust's instalment income for the period worked out in accordance with the formula specified in the respective sections.

3.30 For the purposes of sections 45-260 and 45-280, TOFA entities who are partnerships or trusts apply the amended instalment income definition in working out the partnership's or the trust's instalment income for 'the last income year' and 'the current period' in the applicable formula where:

•

'the current period' starts after this Bill receives Royal Assent; and

•

'the last income year' in the formula is the partnership/trust's first TOFA year or a later year.

[Schedule 3, subitems 3(3) and (5)]

3.31 To ease compliance costs and avoid the potential for a mismatch between the:

•

instalment income for 'the last income year' in the numerator of the two formulae; and

•

instalment income of the current period which is the multiplier in the two formulae,

the application rules for partnerships and trusts defers the application of the amended instalment income definition in working out the partnership's or trust's instalment income for the current period until a partner's or a beneficiary's last income year is on or after the partnership's or trust's first TOFA year. [Schedule 3, subitems 3(4) and (6)]

Example 3.14

XYZ Trust is a TOFA entity with an income year ending on 30 June, and has reported assessable TOFA gains and deductible TOFA losses in its income tax return for the 2011-12 income year. This is XYZ Trust's first TOFA year.

Michael is a beneficiary of XYZ Trust. Michael's most recent income year for which there is an assessment is the 2011-12 income year. The assessment was issued on 2 December 2012 (which is in Michael's second instalment period of the 2012-13 income year). As such, from the second instalment period, Michael's last income year under subsection 45-280(2) is the 2011-12 income year. This is also the first TOFA year for XYZ Trust.

Accordingly, from the second instalment period of the 2012-13 income year the trustee of XYZ Trust starts to use the amended instalment income definition in working out the XYZ Trust's instalment income for 'the last income year' (2011-12 income year) and 'the current period' for Michael.

Example 3.15

The ABC Partnership was created on 1 July 2011 and is constituted by two equal partners, David Co and Sonida Co investment banks. The ABC Partnership was created to borrow money from the wholesale market and on-lend it to DEF Co. The ABC Partnership, David Co and Sonida Co have an income year ending on 30 June.

On 1 July 2011, the ABC Partnership borrowed $1 billion at 5 per cent per annum fixed for three years, and on-lent the funds to DEF Co on the same day at 6 per cent per annum fixed for three years (that is, ABC Partnership will have assessable TOFA gains of $60 million for the next three years, and deductible TOFA losses of $50 million in each of those years). Both loans are Division 230 financial arrangements.

The 2011-12 income year was the first TOFA year for the ABC Partnership, and for that year:

•

the ABC Partnership had assessable income of $60 million, allowable deductions of $50 million and net income of $10 million; and

•

each partner had $5 million assessable income from the partnership.

Both David Co and Sonida Co lodged their 2011-12 income tax returns on 3 September 2012. In working out the partners' instalment income for the first instalment period of their 2012-13 income year (that is, Q1 - 1 July 2012 to 30 September 2012) for the ABC Partnership, the amended instalment income definition applies:

•

the partnership's instalment income for the period is $2.5 million - this is worked out as the TOFA gain attributable to the period ($15 million) less the TOFA loss attributable to the period ($12.5 million), and

•

the partnership's instalment income for the last income year is $10 million (being a TOFA gain of $60 million less a TOFA loss of $50 million)

Using the formula in subsection 45-260(1) of Schedule 1 to the TAA 1953, David Co and Sonida Co each includes $1.25 million in their instalment income for that period from the ABC Partnership calculated as follows:

•

$5 million/$10 million * $2.5 million.

Application - Early application of the amended instalment income definition

3.32 Under the main application rules, the amended instalment income definition commences for a taxpayer from the first instalment period of an income year where the base year, for the purposes of the Commissioner calculating an instalment rate for that first quarter, is the taxpayer's first TOFA year. This means that TOFA entities generally cannot apply the amended instalment income definition in the instalment period when they lodge their first TOFA tax return. Rather, it does not generally apply until the first instalment period of the income year that follows the year in which that first TOFA return is lodged. This generally involves an 18 month delay.

3.33 For TOFA entities that do not wish to maintain the gross income system for PAYGI purposes and the net gain or loss system for income tax purposes, they may elect to start applying the amended instalment income definition where the base year, for the purposes of the Commissioner calculating an instalment rate, is an income year before the taxpayer's first TOFA year. [Schedule 3, subsection 3(7)]

3.34 The election only applies where the Commissioner is satisfied that it would be reasonable to do so having regard to the objects of the PAYGI provisions. [Schedule 3, paragraph 3(7)(d)]

3.35 Given the base year is an income year before the taxpayer's first TOFA year, the base assessment will generally not contain amounts resulting from the application of the TOFA provisions for the Commissioner to issue an instalment rate based on the amended instalment income definition.

3.36 Taxpayers can only apply the amended instalment income definition for an instalment period, where the base year for the purposes of calculating the corresponding instalment rate is an income year before the taxpayer's first TOFA year, if the Commissioner has sufficient TOFA related information for the base year to issue a TOFA related instalment rate for a relevant current period. This is to ensure the instalment income and instalment rate for an instalment period are both worked out using the amended instalment income definition, and therefore ensure the integrity of the PAYGI provisions. [Schedule 3, subitems 3(7) and (8)]

3.37 Where the early opt in results in the base year being an income year before a taxpayer's first TOFA year, the TOFA provisions are taken to apply to the taxpayer's financial arrangements for the base year in the same way that they would have applied in the taxpayer's first TOFA year. [Schedule 3, subitem 3(9)]

Example 3.16

Evan Ltd is a TOFA entity from the beginning of its income year commencing 1 January 2012 (that is, its 2012-13 income year). Assume that the amended instalment income definition commences on 1 January 2012.

It lodges the following income tax returns:

•

for the 2011-12 income year (which commences on 1 January 2011) on 6 June 2012; and

•

for the 2012-13 income year (which commences on 1 January 2012) on 6 June 2013.

It lodges its 2012-13 income tax return in the second quarter (Q2) of its 2013-14 income year (that commences on 1 January 2013).

Under the main application rules, Evan Ltd starts to apply the amended instalment income definition from the first instalment period of the 2014-15 income year (which commences on 1 January 2014).

Instead, Evan Ltd elects to apply the amended instalment income definition from the first instalment period of the 2013-14 income year (which commences 1 January 2013).

For the first instalment quarter of the 2013-14 income year, the base year is the 2011-12 income year as Evan Ltd's most recent assessment is in relation to that income year.

Because the base year is an income year before Evan Ltd's first TOFA year, Evan Ltd's base assessment does not include information for the Commissioner to work out the base assessment instalment income using the amended instalment income definition (that is, the net TOFA gains from Evan Ltd's Division 230 financial arrangements). As such, in making the election, Evan Ltd needs to provide sufficient information for the Commissioner to calculate a new instalment rate on the basis that the TOFA provisions had relevantly applied to Evan Ltd in that income year.