House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Glossary

The following abbreviations and acronyms are used throughout this explanatory memorandum.

General outline and financial impact

Removal of the taxing point on conversion or exchange of certain traditional securities

This bill proposes to remove the taxing point at conversion or exchange of certain financial instruments. The proposed amendments:

•

will remove the taxing point when traditional securities issued after the date of effect convert or exchange into ordinary shares;

•

will insert a new Subdivision (Subdivision 130-E) into the CGT provisions that will ensure that the amount of gain or loss recognised for income tax purposes is correctly calculated, by modifying the cost base and reduced cost base of shares acquired on the exchange of an exchangeable interest; and

•

will amend the cost base and reduced cost base CGT provisions relating to the conversion of convertible interests and the exercising of rights, to ensure that the amount of gain or loss recognised for income tax purposes is correctly calculated.

Date of effect: After 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002 for the proposed amendments to remove the taxing point on conversion or exchange of certain traditional securities. The consequential changes in relation to the conversion of convertible interests and the exercise of rights will apply from 1 July 2001.

Proposal announced: The removal of the taxing point on conversion or exchange was announced in Minister for Revenue and Assistant Treasurer's Press Release No. C57/02 of 14 May 2002.

Financial impact: This measure will have no impact on the revenue over the forward estimate period. As the measure will apply to issues of traditional securities that are convertible interests or exchangeable interests issued after the date of effect there is unlikely to be any impact on the revenue until 2006-2007 because conversion or exchange is unlikely to occur before then. Whether the measure will have a positive or negative impact on the revenue after that will depend on the extent of gains and losses made on conversion or exchange.

Compliance cost impact: The measure will have a minor compliance impact on the issuers of traditional securities that are subject to the measure. However, the measure will reduce the compliance costs of investors in these traditional securities.

Summary of regulation impact statement

Regulation impact on business

Impact: This measure will impact on companies, which are the predominant issuers of traditional securities that are convertible interests or exchangeable interests that will or may convert or exchange into ordinary shares. The measure will also impact on superannuation funds, large/medium business, small business, and individuals to the extent that they invest in these traditional securities.

Main points:

•

This measure will prevent potential cash flow difficulties arising where the holder of traditional securities that convert or exchange into ordinary shares does not have the cash from the conversion or exchange to pay the tax on conversion or exchange gains. This is designed to remove an impediment to the issue of such instruments.

•

The affected issuers of these traditional securities will be potentially any company but mainly small and medium sized companies, new ventures and expanding companies that have a sophisticated understanding of the tax law and have ready access to high level tax advice so that they will quickly and easily understand the changes to the law.

•

Affected issuers will need to inform holders if the tax treatment of their securities changes. However, it is not expected that this will often occur, because this measure does not affect traditional securities issued before its date of effect.

Foreign currency gains and losses

This bill also outlines the proposal to address a number of uncertainties and anomalies relating to the tax treatment of foreign currency. The proposed amendments:

•

introduce a general translation rule into the income tax law that converts foreign currency denominated amounts into A$ so that Australian income tax liability is calculated by reference to a common unit of account. This general rule covers payments, receipts, rights and obligations denominated or expressed in a foreign currency;

•

introduce 'functional currency' rules, under which the net income or loss of an entity (or specified part of an entity) that functions predominantly in a particular foreign currency can under certain circumstances be determined in that currency, with the net amount being converted into A$;

•

introduce a core realisation principle into the income tax law which, together with the translation rule, ensures that foreign currency gains and losses are brought to account when realised, regardless of whether there is an actual conversion of foreign currency amounts into A$. This reform addresses a number of uncertainties and anomalies under the current law's treatment of foreign currency gains and losses;

•

ensure that foreign currency gains and losses have a revenue character, subject to limited exceptions. This is done by including foreign currency gains in assessable income, and treating foreign currency losses as allowable deductions, when they are realised;

•

implement exceptions to the timing and characterisation aspects of the realisation approach where the foreign currency gain or loss is closely linked to a capital asset. Broadly, and subject to a once-off election available for a limited time:

-

any foreign currency gain or loss on a transaction to acquire a depreciating or capital asset is included in the cost of the asset if the gain or loss arises before the asset is recognised for tax purposes, or as long as the payment is to occur not more than 12 months after the time the asset is acquired; and

-

any foreign currency gain or loss on a transaction to dispose of a depreciating or capital asset will be incorporated into the disposal proceeds of the asset to the extent that the gain or loss arises before the time that the asset is disposed of for tax purposes. Any foreign currency gain or loss on a transaction to dispose of a capital asset arising after the time of disposal will be treated as a capital gain or loss if the payment is to be made not more than 12 months after the disposal of the asset;

•

provide optional roll-over relief for foreign currency gains and losses to an issuer under certain finance facility agreements; and

•

provide optional treatment to assist taxpayers in reducing compliance costs associated with foreign currency denominated bank accounts. In addition to the normal treatment which is available under the proposals (FIFO), 2 additional options for accounting for certain foreign currency denominated bank accounts are:

-

the limited balance or de minimis account exemption. This allows foreign currency gains and losses on low balance transaction accounts to be disregarded; and

-

the retranslation option. This allows gains and losses to be brought to account by annually restating the balance of the account by reference to the exchange rate prevailing at the beginning and the end of each year and taking into account withdrawals and deposits at the exchange rates prevailing at the time of the respective withdrawals and deposits. It removes the requirement to calculate a foreign currency gain or loss on each withdrawal from the account.

Date of effect: It is proposed that the legislative amendments apply to:

•

all foreign currency gains and losses on transactions entered into in or after the first income year commencing on or after 1 July 2003; and

•

at the option of the taxpayer, foreign currency gains and losses on transactions entered into prior to the first income year commencing after 1 July 2003 but realised after that time.

This prospective application means that the amendments will not disturb prior year assessments, nor bring to account for taxation purposes, other than at the option of the taxpayer, foreign currency gains and losses on transactions entered into prior to the date of effect.

Proposal announced: This proposal was announced in Minister for Revenue and Assistant Treasurer's Press Release No. C57/02 of 14 May 2002. An exposure draft of these measures was released for public comment (Minister for Revenue and Assistant Treasurer's Press Release No C132/02 of 17 December 2002).

Financial impact: The impact on the revenue is unquantifiable. However, the proposed reforms to the taxation of foreign currency gains and losses is expected to protect the revenue base which is potentially at risk of being eroded due to the uncertainties with the current tax law.

Compliance cost impact: The proposed roll-over relief for securities issued under a facility agreement, the functional currency provisions and the options available for foreign currency denominated bank accounts are expected to lower compliance costs relative to the current law. There may be some small compliance costs for taxpayers in the short term as they familiarise themselves with the new law.

Summary of regulation impact statement

Regulation impact on business

Impact: These measures will affect all taxable entities, other than ADIs and non-ADI financial institutions, with transactions denominated in a foreign currency.

Main points:

•

The reforms address a number of uncertainties and anomalies under the current law's treatment of foreign currency gains and losses.

•

The reforms will improve neutrality, clarity and certainty in relation to the taxation of foreign currency gains and losses.

•

The proposed roll-over relief for securities issued under certain facility agreements, the functional currency provisions and the options available for foreign currency denominated bank accounts, are expected to lower compliance costs relative to the current law. There may be some small compliance costs for taxpayers in the short term as they familiarise themselves with the new law.

Chapter 1 - Removal of the taxing point on conversion or exchange of certain traditional securities

Outline of chapter

1.1 This chapter explains how the proposed amendments to remove the taxing point on conversion or exchange of traditional securities into ordinary shares will apply. It also explains the consequential amendments required to ensure the gain or loss on ultimate disposal of the ordinary shares is correctly calculated.

Context of reform

1.2 In the absence of these proposed amendments there would, under specific provisions of the income tax law, generally be a taxing point upon the conversion or exchange of a traditional security into ordinary shares. In broad terms, the cost of the traditional security at that time would be compared with the value of the cash or property received on conversion to determine if an amount is to be included in assessable income or allowed as a deduction.

1.3 The removal of the taxing point on the conversion or exchange of traditional securities into ordinary shares will prevent potential cash flow difficulties arising where the holder does not have the cash from the conversion or exchange to pay the tax on the conversion or exchange gains. Removing this taxing point and the associated potential cash flow consequences removes an impediment to the issue of such instruments, which typically have lower initial servicing costs than would otherwise be the case due to the conversion or exchange feature. Compared to the old law, this legislation will effectively defer the taxing point until the disposal of the ordinary shares acquired on conversion or exchange of a traditional security. This measure will implement Recommendation 9.7 (b)(i) of A Tax System Redesigned.

Summary of new law

1.4 The proposed amendments will:

•

remove the taxing point, under sections 26BB and 70B of the ITAA 1936, in respect of the conversion or exchange (into ordinary shares) of traditional securities issued after 7.30 pm, legal time in the Australian Capital Territory, on 14 May 2002; and

•

modify the cost base and reduced cost base of shares acquired on the exchange of traditional securities.

Detailed explanation of new law

1.5 The following explanation of the new law will be divided into 2 sections:

•

the first section deals with the amendments - to sections 26BB and 70B, of the ITAA 1936 - that remove the taxing point on conversion or exchange of a traditional security into ordinary shares; and

•

the second section explains the modifications to the cost base and reduced cost base of ordinary shares acquired on the exchange of an exchangeable interest.

Overview of current legislation

1.6 Sections 26BB and 70B of the ITAA 1936 are complementary provisions that deal with gains and losses on the disposal of traditional securities acquired after 10 May 1989. They require gains to be included in assessable income (section 26BB), and treat losses as allowable deductions (section 70B).

1.7 Broadly, by subsection 26BB(2) the amount of any gain on the disposal or redemption of a traditional security is included in the assessable income of the holder of the traditional security at the time of disposal or redemption. Subsection 70B(2), subject to exceptions, essentially provides that the amount of any loss on the disposal or redemption of a traditional security is allowable as a deduction to the holder of the traditional security at the time of the disposal or redemption.

1.8 Where section 26BB applies in respect of a conversion or exchange gain the first element of the cost base of the ordinary shares acquired on conversion or exchange will include the gain. The 'stepped-up' cost base of the ordinary shares means that only those gains arising subsequent to acquisition of the ordinary shares are subject to tax in accordance with the CGT provisions.

Proposed amendments to sections 26BB and 70B of the ITAA 1936

1.9 The proposed amendments to remove the taxing point on conversion or exchange will apply in respect of:

•

traditional securities that will or may convert into ordinary shares of the issuing company or a connected entity of the issuing company [Schedule 1, item 2, subsection 26BB(4) and item 3, subsection 70B(2B)]; and

•

traditional securities that will or may exchange into ordinary shares of a company other than the issuing company or a company that is a connected entity of the issuing company [Schedule 1, item 2, subsection 26BB(5) and item 3, subsection 70B(2C)].

1.10 The amendments only apply to those traditional securities that convert into ordinary shares and those traditional securities that exchange into ordinary shares. The amendments will not apply to those traditional securities that convert or exchange into interests other than ordinary shares.

1.11 The benefit of convertible instruments (broadly, those that may or will convert into shares in the issuer) and exchangeable instruments (broadly, those that may or will convert into shares in a company other than the issuer) to issuers has traditionally been the ability to raise relatively cheap debt-like capital that will or may add to, or replace, ordinary share capital. The issuer uses the embedded call option over the ordinary shares to substantially reduce the servicing costs during the debt phase of the security. The taxing point on conversion or exchange was a factor inhibiting the ability of issuers to issue such securities. It is for this reason that the amendments are limited to traditional securities that convert or exchange into ordinary shares.

1.12 Where sections 26BB and 70B no longer apply to the conversion or exchange into ordinary shares, and any gain or loss on ultimate disposal of the shares is subject to the CGT provisions, it will not be necessary to treat the pre-conversion or pre-exchange period as on revenue account. In this situation, the amendments will not only defer the taxing point in this situation, but will also allow capital treatment for the period before, as well as after, conversion or exchange.

1.13 It should be noted that, in accordance with paragraph 23(b) of the Acts Interpretation Act 1901, the term 'shares' includes a single share. The term 'connected entity' has the same meaning as in subsection 995-1(1) of the ITAA 1997. [Schedule 1, item 1, subsection 26BB(1)]

Disposal or redemption of a traditional security

1.14 The amendments are to apply to certain disposals and redemptions of traditional securities. In relation to exchangeable interests, the amendments are limited to disposals to the issuer of the traditional security or a connected entity of the issuer. In relation to convertible (and converting) instruments, disposal is limited to conversion into ordinary shares of the issuer of the traditional security or a connected entity of the issuer. The amendments do not apply to disposal of traditional securities on the secondary market or to a disposal of an interest to the issuer or connected entity of the issuer where there has been no conversion or exchange. There is no need for a similar limitation in respect of the term 'redemption' as only the issuer may redeem securities. [Schedule 1, items 2 and 3, subsections 26BB(4), 26BB(5), 70B(2B) and 70B(2C)]

What are traditional securities?

1.15 Broadly, a traditional security, as defined in subsection 26BB(1), is a security that is not issued at a deep discount, does not bear a significant deferred interest element and is not capital indexed. A traditional security may be, for example, a bond, a debenture, a deposit with a financial institution or a secured or unsecured loan.

To what traditional securities that convert will the measures apply?

1.16 The amendments in proposed subsections 26BB(4) and 70B(2B) will apply in respect of those traditional securities that mandatorily convert into ordinary shares (a type of 'converting instrument') and traditional securities that may convert into ordinary shares (a type of 'convertible interest'). [Schedule 1, items 2 and 3, subsections 26BB(4) and 70B(2B)]

What are exchangeable interests?

1.17 An exchangeable interest is an interest that is a traditional security that is issued on the basis that it will or may exchange into shares in a company that is neither the issuer of the exchangeable interest nor a connected entity of the issuer. At exchange, the exchangeable interest is redeemed by the issuer or disposed of by the holder to the issuer or a connected entity of the issuer. [Schedule 1, item 15, section 130-100]

How amendments will apply to convertible interests that fall within the measures

1.18 No gain will be included in assessable income under section 26BB and no deduction for loss will be allowed under section 70B from the conversion of a traditional security that converts into ordinary shares of the issuer. [Schedule 1, items 2 and 3, subsections 26BB(4) and 70B(2B)]

How amendments will apply to exchangeable interests that fall within the measures

1.19 No gain will be included in assessable income under section 26BB and no deduction for loss will be allowed under section 70B from the exchange of a traditional security that exchanges into ordinary shares of a company other than the issuer or a connected entity of the issuing company. [Schedule 1, items 2 and 3, subsections 26BB(5) and 70B(2C)]

Amendments to CGT provisions

Any capital gain or loss on disposal or redemption is to be disregarded

1.20 Any capital gain or loss from the disposal of an exchangeable interest to the issuer of the interest or to a connected entity of the issuer, or from its redemption, will be disregarded. [Schedule 1, item 15, subsection 130-105(4)]

Acquisition of ordinary shares on exchange

1.21 The holder of an exchangeable interest that is exchanged into shares of a company acquires the shares when the exchange of the exchangeable interest happens. [Schedule 1, item 4, section 109-55]

1.22 For the purpose of the CGT discount in Subdivision 115-A of the ITAA 1997, the period of ownership of a share acquired on exchange commences when the share is acquired on exchange, not when the exchangeable interest is purchased.

Example 1.1: CGT discount and shares acquired on exchange

An individual purchases an exchangeable interest on 1 July 2002. On 1 October 2002 the individual exchanges the interest for ordinary shares in ABC Company (ABC). Ten months later the individual disposes of the ABC shares. As the period of share ownership is 10 months rather than 12 months or more, the CGT discount will not apply to the disposal of the ABC shares.

Cost base modification rule for shares acquired on disposal or redemption of an exchangeable interest

1.23 For exchangeable interests that fall within Subdivision 130-E of the ITAA 1997, the first element of the cost base of shares acquired on the disposal or redemption of an exchangeable interest will be modified so that it is the total of:

•

the cost base of the exchangeable interest at the time of disposal or redemption;

•

an amount (if any) paid for the exchange; and

•

an amount (if any) by which a capital gain from the exchange of the exchangeable interest has been reduced under section 118-20.

[Schedule 1, item 15, section 130-105]

1.24 A payment for the exchange of an exchangeable interest can include giving property. [Schedule 1, item 15, subsection 130-105(3)]

1.25 The cost base of the exchangeable interest at the time of exchange does not take into account the market value of the exchangeable interest at the time of exchange. Rather, by looking at the cost base at the time of disposal or redemption, it takes into account the amount paid for the exchangeable interest at the time of its acquisition.

1.26 For exchangeable interests that fall within the proposed Subdivision 130-E, the first element of the cost base or reduced cost base (acquisition cost) will be increased by amounts that have reduced a capital gain the taxpayer has made from exchange. This is so even though the capital gain is disregarded under this Subdivision. This is achieved by providing a direct link to section 118-20 of the ITAA 1997. Section 118-20 avoids double taxation, as a capital gain made from a CGT event is reduced under this section to take account of any other provisions that include an amount in assessable or exempt income.

1.27 Subdivision 130-E does not require a capital gain to be realised on exchange of an exchangeable interest. Rather, it defers the realisation of a capital gain to the final disposal of the share. As a result, section 118-20 is unable to reach back to the exchangeable interest before it was exchanged into a share. This is because section 118-20, in working out the capital gain to be realised on the sale of the share, only takes account of any other provision that includes an amount in assessable or exempt income because of the CGT event happening to the share, and not the exchangeable interest. Thus, a specific link is needed within Subdivision 130-E to take into account amounts included in assessable income or exempt income because of a CGT event happening to an exchangeable interest. This avoids double tax on that final disposal of a share. [Schedule 1, item 15, subsection 130-105(2)]

1.28 For exchangeable interests that fall within the amendments to sections 26BB and 70B, the first element of the cost base of ordinary shares acquired by conversion or exchange will not be increased (or 'stepped-up') to reflect its then market value. This is not necessary where an amount will not be included in assessable income under section 26BB. However, if an amount is so included (e.g. because there is an exchange into preference shares), the cost base will be increased where a gain is taxed on conversion or exchange. [Schedule 1, item 15, paragraph (c) in the table in subsection 130-105(1) and item 15, subsection 130-105(2)]

Example 1.2: Cost base of a share acquired on exchange of an exchangeable interest where no amount is included in assessable income under section 26BB

A taxpayer in year 1 acquires on issue an exchangeable note for $100 which has a face value of $100. The interest is acquired on 1 July 2002. The exchangeable interest has a term of 5 years, subject to the holder's annual option to exchange it into one ordinary share. In each of the years the exchangeable interest is not exchanged the taxpayer will receive $5 interest income.

The exchangeable note is a traditional security and is an exchangeable interest under section 130-100 of the ITAA 1997.

At the beginning of year 3, the taxpayer exchanges the interest for a share with a market value of $110.

Due to the application of proposed subsection 26BB(5) of the ITAA 1936, the gain of $10 is not included in the taxpayer's assessable income at the time of exchange. There will be no need to avoid double taxation occurring on the eventual sale of the share because there is no taxing point in relation to disposal of the share prior to that time. Accordingly, when working out the first element of the cost base of the share there is no need to increase the cost base by an amount that has reduced a capital gain made on the exchangeable interest.

The exchange of the interest leads to the taxpayer making a capital gain (even though the capital gain is disregarded).

Subsection 118-20(1) of the ITAA 1997 does not reduce that capital gain because there is no section 26BB amount.

As a result, the first element of the cost base of the share would be $100. This is the $100 purchase price of the exchangeable interest (assuming this is the cost base of the interest at the time of conversion).

The $5 interest the taxpayer receives annually on the exchangeable interest does not form part of the cost base of the share. This is because section 118-20 does not reduce the capital gain by those amounts.

If the taxpayer then sells the share for $120, the taxpayer will have a capital gain of $20, being the difference between the cost base (assuming it is still $100) and the capital proceeds of $120.

1.29 Similar cost base modification rules apply to convertible interests. [Schedule 2, item 7, subsection 130-60(1)]

Amounts deducted

1.30 By referencing the first element of the cost base and reduced cost base of the share to the cost base of the exchangeable interest at the time of its disposal or redemption, an amount in respect of the cost base that is deductible to the taxpayer would reduce that cost base before it is incorporated into the first element of the cost base of the share. Division 110 of the ITAA 1997 provides rules for working out an asset's cost base and reduced cost base. [Schedule 1, item 15, subsection 130-105(1)]

Application and transitional provisions

1.31 There is no taxing point, at conversion or exchange, under these proposed provisions in respect of a traditional security that is a convertible or exchangeable interest respectively issued after 7.30 pm, legal time in the Australian Capital Territory, on 14 May 2002. A traditional security that is a convertible instrument, a converting instrument or an exchangeable interest that was issued at or before that time will be subject to the then existing law. [Schedule 1, item 17]

1.32 The amendments to CGT measures in respect of a share acquired on the exchange of an exchangeable interest will apply to exchangeable interests issued on or after 1 July 2001. [Schedule 1, items 4 to 17]

1.33 The amendment to section 130-40 will apply to the exercise of a right on or after 1 July 2001 [Schedule 3, item 2] and the amendment to section 130-60 will apply to the conversion of a convertible interest on or after 1 July 2001 [Schedule 2, item 9].

Technical corrections

1.34 Technical corrections will be made to replace the term 'convertible note' with the term 'convertible interest' to ensure consistency throughout the CGT measures. [Schedule 1, item 14, new subsection 130-1; Schedule 2, item 1, paragraph 122-25(4)(a), item 2, paragraph 122-25(4)(b), item 3, paragraph 122-135(4)(a), item 4, paragraph 122-135(4)(b), item 5, paragraph 126-50(3)(a), item 6, paragraph 126-50(3)(b), item 7, subsection 130-60(1) and item 8, subsection 130-60(1B)]

1.35 These technical corrections will apply to the conversion of a convertible interest on or after 1 July 2001. [Schedule 2, item 9]

1.36 Sections 130-40 and 130-60 will be amended to clarify that the first element of the cost base for shares or units in a unit trust acquired on conversion of a convertible interest includes any amount paid to convert a convertible interest and for shares, units or options acquired on exercising a right includes any amount paid to exercise the right [Schedule 2, item 7, subsection 130-60(1); Schedule 3, item 1, subsection 130-40(6)]. Another amendment will ensure that a payment to convert a convertible interest can include giving property [Schedule 2, item 8, subsection 130-60(1B)].

1.37 The amendment to section 130-40 will apply to the exercise of a right on or after 1 July 2001 [Schedule 3, item 2] and the amendment to section 130-60 will apply to the conversion of a convertible interest on or after 1 July 2001 [Schedule 2, item 9].

Regulation impact statement

Policy objective

1.38 The policy objective of the proposed amendments is to prevent potential cash flow difficulties arising where the holder of traditional securities that convert or exchange into ordinary shares does not have the cash from the conversion or exchange to pay the tax on conversion or exchange gains. This is designed to remove an impediment to the issue of such instruments.

Implementation options

1.39 The measure to remove the taxing point on conversion or exchange of traditional securities, issued after 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002, into ordinary shares will implement Recommendation 9.7 (b)(i) of A Tax System Redesigned. The recommendations of that report were the subject of extensive consultation. A Tax System Redesigned itself reflected earlier consultation on A Platform for Consultation.

1.40 A Platform for Consultation discussed the options as to when a taxing point should occur in respect of a convertible note. The issue was whether there should be a taxing point on conversion when the risk profile changed from debt to equity or no taxing point until the ultimate disposal of the share. As indicated, A Tax System Redesigned recommended the latter approach.

1.41 The proposed legislation will remove the taxing point on conversion or exchange of certain traditional securities that are issued after 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002. This means that an investor who acquires an ordinary share through the conversion or exchange of a traditional security issued after that time will not be subject to tax until that ordinary share is ultimately sold. Furthermore, where the gain or loss on disposal of a traditional security is of a capital nature, the investor will be able to qualify for capital gains treatment for the period before, and after, conversion or exchange. The existing legislation will continue to apply to traditional securities issued before 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002.

Assessment of impacts

1.42 The potential compliance, administrative and economic impacts of the measures in this bill have been carefully considered, both by the Government and the Review of Business Taxation and through extensive consultation with the business sector. Submissions received during consultation on the exposure draft of the New Business Tax System (Taxation of Financial Arrangements) Bill 2002 did not indicate significant concerns about compliance issues.

Impact group identification

1.43 Companies as the predominant issuers of traditional securities that are convertible interests or exchangeable interests will need to familiarise themselves with the changed tax treatment of traditional securities that convert or exchange into ordinary shares.

1.44 Superannuation funds, large/medium business, small business, and individuals will be impacted to the extent that they invest in these traditional securities. However, issuers will generally advise investors of the tax treatment of the instruments.

Analysis of costs / benefits

Compliance costs

1.45 The issuers of these traditional securities will be potentially any company. However, many issuers will be small and medium sized companies, new ventures and expanding companies that have a sophisticated understanding of the tax law and have ready access to high level tax advice so that they would quickly and easily understand the changes to the law. The benefits of the legislative change are likely to be disseminated widely by tax advisers.

1.46 The proposed amendments will predominantly impact on the holders of traditional securities that are convertible interests or exchangeable interests issued after 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002. The removal of the taxing point on conversion or exchange means that the holder will no longer have to make a calculation of the gain or loss to be included in assessable income or allowed as a deduction for that point in time. The removal of the taxing point will also mitigate any potential cash flow difficulties that may otherwise have arisen when a gain arose and the holder did not have the cash from the conversion or exchange to pay the tax.

1.47 To the extent that the tax treatment of a particular security is changed by the legislation, issuers will be required to tell their holders of that change in accordance with Australian Stock Exchange disclosure rules. However, it is expected that this will be a transitional requirement, because the measure does not affect traditional securities issued before its date of effect.

Administration costs

1.48 The administrative impact on the ATO will arise from enquiries by holders as to the correct tax treatment of their traditional securities. The ATO will be taking steps to change its information products for individual taxpayers to reflect the new measure, as well as to educate tax agents. Education needs of issuers will be low as most will be assisted by sophisticated advisers with ready access to tax advice.

1.49 To the extent that the tax treatment of particular securities is changed by the legislation, the ATO will also have a responsibility to ensure that taxpayers are informed of changes affecting them.

Government revenue

1.50 This measure is estimated to have no impact on the revenue over the forward estimates period. This is because convertible/exchangeable interests typically have a minimum term of 4 years and the proposed amendments apply only to traditional securities that are convertible interests or exchangeable interests issued after 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002. After this period, the measure may have a negative impact on revenue due to more concessional taxation of gains on conversion or exchange under the capital gains tax provisions and due to the deferral of the taxing point.

1.51 However, the impact on the revenue will depend upon the extent of gains or losses made on conversion or exchange. On average it can be expected that the value of the investments will appreciate over time.

1.52 If gains were made there would be a negative impact on revenue for 2 reasons. First, capital gains are taxed concessionally relative to income tax. In particular, for individuals subject to CGT, half of the gain is included in assessable income while for superannuation funds a capital gain is taxed at the rate of 10%. This cost arises because under current law gains/losses prior to conversion/exchange are subject to income tax and gains/losses post conversion/exchange are subject to CGT, whereas under the proposed reform gains/losses would be subject to CGT over the whole period. Second, tax is deferred until the ultimate sale of the shares (possibly many years in the future), which imposes a cost on the Commonwealth due to the time value of money.

1.53 Conversely, if losses are made on conversion or exchange there would be a positive affect on revenue for 2 reasons. First, as capital gains are taxed concessionally relative to income tax a capital loss will be of less value relative to a loss on income. Second, the realisation of the loss will be deferred until the ultimate sale of the shares.

Economic benefits

1.54 This proposed measure will benefit both holders and issuers. For holders it will remove potential cash flow disadvantages and will effectively defer the taxing point until the disposal of the ordinary shares acquired on conversion or exchange. The benefits to holders should create a greater demand for these traditional securities.

1.55 This increased demand will allow issuers (including start-up entities) to raise more capital at initially cheaper rates. These traditional securities provide an initially cheaper form of capital than ordinary debt because the return paid during the debt phase is relatively lower because the holder effectively has the benefit of an option to convert or exchange the traditional security into ordinary shares.

1.56 Australian issuers will be more competitive as they will be able to issue such traditional securities on the same basis as foreign issuers from countries that also defer the taxing point.

Consultation

1.57 The consultation process began with the release of A New Tax System in August 1998. The Government established the Review of Business Taxation in that month. Since then, the Review of Business Taxation has published 4 documents about business tax reform: in particular A Platform for Consultation and A Tax System Redesigned which canvassed options, discussed issues and sought public input.

1.58 Throughout that period, the Review of Business Taxation held numerous public seminars and focus group meetings with key stakeholders in the tax system. It received and analysed 376 submissions from the public about reform options. Further details are contained in paragraphs 11 to 16 in the Overview of A Tax System Redesigned.

1.59 In analysing options, the published documents frequently referred to, and were guided by, views expressed during the consultation process.

1.60 The measure removing the taxing point on conversion on exchange of traditional securities into ordinary shares was included in the exposure draft of the New Business Tax System (Taxation of Financial Arrangements) 2002 Bill, on which there was consultation followed by submissions from interested parties.

Conclusion and recommended option

1.61 This proposal will address potential cash flow disadvantages by removing the taxing point on conversion or exchange for those traditional securities issued after 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002, that will or may convert or exchange into ordinary shares.

Chapter 2 - Foreign currency gains and losses

Outline of chapter

2.1 This chapter explains the following issues:

•

how to work out the amount of a foreign currency gain or loss and when it has been realised for tax purposes;

•

the tax consequences of realising such a gain or loss;

•

the roll-over for foreign currency gains and losses available to an issuer under certain facility agreements; and

•

the operation of rules which allow foreign currency gains and losses arising in respect of certain foreign currency denominated bank accounts to be:

•

disregarded; or

•

brought to account on a retranslation basis.

2.2 The applicable rules are contained in Division 775. These rules, together with Subdivisions 960-C and 960-D (see Chapter 3) are referred to as 'the forex provisions'.

Context of reform

2.3 As explained in Chapter 3, the economic consequences of a foreign currency denominated transaction must be translated into an equivalent amount of A$ (or another appropriate functional currency) for the purposes of determining an entity's Australian income tax liability.

2.4 This would be a straightforward matter if the tax system only recognised receipts and payments of foreign currency. However, rights to receive and obligations to pay foreign currency are often just as important as the currency itself in determining the tax consequences of a transaction. As rights and obligations denominated in a foreign currency subsist over a period of time, their A$ value may fluctuate.

2.5 Where this occurs, disparities may arise between the amount of A$ value recognised at a particular point in time, for example when an amount of assessable income is derived, and the A$ value of the consideration ultimately provided in settlement of the transaction. These disparities represent a gain or loss, in terms of A$, that occurs as a result of currency exchange rate movements or fluctuations.

2.6 The forex provisions provide a statutory framework under which the gain or loss arising from these disparities is brought to account when it has been 'realised'. This is the case even if the monetary elements of the transaction are not converted to A$.

2.7 Without such a framework, foreign currency gains and losses arising out of 'business' transactions may fall outside the income tax net. This possibility is illustrated by FC of T v Energy Resources of Australia Ltd (1996)
185 CLR 66 ('the ERA case'). In that case, the High Court held that a taxpayer makes no foreign currency gain or loss where a foreign currency denominated obligation is satisfied on capital account without converting any of the proceeds of the transaction into A$ or any amounts of A$ to foreign currency.

2.8 While foreign currency gains and losses on rights to currency attract recognition under the CGT provisions, economically identical gains and losses on obligations may receive no recognition.

2.9 The realisation rules, in conjunction with the core translation rule discussed in Chapter 3, confirm the policy intent behind the tax treatment of foreign currency denominated transactions. These rules ensure that foreign currency gains and losses, whether on revenue or capital account, are brought to account, regardless of whether there is an actual conversion to A$. This will generally occur when the gains and losses are realised. In some cases, the foreign currency gains and losses are recognised for tax purposes at a given point after realisation and, in other cases, before realisation: these cases are covered by special rules.

Summary of new law

2.10 The general principle is that foreign currency gains are included in an entity's assessable income, and foreign currency losses are deductible. Gains and losses of this nature are treated as being on revenue account. Where they are brought to account under Division 775, they are referred to as 'forex realisation gains' and 'forex realisation losses'.

2.11 An important exception to this general principle applies to certain short-term forex realisation gains and losses, which are regarded as those transactions where the time between the acquisition or disposal of a capital asset and the due date for payment is not more than 12 months. In such a case, any forex realisation gain or loss is either integrated into the tax treatment of, or draws its character from, the capital asset to which it relates. This treatment recognises that a forex realisation gain or loss may be seen as incidental, or closely related, to a gain or loss arising in respect of another asset on capital account. In these cases, a 'character matching' treatment applies.

2.12 More specifically:

•

where the asset is acquired - any forex realisation gain will reduce, and forex realisation loss will increase, the asset's cost base, reduced cost base, cost or adjustable value; and

•

where the asset is disposed of - any forex realisation gain or loss will be recognised on capital account unless the asset is a depreciating asset.

2.13 Other important exceptions to the general principle relate to forex realisation gains and losses which are or which relate to gaining or producing exempt income, or which are of a private or domestic nature.

2.14 The forex provisions (that is Division 775 and Subdivisions 960-C and 960-D) will not apply to ADIs or non-ADI financial institutions. The current provisions of the income tax law will continue to apply to the foreign currency gains and losses of these entities. It is, however, expected that the new provisions will apply to these entities when the retranslation module of the taxation of financial arrangements regime comes into effect.

Forex realisation events

2.15 Forex realisation gains and losses are recognised, for income tax purposes, when a forex realisation event occurs. There are 5 main^[F1] types of forex realisation events, all of which may give rise to a forex realisation gain or loss:

•

forex realisation event 1, which happens when an entity disposes of foreign currency or a right to it to another entity;

•

forex realisation event 2, which happens when an entity stops having a right to foreign currency;

•

forex realisation event 3, which happens when an entity ceases to have an obligation to receive foreign currency;

•

forex realisation event 4, which happens when an entity stops having an obligation to pay foreign currency; and

•

forex realisation event 5, which happens when an entity stops having a right to pay foreign currency.

2.16 The gain or loss measured by each of these events represents an exchange-rate-generated disparity between:

•

the A$ cost of foreign currency (or a right to it) and its proceeds of disposal; or

•

the value, for tax purposes, of:

-

a foreign currency denominated right or obligation at the time it is first recognised by the tax system (i.e. as income, a deduction, a cost or disposal proceeds); and

-

the value given or received in satisfaction of that right or obligation (usually by way of a receipt or payment).

2.17 This concept exists in the current income tax law in certain respects, for example, in relation to agreements to buy trading stock using foreign currency.^[F2] In this regard, the new law incorporates certain existing law concepts. However, there is uncertainty about the scope of the concept as a result of judicial decisions. Distortions and anomalies can arise when the tax system recognises foreign currency gains and losses from, for example, trading stock transactions but not from financing transactions of the kind considered in the ERA case (see paragraph 2.7). Hence the need for a statutory framework to confirm this concept as an overarching income tax law principle.

Roll-over relief for facility agreements

2.18 Subdivision 775-C contains rules relating to roll-over relief for certain facility agreements. This relates to certain facilities that permit an entity to obtain finance in a foreign currency through the issue of a succession of short term foreign currency bills or other securities. These rules allow the issuer of such securities to defer tax recognition of any forex realisation gains and losses that may otherwise arise on roll-over of securities.

2.19 Roll-over relief has the effect of disregarding the forex realisation gains and losses (if any) which would otherwise arise under forex realisation event 4, in respect of the face value, on discharge of each security. The face value of the first security issued under the facility, and each increase in the principal balance outstanding, is treated as a separate loan made to the issuer. Each decrease in the face value is treated as a repayment, to the extent of the decrease, of these notional loans. The effect of this approach is to defer recognition of forex gains and losses only to the extent that money remains outstanding under the facility.

Compliance cost relief for foreign currency bank accounts

2.20 Applying a strict realisation approach to foreign currency denominated bank accounts with a high transaction volume may give rise to significant compliance costs for some taxpayers. In low-value, high-transaction-volume accounts, recording the A$ denominated tax recognition time value of all account debts and tracing them to the value of each deposit or withdrawal is a potentially complex exercise. Such a process entails compliance costs that may be disproportionately high, compared with the amount of taxation revenue concerned.

2.21 Accordingly, 2 options are provided to assist taxpayers in reducing the compliance costs associated with transacting through foreign currency denominated bank accounts:

•

the limited balance account exemption. This allows the foreign currency gains and losses on low balance transactional accounts to be disregarded; and

•

the retranslation option. This allows foreign currency gains and losses to be brought to account by annually restating the balance of a foreign currency denominated bank account by reference to deposits, withdrawals, and the exchange rate prevailing at the beginning and end of each year.

Detailed explanation of new law

2.22 The core realisation framework for forex realisation gains and losses is contained in Subdivision 775-B. The purpose of this framework is to ensure that economic gains and losses arising from currency exchange rate effects are brought to account for income tax purposes when realised, regardless of whether there is an actual conversion of amounts into A$.

How are forex realisation gains treated?

2.23 A core principle underpinning the foreign currency rules is that in the sort of situation in which the non-forex component of a gain would be assessable, any forex component is also assessable.

What is the basic rule?

2.24 The basic rule is that an entity's forex realisation gains are assessable income [Schedule 4, item 58, subsection 775-15(1)]. This is consistent with the fact that gains that have a forex component often are included in assessable income, even where they are of a non-forex nature. Also, the tax policy relating to forex gains is that they are generally on revenue account.

2.25 However, there are various reasons why a gain containing a forex component may not be assessable income (see paragraphs 2.26 to 2.32).

How are private or domestic gains treated?

2.26 First, a gain may not be assessable because it is of a private or domestic nature. In those cases, the forex component of the gain is not assessable income either [Schedule 4, item 58, subsection 775-15(2)]. Even so, the income tax system does tax some private or domestic gains. In particular, private gains arising under the CGT provisions that do not qualify for the private use asset exclusions^[F3] are taxable.

2.27 Accordingly, the forex component of the following private or domestic gains is taxable under the forex rules if a gain upon a realisation event happening to the CGT asset mentioned would be taxable under the CGT provisions:

•

a gain arising upon disposal of a CGT asset being foreign currency or a right thereto [Schedule 4, item 58, paragraph 775-15(2)(b), item 1 in the table];

•

a gain arising upon the discharge of a right where the right was acquired in return for the realisation of another kind of CGT asset, [Schedule 4, item 58, paragraph 775-15(2)(b), item 2 in the table]; and

•

a gain arising upon the discharge of an obligation where the obligation is incurred to acquire a CGT asset [Schedule 4, item 58, paragraph 775-15(2)(b), item 3 in the table].

How is exempt income treated?

2.28 Second, a gain containing a forex component may not be assessable income because it represents exempt income. In those cases, the forex component of the gain is given the same tax treatment as the non-forex component.

2.29 More specifically, the forex realisation gain is also exempt income where, had it been a forex realisation loss, it would have been made in gaining or producing exempt income. [Schedule 4, item 58, section 775-20]

How is non-assessable non-exempt income treated?

2.30 Third, a gain containing a forex component may not be assessable income because it represents non-assessable non-exempt income. In those cases, the forex component of the gain is given the same tax treatment as the non-forex component.

2.31 That is, the forex realisation gain is also non-assessable non-exempt income where, had it been a forex realisation loss, it would have been made in gaining or producing non-assessable non-exempt income. [Schedule 4, item 58, section 775-25]

How are gains relating to capital assets treated?

2.32 Finally, in recognition of the fact that a forex realisation gain may be seen as incidental, or closely related, to an asset on capital account, an important exception applies to certain capital assets (see also paragraphs 2.182 to 2.202).

How are forex realisation losses treated?

2.33 The basic principle explained in paragraph 2.24 applies equally to losses. That is, the tax treatment of the forex component of a loss should be consistent with the tax treatment applicable to any non-forex component of a loss of that sort.

What is the basic rule?

2.34 The basic rule is that an entity's forex realisation losses are deductible [Schedule 4, item 58, subsection 775-30(1)]. This is consistent with the fact that losses that have a forex component often are deductible, even where they are of a non-forex nature.

2.35 However, there are various reasons why a loss containing a forex component may not be deductible (see paragraphs 2.36 to 2.42).

How are private or domestic losses treated?

2.36 First, a loss may not be deductible because it is of a private or domestic nature.^[F4] In those cases, any forex component of the loss is not deductible either [Schedule 4, item 58, paragraph 775-30(2)(a)]. Even so, the income tax system does provide tax relief for a very limited range of private or domestic losses (e.g. a loss on the sale of privately used land to which the main residence exemption does not apply).

2.37 Accordingly, the forex component of the following private or domestic losses is given tax relief under the forex rules if a gain or loss upon a realisation event happening to the CGT asset mentioned would be taken into account under the CGT provisions:

•

a loss arising upon the discharge of a right where the right was acquired in return for realising another kind of CGT asset [Schedule 4, item 58, paragraph 775-30(2)(b), item 1 in the table]; and

•

a loss arising upon the discharge of an obligation where the obligation is incurred to acquire a CGT asset [Schedule 4, item 58, paragraph 775-30(2)(b), item 2 in the table].

How are losses incurred in gaining or producing exempt income or non-assessable non-exempt income treated?

2.38 Second, a loss containing a forex component may not be deductible because it was incurred in gaining or producing exempt income. In those cases, the forex component of the loss is given the same tax treatment as the non-forex component.

2.39 That is, a forex realisation loss made as a result of realising foreign currency or a right thereto is generally disregarded to the extent that it is made in gaining or producing exempt income. [Schedule 4, item 58, subsection 775-35(1)]

2.40 Further, a forex realisation loss made as a result of ceasing to have an obligation to pay for or receive foreign currency (see forex realisation events 3, 4 and 6) is disregarded to the extent that it is made in gaining or producing exempt or non-assessable non-exempt income and the obligation does not give rise to a deduction. [Schedule 4, item 58, paragraphs 775-35(2)(a) and (b)]

2.41 There are some instances in which a deduction is available for a loss or outgoing, despite it being incurred to gain or produce exempt income.^[F5] In those cases, the forex component of the loss is also deductible. [Schedule 4, item 58, paragraph 775-35(2)(b)]

How are losses relating to capital assets treated?

2.42 Finally, in recognition of the fact that a forex realisation loss may be seen as incidental, or closely related, to an asset on capital account, an important exception applies to certain capital assets (see also paragraphs 2.182 to 2.202).

Forex realisation event 1

2.43 Forex realisation event 1 is CGT event A1, which happens when an entity disposes of foreign currency, or a right, or part of a right, to receive it. [Schedule 4, item 58, subsection 775-40(1)]

2.44 Foreign currency is a currency other than Australian currency [Schedule 4, item 65, definition of 'foreign currency' in subsection 995-1(1)]. A right to receive foreign currency has a meaning affected by section 775-135. That provision is discussed in greater detail in paragraphs 2.210 to 2.211.

What is the CGT event A1 requirement?

2.45 Forex realisation event 1 only happens when CGT event A1 happens. Under section 104-10, CGT event A1 occurs where beneficial ownership of a CGT asset changes from one entity to another. Thus, forex realisation event 1 only applies where there has been a change in beneficial ownership, and the right to receive foreign currency continues to exist after the event [Schedule 4, item 58, subsection 775-40(2)]. For the treatment of rights to foreign currency which are discharged or extinguished by the event, see paragraphs 2.54 to 2.80.

When does the event happen?

2.46 Forex realisation event 1 happens when the foreign currency or a right to foreign currency is disposed of [Schedule 4, item 58, subsection 775-40(3)]. A disposal of a right to receive foreign currency occurs at the time when the ownership of the right changes.

What is the forex realisation gain?

2.47 An entity makes a forex realisation gain if it makes a capital gain from CGT event A1 and some or all of that capital gain is attributable to a currency exchange rate effect. The amount of the forex realisation gain is that part of the capital gain (if any) which is attributable to the currency exchange rate effect.

2.48 A currency exchange rate effect is either:

•

currency exchange rate fluctuations worked out using the translation rules in Subdivisions 960-C (the core translation rules - see Chapter 3) and 960-D (the functional currency rules - also see Chapter 3); or

•

a difference between an expressly or implicitly agreed currency exchange rate for a future date or time and the actual currency exchange rate at the date or time.

[Schedule 4, item 58, section 775-105]

2.49 For an explanation of the meaning of the second type of currency exchange rate effect, see paragraph 2.208.

What is the forex realisation loss?

2.50 An entity makes a forex realisation loss if they make a capital loss from CGT event A1 and some or all of that capital loss is attributable to a currency exchange rate effect.

2.51 The amount of the forex realisation loss is that part of the capital loss (if any) which is attributable to the currency exchange rate effect (see paragraph 2.48).

What modifications to CGT event A1 apply?

2.52 There are 5 modifications to CGT event A1 which apply for the purposes of forex realisation event 1:

•

first, as stated in paragraph 2.46, the time of the event is moved from the time of contract to the time of disposal;

•

second, section 118-20 is disregarded in working out the amount of the capital gain [Schedule 4, item 58, subsection 775-40(5)]. That provision reduces the amount of a capital gain by amounts which are assessable under parts of the ITAA 1936 or ITAA 1997 outside the CGT provisions;

•

third, indexation of cost base is disregarded for the purposes of calculating the capital gain or loss [Schedule 4, item 58, subsection 775-40(7)];

•

fourth, section 118-55 is disregarded [Schedule 4, item 58, subsection 775-40(8)]. That provision specifies that some foreign currency hedging gains and losses are not taken into account for the purposes of the CGT provisions; and

•

finally, the capital proceeds of CGT event A1 are deemed to be equal to the market value of the currency or right where they would otherwise be a different amount [Schedule 4, item 58, subsection 775-40(9)]. As explained in paragraph 2.218, this provision is necessary to deal with currency gains and losses arising under certain derivative instruments.

Example 2.1: Operation of forex realisation event 1

Tacoma Pty Ltd (Tacoma) purchases a parcel of units in a Japanese investment fund for ¥20 million. At the time, A$1 buys ¥65. Therefore, ¥20 million translates to A$307,692.31.

Tacoma makes the purchase from its existing holdings of ¥. When the ¥20 million was acquired, A$1 was equivalent to ¥70. The ¥20 million therefore has a cost base of A$285,714.29.

Upon purchasing the units, CGT event A1 happens to the ¥20 million; a forex realisation gain of A$21,978.02 therefore arises under forex realisation event 1. This amount represents the difference between a cost base (not indexed) of A$285,714.29 and capital proceeds of A$307,692.31, being the market value of the units acquired at the time of the event. The event occurs when the ¥20 million is paid.

2.53 Where forex realisation event 1 happens to currency which is part of a larger, fungible pool of currency, how does an entity work out the cost base applicable to the relevant payment? This issue is discussed in paragraphs 2.225 to 2.229.

Forex realisation event 2

2.54 An important reason for exchange-rate-related gains and losses is the discharge, satisfaction or extinguishment of rights to receive amounts of foreign currency.

2.55 Forex realisation event 2 is concerned with ceasing to have a right to receive foreign currency. There are 2 main requirements:

•

the ceasing requirement; and

•

the class of right requirement.

What is the ceasing requirement?

2.56 Forex realisation event 2 happens when an entity ceases to have certain types of right (or parts thereof) to receive foreign currency [Schedule 4, item 58, paragraph 775-45(1)(a)]. The event does not occur where forex realisation event 1 applies (see paragraphs 2.43 to 2.53) [Schedule 4, item 58, paragraph 775-45(1)(c)].

2.57 Forex realisation event 2 will most commonly happen where a right to receive is discharged by way of receipt.

2.58 The term 'right' is intended to carry its ordinary legal meaning. It is not necessarily limited to those rights which are recognised as assets for the purposes of the Australian Accounting Standards. Even so, the term has an extended meaning in some circumstances: see also paragraphs 2.209 to 2.211.

What is the class of right requirement?

2.59 There are 4 main classes of right to which forex realisation event 2 applies:

•

rights to receive, or which represent, ordinary income or statutory income other than income which is assessable under the CGT provisions [Schedule 4, item 58, subparagraph 775-45(1)(b)(i)];

•

rights created in return for ceasing to hold a depreciating asset [Schedule 4, item 58, subparagraph 775-45(1)(b)(ii)];

•

rights created or acquired in return for paying or agreeing to pay Australian or foreign currency [Schedule 4, item 58, subparagraph 775-45(1)(b)(iii)]; and

•

rights created in return for a realisation event happening in relation to a CGT asset not covered by the previous classes of right [Schedule 4, item 58, subparagraph 775-45(1)(b)(iv)].

When does the event happen?

2.60 Forex realisation event 2 happens when the entity ceases to have the right or part thereof. [Schedule 4, item 58, subsection 775-45(2)]

What is the forex realisation gain?

2.61 An entity makes a forex realisation gain under forex realisation event 2 if the amount they receive in respect of the event happening exceeds the amount the entity was entitled to receive at the tax recognition time and some or all of that excess is attributable to a currency exchange rate effect (see paragraph 2.48).

2.62 The amount of the forex realisation gain is that part of the excess (if any) which is attributable to the currency exchange rate effect. [Schedule 4, item 58, subsection 775-45(3)]

2.63 The meaning of tax recognition time is explained in paragraphs 2.70 to 2.77.

What is the forex realisation loss?

2.64 There are two circumstance under which an entity makes a forex realisation loss under forex realisation event 2:

•

when the proceeds of a right fall short of the amount assessed at the tax recognition time; and

•

when the right is an option which expires without being exercised or is cancelled.

Proceeds fall short of the amount assessed

2.65 If the amount the entity receives in respect of the event happening falls short of the amount the entity was entitled to receive at the tax recognition time there will be a forex realisation loss if some or all of that shortfall is attributable to a currency exchange rate effect (see paragraph 2.48).

2.66 The amount of the forex realisation loss is that part of the shortfall (if any) which is attributable to the currency exchange rate effect. [Schedule 4, item 58, subsection 775-40(4)]

2.67 The meaning of tax recognition time is explained in paragraphs 2.70 to 2.77.

An option expires without being exercised

2.68 The relevant right may be an option to buy foreign currency that the entity has the right to exercise immediately before the option ceases to exists. A forex realisation loss will also be allowed when the event occurs because such an option expires without having been exercised, or when such an option is cancelled, released or abandoned for no consideration. [Schedule 4, item 58, subsection 775-45(5)]

2.69 The amount of the forex realisation loss is the amount that the entity paid for the creation or the acquisition of the option.

What is the tax recognition time?

2.70 A tax recognition time is essentially a time at which an event occurs that creates consequences for the tax law. Derivation of income, or the calculation of the capital proceeds or termination value of an asset, are common examples. Forex realisation event 2 (and forex realisation events 3, 4 and 5 - see paragraphs 2.81 to 2.166) operates by reference to this time because the forex provisions are concerned with making exchange-rate-related adjustments to tax outcomes which are already recognised by other parts of the tax law (see paragraph 2.5).

2.71 The tax recognition time for a right to receive foreign currency depends upon the nature of the right. The classes of right used to define the tax recognition time correspond to the classes of right to which forex realisation event 2 applies (see paragraph 2.59).

Rights to receive, or which are, income

2.72 For rights to receive, or which represent ordinary or statutory income, the tax recognition time is when the income first becomes assessable. In the case of ordinary income, that time is the time of derivation. For statutory income, that time is the statutory equivalent of derivation - that is, when the requirement first arises to include the statutory income in assessable income. [Schedule 4, item 58, subsection 775-45(7), item 1 in the table]

2.73 An entity which derives income on a cash basis has a right to receive an amount which is income when received. In contrast, entities which derive income on an accruals or earnings basis have a right which is itself or which represents such income.

Example 2.2: Right which represents income

At the end of year 1, Puget Pty Ltd (Puget ) lends US$1 million to USA company Denny Inc for 5 years. At the end of year 2, Puget has accrued the right to receive US$80,000 in interest. However, it does not actually receive that interest until year 3.

Assuming Puget is a money lender, it is required to return interest income on an accruals basis.^[F6] The right to interest therefore has a series of tax recognition times which span the period from the end of year 1 to the end of year 2: subsection 775-45(7), item 1 in the table.

Assuming that the exchange rate for that period was A$1.00:US$0.55, the amount Puget has the right to receive at the tax recognition time will be A$145,454.55. Any difference between this value and the A$ value of the amount actually received will be a forex realisation gain or loss, to the extent that it is attributable to a currency exchange rate effect.

Rights created in return for ceasing to hold a depreciating asset

2.74 For rights to receive foreign currency created or acquired in return for ceasing to hold a depreciating asset, the tax recognition time is when the asset stops being held. [Schedule 4, item 58, subsection 775-45(7), item 2 in the table]

Rights created in return for currency

2.75 For rights to receive foreign currency created or acquired in return for a payment of Australian or foreign currency, the tax recognition time is when payment occurs. [Schedule 4, item 58, subsection 775-45(7), items 4 and 5 in the table]

Example 2.3: Right to repayment of principal under a foreign currency-denominated loan

To follow on from Example 2.2, Puget Pty Ltd (Puget) lends US$1 million to USA company Denny Inc for 5 years, at the end of year 1. The tax recognition time of Puget's right to be repaid the principal of US$1 million is the end of year 1.

Assuming that, at the end of year 1, A$1 is equivalent to US$0.50, the value of Puget's right at that time will be A$2 million.

Rights created in return for other CGT assets

2.76 Finally, for rights to receive foreign currency created in return for a realisation event happening in relation to a CGT asset (other than foreign currency), the tax recognition time is when the realisation event occurs. [Schedule 4, item 58, subsection 775-45(7), item 6 in the table]

Extended loans

2.77 A transitional tax recognition time rule applies for extended loans [Schedule 4, item 58, subsection 775-45(7), item 3 in the table]. See also paragraphs 2.329 and 2.330.

How are non-cash benefits treated?

2.78 The amount an entity receives in respect of the event happening can include a non-cash benefit. The market value of the benefit (worked out at the time of the event) is taken to be the amount of the receipt [Schedule 4, item 58, subsection 775-45(6)]. Under subsection 995-1(1), a non-cash benefit is a service or property in any form other than money.

What if there is a non-arm's length transaction?

2.79 The amounts of any receipts or amounts which an entity is entitled to receive are adjusted to their arm's length values where the amount or right arises under a non-arm's length dealing. [Schedule 4, item 58, section 775-120]

How are constructive receipts treated?

2.80 An amount is a constructive receipt if, rather than receiving it, an amount is or would be applied for the entity's benefit or as they direct (including by discharging all or part of an obligation the entity owes). If an entity ceases to have a right, or part of a right, to receive foreign currency wholly or partly because of a constructive receipt, forex realisation event 2 applies as if the entity had received the amount in respect of ceasing to have the right. [Schedule 4, item 58, section 775-110]

Forex realisation event 3

2.81 A foreign currency related gain may also arise where an entity ceases to have an obligation to receive foreign currency. An example of where an entity would have an obligation to receive foreign currency is where that entity writes a put option over foreign currency.

2.82 Forex realisation event 3 is concerned with entities ceasing to have such an obligation, or part of such an obligation. There are again two major requirements for the event to occur:

•

the ceasing requirement; and

•

the circumstances of acquisition requirement.

What is the Ceasing Requirement?

2.83 Forex realisation event 3 happens when an entity ceases to have an obligation, or part thereof, to receive foreign currency which was incurred in certain circumstances. [Schedule 4, item 58, paragraph 775-50(1)(a)]

2.84 Forex realisation event 3 will most commonly occur when an entity fulfils an obligation to receive foreign currency, thus ceasing to have the obligation.

2.85 The term 'obligation' in this context is intended to have its ordinary legal meaning. This, however, is extended by the inclusion of obligations to receive amounts calculated by reference to foreign currency exchange rates (see paragraphs 2.220 to 2.222). An obligation will include an obligation which is contingent on one or more events. [Schedule 4, item 58, subsection 775-140(4)]

What is the Circumstance of Acquisition Requirement?

2.86 Forex realisation event 3 will apply on the cessation of obligations acquired in two circumstances:

•

when the obligation, or the obligation of which the discharged obligation is a part, was incurred in return for the creation or acquisition of a right to pay foreign currency; and

•

when the obligation, or the obligation of which the discharged obligation is a part, was incurred in return for the creation or acquisition of a right to pay Australian currency.

[Schedule 4, item 58, paragraph 775-50(1)(b)]

2.87 In this context, the acquired right to pay foreign or Australian currency can be a contingent right to pay. [Schedule 4, item 58, subsections 775-50(8) and 775-135(4)]

When does the event happen?

2.88 Forex realisation event 3 happens when the entity ceases to have the obligation or part of the obligation. [Schedule 4, item 58, subsection 775-50(2)]

What is the forex realisation gain?

2.89 There are two circumstances under which an entity may make a forex realisation gain as a result of forex realisation event 3:

•

the value of the foreign currency bought exceeds amounts you expend to get it (see paragraph 2.90 to 2.92); or

•

an option to sell foreign currency under which you are obliged to buy expires without being exercised or is cancelled released or abandoned.

Value of currency bought exceeds the amounts expended

2.90 If at the tax recognition time the Australian dollar value of the currency received exceeds the value of the amounts the entity paid in order to receive it - the net costs of assuming the obligation - the amount of that excess which is attributable to a foreign currency exchange rate effect is a forex realisation gain. [Schedule 4, item 58, subsection 775-50(3)]

2.91 The net cost of assuming the obligation to receive the foreign currency can include an amount of Australian or foreign currency paid in exchange, non-cash benefits given and any amounts paid in entering into the obligation. However, those amounts are reduced by amounts received to assume the obligation which are not assessable under another provision of the income tax law. [Schedule 4, item 58, section 775-100]

2.92 The meaning of tax recognition time is explained in paragraphs 2.98 to 2.100.

An option expires or is cancelled

2.93 If an entity writes or acquires an option which obliges it to buy foreign currency if the option is exercised then the entity makes a profit if that option is not exercised, expires, or is cancelled for no consideration.

2.94 In such a circumstance, a forex realisation gain will be assessed for the amount that the entity received in order to take on the obligation. In general this will be the option premium paid by the party that held the option. [Schedule 4, item 58, subsection 775-50(4)]

What is the forex realisation loss?

2.95 A forex realisation loss under forex realisation event 3 will occur if the Australian dollar value of foreign currency received falls short of the net cost of assuming the obligation, which is the total amount that the entity paid in order to purchase the foreign currency. [Schedule 4, item 58, subsection 775-50(5)]2

2.96 The net cost of assuming the obligation is determined in the same way as for a forex realisation gain and all amounts are assessed at the tax recognition time (see paragraph 2.91).

2.97 For the tax recognition time, see paragraph 2.98 to 2.100.

Example 2.4: Forward purchase of foreign currency

Australian Broaches Pty Ltd (AB) enters into a contract to buy produce from the Cook Islands (CI) for CI$100,000. AB enters into a forward contract to purchase CI$100,000 for A$90,000 to hedge against currency movements. AB pays a premium of A$2,000 for this contract.

When the currency exchange takes place the exchange rate is A$1:CI$1.25. Hence AB pays A$90,000 for CI$100,000 which is worth A$80,000 at the time - and realises a forex loss of A$12,000 (including the premium).

As AB has ceased to have an obligation to buy foreign currency, forex realisation event 3 will apply. The amount AB has received in respect of the event is CI$100,000 (= A$80,000). The net costs of the obligation are A$90,000, which AB is required to pay under the contract plus the A$2,000 AB paid as a premium. This gives a net cost of assuming the obligation of A$92,000. Hence the amount received falls short of the net costs and a forex realisation loss of A$12,000 will be allowed.

What is the tax recognition time?

2.98 As stated in paragraph 2.70, the tax recognition time is the time at which an event which has taxation consequences occurs. Foreign exchange realisation events make reference to this time as they adjust the taxable amounts resulting from transactions to allow for the difference in exchange rates between when a transaction was entered into and when payment was actually made.

2.99 Where forex realisation event 3 occurs because an obligation to received foreign currency is discharged, the tax recognition time is the time at which you receive the amount in respect of the event happening [Schedule 4, item 58, subsection 775-50(7)]. This would usually be the foreign currency that was the subject of the obligation to received.

2.100 Where an option lapsing or being cancelled is the cause of the event, no tax recognition time is required as the amount of the gain is simply the premium paid and no comparison is required.

How are non-cash benefits treated?

2.101 As stated in paragraph 2.91 the total amount an entity paid in obtaining and fulfilling an obligation to received foreign currency can include a non-cash benefit. The market value of the benefit (worked out at the time of the event) is taken to be the amount of the receipt [Schedule 4, item 58, subsection 775-50(6)]. Under subsection 995-1(1), a non-cash benefit is a service or property in any form other than money.

What if there is a non-arm's length transaction?

2.102 The amounts of any receipts or amounts which an entity is entitled to receive are adjusted to their arm's length values where the amount or right arises under a non-arm's length dealing. [Schedule 4, item 58, section 775-120]

How are constructive receipts treated?

2.103 An amount is a constructive receipt if, rather than receiving it, an amount is or would be applied for the entity's benefit or as they direct (including by discharging all or part of an obligation the entity owes). If an entity ceases to have an obligation, or part of an obligation, to receive foreign currency wholly or partly because of a constructive receipt, forex realisation event 3 applies as if the entity had directly received the amount. [Schedule 4, item 58, section 775-110]

Forex realisation event 4

2.104 Disposing of foreign currency and ceasing to have a right or obligation to receive it are not the only ways in which an entity can make an economic gain or loss from currency exchange rate effects. It is just as important to consider cases where a gain or loss arises from the discharge of a right or obligation to pay or sell foreign currency. It is this type of discharge which forex realisation events 4 and 5 are designed to recognise.

2.105 Forex realisation event 4 is concerned with ceasing to have an obligation to pay foreign currency. There are 2 main requirements:

•

the ceasing requirement; and

•

the class of obligation requirement.

What is the ceasing requirement?

2.106 Forex realisation event 4 happens when an entity ceases to have certain types of obligation (or parts thereof) to pay foreign currency. [Schedule 4, item 58, paragraph 775-55(1)(a)]

2.107 Forex realisation event 4 will most commonly happen where an obligation to pay is discharged by way of payment.

2.108 The term 'obligation' is intended to carry its ordinary legal meaning. It is not necessarily limited to those obligations that are recognised as liabilities for the purposes of the Australian Accounting Standards. Even so, the term has an extended meaning in some circumstances (see also paragraph 2.213 and 2.214).

What is the class of obligation requirement?

2.109 There are 5 main classes of obligation to which forex realisation event 4 applies:

•

obligations which represent an expense or outgoing the entity deducts [Schedule 4, item 58, subparagraph 775-55(1)(b)(i)];

•

obligations which are an element in the calculation of a net assessable or deductible amount (other than assessable amounts arising under Division 775 or Division 102 of the ITAA 1997 or Divisions 5 and 6 of Part III of the ITAA 1936) [Schedule 4, item 58, subparagraphs 775-55(1)(b)(ii) and (iii)];

•

obligations (or parts thereof) which are incurred for the acquisition of a CGT asset or for the addition of an element to its cost base [Schedule 4, item 58, subparagraphs 775-55(1)(b)(iv) and (v)];

•

obligations which obtain a capital allowances treatment under the tax law and for which a deduction is claimed. These are obligations incurred in order to start holding a depreciating asset, to add a second element to its cost, or as a project amount [Schedule 4, item 58, subparagraphs 775-55(1)(b)(vi), to (viii)]; and

•

obligations incurred in return for receiving Australian or foreign currency or the right to receive Australian or foreign currency [Schedule 4, item 58, subparagraphs 775-55(1)(b)(ix) and (x)].

When does the event happen?

2.110 Forex realisation event 4 happens when the entity ceases to have the obligation or part thereof. [Schedule 4, item 58, subsection 775-55(2)]

What is the forex realisation gain?

2.111 There are two ways in which an entity may make a forex realisation gain under forex realisation event 4:

•

if the entity discharges the obligation for less than they received to assume it; and

•

if the entity ceases to have an obligation under a put option without the option being exercised or assigning its obligations.

Cost of discharging obligation less than amount received

2.112 An entity makes a forex realisation gain if the amount they pay in order to have their obligation to pay foreign currency discharged is less than the net proceeds of their assuming the obligation and part of the shortfall is attributable to a currency exchange rate effect. [Schedule 4, item 58, subsection 775-55(3)]

2.113 The proceeds of assuming the obligation includes any money, and the market value of any non-cash benefit, which the entity receives, is entitled to receive, or would be entitled to receive if an option were exercised, as a result of assuming the obligation. [Schedule 4, item 58, section 775-95]

2.114 The amount of the forex realisation gain is that part of the shortfall (if any) which is attributable to the currency exchange rate effect. [Schedule 4, item 58, subsection 775-45(3)]

2.115 The meaning of tax recognition time is explained in paragraphs 2.122 to 2.123.

Ceasing to have an obligation under an option

2.116 An entity makes a forex realisation gain if they cease to have obligations under an option to sell foreign currency without having to buy the currency or pay consideration. Such obligations may cease either because the option expires without having been exercised or because the option is cancelled, released or abandoned. [Schedule 4, item 58, subsection 775-55(4)]

2.117 The amount of the gain is the amount the entity was paid in order to grant the option. [Schedule 4, item 58, subsection 775-55(4)]

What is the forex realisation loss?

2.118 An entity makes a forex realisation loss under forex realisation event 4 if the amount they pay in order to have their obligation to pay foreign currency discharged exceeds the net proceeds of their assuming the obligation and part of the excess is attributable to a currency exchange rate effect. [Schedule 4, item 58, subsection 775-55(5)]

2.119 The net proceeds of assuming the obligation are calculated as for a forex realisation gain. In other words they include any money, and the market value of any non-cash benefit which the entity receives, is entitled to receive or would be entitled to receive if an option were exercised, as a result of assuming the obligation. [Schedule 4, item 58, section 775-95]

2.120 The amount of the forex realisation loss is that part of the excess (if any) which is attributable to the currency exchange rate effect. [Schedule 4, item 58, subsection 775-55(5)]

2.121 The meaning of tax recognition time is explained in paragraphs 2.122 to 2.123.

What is the tax recognition time?

2.122 As stated in paragraph 2.70 tax recognition time is essentially a time at which an event occurs that creates consequences for the tax law. The incurrence of a deductible expense, or the setting of the cost or cost base of an asset are common examples. Forex realisation event 4 operates by reference to this time because the forex provisions are concerned with making exchange-rate-related adjustments to tax outcomes which are already recognised by other parts of the tax law (see paragraph 2.104).

2.123 The tax recognition time for an obligation to pay foreign currency depends upon the nature of the obligation. The classes of obligation used to define the tax recognition time correspond to the classes of obligation to which forex realisation event 4 applies (see paragraph 2.109).

An obligation which is deductible, but not incurred for the purchase of an asset

2.124 Where the obligation (or part thereof) is an expense or outgoing that the entity can deduct, but is not incurred to acquire trading stock or a depreciating asset, the tax recognition time is the time that the expense or outgoing first gave rise to the entitlement to deduct. [Schedule 4, item 58, subsection 775-55(7), item 1 in the table]

Example 2.5: Entitlement to deduct - incurrence and deduction entitlement arise at the same time

On 30 June, year 1, Elliott Ltd (Elliott) incurs an obligation to pay management fees of €100,000 to a French company. However, Elliott does not pay the fees until year 2. The tax recognition time is 30 June, year 1, because this is the date at which Elliott's entitlement to a deduction arose.

2.125 It should be noted that the date of incurrence of an obligation is not necessarily the date at which an entitlement to deduct arises.

Example 2.6: Entitlement to deduct - incurrence and deduction entitlement arise at different times

On 1 April, year 1, Elliott Finance Ltd (Elliott) drew a 180-day bill of exchange, which it sold to American company Alki Finance Inc for US$67 million. Upon maturity, Elliott Ltd must pay the face value of US$70 million.

Elliott Ltd incurs the obligation to pay the face value on 1 April, year 1. However, it is only entitled to a deduction for the discount in year 1 to the extent that it is 'properly referable' to that year.^[F7]

A tax recognition time arises under subsection 775-45(9), item 1 in the table, each time there is an accrual of the obligation which gives rise to a properly referable amount.

An obligation incurred to acquire trading stock

2.126 Where the obligation (or part thereof) is incurred in order to acquire trading stock, the tax recognition time is the time when the stock begins to be on hand [Schedule 4, item 58, subsection 775-55(7), item 2 in the table]. The time that trading stock becomes 'on hand' is determined in accordance with Division 70.

Obligations which are an element in the calculation of a net amount

2.127 Where the obligation is an element in the calculation of a net amount for tax purposes, either as a deduction or as assessable income, the tax recognition time is, with a few exceptions, the time at which the exchange rate is determined in order to translate the obligation to calculate the net amount. [Schedule 4, item 58, subsection 775-55(7), items 3 and 4 in the table]

2.128 The exception is for amounts which are calculated under Divisions 102 and 775 of the ITAA 1997 and Divisions 5 and 6 of Part III of the ITAA 1936.

Obligations which obtain a capital allowances tax treatment

2.129 A number of tax recognition times relate to obligations to which a capital allowances treatment applies. Where the obligation (or part thereof) is incurred to acquire a depreciating asset, the tax recognition time is when the entity begins to hold the asset [Schedule 4, item 58, subsection 775-55(7), item 5 in the table]. An entity begins to hold a depreciating asset where it starts to satisfy any of the items in the table in section 40-40 in respect of the asset.

2.130 In addition, where the obligation is incurred as the second element of the cost of a depreciating asset, the tax recognition time is when the expenditure forming that element of cost is incurred [Schedule 4, item 58, subsection 775-55(7), item 5 in the table]. The second element of cost is addressed in section 40-190.

2.131 Further, where an obligation is incurred as part of a project amount, the tax recognition time is when the amount becomes deductible [Schedule 4, item 58, subsection 775-55(7), item 6 in the table]. A project amount is an amount falling within section 40-840.

Obligations under extended pre-commencement loans

2.132 An obligation under a loan which was entered into prior to the commencement date will not normally be assessable under the forex provisions [Schedule 4, item 58, subsection 775-165(4)]. However, if such a loan is extended in such a way that the extension amounts to a variation in the loan contract, the obligation becomes assessable from the date of that variation [Schedule 4, item 58, subsection 775-165(5)].

2.133 When an obligation under an extended loan is discharged forex realisation event 4 will occur, and the tax recognition time will be the time at which the loan was first extended. [Schedule 4, item 58, subsection 775-55(7), item 7 in the table]

2.134 For more detail on application to extended loans, (see paragraphs 2.329 to 2.330).

Obligations incurred in return for currency

2.135 For obligations incurred in return for a receipt of Australian or foreign currency or the creation or acquisition of a right to receive Australian or foreign currency which are not incurred in the extension of a pre-commencement loan, the tax recognition time is when the receipt occurs. [Schedule 4, item 58, subsection 775-55(7), item 8 in the table]

Example 2.7: Borrowing under a Euronote facility

On 30 June, year 1, ARE Pty Ltd (ARE) enters into a Euronote agreement under which it will issue a note to a tender panel of foreign banks. Under the note, ARE promises to pay the bearer, on maturity, the principal amount of the note and interest thereon. Payments in respect of the note are, upon surrender and presentation of the note, to be made by transfer of US$ to the successful tenderer's bank account.

In year 2, the Euronote is discharged. The issue price and face values, expressed in US$ and A$ are as follows:

Description	A$1 buys this many US$	Amount (US$)	Amount (A$)
Issue price	0.7083	34,383,461.97	48,543,642.48
Face value (issue date)	0.7083	35,000,000.00	49,414,090.07
Cost of discharge (discharge date)	0.7131	35,000,000.00	49,081,475.25
Currency gain		332,614.82

Under subsection 775-45(9), item 1 in the table, the tax recognition time for ARE's obligation to pay the discount is when it became deductible. Meanwhile, under subsection 775-45(9), item 6 in the table, the tax recognition time for ARE's obligation to repay the issue price is the time when the foreign currency is received; that is, 30 June, year 1.

The forex realisation gain on the issue price is therefore A$326,755.69 (= A$48,543,642.48 - A$48,216,886.79), and the forex realisation gain on the discount is A$5,859.13 (= A$870,447.59 - A$864,588.46).

The total forex realisation gain is therefore A$332,614.82. It does not matter whether there is any actual conversion from US$ to A$.

Obligations incurred in return for other CGT assets

2.136 For obligations to pay foreign currency created in return for the acquisition of a CGT asset (other than foreign currency), the tax recognition time is when the asset is acquired for CGT purposes [Schedule 4, item 58, subsection 775-55(7), item 9 in the table]. The general rule, under subsection 109-5(1), is that an entity acquires a CGT asset when it becomes the asset's owner.

Example 2.8: Obligation incurred in return for a CGT asset

On 30 June, year 1, Mariners Ltd (Mariners) enters into a contract to purchase shares from British company Puget Plc for £80,000. At that time, A$1 buys £0.35; the contract price therefore translates to A$228,571.43.

In year 2, Mariners pays for the shares. At that time, A$1 only buys £0.30; Mariners therefore pays the sterling equivalent of A$266,666.67. CGT event A1 happens to the shares (section 104-10); the time of that event is when the contract was entered into in year 1. Therefore, the cost base of the shares is A$228,571.43.

Forex realisation event 4 also happens. The amount of Mariners' obligation at the tax recognition time (i.e. the date of the disposal contract - see section 109-5, CGT asset A1 (case 1)) is A$228,571.43. The amount paid to cease having that obligation is A$266,666.67. Mariners therefore has a forex realisation loss of A$38,095.24.

Forex realisation event 1 will also happen to Mariners' holding of sterling when payment occurs. Assuming this was acquired when the contract was entered into, it would have a cost base of A$228,571.43. The capital proceeds would be A$266,666.67, that is the market value of the shares (translated to A$) at the time of payment. Thus, a forex realisation gain of A$38,095.24 arises.

In summary, there is: a gain of A$38,095.24 on the sterling, a loss of A$38,095.24 on the obligation to pay, and an unrealised gain of A$38,095.24 embedded in the cost base of the shares.^[F8] Overall, therefore, Mariners makes a gain of A$38,095.24.

2.137 If the obligation was incurred as an expense contributing to the 2nd, 3rd, 4th or 5th elements of the cost base of a CGT asset the tax recognition time will be the time of the transaction under which you incurred the obligation., [Schedule 4, item 58, subsection 775-55(7), item 10 in the table]

How are non-cash benefits treated?

2.138 The amount an entity pays in respect of the event happening can include a non-cash benefit. For the calculation of the total payment, the market value of the benefit (worked out at the time of the event) is used [Schedule 4, item 58, subsection 775-55(6)]. Under subsection 995-1(1), a non-cash benefit is a service or property in any form other than money.

What if there is a non-arm's length transaction?

2.139 The amounts of any payments or amounts which an entity is obliged to pay are adjusted to their arm's length values where the amount or right arises under a non-arm's length dealing. [Schedule 4, item 58, section 775-120]

How are constructive payments treated?

2.140 If an entity ceases to have an obligation, or part of an obligation, to pay foreign currency wholly or partly because a third party applied an amount for the entity's benefit or as the entity directed, forex realisation event 4 applies as if the entity had paid the amount in respect of ceasing to have the obligation. [Schedule 4, item 58, section 775-110]

Forex realisation event 5

2.141 A foreign currency related gain may also arise where an entity ceases to have a right to pay foreign currency.

2.142 Forex realisation event 5 is concerned with assessment of taxation at the cessation of such a right. There are again 2 major requirements for the event to occur:

•

the ceasing requirement; and

•

the circumstances of acquisition requirement.

What is the Ceasing Requirement?

2.143 Forex realisation event 5 happens when an entity ceases to have a right, or part of a right, to pay foreign currency which was acquired in certain circumstances. [Schedule 4, item 58, paragraph 775-60(1)(a)]

2.144 Forex realisation event 5 will most commonly occur when an entity exercises a right to pay foreign currency or allows the right to lapse, thus ceasing to have the right.

2.145 The term 'right' in this context is intended to have its ordinary legal meaning. This, however, is extended by the inclusion of rights to payamounts calculated by reference to foreign currency exchange rates, even if the amount is not an amount of foreign currency (see paragraphs 2.210 to 2.212).

2.146 A right to pay foreign currency includes a right which is contingent on one or more events. [Schedule 4, item 58, subsection 775-135(4)]

What is the Circumstance of Acquisition Requirement?

2.147 Forex realisation event 5 will apply on the cessation of rights obtained in two circumstances:

•

when the right, or the right of which the right which has ceased was a part, was obtained or created in exchange for the assumption of an obligation to pay foreign currency; and

•

when the right, or the right of which the right which has ceased was a part, was obtained or created in exchange for the assumption of an obligation to pay Australian currency.

[Schedule 4, item 58, paragraph 775-60(1)(b)]

2.148 In this context, an obligation to pay foreign or Australian currency can be a contingent obligation to pay. [Schedule 4, item 58, subsection 775-60(8) and 775-135(4)]

When does the event happen?

2.149 Forex realisation event 5 happens when the entity ceases to have the right or the part of the right. [Schedule 4, item 58, subsection 775-60(2)]

What is the forex realisation gain?

2.150 An entity will make a forex realisation gain as a result of forex realisation event 5 if the foreign currency they pay under the right falls short of the forex entitlement base of the right at the tax recognition time and some or all of the shortfall is attributable to a foreign exchange effect. [Schedule 4, item 58, subsection 775-60(3)]

2.151 The amount of the shortfall that is attributable to foreign exchange effects is the forex realisation gain. [Schedule 4, item 58, subsection 775-60(3)]

2.152 The forex entitlement base of a right can include amounts of Australian and foreign currency they are entitled to receive and the value of non-cash benefits. This is reduced by any amounts paid in order to obtain the right but not including amounts that are deductable under another provision of the income tax law. [Schedule 4, item 58, section 775-90]

2.153 The meaning of tax recognition time is explained in paragraphs 2.161 to 2.163.

What is the forex realisation loss?

2.154 There are two ways in which an entity may make a forex realisation loss under forex realisation event 5:

•

if the value of the foreign currency they pay under the right exceeds the forex entitlement base; and

•

if the entity ceases to have a right to exercise an option it paid for without exercising or selling it.

Value of currency paid greater than forex entitlement base

2.155 An entity makes a forex realisation loss if the foreign currency they pay under the right exceeds the forex entitlement base of the right at the tax recognition time and some or all of the excess is attributable to a foreign exchange effect. [Schedule 4, item 58, subsection 775-60(4)]

2.156 The meaning of forex entitlement base is explained in paragraph 2.152.

2.157 The amount of the forex realisation loss is that part of the excess (if any) which is attributable to the currency exchange rate effect. [Schedule 4, item 58, subsection 775-60(4)]

2.158 The meaning of tax recognition time is explained in paragraphs 2.161 to 2.163.

The entity ceases to have a right to exercise an option

2.159 An entity makes a forex realisation loss if they cease to have a right to sell foreign currency under an option without having exercised the option. Such a right may cease because the option expires, or because the option is cancelled, released or abandoned for no consideration. [Schedule 4, item 58, subsection 775-60(5)]

2.160 The amount of the forex realisation loss is the amount that the entity paid in order to obtain the right. [Schedule 4, item 58, subsection 775-60(5)]

What is the tax recognition time?

2.161 As stated in paragraph 2.70, the tax recognition time is the time at which an event which has taxation consequences occurs.

2.162 Where forex realisation event 5 occurs because an entity ceases to have a right to pay foreign currency, the tax recognition time is the time at which the entity receives an amount in respect of the right. [Schedule 4, item 58, subsection 775-60(7)]

2.163 Where an option lapsing or being cancelled is the cause of the event, no tax recognition time is required as the amount of the gain is simply the premium paid and no comparison is required.

How are non-cash benefits treated?

2.164 As stated in paragraph 2.152 the total amount an entity is entitled to receive for a right to pay foreign currency can include a non-cash benefit. The amount paid in respect of the event happening can also include the market value of a non-cash benefit [Schedule 4, item 58, subsection 775-60(6)]. Under subsection 995-1(1), a non-cash benefit is a service or property in any form other than money.

What if there is a non-arm's length transaction?

2.165 The amounts of any receipts or amounts which an entity is entitled to receive are adjusted to their arm's length values where the amount or right arises under a non-arm's length dealing. [Schedule 4, item 58, section 775-120]

How are constructive receipts treated?

2.166 An amount is a constructive receipt if, rather than receiving it, an amount is or would be applied for the entity's benefit or as they direct (including by discharging all or part of an obligation the entity owes). If an entity ceases to have a right, or part of a right, to pay foreign currency wholly or partly because of a constructive receipt, forex realisation event 5 applies as if the entity had been directly received. [Schedule 4, item 58, section 775-110]

Transactions giving rise to multiple events

2.167 Under several circumstances it is possible for one transaction to give rise to multiple forex realisation events. Most significantly, any transaction involving the future sale of one foreign currency in exchange for another foreign currency will involve both a future right or obligation to receive and a future right or obligation to pay.

2.168 Under these circumstances, the event which best reflects economic and accounting practice in that circumstance will be preferred, and any other events that occur will be ignored.

Options to buy foreign currency with foreign currency strike price

Entity which holds the option

2.169 From the point of view of the entity which holds the option, an option to buy one foreign currency in exchange for a second foreign currency consists of a right to buy foreign currency and an obligation to pay foreign currency which is contingent on their exercising the right.

2.170 If the entity sells their option to buy, forex realisation events 1 and 4 will occur. In this circumstance, forex realisation event 4 will be ignored, and the gain or loss calculated under event 1 will be applied. [Schedule 4, item 58, subsection 775-65(1), item 1 in the table]

2.171 If the entity exercises the option, forex realisation events 2 and 4 will occur. In this circumstance, event 4 will be ignored and the gain or loss calculated under event 2 will be used. [Schedule 4, item 58, subsection 775-65(1), item 2 in the table]

Entity bound by the option

2.172 From the point of view of the entity which is bound to sell foreign currency if the option is exercised, an option to buy one foreign currency in exchange for a second foreign currency consists of an obligation to sell foreign currency and an obligation to buy foreign currency, both of which are contingent on the other party exercising their right.

2.173 If the holder exercises the option, forex realisation events 3 and 4 will occur. In this circumstance, event 3 will be ignored and the gain or loss calculated under event 4 will be used. [Schedule 4, item 58, subsection 775-65(1), item 3 in the table]

Options to sell foreign currency with foreign currency strike price

Entity which holds the option

2.174 From the point of view of the entity which holds the option, an option to sell one foreign currency in exchange for a second foreign currency consists of a right to sell foreign currency and an obligation to buy foreign currency which is contingent on the entity exercising the right.

2.175 If the entity exercises the option, forex realisation events 3 and 5 will occur. In this circumstance, event 3 will be ignored and the gain or loss calculated under event 5 will be used. [Schedule 4, item 58, subsection 775-65(2), item 1 in the table]

Entity bound by the option

2.176 From the point of view of the entity which is bound to buy foreign currency if the option is exercised, an option to buy one foreign currency in exchange for a second foreign currency consists of an obligation to buy foreign currency and an obligation to sell foreign currency, both of which are contingent on the other party exercising their right.

2.177 If the holder exercises the option, forex realisation events 3 and 4 will occur. In this circumstance, event 3 will be ignored and the gain or loss calculated under event 4 will be used. [Schedule 4, item 58, subsection 775-65(2), item 2 in the table]

Forward sales of foreign currency with a foreign currency price

2.178 Each of the parties to a forward sale of one foreign currency for another, or a swap between two foreign currencies, has an obligation to pay foreign currency and a right to receive foreign currency.

2.179 If either entity sells their rights under the contract, forex realisation events 1 and 4 will occur. In this circumstance, the amount calculated under forex realisation event 4 will be ignored, and the gain or loss calculated under event 1 will be applied. [Schedule 4, item 58, subsection 775-65(3), item 1 in the table]

2.180 When the foreign currencies are exchanged, forex realisation events 2 and 4 will occur. In this circumstance, event 4 will be ignored and the gain or loss calculated under event 2 will be used. [Schedule 4, item 58, subsection 775-65(3), item 2 in the table]

Other cases

2.181 In any other case, if 2 or more of forex realisation events 1 to 5 occur as a result of the discharge or assignment of an entity's rights or obligations under an arrangement, the most appropriate forex realisation event is applied. Any amounts calculated under other forex realisation events are ignored. [Schedule 4, item 58, subsection 775-65(4)]

Tax consequences of certain short-term forex realisation gains and losses

2.182 As noted above, an important exception to the core assessment and deduction provisions in the forex rules applies in respect of the acquisition or disposal of capital assets in certain circumstances [Schedule 4, item 58, sections 775-70 and 775-75]. Broadly, where a capital asset is acquired or disposed of, and the time between the acquisition or disposal and the due date for payment is less than 12 months, any forex realisation gain or loss is integrated into the tax treatment of, or draws its character from, the capital asset to which it relates.

2.183 An entity can choose not to apply short-term rules, provided it makes a once-off, irrevocable, written election to that effect. [Schedule 4, item 58, section 775-70]

Character matching

2.184 This exception recognises that a forex realisation gain or loss may be seen as incidental, or closely related, to a gain or loss arising in respect of another asset on capital account. Therefore, for tax purposes, the foreign currency gains and losses are treated as having the same character as the gains and losses on the asset to which the foreign currency right or obligation relates. This approach is sometimes referred to as 'character matching'.

2.185 However, character matching treatment will only apply where the forex realisation gain or loss is short-term in nature. Broadly, such a gain or loss arises where the time between the time of acquisition or tax recognition time and the due date for payment for that asset is 12 months or less. A 24-month rule applies to the acquisition of depreciating assets - character matching payments that are due in the 12 months before the asset comes to be held as well as the subsequent 12 months.

2.186 These time limits are a statutory rule-of-thumb which attempts to distinguish between those rights and obligations to receive and pay foreign currency which are considered to be incidental to another transaction (e.g. the purchase and sale of a depreciating asset) and those which, in themselves, represent a separate financing arrangement.

What classes of asset does the short-term rule apply to?

2.187 The short-term exception applies to:

•

depreciating assets [Schedule 4, item 58, subsection 775-70(1), items 3 and 4 in the table and subsection 775-75(1), items 3 and 4 in the table]; and

•

those classes of asset which fall within subsection 775-45(7), item 6 in the table or subsection 775-55(7), item 9 in the table, that is CGT assets which are not foreign currency or rights thereto, revenue assets or depreciating assets [Schedule 4, item 58, subsection 775-70(1), items 1 and 2 in the table, and subsection 775-75(1), items 1 and 2 in the table].

2.188 Thus, the exception is only concerned with assets of a capital nature.

What are the consequences of the exception applying?

2.189 A consequence of the exception applying is that, where a forex realisation gain or loss arises in respect of the acquisition, addition to cost, or disposal of a capital asset, and the time between the date of contract the due date for payment is 12 months or less, that gain or loss is either:

•

integrated into the gain or loss (whether realised or unrealised) associated with the capital asset (thereby giving rise to character matching); or

•

given the same character as the capital asset (but not integrated into the gain or loss arising upon its realisation).

2.190 For acquisitions of depreciating assets, however, the relevant time limit is a 24-month period beginning 12 months before the time when the asset begins to be held (see also paragraph 2.195).

Short-term forex realisation gains

2.191 There are 3 cases covered by the rules for short-term forex realisation gains:

•

gains on a right to receive foreign currency arising from realising a CGT asset;

•

gains on an obligation to pay foreign currency for acquiring a CGT asset or increasing its cost; and

•

gains on an obligation to pay foreign currency where a capital allowance applies.

[Schedule 4, item 58, subsection 775-70(1)]

Gains on a right to receive foreign currency arising from realising a CGT asset

2.192 Where a short-term forex realisation gain arises under forex realisation event 2 as a result of an entity realising a capital asset other than a depreciating asset, 2 results follow:

•

first, the forex realisation gain is not assessable under section 775-15; and

•

second, CGT event K10 occurs, which assesses the forex realisation gain as a non-discountable capital gain.

[Schedule 4, item 58, subsection 775-70(1), item 1 in the table]

Gains on an obligation to pay foreign currency for acquiring a CGT asset

2.193 Where a short-term forex realisation gain arises under forex realisation event 4 as a result of acquiring a CGT asset or increasing its cost base, 2 results follow:

•

first, the forex realisation gain is not assessable under section 775-15; and

•

second, the cost base and reduced cost base of the CGT asset are reduced by the forex realisation gain. See paragraph 2.201 and 2.202 for the special case where the forex realisation gain is greater than the cost base.

[Schedule 4, item 58, subsection 775-70(1), item 2 in the table]

Gains on an obligation to pay foreign currency where a capital allowance applies

2.194 A short-term forex realisation gain may arise under forex realisation event 4 as a result of starting to hold a depreciating asset, increasing its cost or the value of a pool in which it resides, or incurring a project amount. Where that occurs, 2 results follow:

•

first, the forex realisation gain is not assessable under section 775-10; and

•

second, the asset's cost, adjustable value, or the opening value of the pool in which the asset resides (as the case may be) is reduced by the gain. See paragraph 2.201 and 2.202 for the special case where forex realisation gain is greater than the cost, adjustable value or opening value of the pool.

[Schedule 4, item 58, subsection 775-70(1), items 3 and 4 in the table]

2.195 Under the capital allowance provisions, an entity may pay (wholly or partly) for a depreciating asset before holding it for tax purposes. In such cases, the purchaser can be seen, notionally, as providing the vendor with finance. However, this prepayment will not be treated as the provision of finance if it falls within the short-term forex rules. Under these rules, the time of payment for the purposes of the short-term rule is a 24-month period beginning 12 months before holding begins. [Schedule 4, item 58, subsection 775-70(1), item 3 in the table, paragraph (b)]

2.196 The 24-month rule applies only to the acquisition of depreciating assets and not to items which add to the second element of the cost of an asset. Amounts which add to the second element of the cost are given the character of the underlying transaction using the normal 12-month rule. [Schedule 4, item 58, subsection 775-70(1), item 3 in the table, paragraph (c)]

Example 2.9: Forex realisation gain on an obligation to pay foreign currency for a depreciating asset

On 1 April, year 1, Sonics Pty Ltd (Sonics) contracts to purchase an item of plant from the USA for US$250,000. At that time, A$1 is equivalent to US$0.50. Sonics begins to 'hold' the asset immediately, and start to use it. Its cost at that time therefore translates to A$500,000.

Sonics does not pay for the plant until 31 July, year 2. By the time it pays, A$1 is worth US$0.55. Sonics therefore pays A$454,545.45, and has a forex realisation gain of A$45,454.55.

Assuming the plant declined in value by A$15,000 during year 1, its opening adjustable value in year 2 (subsection 40-85(2)) would be A$485,000. However, Sonics reduces this opening value to A$439,545.45 under subsection 775-70(1), item 3 in the table, for the purposes of calculating its decline in value for year 2 and later years.

2.197 Where the 'prime cost' method of calculating depreciation is used, the adjustable value is substituted for the cost for the purposes of the formula in subsection 40-75(1). [Schedule 4, item 45, paragraphs 40-75(2)(g) and (h)]

What if the forex realisation gain is brought to account under another provision of the law?

2.198 To the extent that a forex realisation gain would be, absent the short-term provisions, assessable income under the forex rules and also under another provision of the ITAA 1936 or ITAA 1997, the amount is only brought to account under the short-term provisions. [Schedule 4, item 58, subsection 775-70(3)]

Short-term forex realisation losses

2.199 There are 3 cases covered by the rules for short-term forex realisation losses:

•

losses on a right to receive foreign currency arising from realising a CGT asset;

•

losses on an obligation to pay foreign currency for acquiring a CGT asset or increasing its cost; and

•

gains on an obligation to pay foreign currency where a capital allowance applies.

[Schedule 4, item 58, section 775-75]

2.200 The same principles applicable to forex realisation gains (explained above), apply to forex realisation losses, but in reverse. That is, forex realisation losses relating to non-depreciating assets are capital losses; and where a capital allowance applies, a forex loss increases the cost, adjustable value, or pool balance affected (as the case may be). [Schedule 4, item 58, subsection 775-75(1), items 1 to 4 in the table]

No adjustments below zero

2.201 Under the short-term forex gains and losses rules, if a forex realisation gain is made on a payment to acquire a depreciating or CGT asset, the cost base, cost, adjustable value or pool value attaching to the asset will be reduced by the amount of the gain. This adjustment is limited in that it is not possible for the relevant value to be adjusted to less than zero. [Schedule 4, item 58, subsection 775-70(1)]

2.202 In circumstances where the adjustment would result in a cost (or similar) less than zero, the cost is taken to be reduced to zero and any excess in the forex realisation gain is included in the entity's assessable income. [Schedule 4, item 58, subsection 775-70(2)]

Treatment of currency derivatives under the forex rules

2.203 Derivatives pose a number of unique issues in the context of the forex realisation framework. Broadly, these issues fall into 3 main themes.

2.204 First, a fluctuation in currency exchange rates, or a right or obligation to receive or pay foreign currency, can be 'synthetically' created (e.g. by a cash-settled forward contract), even though no fluctuation, right or obligation occurs or actually exists. Rights and obligations which are economically related to currency exchange rates should be treated as such, regardless of their legal form.

2.205 Second, because instruments such as options are executory in nature and are usually subject to one or more contingencies, uncertainties may arise as to what the relevant rights and obligations are, and the value that should be assigned to them.

2.206 Finally, cash-settled derivatives usually involve the receipt or payment of a net amount. That amount is, economically at least, the result of a set-off between a gross right and a gross obligation arising under the derivative. It is necessary to ensure that these economics are supported by the legal framework of the forex rules.

Forex and derivatives: 4 main elements

2.207 There are 4 main elements in the forex rules which are included in order to address the treatment of currency derivatives:

•

the 'currency exchange rate effect' concept, which is designed to address 'synthetic' currency exchange rate fluctuations;

•

extended meanings for the phrases 'right to receive foreign currency' and 'obligation to pay foreign currency' which are designed to address 'synthetic' rights to receive and obligations to pay foreign currency;

•

modifications to the forex realisation events to address option costs and interactions between forex realisation events 1 and 4 under derivative arrangements; and

•

provisions to address expired currency options.

How does the 'currency exchange rate effect' concept address 'synthetic' currency exchange rate fluctuations?

2.208 As mentioned in paragraph 2.48 the currency exchange rate effect concept encompasses disparities between a contracted exchange rate and an actual exchange rate in the future [Schedule 4, item 58, paragraph 775-105(1)(b)]. Thus, a currency exchange rate effect can arise, even if the actual exchange rate does not 'fluctuate' at all.

Example 2.10: A 'synthetic' currency exchange rate fluctuation

Northwest Ltd (Northwest) enters into a forward contract under which it will purchase US$100. The exchange rate details of the arrangement are as follows:

•

spot price of US$100 at date of contract: A$178.57;

•

forward price of US$100: A$181.82; and

•

spot price of US$100 at maturity: A$178.57.

In these circumstances, the forward contract would result in Northwest making a forex realisation loss of A$3.25, even though it might be argued that there has been no 'fluctuation' in the exchange rate. Even so, the loss can be wholly characterised as being attributable to a currency exchange rate effect because it relates to a difference between the spot rate of the currency at the date of settlement and an (implicitly) agreed rate for it under contract.

How are the meanings of 'right to receive' and 'obligations to pay' foreign currency' extended in order to address derivatives?

2.209 In most cases, the phrases 'right to receive foreign currency' and 'obligation to pay foreign currency' carry their ordinary meanings. However, in the context of some derivative arrangements, they carry an extended meaning.

Rights to receive or pay foreign currency - extended meanings

2.210 First, a right to receive or pay foreign currency can include:

•

a right to receive or pay foreign currency that is capable of, or will be, discharged or settled otherwise than by delivery of foreign currency; or

•

a right to receive or pay foreign currency which is discharged or settled by delivery of an amount of Australian currency calculated by reference to a currency exchange rate.

[Schedule 4, item 58, subsections 775-135(1) and (3)]

Example 2.11: A 'synthetic right to receive foreign currency'

Pioneer Pty Ltd (Pioneer) enters into a forward contract to purchase US$ for A$. When the contract matures, it is settled in A$ without delivery of the US$. Pioneer receives a payment of A$ equal to the difference between the forward price and the spot price of the US$.

Pioneer's right to receive A$ is treated as a right to receive foreign currency because its amount is determined by reference to the US$:A$ exchange rate.

2.211 Second, a right to receive or pay foreign currency is taken to include a right, the existence or value of which is contingent upon the existence or value of an offsetting right or obligation. This is achieved by deeming any contract involving the economic setting-off of amounts to be a legal set-off, and so deeming all amounts paid to be what the amounts they would be if a legal set-off had been used. [Schedule 4, item 58, section 775-110]

Example 2.12: Economic set-off deemed to be a legal set-off

Pioneer Pty Ltd (Pioneer) enters into a contract under which it forward purchases US$100. The exchange rate details of the arrangement are as follows:

•

spot price of US$100 at date of contract: A$166.67;

•

forward price of US$100: A$181.82; and

•

spot price of US$100 at maturity: A$200.00.

However, no delivery of US$ occurs or is intended to occur; the transaction will be cash-settled in A$. Pioneer's position under the contract depends on the value of the US$ relative to A$ at the date of maturity. Pioneer may have a right to receive US$, or it may have an obligation to pay it; this will not be certain until maturity.

The contract provides:

'Netting: at the maturity date, each party's obligation to make payment of any amounts owing will be automatically satisfied and discharged and, if the aggregate amount that would otherwise have been payable by one part exceeds the aggregate amount that would otherwise have been payable by the other party, replaced by an obligation, upon the party by whom the larger aggregate amount would have been payable, to pay to the other party the excess of the larger aggregate amount over the smaller aggregate amount.'

The exchange rate moves in Pioneer's favour, and it receives a payment of A$18.18 (i.e. the difference between the forward price of the US$ at the contract's inception and the spot price of the US$ at maturity).

Pioneer is treated as having a gross right to receive foreign currency, even though, contractually, there is an extinguishment of that right and replacement with a net amount. Satisfaction of that right is dealt with by applying the constructive receipt rule (subsection 775-110) to work out the discharge proceeds on a gross, rather than net, basis had the transaction involved a legal off-set of rights rather than an economic off-set of values. That is, Pioneer is treated as if it had received A$200 and paid back A$181.82. Since the value of Pioneer's right at the tax recognition time is A$181.82 and the deemed receipt is A$200, a forex realisation gain of A$18.18 arises.

2.212 Finally, a special rule provides that a right that is, or is contingent upon the exercise of, an option is a right to receive foreign currency for the purposes of the forex rules. [Schedule 4, item 58, subsections 775-135(2) and (4)]

Obligations to pay or receive foreign currency - extended meanings

2.213 The meanings of 'obligation to pay foreign currency' and 'obligation to receive foreign currency' are extended in the same way as for rights. That is, an obligation to pay or receive foreign currency exists even if it can or will be settled otherwise than by payment, or respectively receipt, of foreign currency, and such obligations include obligations calculated by reference to an exchange rate. [Schedule 4, item 58, subsections 775-140(1) and (3)]

2.214 Further, obligations to pay or receive foreign currency which are subject to contingencies (for example an obligation under an option) are taken to be obligations to pay foreign currency for the purposes of the forex rules [Schedule 4, item 58, subsections 775-140(2) and (4)], and economic set-offs are treated as legal set-offs [Schedule 4, item 58, section 775-110].

How are the forex realisation events modified to address derivatives?

2.215 Each of forex realisation events 2 to 5 involve an offsetting amount which is used to determine the amount of the gain or loss (these are, respectively: the forex cost base, net costs of assuming an obligation, the proceeds of assuming an obligation and the forex entitlement base).

2.216 Each of these amounts contains an adjustment designed to ensure that the costs of acquiring currency options are reflected in the forex realisation gain or loss arising from a currency option transaction. [Schedule 4, item 58, sections 775-85, 775-90, 775-95 and 775-100]

2.217 Further, a rule applies to adjust the cost base of foreign currency acquired pursuant to forex realisation events 2 and 4, in order to reflect the fact that acquisition of currency under a derivative may constitute a taxing point. [Schedule 4, item 58, sections 775-85 and 775-95]

Example 2.13: Adjustment rules applicable to a call option over foreign currency

Puget Pty Ltd (Puget) purchases a call option over US$100. The exchange rate details of the arrangement are as follows:

•

spot price of US$100 at date of contract: A$166.67;

•

strike price for US$100: A$181.82; and

•

spot price of US$100 at maturity: A$200.00.

The option premium is A$10 (equivalent to US$6). Assume that the premium is not deductible outside of the forex rules.

Upon entering into the option agreement, Puget acquires a right to receive foreign currency; it does not matter that the value of the right to receive (or depending upon the contract, the existence of such a right) is contingent upon the exercise of an option (subsection 775-135(2)).

Under the rule in section 775-85, forex cost base at the tax recognition time is A$191.82 (= A$181.82 + A$10). Note that, under section 775-85, the option premium is embedded in the right to foreign currency, not the currency itself (which would otherwise be the case under subsection 134-1(1)).

Assuming the option is exercised, forex realisation event 2 happens. The amount received in respect of ceasing to have the right is A$200. A forex realisation gain of A$8.18 arises (subsection 775-45(3)). This result can be analysed as a gain on the option of A$18.18, offset by a loss on the option premium of A$10.

The cost base of the US$ acquired, measured at the date of receipt (section 775-125), will be A$200.

2.218 In addition, adjustments occur to the disposal proceeds (forex realisation event 1) [Schedule 4, item 58, subsection 775-40(9)] (and tax recognition time values (forex realisation events 4 and 5) which apply where foreign currency is disposed of pursuant to a derivative [Schedule 4, item 58, subsections 775-55(7) and 775-60(7)]).

Example 2.14: Adjustment rules applicable to a put option over foreign currency

Puget Pty Ltd (Puget) purchases a put option over its US$100. The exchange rate details of the arrangement are as follows:

•

spot price of US$100 at date of contract: A$200.00;

•

strike price for US$100: A$208; and

•

spot price of US$100 at maturity: A$195.

The option premium is A$10 (equivalent to US$5). Assume that the premium is not deductible outside of the forex rules.

Forex realisation event 1

Forex realisation event 1 happens when the US$ is disposed of. Assuming the US$ was acquired at the start of the contract, its cost base will be A$200. The capital proceeds upon disposal would ordinarily be A$208. However, under subsection 775-40(9) they are adjusted downwards by A$13 to the market value at maturity, that is, A$195. Puget's forex realisation loss will therefore be A$5 (A$195 - A$200).

Forex realisation event 5

Puget has a right to sell foreign currency. The tax recognition time is when it pays the US$ (subsection 775-60(7)). The forex entitlement base of the obligation at this time will be A$208, less A$10 (reflecting the option cost - paragraph 775-90(c)), that is A$198. The amount actually paid to discharge the obligation will be A$195. Thus, a forex realisation gain of A$3 arises.

Summary

Overall, there will be a forex loss of A$2. This result can be analysed as a loss of A$5 on the currency, combined with a gain of A$3 on the put option.

How are expired options treated?

2.219 A number of provisions relate to expired currency options.

Option-related rights and obligations to receive foreign currency

2.220 As explained in paragraph 2.59, a right under an option to acquire foreign currency is treated as a right to receive foreign currency for the purposes of the forex rules. Where forex realisation event 2 happens because an entity's option to purchase foreign currency expires without having been exercised, or is cancelled, released or abandoned for no consideration, a forex realisation loss arises to the entity which has the right to exercise the option immediately before it ceased. The amount of the forex realisation loss is the amount that entity paid to acquire the option. [Schedule 4, item 58, subsection 775-45(5)]

2.221 This provision would ordinarily apply where an entity purchases a call option over foreign currency but does not exercise it, with the result that CGT event C2 happens to their option right, giving rise to a capital loss equal to the option premium.

2.222 As explained in paragraph 2.109, an obligation under an option to acquire foreign currency is treated as an obligation to pay foreign currency for the purposes of the forex rules. Where forex realisation event 4 happens because an option under which an entity was obliged to pay foreign currency expires without having been exercised, or is cancelled, released or abandoned for no consideration, a forex realisation gain to the entity occurs. The amount of the forex realisation gain is the amount that the entity received to assume the obligation. [Schedule 4, item 58, subsection 775-55(4)]

Option-related rights and obligations to pay foreign currency

2.223 A right to sell foreign currency under an option is also treated as a right to pay foreign currency for the purposes of the forex rules (see paragraph 2.147). Where forex realisation event 5 happens because an entity's option to sell foreign currency expires without having been exercised, or is cancelled, released or abandoned for no consideration, a forex realisation loss arises. The amount of the forex realisation loss is the amount the entity paid to acquire the right. [Schedule 4, item 58, subsection 775-60(5)]

2.224 Finally, an obligation under an option to sell foreign currency is treated, as explained in paragraph 2.86, as an obligation to purchase foreign currency for the purposes of the forex rules. Where forex realisation event 3 happens because an option under which an entity was obliged to purchase foreign currency expires without having been exercised, or is cancelled, released or abandoned for no consideration, a forex realisation gain to the entity occurs. The amount of the forex realisation gain is the amount that the entity received to assume the obligation. [Schedule 4, item 58, subsection 775-50(4)]

Fungible currency, rights and obligations

2.225 Monetary assets and obligations are often described as 'fungible'. Since one unit of currency is functionally identical to every other unit of the same currency within a homogenous pool (e.g. a bank account), there may be no obvious way of applying a realisation principle to part of that pool. This question is relevant for tax purposes, because the existence and amount of any gain or loss upon realisation depends upon the cost base or value at the tax recognition time of the relevant currency, right or obligation. This, in turn, depends upon the time of acquisition or incurrence of the relevant asset or obligation.

2.226 Where any of the forex realisation events happen to foreign currency or a fungible right or obligation to receive or pay foreign currency, the event is applied on a 'first-in-first-out' basis. [Schedule 4, item 58, subsection 775-145(1)]

What is FIFO and how does it apply to forex?

2.227 The FIFO principle is well-known in an accounting context. It refers to the process of accounting for a series of events happening with respect to a fungible set of items by applying the event to the earliest-acquired item first. For ordinary bank accounts, this FIFO rule simply confirms the principle applicable under the common law.^[F9]

2.228 In the context of the forex rules, applying the FIFO principle means assuming that the forex realisation event happens to the first acquired amount of currency or right, or the first incurred obligation, first. To the extent that the proceeds of the event exceed the amount of that first acquired or first incurred currency, right or obligation, the event is taken to have happened to the amount acquired or incurred next in time, and so on.

Example 2.15: Applying FIFO to physical holdings of foreign currency

Maximus Pty Ltd (Maximus) begins with no foreign currency. It then receives the following amounts from sales in Italy:

•

1 July: €5,000, which is equivalent to A$10,000;

•

5 September: €1,000, which is equivalent to A$2,100; and

•

9 November: €6,000, which is equivalent to A$10,714.

On 1 January, Maximus makes a payment to a creditor of €7,000. Assuming Maximus has no other receipts of €, this payment constitutes forex realisation event 1, happening to:

•

€5,000 of the amount received in 1 July;

•

€1,000 of the amount received in 5 September; and

•

€1,000 of the amount received in 9 November.

The cost bases of the € paid are therefore worked out on that basis; that is the aggregate cost base associated with the payment is A$13,885.67 (= A$10,000 + A$2,100 + A$1,785.67).

The weighted average approach

2.229 Despite the FIFO principle, regulations may provide that the forex realisation events apply to fungible currency, rights to receive it, or obligations to pay it, on a weighted average basis. [Schedule 4, item 58, subsection 775-90(2)]

Example 2.16: Applying weighted averaging to physical holdings of foreign currency

Nero Pty Ltd (Nero) begins with no foreign currency. The regulations provide that Nero should deal with fungible currency, rights and obligations on a weighted average basis. Nero receives the following amounts from sales in Italy:

•

1 July: €5,000, which is equivalent to A$10,000 - giving a weighted average of €1 = A$2;

•

5 September: €1,000, which is equivalent to A$2,100 - giving a weighted average of approximately €1 = A$2.02;

•

9 November: €6,000, which is equivalent to A$10,714 - giving a weighted average of approximately €1 = A$1.90; and

•

On 1 January, Nero makes a payment to a creditor of €7,000. Assuming Nero has no other receipts of €, this payment constitutes forex realisation event 1, happening to €7,000 from their fungible pool at a weighted average exchange rate of €1 = A$1.90.

The cost base of the € paid is therefore worked out on that basis; that is the weighted average cost base associated with the payment is A$13,308.17 (= €7000 at €1 = A$1.90).

Roll-over relief for facility agreements

2.230 Subdivision 775-C contains rules relating to roll-over relief for facility agreements. These rules allow the issuer of securities under certain facility agreements to defer tax recognition of any forex realisation gains or losses which may otherwise arise in relation to the face value of each security in that facility. As the rules only apply to the issuer, they only defer forex gains and losses arising from the discharge of liabilities.

Why have a roll-over for facility agreements?

2.231 Finance facility agreements under which short-term discounted securities are issued and can be rolled over represent a relatively common form of financing with certain commercial advantages over loans. At the same time, such arrangements functionally resemble loans. The exception to the core forex realisation rules relating to certain facility arrangements recognises these considerations.

What is a facility agreement?

2.232 A facility agreement is essentially a financing arrangement involving the rolling over of discounted securities [Schedule 4, item 58, section 775-185 and item 63, definition of 'facility agreement' in subsection 995-1(1)]. There are 2 main requirements which must be satisfied in order for a facility agreement to exist:

•

the 'security issue' requirement; and

•

the 'economic effect' requirement.

Security issue requirement

2.233 First, the agreement must be an agreement between an entity and one or more other entities under which the first entity has a right to issue eligible securities [Schedule 4, item 58, paragraph 775-185(a)]. The meaning of 'eligible security' is explained in paragraphs 2.235 to 2.240.

2.234 The agreement must also require an entity to acquire those securities. [Schedule 4, item 58, paragraph 775-185(b)]

Economic effect requirement

2.235 Second, the economic effect of the agreement must be such that it enables the first entity to obtain finance in a particular foreign currency up to the foreign currency amount specified in the agreement [Schedule 4, item 58, paragraph 775-185(c)] and during the term of the arrangement [Schedule 4, item 58, paragraph 775-185(d)].

What is an eligible security?

2.236 In order for the roll-over to apply, the securities in question must constitute an eligible security [Schedule 4, item 58, section 775-190; item 62, definition of 'eligible security' in subsection 995-1(1)]. There are potentially 2 categories of eligible security:

•

bills of exchange and promissory notes; and

•

securities specified in the regulations.

Bills of exchange and promissory notes

2.237 A security will be an eligible security where it is a bill of exchange or promissory note which is:

•

non-interest bearing;

•

issued at a discount;

•

denominated in a foreign currency; and

•

for a fixed term.

[Schedule 4, item 58, paragraph 775-190(a)]

2.238 A 'bill of exchange' is an unconditional written order, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable future time, a sum certain in money to or to the order of a specified person, or to bearer (subsection 8(1), Bills of Exchange Act 1909).

2.239 Commonly where a bill of exchange is issued to raise finance it is accepted by another party, usually a bank, who undertakes to pay the face value of the bill on maturity. However, it is the drawer of the bill, and not the acceptor, who for the purposes of paragraph 775-185(1)(a) has the right to issue eligible securities under the facility agreement.

2.240 A 'promissory note' is an unconditional written promise made by one person to another, signed by the maker, engaging to pay on demand or at a fixed or determinable future time, a sum certain in money, to or to the order of a specified person, or to bearer (subsection 89(1), Bills of Exchange Act 1909).

Securities specified in the regulations

2.241 In addition, a security may be an eligible security where it is denominated in a foreign currency, for a fixed term and specified in the regulations. [Schedule 4, item 58, paragraph 775-190(b)]

When does roll-over relief apply?

2.242 An entity satisfying the above requirements can roll-over forex gains and losses under a facility by choosing to do so [Schedule 4, item 58, subsection 775-195(1)]. However, that choice must be made within 90 days after either the first time a bill is issued under the security, or the applicable commencement date. [Schedule 4, item 58, subsection 775-195(2)].

2.243 As an ADI or a non-ADI financial institution is excluded from the operation of Division 775, it cannot make a choice for roll-over. [Schedule 4, item 58, subsection 775-195(8)]

2.244 The choice must be in writing [Schedule 4, item 58, subsection 775-195(5)]. That choice applies from immediately before the first time a security is issued under the facility agreement, or the applicable commencement date [Schedule 4, item 58 subsection 775-195(3)]. The choice continues to apply until the facility agreement ends [Schedule 4, item 58, subsection 775-195(6)] and cannot be revoked [Schedule 4, item 58, subsection 775-195(7)].

2.245 The applicable commencement date is explained in paragraphs 2.323.

What are the consequences of choosing a roll-over?

2.246 The immediate consequence of choosing a roll-over is that any forex realisation gains or losses arising from discharging each eligible security are disregarded [Schedule 4, item 58, section 775-200]. Such gains and losses might otherwise arise as a result of forex realisation event 4.

Interrelationship between each eligible security under the facility

2.247 For a roll-over to apply, the new security issued at the roll-over must be issued after the applicable commencement date, as must the rolled over security unless the taxpayer has made a choice under section 775-150. [Schedule 4, item 58, paragraphs 775-205(e) and (f)]

2.248 Also, there must be a particular interrelationship between each security issued under the facility and the one which replaces it. A roll-over will only happen where the issuer discharges their liability under an eligible security and, at the same time, issues a new one pursuant to the agreement. [Schedule 4, item 58, paragraphs 775-200(a) and (b)]

2.249 Further, the new security must be related to the discharge of the issuer's liability under the rolled over security in one of 2 ways:

•

the issuer's obligation to discharge the liability under the rolled over security is wholly or partly set-off against their right to receive the foreign currency issue price of the new security [Schedule 4, item 58, subparagraph 775-205(c)(i)]; or

•

their obligation to discharge the liability under the rolled over security is wholly or partially satisfied by the issue of the new security [Schedule 4, item 58, subparagraph 775-205(c)(ii)]

Example 2.17: Interrelationship between each eligible security

Pike Pty Ltd (Pike) raises US$97,677 from USA company Elliott Inc (Elliott) under a facility consisting of 3 90-day bills. Since the bills have a 10% yield per annum, the face value of the first bill ('bill 1') is US$100,000. On maturity of the first bill, Pike constructively receives an advance of US$97,677 from Elliott under bill 2, which it uses along with US$2,323 of its own, to pay off bill 1.

Bill 2 is discharged by another constructive advance of US$97,677 from Elliott under bill 3, combined with an actual payment of US$2,323 of Pike's own money.

Bill 3 will be discharged entirely from Pike's own funds.

This arrangement satisfies the requirements in section 775-205, because Pike's obligation to discharge each rolled over security is being partially offset by its right to receive the issue price of the new security.

2.250 In order for roll-over relief to apply, it must first have been chosen, and that choice must be in effect. [Schedule 4, item 58, paragraph 775-200(b)]

Notional loan treatment

2.251 A facility comprising a series of discounted instruments can be seen in certain circumstances as analogous, in economic terms, to a single loan. The rules use this observation to build a forex roll-over rule, treating the individual bills in a facility agreement as if they comprised a single loan transaction. However, this treatment only applies for the purposes of Division 775. [Schedule 4, item 58, subsection 775-210(1)]

2.252 The purpose of this methodology is to establish appropriate points in time at which to measure the A$ (or functional currency) value of the liabilities and cashflows arising under the facility. Where the amount outstanding under the facility is increased, it is necessary to establish the time at which this increase occurred, so that the issuer's liability can be given an appropriate value. Where, on the other hand, the amount outstanding is decreased, it is necessary to establish which particular liability is being addressed, as well as the time at which payment occurs, so that a comparison can be made between the liability's A$ (or functional currency) value and that of the payment. This approach provides a mechanism which allows recognition of forex realisation gains and losses arising under the facility to be deferred, but not disregarded.

2.253 As Diagram 2.1 illustrates, each increase in the face value outstanding under the facility is treated as a fresh notional loan, made at the time of the increase.

2.254 Where a roll-over election is in effect, a security issued under a facility agreement otherwise than as a result of a roll-over is deemed to be a loan to the issuer:

•

of a foreign currency principal amount equal to the foreign currency face value of the security;

•

for a period equal to the term of the security;

•

that is taken to be attached to the security; and

•

the start time of which is the time when the security was issued.

[Schedule 4, item 58, subsection 775-210(2)]

What is the effect of the roll-over?

2.255 Where the roll-over relief applies, the forex realisation gains and losses (if any), which would otherwise arise under forex realisation event 4, on discharge of each security, are disregarded. The face value of the first security issued under the facility, and each increase in the principal balance outstanding, is treated as a separate loan made to the issuer. Each decrease in the principal balance outstanding is treated as a repayment, to the extent of the decrease, of these notional loans. The effect of this approach is to defer recognition of forex gains and losses only to the extent that money remains outstanding under the facility.

2.256 The linkage between each security and the notional loans to which it relates is achieved through the concept of 'attachment' (see paragraphs 2.259 to 2.262).

2.257 The effect of the roll-over depends upon how the foreign currency face value of the new security compares to that of the rolled over security [Schedule 4, item 58, subsection 775-210(3)]. In this context, 'foreign currency' refers to the foreign currency in which the securities are denominated [Schedule 4, item 58, subsection 775-210(5)].

2.258 Where the face value of a new security is the same as that of the previous one, the notional loan is treated as having been extended. Where additional capital is raised under the facility (i.e. there is a 'draw-down'), a new notional loan is taken to arise for the increased amount. Where there is a reduction in the capital outstanding under the facility, roll-over treatment is wound-down to the extent of the reduction, and forex realisation gains and losses may therefore be triggered to that extent.

Face value of new security equal to face value of rolled over security

2.259 Where the foreign currency face value of the new security is equal to the foreign currency face value of the rolled over security, 2 things happen:

•

the period of each notional loan attached to the rolled over security is extended by the term of the new security; and

•

each notional loan attached to the roll-over security is taken to be attached to the new security.

[Schedule 4, item 58, subsection 775-210(3), item 1 in the table]

Face value of new security greater than face value of rolled over security

2.260 Where the foreign currency face value of the new security is greater than the foreign currency face value of the rolled over security, 3 things happen:

•

the issuer is taken to have been given an additional notional loan:

-

of an amount equal to the excess;

-

for a period equal to the term of the new security;

-

attached to the new security; and

-

with a start time set at the time it was issued;

•

the period of each notional loan attached to the rolled over security is extended by the term of the new security; and

•

each notional loan attached to the rolled over security is taken to be attached to the new security.

[Schedule 4, item 58, subsection 775-210(3), item 2 in the table]

Face value of new security less than face value of rolled-over security to which only one notional loan is attached

2.261 Where the foreign currency face value of the new security is less than the foreign currency face value of the rolled over security and only one notional loan is attached to the rolled over security, 3 things happen:

•

the issuer is taken to have paid a foreign currency amount in order to discharge their liability to the extent of the shortfall;

•

the period of the notional loan is extended by the term of the new security; and

•

the notional loan is taken to be attached to the new security.

[Schedule 4, item 58, subsection 775-210(3), item 3 in the table]

Face value of new security less than face value of rolled over security to which 2 or more notional loans are attached

2.262 Where the foreign currency face value of the new security is less than the foreign currency face value of the rolled over security, and there are 2 or more notional loans attached to the rolled over security, 3 things happen:

•

the issuer is taken to have paid a foreign currency amount in order to discharge their liability to the extent of the shortfall on a first-in-first-out basis;

•

the period of each notional loan attached to the rolled over security that is not fully discharged is extended by the term of the new security; and

•

each of those notional loans is taken to be attached to the new security.

[Schedule 4, item 58, subsection 775-210(3), item 4 in the table]

2.263 The operation of the principles explained above is illustrated by the following example.

Example 2.18: Facility with multiple draw-downs

Emerald Ltd (Emerald) enters into a bill facility with USA Bank Yessler Inc. The facility comprises of a series of 90-day discounted bills. The implicit interest rate is 8.36%. The facility begins on 1 July year 1 and ends on 23 March year 3. The following draw-downs occur during the facility:

•

1 July, year 1: US$1 million advance received;

•

29 September, year 1: US$100,000 advance received;

•

28 December, year 1: US$100,000 advance received;

•

28 March, year 2: US$100,000 advance received;

•

26 June, year 2: US$100,000 return of capital;

•

24 September, year 2: US$100,000 return of capital;

•

23 December, year 2: US$100,000 return of capital; and

•

23 March, year 3: US$1 million return of capital.

This facility is economically equivalent to a continuous loan at 8.362% interest per annum. The following table summarises the cash flows, exchange rates, and forex realisation gains and losses which arise, in the absence of a roll-over:

Date	Receipt / Payment (US$)	Draw-down (US$)	Discount payment	Exchange rate (A$:US$)	Forex gain/loss	Forex gain/ loss on discount[F10]
1 July year 1	1,000,000	1,000,000		0.56
29 Sep year 1	- 1,020,000		- 20,000	0.57	31,328.32	626.57
29 Sep year 1	1,100,000	100,000		0.57
28 Dec year 1	- 1,122,000		- 22,000	0.61	126,545.87	2,530.92
28 Dec year 1	1,200,000	100,000		0.61
28 Mar year 2	- 1,224,000		- 24,000	0.65	121,059.27	2,421.19
28 Mar year 2	1,300,000	100,000		0.65
26 Jun year 2	- 1,326,000		- 26,000	0.64	- 31,250.00	-625.00
26 Jun year 2	1,200,000	- 100,000		0.64
24 Sep year 2	- 1,224,000		- 24,000	0.62	- 60,483.87	-1,209.68
24 Sep year 2	1,100,000	- 100,000		0.62
23 Dec year 2	- 1,122,000		- 22,000	0.60	- 59,139.78	-1,182.80
23 Dec year 2	1,000,000	- 100,000		0.60
23 Mar year 3	- 1.020,000	- 1,000,000	- 20,000	0.65	128,205.13	2,564.10
TOTAL	- 158,000	0	- 158,000		256,264.94	5,125.30

The total forex realisation gain is therefore A$261,390.24 (i.e. A$256,264.94 + A$5,125.30).

Assume that Emerald validly elects a roll-over in respect of this facility. Under section 775-200, it can disregard any forex realisation gains or losses which would otherwise arise under forex realisation event 4, until 26 June year 2 (i.e. until the fourth roll-over).

Before the fourth roll-over

At 29 September year 1, 28 December year 1, and 28 March year 2, the face value of each new security will exceed the face value of the rolled over security. Thus, item 2 in the table in subsection 775-210(3) will apply. Each increase in the face value is deemed to be a new loan, commencing at the date of issuing the new bill. Meanwhile, the duration of each previous notional loan is extended by the term of the new bill.

From the fourth roll-over

From 26 June year 2, the face value of the new securities will fall short of the face value of the rolled over securities. The roll-over must therefore be 'wound down' to the extent of that shortfall.

To summarise the treatment from that date:

•

26 June, year 2: Emerald issues a security with a face value of US$1.224 million. The face value of the rolled over security is US$1.326 million. Under subsection 775-210(3), item 4 in the table, Emerald is taken to have discharged US$102,000 of the earliest notional loan it received, that is the US$1.02 on 1 July year 1.

•

24 September, year 2: Emerald issues a security with a face value of US$1.122 million. The face value of the rolled over security is US$1.224 million. Under subsection 775-210(3), item 4 in the table, Emerald is taken to have discharged US$102,000 of the earliest notional loan outstanding. This will be the US$918,000 remaining of the 1 July year 1 notional loan.

•

23 December, year 2: Emerald issues a security with a face value of US$1.02 million. The face value of the security rolled over is US$1.122. Under subsection 775-210(3), item 4 in the table, Emerald is taken to have discharged US$102,000 of the earliest notional loan outstanding. This will be the US$816,000 remaining on 1 July year 1 notional loan.

•

23 March, year 3: Emerald redeems the outstanding bill of US$1.02 million. A new bill is not issued under the facility agreement. Under subsection 775-210(3), item 4 in the table, Emerald is taken to have discharged all of the notional loans outstanding. This will be the US$714,000 remaining from the 1 July year 1 notional loan, US$102,000 from the 29 September year 1 notional loan, US$102,000 of the 28 December year 1 notional loan, and US$102,000 of the 28 March year 2 notional loan.

What happens if the security is not rolled over?

2.264 Where the issuer discharges their liability under an eligible security and there is no roll-over, the notional loans are deemed to be discharged and the roll-over treatment is effectively unwound.

2.265 The issuer is deemed to have paid off all of the outstanding notional loan principal amounts. [Schedule 4, item 58, subsection 775-210(4)]

What happens when the facility is discharged?

2.266 The aim of the roll-over mechanism is to defer, not remove, tax recognition of forex realisation gains and losses arising under the facility. Thus, a mechanism is needed to calculate an appropriate gain or loss amount when the facility is wound-down or comes to an end.

2.267 Forex realisation event 6 happens where the issuer discharges their liability to pay the foreign currency principal amount of a notional loan attached to an eligible security that they issued under a facility agreement. [Schedule 4, item 58, paragraph 775-215(1)(a)]

2.268 The event only occurs where the issuer has made a choice for roll-over relief for the agreement, and that choice is in effect [Schedule 4, item 58, paragraph 775-215(1)(b)]. The time of the event is when the liability or part thereof is discharged [Schedule 4, item 58, subsection 775-215(2)].

What is the forex realisation gain?

2.269 The issuer makes a forex realisation gain if the amount of the liability (or part thereof) at the start time of the notional loan exceeds the amount paid in order to discharge it, and some or all of the excess is attributable to exchange rate fluctuations. The amount of the gain is so much of the excess as is so attributable [Schedule 4, item 58, subsection 775-215(3)]. It is important to note that in determining this gain (or loss) the translation rules (discussed in Chapter 3) must be applied in order to establish a uniform unit of account (usually A$).

Example 2.19: Facility with multiple draw-downs (continued)

In Example 2.16, it was explained how the table in subsection 775-145(3) applies in order to deem a series of notional loans to be paid off as the amount outstanding under the facility falls.

To summarise the treatment from 26 June year 2:

•

26 June, year 2: A forex realisation gain of A$22,767.86 arises;

•

24 September, year 2: A forex realisation gain of A$17,626.73 arises;

•

23 December, year 2: A forex realisation gain of A$12,142.86 arises; and

•

23 March, year 3: A forex realisation gain of A$208,852.79 arises.

The sum of forex realisation gains arising under the facility is A$261,390.24. As can be seen by comparing this result to that shown in the table in Example 2.17, the effect of the roll-over is to defer, not to eliminate, the forex realisation gains (or losses) arising under the arrangement.

What is the forex realisation loss?

2.270 The issuer makes a forex realisation loss if the amount of the liability, or part thereof, at the start time of the notional loan, falls short of the amount they paid in order to discharge it and some or all of the excess is attributable to exchange rate fluctuations. The amount of the loss is so much of the shortfall as is so attributable. [Schedule 4, item 58, subsection 775-215(4)]

Exempt income exceptions

2.271 The exempt income and non-assessable non-exempt income provisions, that is, sections 775-15, 775-25 and 775-35 (see paragraphs 2.28 to 2.31 and 2.38 to 2.41) are applicable to forex gains and losses arising from forex realisation event 6. Those provisions are applied on the basis that the notional loans are actual loans. [Schedule 4, item 58, subsection 775-215(5)]

Material variation of a facility agreement - forex realisation event 7

2.272 The rationale behind the forex roll-over on the 'principal' component of eligible securities is that a facility agreement is economically analogous to a continuous loan, which would contain fewer realisation points for tax purposes in respect of that principal.

2.273 A corollary of this reasoning is that, where a facility agreement ceases to exhibit the economic characteristics of a continuous loan, roll-over treatment should terminate.

2.274 Forex realisation event 7 happens where there is a material variation to the terms or conditions or effect of a facility agreement, or to the types of security which can be issued under it, provided a choice for roll-over relief has been made in respect of that agreement [Schedule 4, item 58, subsection 775-220(1)]. A material variation can include a variation to the conditions, or effect, of an agreement which results in that agreement ceasing to be a facility agreement [Schedule 4, item 58, subsection 775-220(7)]. In addition, the regulations may provide that a specified kind of variation is a material variation [Schedule 4, item 58, subsection 775-220(8)].

When does the event happen?

2.275 The event occurs when the material variation happens. [Schedule 4, item 58, subsection 775-220(2)]

What is the forex realisation gain?

2.276 The provisions are applied by summing the gains arising from forex realisation event 6, and netting these off against the losses arising from that event, upon the assumption the issuer discharged all of its liabilities under the agreement without any roll-over. A forex realisation gain arises if the sum of the gains under event 6 exceeds the sum of those losses. The amount of the gain is the amount of that excess. [Schedule 4, item 58, subsection 775-220(3)]

2.277 The sum may be zero, in which case no forex realisation gain arises. [Schedule 4, item 58, subsection 775-220(9)]

What is the forex realisation loss?

2.278 Conversely, the issuer makes a forex realisation loss if the sum of the losses calculated under forex realisation event 6 exceeds the sum of the gains so calculated. This is simply a mirror-image of the rule relating to forex realisation gains described above. [Schedule 4, item 58, subsection 775-220(4)]

2.279 The sum may be zero, in which case no forex realisation loss arises. [Schedule 4, item 58, subsection 775-155(9)]

How is the remainder of the facility treated?

2.280 When roll-over treatment ceases because of forex realisation event 7, the facility will cease to be treated as a notional loan for the purposes of Division 775. Thus, forex realisation gains and losses may be recognised under forex realisation event 4 each time a security is discharged under the remainder of the facility (see paragraphs 2.104 to 2.130).

2.281 In order to ensure that there is no overlap between the forex realisation gains or losses generated by forex realisation event 7 and forex realisation event 4, the tax recognition time for the remaining liabilities under the facility is set at the time of forex realisation event 7. [Schedule 4, item 58, subsection 775-220(6)]

What happens to the roll-over choice?

2.282 If forex realisation event 7 happens in relation to a facility agreement, the choice for roll-over relief ceases to have effect and the issuer is not entitled to make another choice in respect of that facility. [Schedule 4, item 58, subsection 775-220(5)]

Qualifying forex accounts

2.283 As explained in paragraphs 2.225 to 2.229, the fungibility of foreign currency and foreign currency denominated rights and obligations means that an ordering rule of some kind is required in order to calculate gains and losses arising in respect of these things on a realisation basis.

2.284 The fungible nature of currency is of particular significance in the context of foreign currency denominated bank accounts. Transactions happening to such an account can give rise to forex realisation events 1, 2 and 4.

2.285 First, a gain or loss can arise under forex realisation event 1 when an entity deposits foreign currency into the account. This represents the disposal of the foreign currency in consideration for a right to repayment or debt.

2.286 Second, a gain or loss can arise under forex realisation event 2 where an entity withdraws an amount from a foreign currency denominated bank account with a credit balance. This is because the entity's right against the bank, represented by the account balance, ends to the extent that a withdrawal is made.

2.287 Finally, a gain or loss can arise under forex realisation event 4 where an entity deposits an amount into a foreign-currency-denominated bank account with a debit balance. This is because the obligations the entity owes to the bank, represented by the account balance, end to the extent that a deposit is made.

Why have qualifying forex account rules?

2.288 Application of the forex realisation events to fungible pools of currency, rights or obligations is governed by the FIFO principle (see paragraphs 2.227 and 2.228).

2.289 While this principle offers a certain and consistent ordering rule for fungible assets and liabilities, applying it to bank accounts with a high transaction volume may give rise to significant compliance costs for some taxpayers. In low-value, high-transaction-volume accounts, recording the A$-denominated value at the tax recognition time of all account debts and tracing them to the value of each deposit or withdrawal is a potentially complex exercise. Such a process entails compliance costs which may be disproportionately high, compared with the amount of taxation revenue concerned.

2.290 Accordingly, 2 options are provided to assist taxpayers in reducing the compliance costs associated with transacting through foreign currency denominated bank accounts:

•

the limited balance account exemption; and

•

the retranslation option.

What is the limited balance exemption?

2.291 The limited balance exemption allows an entity to disregard forex realisation gains and losses arising from forex realisation events 2 and 4 which happen to a low-value account. More specifically, while an entity passes the limited balance test, any forex realisation gains and losses arising in respect of the account from forex realisation events 2 or 4 are disregarded. [Schedule 4, item 58, subsection 775-250(1)]

2.292 Further, any exchange-rate-generated capital gains and losses which might otherwise arise in respect of withdrawals from the credit balance of a limited balance account can also be ignored for tax purposes. [Schedule 4, item 58, subsection 775-250(2)]

2.293 It should be noted that the limited balance exemption does not disregard forex realisation gains and losses arising from forex realisation event 1 happening when an entity makes a foreign currency deposit into a qualifying forex account. In those cases, any forex realisation gain or loss is worked out by having regard to the FIFO principle (see paragraph 2.228).

When does the limited balance account exemption apply?

2.294 To be eligible for the limited balance account exemption, an entity must:

•

satisfy the threshold requirements for limited balance exemption; and

•

elect in writing for Subdivision 775-D to apply to the relevant account.

2.295 The rules applicable to the making of the election are discussed in paragraphs 2.305 to 2.308.

What are the threshold requirements for the limited balance exemption?

2.296 The first requirement for limited balance exemption relates to the type of bank account concerned. The subject-matter of the exemption is a qualifying forex account, that is an account which is:

•

denominated in a particular foreign currency;

•

maintained with an ADI or similar institution; and

•

either a credit card account or an account the primary purpose of which is to facilitate transactions.

[Schedule 4, item 72, definition of 'qualifying forex account' in subsection 995-1(1)]

2.297 The second requirement for the limited balance exemption is that the total credit or debit balances of the account and each of the entity's other qualifying forex accounts must not be more than the foreign currency equivalent of A$250,000 [Schedule 4, item 58, paragraphs 775-245(1)(b) and (c)]. In determining whether this requirement is satisfied, debit balances are expressed as a positive number [Schedule 4, item 58, subsection 775-245(5)] .

2.298 The foreign currency equivalent range of -A$250,000 to +A$250,000 is worked out, for these purposes, by translating A$250,000 to the foreign currency in which the account is denominated, at the average exchange rate prevailing for the third month preceding the start of the relevant income year [Schedule 4, item 58, subsection 775-245(5)]. This approach is designed to minimise compliance costs by removing the need to continually monitor, during an income year, the A$-translated balance of the account by reference to a fluctuating exchange rate.

2.299 Satisfaction of the ±A$250,000 limit is measured on an ongoing basis, however. That is, an account may cease to satisfy the threshold requirements for the limited balance exemption at any time if the ±A$250,000 limit is breached. This is subject to a buffering rule, however, discussed in paragraphs 2.300 to 2.304.

Buffering rule

2.300 In light of the requirement to continually comply with the ±A$250,000 limit, a 'buffer' rule allows an entity's qualifying forex accounts to retain the limited balance exemption if the breach is remedied within a short period of time [Schedule 4, item 58, subsection 775-245(2) and (3)]. This approach is designed to provide some tolerance for temporary limit breaches.

2.301 More specifically, the ±A$250,000 test is not applied to those increased balance periods which are 15 days or less [Schedule 4, item 58, subsection 775-245(3), item 1 in the table]. An increased balance period is a continuous period during which the total credit or debit balances of the account and the entity's other qualifying forex accounts is more than the foreign currency equivalent of A$250,000 but less than or equal to A$500,000 [Schedule 4, item 58, subsection 775-245(2)].

2.302 The buffer can be relied upon a maximum of 2 times per year. A third increased balance period will automatically place an entity outside of buffering, and therefore, limited balance account treatment. [Schedule 4, item 58, section 775-245]

2.303 Where the increased balance period extends beyond 15 days, all of the entity's qualifying forex accounts are ineligible for limited balance account treatment until the breach is remedied [Schedule 4, item 58, subsection 775-245(3), item 3 in the table]. As a result, any forex realisation gains and losses arising in respect of deposits into and withdrawals from the account must thereafter be brought to account to the extent that they occur after the breach date. A special tax recognition time rule ensures that only gains and losses arising from the breach date are recognised in these circumstances [Schedule 4, item 58, section 775-260].

2.304 The entity can re-test those accounts at any time following such a breach, and, if they satisfy the ±A$250,000 test, limited balance account treatment re-commences without a fresh election. A notional realisation rule applies in these circumstances, which ensures that any gain or loss which accrued during the period of breach is brought to account upon re-entry. [Schedule 4, item 58, section 775-255]

How is the election made?

2.305 An entity wishing to have the limited balance exemption apply to a particular qualifying forex account must elect, in writing, to have Subdivision 775-D apply to that account. [Schedule 4, item 58, subsections 775-230(1) and (2)]

2.306 That election continues to be effective in relation to the applicable qualifying forex account until one of the following things happens:

•

the entity ceases to hold the account;

•

the account ceases to be a qualifying forex account;

•

the election is varied by removing the account; or

•

the election is withdrawn.

[Schedule 4, item 58, subsection 775-230(3)]

2.307 If an entity wishes to increase or decrease the number of qualifying forex accounts in respect of which the limited balance exemption applies, that variation must be in writing [Schedule 4, item 58, subsections 775-235(1) and (2)]. An account which has been removed from limited balance treatment can be given that treatment again through another written election [Schedule 4, item 58, subsection 775-235(3)].

2.308 An entity can decrease the number of qualifying forex accounts which are subject to the limited balance exemption through a written withdrawal [Schedule 4, item 58, subsections 775-235(1) and (2)]. A withdrawal does not prevent an entity from making a new election in respect of any or all of the same accounts [Schedule 4, item 58, subsection 775-235(3)].

What is qualifying forex account retranslation?

2.309 Subdivision 775-E provides an alternative to the limited balance account treatment for entities with a qualifying forex account.

2.310 The retranslation option allows an entity to bring to account the foreign currency gains and losses arising in respect of their qualifying forex accounts by annually restating the balance by reference to deposits, withdrawals, and the exchange rate prevailing at the beginning and end of each year.

2.311 More specifically, while an entity passes the requirements for qualifying forex account retranslation, any forex realisation gains and losses arising in respect of the account from forex realisation events 2 or 4 are disregarded. [Schedule 4, item 58, subsection 775-280(1)]

2.312 Further, any exchange-rate-generated capital gains and losses which might otherwise arise in respect of withdrawals from the credit balance of a retranslated account can also be ignored for tax purposes. [Schedule 4, item 58, subsection 775-280(2)]

What is forex realisation event 8?

2.313 Instead, gains and losses are brought to account under forex realisation event 8 [Schedule 4, item 58, section 775-285]. Forex realisation event 8 calculates forex realisation gains and losses by determining a retranslation amount. That amount is worked out using the following formula:

[Schedule 4, item 58, subsection 775-285(4)]

2.314 The term 'deposit' includes any amount paid or transferred into the account [Schedule 4, item 58, subsection 775-285(10)], and 'withdrawal' includes any amount paid, advanced, drawn or transferred out of the account [Schedule 4, item 58, subsection 775-285(11)].

2.315 This formula essentially measures the A$-translated change in the balance of the qualifying forex account for the year, and then adjusts for the A$-translated value of deposits and withdrawals during that same period. That adjustment is needed in order to recognise that fluctuations in the account balance may be attributable to deposits and/or withdrawals, as well as exchange rate fluctuations (if any).

What is the forex realisation gain?

2.316 Where the retranslation amount is positive (a positive retranslation amount ), a forex realisation gain arises equal to the positive amount. [Schedule 4, item 58, subsections 775-285(2) and (6)]

What is the forex realisation loss?

2.317 Where the retranslation amount is negative (a negative retranslation amount ), a forex realisation loss arises equal to the negative amount, expressed as a positive number. [Schedule 4, item 58, subsections 775-285(3), (7) and (8)]

Translation rules applying to bank account retranslation

2.318 For the purposes of applying the translation rules (see Chapter 3) to the retranslation formula [Schedule 4, item 58, subsection 775-285(9)]:

•

the opening balance of the account is translated to A$ at the exchange rate prevailing at the start of the retranslation period;

•

each deposit is translated to A$ at the exchange rate prevailing at the time of deposit;

•

each withdrawal is translated to A$ at the exchange rate prevailing at the time of withdrawal; and

•

the closing balance of the account is translated to A$ at the exchange rate prevailing at the end of the retranslation period.

How is the election made?

2.319 An entity wishing to apply retranslation to a particular qualifying forex account must choose, in writing, to use that approach. [Schedule 4, item 58, subsections 775-270(1) and (2)]

2.320 That election continues to be effective in relation to the applicable qualifying forex account until one of the following things happens:

•

the entity ceases to hold the account;

•

the account ceases to be a qualifying forex account; or

•

the choice is withdrawn.

[Schedule 4, item 58, subsection 775-270(3)]

2.321 An entity can elect to cease to have retranslation apply to a particular account through a written withdrawal [Schedule 4, item 58, subsections 775-275(1) and (2)]. A withdrawal does not prevent an entity from making a new choice [Schedule 4, item 58, subsection 775-275(3)].

Application and transitional provisions

2.322 The forex rules contain 2 general transition principles, to which exceptions apply:

•

the 'pre-commencement events' principle; and

•

the 'pre-commencement rights and obligations' principle.

What is the 'pre-commencement events' principle?

2.323 The pre-commencement events principle holds that a forex realisation gain or loss arising under forex realisation events 1, 2, 3, 4 or 5 is disregarded if the event happened before the applicable commencement date [Schedule 4, item 58, subsection 775-160(1)]. The applicable commencement date is the first day of the 2003-2004 income year, or, if that day is earlier than 1 July 2003, the first day of the 2004-2005 income year [Schedule 4, item 58, section 775-155].

2.324 This principle is a broad one, and is subject to only one exception, based upon an anti-avoidance rule.

When does the anti-avoidance exception apply?

2.325 The anti-avoidance exception applies where an entity makes a transitional election (see also paragraphs 2.331 to 2.334) and the Commissioner is satisfied that the forex realisation event happened because of an arrangement entered into or carried out for the purpose, or a purpose, of obtaining the benefit of the general transitional rule. [Schedule 4, item 58, subsection 775-160(2)]

What is the 'pre-commencement rights and obligations' principle?

2.326 The pre-commencement rights and obligations principle holds that a forex realisation gain or loss arising under forex realisation events 1, 2, 3, 4 or 5 is disregarded if the relevant asset was acquired, or obligation incurred, before the applicable commencement date. [Schedule 4, item 58, subsections 775-165(1), (2) and (4)]

2.327 A forex realisation gain or loss attributable to rights or obligations arising under an eligible contract entered into before the applicable commencement date is also disregarded [Schedule 4, item 58, subsections 775-165(2) and (4)]. Under subsection 82V(1) of the ITAA 1936, an 'eligible contract' is a non-hedging contract, or contract hedging such a contract, entered into by a taxpayer after 18 February 1986.

2.328 The pre-commencement rights and obligations principle is subject to 2 exceptions: one relating to loan extensions and the other relating to transitional elections.

How are loan extensions treated?

2.329 First, where a loan contract is extended by way of a new contract or a variation of an existing one, the forex rules will apply to the extension. [Schedule 4, item 58, subsections 775-165(3) and (5)]

2.330 Special tax recognition time rules apply to generate appropriate (post-commencement) values to any rights or obligations arising in these circumstances. Those rules effectively mean that the amount that an entity has the right to receive, or the amount it is obliged to pay, is translated by reference to the extension time rather than by reference to the pre-commencement cashflows relating to the original loan. [Schedule 4, item 58, subsection 775-45(7), item 3 in the table, and subsection 775-55(7), item 7 in the table]

What are the consequences of making a transitional election?

2.331 Second, the pre-commencement rights and obligations principle is subject to an important exception relating to the making of a transitional election. [Schedule 4, item 58, subsection 775-150(1)]

2.332 Where an entity makes such an election, the pre-commencement rights and obligations exception does not apply. This means that currency, and rights to receive and obligations to pay it, existing at the time of commencement, will be subject to the forex rules. [Schedule 4, item 58, paragraphs 775-165(1)(b), 775-165 (2)(b), and 775-165(4)(b)]

2.333 A consequence of this is that some forex gains and losses accruing prior to the commencement date will be subject to the forex rules. However, (subject to paragraph 2.325) the forex rules will not apply to transactions which are completed prior to the applicable commencement date.

How is an election made?

2.334 The election must be in writing [Schedule 4, item 58, subsection 775-150(2)], and made within 60 days after the applicable commencement date [Schedule 4, item 58, subsection 775-150(3)]. The election is irrevocable [Schedule 4, item 58, subsection 775-150(4)].

Consequential amendments

2.335 The list in section 10-5 of the ITAA 1997 is updated to reflect the replacement of section 82Y of the ITAA 1936 with section 775-15. [Schedule 4, item 38]

2.336 The list in section 12-5 of the ITAA 1997 (heading 'foreign exchange') is updated to reflect the replacement of sections 82U to 82ZB of the ITAA 1936 with section 775-30. [Schedule 4, item 39]

2.337 The list in section 12-5 of the ITAA 1997 (heading 'losses') is updated to reflect the replacement of section 82U to 82ZB of the ITAA 1936 with section 775-30. [Schedule 4, item 40]

2.338 The table in subsection 20-30(1) of the ITAA 1997 is updated to include forex realisation losses in the list of expenses to which the recoupment provisions apply. [Schedule 4, item 41]

2.339 The table in subsection 20-30(2) of the ITAA 1997 is updated by omitting reference to subsection 82Z(1) of the ITAA 1936 in item 2.16. [Schedule 4, item 42]

2.340 Paragraphs are added to the list of adjustments in subsection 40-75(2) of the ITAA 1997, to ensure that adjustable value changes made under sections 775-70 and 775-75 are reflected in the prime cost calculation. [Schedule 4, items 44 and 45]

2.341 Subsection 40-35(1) of the ITAA 197 is updated to include reference to Division 775. [Schedule 4, item 43]

2.342 Notes at the end of subsection 40-85(2) and section 40-175 of the ITAA 1997 are updated to include references to sections 775-70 and 775-75. [Schedule 4, items 46 and 47]

2.343 Section 104-5 of the ITAA 1997 is updated to include references to CGT events K10 and K11. [Schedule 4, item 49]

2.344 A new CGT event K10 is introduced in new section 104-260. This event happens if an entity makes a forex realisation gain as a result of forex realisation event 2 and item 1 in the table in subsection 775-75(1) applies [Schedule 4, item 50]. Only a capital gain, not a capital loss, can arise when CGT event K10 happens.

2.345 A new CGT event K11 is introduced in new section 104-260. This event happens if an entity makes a forex realisation loss as a result of forex realisation event 2 and item 1 in the table in subsection 775-75(1) applies [Schedule 4, item 50]. Only a capital loss, not a capital gain, can arise when CGT event K11 happens.

2.346 The table in section 110-10 of the ITAA 1997 is updated to include references to CGT events K10 and K11. [Schedule 4, item 51]

2.347 The table in section 112-97 of the ITAA 1997 is updated to reflect cost base modifications arising under section 775-140. [Schedule 4, item 52]

2.348 The note to section 115-5 of the ITAA 1997 is updated to include a reference to the capital gains which are not discountable by virtue of section 775-70. [Schedule 4, item 53]

2.349 Section 134-1 is amended to reflect the fact that premium costs under currency options are brought to account under the forex rules rather than under the CGT provisions. [Schedule 4, item 55]

2.350 Division 3B of Part III of the ITAA 1936 is repealed to reflect the insertion of Division 775. [Schedule 4, item 22]

2.351 However, Division 3B of Part III of the ITAA 1936 (about foreign currency gains and losses) continues to apply in the calculation of assessable income and allowable deductions of an ADI or non-ADI financial institutions and in relation to eligible contracts entered into before the applicable commencement date [Schedule 4, subitem 77(1)]. If an entity (other than an ADI or a non-ADI financial institution) makes an election under section 775-150 (see paragraphs 2.330 to 2.331), Division 3B of the ITAA 1936 and Division 775 may apply to an eligible contract which continues to exist after the applicable commencement date. However, in such cases subsection 775-15(4) or 775-30(4) excludes any income and denies any deduction under Division 3B to the extent that the gain is assessable or loss deductible under Division 775.

2.352 A rule also ensures that subsection 20-30(2) (about assessable recoupments) of the ITAA 1997, and subsection 170(10) of the ITAA 1936 (about amendment to assessments), continue to apply, in relation to Division 3B of Part III of the ITAA 1936. [Schedule 4, subitem 77(2)]

2.353 Subsections 57-25(6) and 57-30(4) in Schedule 2D of ITAA 1936 is amended to reflect the repeal of Division 3B of PartIII of ITAA 1936 and to include a reference to Division 775. [Schedule 4, items 31 to 37]

2.354 The Financial Corporations (Transfer of Assets and Liabilities) Act 1993 is amended in order to:

•

replace references to section 82Y of the ITAA 1936 with references to the new section 775-15 [Schedule 4, items 1, 2, 5, 6, 10, 11 and 14 to 17];

•

replace references to section 82Z of the ITAA 1936 with references to the new section 775-30 [Schedule 4, items 3, 4, 7, 8, 12, 13, 18 and 19]; and

•

adds notes to sections 15 and 16 referring to transitional provisions [Schedule 4, items 9 and 20].

Chapter 3 - Translation of amounts into Australian or functional currency

Outline of chapter

3.1 This chapter explains how amounts which are expressed in a foreign currency are translated into Australian currency, or an applicable functional currency, for the purposes of the ITAA 1936 and the ITAA 1997.

3.2 The rules are contained in Subdivisions 960-C and 960-D.

Context of reform

3.3 An income tax that determines liability by reference to the sum of a number of amounts requires those amounts to be determined by reference to a constant unit of account. For Australian income tax purposes, that unit of account is A$. Accordingly, where a transaction (or, as explained below, the net result of a group of transactions) is denominated in a foreign currency, its economic consequences must be translated into an equivalent amount of A$ for the purposes of determining Australian income tax liability.

3.4 The current income tax law contains a number of provisions which require foreign currency amounts to be expressed in Australian currency. However, these rules are of an ad hoc nature, are found in different places in the law and are incomplete in a number of respects.

3.5 The amendments introduce a core translation principle into the income tax law. That principle applies not only to assessable income and allowable deductions, but to all amounts which are relevant to calculating an entity's income tax liability.

3.6 In conjunction with the realisation framework for foreign currency gains and losses (explained in Chapter 2), the translation rules ensure that foreign currency gains and losses are generally recognised by the tax system when they have been realised. This is the case even if the monetary elements of a foreign currency denominated transaction are not exchanged for A$.

Summary of new law

3.7 The new law clarifies that Australian income tax liability is determined by measuring amounts in A$, even when they are denominated in a foreign currency. In some cases, an intermediate step may be carried out by measuring certain amounts in a foreign currency; however, the sum of those amounts is to be converted to A$ in ultimately determining liability to Australian income tax.

Translation of amounts into Australian currency

3.8 The core translation rule provides that, for the purposes of the ITAA 1936 and the ITAA 1997, an amount of foreign currency is to be expressed in Australian currency.

3.9 The rule applies to amounts generally, and is intended to be interpreted broadly. Examples of an 'amount' include:

•

an amount of ordinary income;

•

an amount of an expense;

•

an amount of an obligation;

•

an amount of a liability;

•

an amount of a receipt;

•

an amount of a payment;

•

an amount of consideration; and

•

a value.

3.10 A number of special translation rules specify the exchange rate to be used for particular amounts that are relevant to an entity's income tax liability. Specifically:

•

amounts of obligations are translated at the exchange rate prevailing at the time the consideration received for them is recognised for tax purposes;

•

the cost of depreciating assets is translated at the exchange rate prevailing upon beginning to hold the asset, or satisfying the liability to pay for it, whichever occurs first;

•

amounts relevant to transactions or events to which the CGT provisions apply are to be translated at the exchange rate prevailing at the time of the transaction or event;

•

ordinary income is to be translated at the exchange rate prevailing at the time of derivation or receipt, whichever occurs first;

•

non-CGT statutory income is translated at the exchange rate prevailing at the time the amount must first be returned as income, or receipt, whichever occurs first;

•

deductible amounts not falling within Division 40 of the ITAA 1997 must be translated at the exchange rate prevailing at the time the amount becomes deductible, or the time of payment, whichever occurs first; and

•

receipts or payments must be translated at the exchange rate prevailing at the time of the receipt or payment.

Translation of amounts into an applicable functional currency

3.11 Some entities or parts of entities are able to choose to account for their activities in a currency other than A$ for income tax purposes (as an intermediate step prior to translating a net amount from those activities into A$). In particular, a choice may be made in respect of the following entities or parts of an entity:

•

residents who are required to prepare financial reports under section 292 of the Corporations Act 2001;

•

residents carrying on a business through an overseas PE;

•

non-residents carrying on a business through an Australian PE;

•

OBUs;

•

attributable taxpayers of a CFC; and

•

transferor trusts.

3.12 The functional currency rules allow those entities which make a valid choice to account for individual transactions using a unit of account other than A$. However, the net amount from those transactions (generally 'taxable income') must be converted into A$.

Detailed explanation of new law

3.13 The translation provisions consist of 2 elements:

•

the core translation rule; and

•

the functional currency rules.

Translation of amounts into Australian currency

3.14 Australian income tax liability is calculated in terms of Australian currency. In order for foreign currency amounts to be appropriately taken into account in determining Australian income tax liability, there is a need for a rule or rules which translate these foreign currency denominated amounts into A$.

What does translation of amounts mean?

3.15 The core translation rule provides that, for the purposes of the ITAA 1936 and the ITAA 1997, an amount of foreign currency is to be translated into, or expressed in, Australian currency [Schedule 4, item 59, subsection 960-50(1)]. While this rule is specifically inserted into the ITAA 1997, it is incorporated into the ITAA 1936. This is by virtue of subsection 995-1(1), under which a reference to 'this Act' includes a reference to the ITAA 1936. Foreign currency is a currency other than Australian currency [Schedule 4, item 65, definition of 'foreign currency' in subsection 995-1(1)].

3.16 The rule applies to amounts generally, and is intended to be interpreted broadly. Examples of an 'amount' include:

•

an amount of ordinary income;

•

an amount of an expense;

•

an amount of an obligation;

•

an amount of a liability;

•

an amount of a receipt;

•

an amount of a payment;

•

an amount of consideration; and

•

a value.

[Schedule 4, item 59, subsection 960-50(2)]

3.17 The term 'amount' is used in a quantitative rather than qualitative sense. That is, it contemplates a numerical unit of account but does not deem an asset which is factually foreign currency to be Australian currency.

3.18 Because the translation rule applies to amounts generally, its relevance extends beyond income and deductions. For example, it will apply to determine the A$ value of an asset's foreign currency denominated cost or disposal proceeds.

Example 3.1: Foreign currency denominated cost expressed in A$

In year 1, Rainier Pty Ltd (Rainier) purchases an item of plant from the USA for US$100,000. At that time, A$1 is equivalent to US$0.50. Rainier becomes the legal owner of the plant in year 1, but does not pay for it until year 2.

Under paragraph 40-185(1)(b) of the ITAA 1997, item 2 in the table, 'cost' is determined by reference to an 'amount'. Applying the translation rule to that amount, the cost of the plant for the purposes of Division 40 would be A$200,000 in year 1.

3.19 The translation rule also applies to 'values' [Schedule 4, item 59, paragraph 960-50(2)(h)]. The term 'value' carries its ordinary meaning. Broadly, it refers to the material or monetary worth of a thing - the amount at which such worth may be estimated in terms of a medium of exchange.

Amounts that are elements in the calculation of other amounts

3.20 In some cases an amount which is taken into account for tax purposes, for example an amount of income or a deduction is the sum or the result of 2 or more other amounts. An example is an amount included in assessable income under section 26BB of the ITAA 1936 or a deduction under section 70B of the ITAA 1936. Any amounts which are elements in the calculation of another amount are to be translated prior to calculating the other amount. [Schedule 4, item 59, subsection 960-50(4)]

3.21 However, in calculating a special accrual amount, amounts which are taken into account in the calculation are not translated under section 960-50 [Schedule 4, item 59, subsection 960-50(5)]. Only the result, that is the special accrual amount, is translated. Special accrual amounts are amounts that are included in assessable income or allowed as a deduction under provisions relating to:

•

luxury car leasing (Division 42A in Schedule 2E of the ITAA 1936);

•

certain arrangements treated as a sale and loan (Division 240 of the ITAA 1997);

•

arrangements for the use of property (Division 16D of Part III of the ITAA 1936); and

•

the accruals assessability and deductibility of certain security payments (Division 16E of Part III of the ITAA 1936).

[Schedule 4, item 73, definition of 'special accrual amount' in subsection 995-1(1)]

Special translation rules

3.22 A number of special translation rules specify the exchange rate to be used for particular amounts that are relevant to an entity's income tax liability. These rules are subject to modification by way of regulation [Schedule 4, item 59, subsections 960-50(7) and (8)]. The regulations might specify, for example, that an entity can use an 'average', rather than 'spot', rate for a particular class of transactions.

Forex realisation event 4

3.23 A special translation rule applies where forex realisation event 4 happens upon ceasing to have an obligation to pay foreign currency (other than an obligation that is an element in the calculation of a net amount which is included in assessable income or allowable as a deduction). The amount of the obligation is translated at the exchange rate prevailing at the tax recognition time [Schedule 4, item 59, subsection 960-50(6), item 1 in the table]. Forex realisation event 4 is explained in Chapter 2 (see paragraphs 2.53 to 2.79).

Cost of a depreciating asset

3.24 A special translation rule also applies where the cost of a depreciating asset is determined before or after an obligation to pay for it has been satisfied. Where holding precedes satisfaction of the obligation, the cost is translated at the exchange rate applicable at the time when holding begins. If satisfaction precedes holding, however, the cost is translated at the date of satisfaction [Schedule 4, item 59, subsection 960-50(6), item 2 in the table]. An entity 'holds' a depreciating asset where it satisfies one of the items in section 40-40 of the ITAA 1997.

Example 3.2: Applying the translation rule to the cost of a depreciating asset

On 30 June, year 1, Seahawks Pty Ltd (Seahawks) purchases an item of plant from France for €10,000. At that time, A$1 is equivalent to €0.56. Although Seahawks becomes the legal owner of the plant immediately, it does not pay for the plant until year 2. When Seahawks pays, A$1 is equivalent to €0.54.

Applying the translation rule for depreciating assets, together with subsection 40-185(1), item 2 in the table, the cost of the plant is A$17,857.14. That is, the cost is worked out on the basis of an exchange rate of A$1.00 : €0.56.

Trading stock

3.25 Trading stock on hand at the end of an income year, and which is valued at cost, is translated at the exchange rate prevailing at the time when it became on hand [Schedule 4, item 59, subsection 960-50(6), item 3 in the table]. Trading stock which is valued at market selling price or replacement value is translated at the exchange rate prevailing at the end of the income year [Schedule 4, item 59, subsection 960-50(6), item 4 in the table].

Transaction or event to which the CGT provisions apply

3.26 Where a transaction or event involves an amount of money or the market value of other property, and it is taken into account under Part 3-1 or 3-3 of the ITAA 1997, the amount or value is translated to A$ at the exchange rate prevailing at the time of the transaction or event [Schedule 4, item 59, subsection 960-50(6), item 5 in the table]. This rule replicates the effect of section 103-20, which applies to CGT assets. That provision is one of the ad hoc conversion rules which the core translation rule replaces.

Ordinary income

3.27 Ordinary income is translated at the exchange rate prevailing at the time of derivation, or receipt of the consideration to which that derivation relates. [Schedule 4, item 59, subsection 960-50(6), item 6 in the table]

3.28 Where derivation precedes receipt, the time of derivation is the relevant translation time.

Example 3.3: Translation of ordinary income - derivation before receipt

Mavis sells opals to foreign retailers. Sales are usually denominated in foreign currencies and payment due within 90 days.

On 1 June, year 1, Mavis sells a number of opals to a retailer in Germany for €6,000. At that time the exchange rate is A$1.00:€0.67. Mavis receives payment on 1 July, year 2, at which time the exchange rate is A$1.00:€0.70.

As Mavis accounts for her income on an earnings basis, she derives the income of €6,000 in year 1. As the income is derived prior to payment being received, Mavis is required to translate the foreign currency denominated income to Australian dollars at the exchange rate prevailing at the time that the income is derived.

Mavis' income from the sale of the opals is A$8,955, that is, €6,000 translated to Australian dollars at the exchange rate of A$1.00 : €0.67.

Mavis' receipt in respect of the opals sale is A$8571, that is, €6000 translated to Australian dollars at the exchange rate of A$1.00 : €0.70. This is the amount taken into account by item 6 in the table in subsection 960-50(6) in determining whether there is a forex realisation gain or loss (see Chapter 2). In this case, the change in the exchange rate between the time of derivation of the income and the time of receipt will result in a forex realisation loss of A$384 (i.e. A$8,955 - A$8,571).

3.29 On the other hand, where derivation occurs after receipt, the time of receipt is the relevant translation time.

Example 3.4: Translation of ordinary income - derivation after receipt

Chan Self Defence Academy Pty Ltd (Chan) teaches self-defence to international students. Students are able to pay for classes in a number of foreign currencies.

On 27 July Bruce pays Chan ¥6,000 for 50 weekly classes which can be taken over the next 12 months. At that time the exchange rate is A$1.00:¥63.00.

As Chan accounts for its income on an accruals basis, Chan will not derive the income until the classes are taken by Bruce.^[F11]

However, as Chan receives payment before the time of derivation the ¥6,000 is translated to Australian dollars at the exchange rate prevailing at the time the ¥ is received.

The Australian dollar amount of the income is:

(¥6,000/63.00) = A$95.24


Non-CGT statutory income

3.30 Statutory income arising outside of the CGT provisions is translated at the exchange rate prevailing at the time the amount must first be returned as income or at the time of receipt of the consideration to which that income relates, whichever occurs first. [Schedule 4, item 59, subsection 960-50(6), item 7 in the table]

Deductible amounts

3.31 Deductible amounts not falling within Division 40 must be translated at the exchange rate prevailing at the time the amount becomes deductible, or at the time of payment, whichever occurs first. [Schedule 4, item 59, subsection 960-50(6), item 8 in the table]

Production expenditure on a film

3.32 Amounts taken into account in quantifying a company's production expenditure or qualifying Australian production expenditure on a film for the purposes of Division 376 are translated at the average exchange rate between the time that photography starts or the production of animated images commences and the time when the film is completed. [Schedule 4, item 59, subsection 960-50(6), item 9 in the table]

Amounts withheld

3.33 An amount that is required to be withheld from a payment by Division 12 of Part 2.5 in Schedule 1 to the TAA 1953 is translated at the exchange rate at the time when the amount is required to be withheld. [Schedule 4, item 59, subsection 960-50(6), item 10 in the table]

Receipts or payments

3.34 Receipts and payments not covered by any other item in the table are translated at the exchange rate prevailing at the time of the receipt or payment. [Schedule 4, item 59, subsection 960-50(6), item 11 in the table]

Exclusions from translation rule

3.35 The core translation rule does not affect the operation of the following provisions:

•

section 775-210 (notional loans under facility agreements);^[F12]

•

Subdivision 960-D (functional currency);^[F13] and

•

subsection 974-35(6) (valuation of financial benefits for the purposes of the debt/equity provisions).

[Schedule 4, item 59, subsection 960-50(10)]

3.36 The core translation rule does not apply in determining the taxable income, or tax loss, of an ADI or a non-ADI financial institution. [Schedule 4, item 59, subsection 960-55(3)]

Using a functional currency

3.37 As explained in paragraph 3.3, calculating income tax liability in respect of the sum of a number of amounts requires those amounts to be measured in a constant unit of account, that is, in the same currency. As also explained above, Australian income tax liability is calculated in terms of Australian currency; a translation rule is therefore needed to deal with amounts of foreign currency.

3.38 To achieve this, however, it is not necessary that each transaction be translated to A$. One way of obtaining an Australian dollar amount from which to determine income tax liability is to account for individual transactions on the basis of a foreign currency, but translate the net amount attributable to those transactions into A$. Such a translation process is depicted in the following diagram.

3.39 This approach involves 2 translations: Translation 1, which ensures that an entity uses a consistent unit of measurement when accounting at a transactional level, and Translation 2, which translates the net result from the particular transactions for a particular period, into A$.

3.40 What is the appropriate unit of measurement under this approach? This is answered by the 'functional currency' concept.

Why have a functional currency option?

3.41 Some entities are subject to Australian income tax, but nonetheless conduct a significant part of their activities in a foreign currency. For these entities, there may be compelling arguments for allowing transactions to be accounted for in a currency other than A$. Use of a non-Australian functional currency may facilitate significant compliance cost savings, whilst not producing any undue distortion to the entity's ultimate A$ income tax liability.

What entities can choose to use a functional currency, and how does the choice apply?

3.42 The functional currency provisions are a compliance cost saving measure. They constitute an exception to the core translation principle in section 960-50. Accordingly, access to a functional currency for tax purposes is limited to those entities or parts of entities which are expected to have substantial international operations.

3.43 The effect of the choice depends upon the type of entity or part of an entity in respect of which the choice is made (as well as how its income tax position is worked out). In particular, a choice can only be made in respect of the following entities or parts of entities:

•

residents which are required to prepare financial reports under section 292 of the Corporations Act 2001;

•

residents carrying on a business through an overseas PE;

•

non-residents carrying on a business through an Australian PE;

•

OBUs;

•

attributable taxpayers of a CFC; and

•

transferor trusts.

[Schedule 4, item 59, subsection 960-60(1)]

Residents who prepare financial reports under the Corporations Act 2001

3.44 A resident that is required to prepare financial reports under section 292 of the Corporations Act 2001 can use the applicable functional currency to work out its taxable income. Such an election will apply to the calculation of all the amounts included in the entity's taxable income, unless they make separate elections in respect of any overseas PE, OBU, the attributable income from a CFC, or transferor trust (see paragraphs 3.46 to 3.52). [Schedule 4, item 59, subsection 960-60(1), item 1 in the table]

3.45 The choice has effect from the commencement of the year of income, or from the time the resident came into existence, if the choice is made within 90 days of the commencement of the income year or of the time the resident came into existence. Otherwise the choice has effect from the first income year following the year in which the choice was made. [Schedule 4, item 59, subsection 960-60(1), item 1 in the table, and subsection 960-65, item 1 in the table]

Residents carrying on a business through an overseas PE

3.46 Residents carrying on business through an overseas PE can use the applicable functional currency to work out the taxable income derived from that PE. [Schedule 4, item 59, subsection 960-60(1), item 2 in the table]

3.47 The choice has effect from the commencement of the year of income, or from the time the PE came into existence, if the choice is made within 90 days of the commencement of the income year or of the time the PE came into existence. Otherwise the choice has effect from the first income year following the year in which the choice was made. [Schedule 4, item 59, subsection 960-60(1), item 2 in the table, and section 960-65, item 2 in the table]

Non-residents carrying on a business through an Australian PE

3.48 Conversely, non-residents carrying on business through an Australian PE can also use the applicable functional currency [Schedule 4, item 59, subsection 960-60(1), item 2 in the table]. The choice has effect from the commencement of the year of income, or from the time the PE came into existence, if the choice is made within 90 days of the commencement of the income year or of the time the PE came into existence. Otherwise the choice has effect from the first income year following the year in which the choice was made. [Schedule 4, item 59, subsection 960-60(1), item 2 in the table, and section 960-65, item 2 in the table]

Offshore banking units

3.49 An OBU can work out its total assessable OB income and its total allowable OB deductions using the applicable functional currency. The choice has effect from the commencement of the year of income, or from the time the OBU came into existence, if the choice is made within 90 days of the commencement of the income year or of the time the OBU came into existence. Otherwise the choice has effect from the first income year following the year in which the choice was made [Schedule 4, item 59, subsection 960-60(1) item 3 in the table, and section 960-65, item 3 in the table]. The term 'offshore banking unit' is defined in section 128AE of the ITAA 1936 [Schedule 4, item 70, the definition of 'offshore banking unit' in subsection 995-1(1)].

Attributable taxpayers of a controlled foreign company

3.50 An attributable taxpayer of a CFC can work out the CFC's total attributable income using the applicable functional currency [Schedule 4, item 59, subsection 960-60(1), item 4 in the table]. The choice has effect from the commencement of the CFC statutory accounting period, or from the time the CFC came into existence, if the choice is made within 90 days of the commencement of the CFC statutory accounting period or of the time the CFC came into existence. Otherwise the choice has effect from the start of the first CFC statutory accounting period following the one in which the choice was made [Schedule 4, item 59, subsection 960-60(1), item 4 in the table, and section 960-65, item 4 in the table]. A CFC may have a number of attributable taxpayers, each of which may make a choice.

Transferor trusts

3.51 Transferor trusts can work out their attributable income using the applicable functional currency [Schedule 4, item 59, subsection 960-60(1), item 5 in the table]. The choice has effect from the commencement of the income year in which it was made if the choice was made within 90 days of commencement of that income year. Otherwise, the choice has effect from the commencement of the following income year [Schedule 4, item 59, subsection 960-60(1), item 5 in the table and section 960-65, item 5 in the table]. 'Attributable income' is defined in Division 6AAA of Part III of the ITAA 1936.

3.52 A transferor trust exists where, having regard to all relevant circumstances, it would be reasonable to conclude that another entity is, or is likely to be, an attributable taxpayer in relation to the trust under Division 6AAA of Part III of the ITAA 1936. [Schedule 4, item 59, section 960-75 and item 74, definition of 'transferor trust' in subsection 995-1(1)]

How is the choice made?

3.53 The choice must be made in writing [Schedule 4, item 59, subsection 960-60(2)]. The choice continues until a withdrawal takes effect (see paragraphs 3.85 to 3.87), or in the case of a resident taxpayer who is required to prepare financial reports under section 292 of the Corporations Act 2001, until the first year after the requirement to prepare financial reports ceases [Schedule 4, item 59, subsection 960-60(3) and (4)].

What is the applicable functional currency?

3.54 The applicable functional currency will depend on the factual circumstances surrounding the entity's operations. Broadly, an entity's applicable functional currency is the sole or predominant currency in which its accounts are kept at the time when the choice was made [Schedule 4, item 59, section 960-70 and item 60, definition of 'applicable functional currency' in subsection 995-1(1)]. This aligns the commercial rationale for accounting in a foreign currency with the use of that currency for income tax purposes.

Residents who prepare financial reports under the Corporations Act 2001

3.55 For Australian residents required to prepare financial reports under section 292 of the Corporations Act 2001, the applicable functional currency for the income year and each later year for which the choice is in effect, is the sole or predominant foreign currency in which the books of account are kept. [Schedule 4, item 59, subsection 960-70(1)]

Permanent establishments, offshore banking units or transferor trusts

3.56 For PEs, OBUs or transferor trusts, the applicable functional currency for the income year and each later year for which the choice is in effect, is the sole or predominant foreign currency in which, at the time of the choice, the PE, OBU, or transferor trust kept its accounts. [Schedule 4, item 59, subsection 960-70(2)]

Controlled foreign companies

3.57 For choices made in relation to a CFC, the applicable functional currency for the statutory accounting period and each later period for which the choice is in effect, is the sole or predominant foreign currency in which, at the time of the choice, the CFC kept its accounts. [Schedule 4, item 59, subsection 960-70(3)]

3.58 'Statutory accounting period' is defined in section 319 of the ITAA 1936. Generally, it is each period of 12 months finishing at the end of 30 June.

What are accounts?

3.59 For all entities, the term 'accounts' denotes ledgers, journals, statements of financial performance, profit and loss accounts, balance sheets and statements of financial position and includes statements, reports and notes attached to, or intended to be read, with such items [Schedule 4, item 59, subsection 960-70(4)]. These terms are intended to be interpreted broadly and in light of their ordinary commercial connotations.

How are amounts translated using an applicable functional currency?

3.60 Again, the translation rules depend upon the type of entity or part of entity concerned and how its income tax position is worked out. This reflects the different methodologies used by the income tax law to determine the income tax liability of these entities or parts of entities.

3.61 Broadly, however, each of the translation rules performs the following functions:

•

translates all amounts to the applicable functional currency;

•

alters the normal foreign currency rules so that the functional currency is no longer treated as 'foreign currency' whereas Australian currency is; and

•

translates the final elements of a tax liability calculation into A$.

Residents who prepare financial reports under the Corporations Act 2001

3.62 Residents convert amounts relevant to their tax liability using the following methodology:

•

amounts not expressed in the applicable functional currency are converted to that functional currency; and

•

the taxable income is translated to Australian dollars.

[Schedule 4, item 59, subsection 960-80(1), item 1 in the table]

3.63 A further consequence of the translation rule applying is that for all tax purposes:

•

the applicable functional currency is taken not to be foreign currency; and

•

Australian currency is taken to be a foreign currency.

[Schedule 4, item 59, subsection 960-80(1), item 1, column 3, subparagraphs (a)(iii) and (iv) in the table]

Residents with an overseas PE, or non-residents with an Australian PE

3.64 Residents with an overseas PE, or non-residents with an Australian PE, translate amounts relevant to the activity or business of the PE using the following methodology:

•

amounts not expressed in the applicable functional currency are translated to that functional currency; and

•

the taxable income derived from the activity or business of the PE is translated into Australian currency.

[Schedule 4, item 59, subsection 960-80(1), item 2 in the table]

3.65 The phrase 'taxable income derived from [an] activity or business' is used in order to correspond to subsection 3(2) of the International Tax Agreements Act 1953.

3.66 A further consequence of the translation rule applying is that:

•

the applicable functional currency is taken not to be foreign currency; and

•

Australian currency is taken to be a foreign currency.

[Schedule 4, item 59, subsection 960-80(1), item 2, column 3, subparagraphs (a)(iii) and (iv) in the table]

Example 3.5: Consequences of a functional currency election

An Australian branch of USA company Snoqualmie Inc (Snoqualmie) makes a valid functional currency election under which its applicable functional currency is US$.

In year 1, Snoqualmie contracts to purchase a depreciating asset from an Australian entity for A$10,000. At the time, A$1.00 = US$0.50. Assuming Snoqualmie holds the asset from the date of contract, its cost will be US$5,000.

In year 2, 13 months after first holding the asset, Snoqualmie pays for the asset. By this time, A$1.00 = US$0.55. As a result, the A$10,000 Snoqualmie pays is equivalent to US$5,500.

For Snoqualmie's purposes, US$ is not foreign currency and A$ is. Therefore, Snoqualmie makes a forex realisation loss of US$500 under forex realisation event 3. This loss will be taken into account in calculating Snoqualmie's Australian taxable income. That taxable income will be calculated in US$ and converted into A$.

Offshore banking units

3.67 OBUs convert amounts relevant to the OB activities using the following methodology:

•

amounts not expressed in the applicable functional currency are converted to that functional currency; and

•

the total assessable OB income and total allowable OB deductions are to be converted into Australian currency.

[Schedule 4, item 59, subsection 960-80(1), item 3 in the table]

3.68 'Assessable OB income' is defined in subsections 121EE(2) and (3A) of the ITAA 1936. 'Allowable OB deductions' is defined in subsection 121EF(2) of the ITAA 1936.

3.69 Again, the applicable functional currency is taken not to be foreign currency and Australian currency is taken to be a foreign currency. [Schedule 4, item 59, subsection 960-80(1), item 3, column 3, subparagraphs (a)(iii) and (iv) in the table]

Attributable taxpayers of a controlled foreign company

3.70 Attributable taxpayers of a CFC convert amounts relevant to attributable income of the CFC using the following methodology:

•

amounts not expressed in the applicable functional currency are converted to that functional currency; and

•

the attributable income is converted to Australian currency.

[Schedule 4, item 59, subsection 960-80(1), item 4 in the table]

3.71 'Attributable income' has the meaning given by Division 7 of Part X of the ITAA 1936.

3.72 Again, the applicable functional currency is taken not to be foreign currency and Australian currency is taken to be a foreign currency. [Schedule 4, item 59, subsection 960-80(1), item 4, column 3, subparagraphs (a)(iii) and (iv) in the table]

Transferor trusts

3.73 Transferor trusts convert amounts using the following methodology:

•

amounts not expressed in the applicable functional currency are converted to that functional currency; and

•

the attributable income is converted to Australian currency.

[Schedule 4, item 59, subsection 960-80(1), item 5 in the table]

3.74 'Attributable income' has the meaning given by Division 7 of Part X of the ITAA 1936.

3.75 Again, the applicable functional currency is taken not to be foreign currency and Australian currency is taken to be a foreign currency. [Schedule 4, item 59, subsection 960-80(1), item 5, column 3, subparagraphs (a)(iii) and (iv) in the table]

What does translation of 'amounts' mean?

3.76 The functional currency translation rules all provide for the translation of 'an amount' into the applicable functional currency.

3.77 The rule applies to amounts generally, and is intended to be interpreted broadly. It does not matter whether the amounts are on revenue or capital account [Schedule 4, item 59, subsection 960-80(3)]. Examples of an 'amount' include:

•

an amount of ordinary income;

•

an amount of an expense;

•

an amount of an obligation;

•

an amount of a liability;

•

an amount of a receipt;

•

an amount of a payment;

•

an amount of consideration;

•

a value; and

•

a monetary limit or other amount set out in the ITAA 1936, the ITAA 1997 or any other Commonwealth law.

[Schedule 4, item 59, subsection 960-80(2)]

Example 3.6: Application of the translation rule to a monetary limit

Exact Ltd (Exact), an OBU, has elected to use a functional currency, and its applicable functional currency is US$. In year 1, Exact purchases a car for US$40,000. At the time, the price is equivalent to A$72,700.

If the car limit under section 40-230 of the ITAA 1997 was A$60,000 in year 1, Exact would apply that provision by converting the limit to US$33,012. The first element of the (US$) cost of a car is therefore reduced to that amount.

3.78 In translating an amount to the applicable functional currency or A$, the regulations (if any) must be complied with [Schedule 4, item 59, subsection 960-80(7)]. Regulations can make provision in relation to any matter by applying, adopting, or incorporating matter contained within the accounting standards (as defined in the Corporations Act 2001) [Schedule 4, item 59, subsection 960-80(8)].

How are events happening before a functional currency choice treated?

3.79 The need for a constant unit of account, combined with the ability to choose an applicable functional currency, raises the question of how to address events which straddle the time of choice. For example, an entity which has chosen to use a functional currency may sell an asset acquired prior to the choice, the cost of which was originally accounted for in A$. A special translation rule deals with these cases. [Schedule 4, item 59, section 960-85]

When does the special rule apply?

3.80 The special rule applies where:

•

an entity makes a choice and is consequently required to convert an amount to the applicable functional currency [Schedule 4, item 59, paragraph 960-85(1)(a)]; and

•

the amount is attributable to an event that happened, or a state of affairs that arose before the current choice took effect [Schedule 4, item 59, paragraph 960-85(1)(b)].

What are the consequences of the special rule applying?

3.81 Where no previous choice was in effect at the event time, a 2-stage translation applies, that is, a conversion:

•

to Australian currency at the rate prevailing at the event time; and

•

a translation of the A$ amount to the applicable functional currency at the rate prevailing at the time the choice took effect.

[Schedule 4, item 59, section 960-85, item 1 in the table]

3.82 Where a previous choice has been made, the same process applies, except the previously applicable functional currency is substituted for Australian currency. [Schedule 4, item 59, section 960-85, item 2 in the table]

3.83 An example of where the translation of an amount which is attributable to an event that happened, or a state of affairs that arose before the current choice took effect, is where a taxpayer purchased a capital asset prior to the choice and sold the asset after making the choice.

3.84 The 2-stage translation process ensures that any unrealised gain or loss at the time of the election is made, does not escape taxation simply because the election is made. Such an unrealised gain or loss is not brought to account at the time of the choice taking effect but will be brought to account when the asset is ultimately realised. The unrealised gain or loss could be either increased or reduced prior to realisation because of changes in value occurring after the time that the choice takes effect.

Example 3.7: Sale of assets acquired prior to a functional currency choice

Airotciv Inc (Airotciv), a non-resident corporation operates through a PE in Australia. Airotciv transacts predominantly in ¥ and in the year ended 30 June year 1 it elects to use ¥ as its functional currency. The election will apply for the year commencing 1 July year 2.

In the year ended 30 June year 3, Airotciv sells a tourist resort for ¥600 million, which it had purchased prior to year 1 for ¥500 million.

As Airotciv's functional currency is ¥ the capital gain or capital loss will be calculated in ¥. However, as ¥ was not the functional currency at the time the asset was acquired, the ¥ cost is converted to A$ at the exchange rate prevailing at the time the cost was incurred. The A$ amount is then converted to ¥ at the exchange rate prevailing at the time the choice to use ¥ as the functional currency took effect.

Assume that the exchange rates were:

At the time of purchase of the asset:	A$1.00:¥68.50;
At the time the choice took effect:	A$1.00:¥62.00.

The cost base for the purposes of calculating the capital gain or loss on the disposal of the asset is:

(¥500,000,000 / 68.50) * 62.00
= $A7,299,270 * 62.00
= ¥452,554,744


The capital gain, calculated in Airotciv's functional currency, is:

Sale proceeds:	¥600,000,000
Less: Cost base	¥452,554,744
Gain	¥147,445,256

When is a choice withdrawn?

3.85 A choice can be withdrawn if the applicable foreign currency has ceased to be the sole or predominant currency in which the entity or part thereof keeps its books of account. For entities other than attributable taxpayers, the withdrawal of a choice has effect from immediately after the end of the year of withdrawal [Schedule 4, item 59, subsection 960-90(1), items 1, 2, 3 and 5 in the table]. Equivalently, an attributable taxpayer's withdrawal has effect from immediately after the end of the statutory accounting period in which withdrawal occurs [Schedule 4, item 59, subsection 960-90(1), item 4 in the table].

3.86 A taxpayer is not compelled to withdraw a choice and the choice can only be withdrawn if the applicable foreign currency has ceased to be the sole or predominant currency in which the entity or thereof keeps its books of account.

3.87 A choice must be withdrawn in writing [Schedule 4, item 59, subsection 960-90(2)]. Withdrawal of a choice does not prevent an entity from making a new choice [Schedule 4, item 59, subsection 960-90(3)]. If a new choice is not made after withdrawing an earlier choice, the entity or part of the entity will be required to use A$ for the purposes of calculating the income tax liability.

Choices made for the sole or dominant purpose of obtaining a tax benefit

3.88 Where the choice to use a functional currency is made with the sole or dominant purpose of obtaining a tax benefit, the choice, or a scheme of which the choice is part, may be subject to the operation of Part IVA of the ITAA 1936, despite subsection 170C(2) (see also paragraph 3.96). For example, the tax benefit arising from a scheme could be increased because a functional currency election has been made.

Application and transitional provisions

3.89 The core translation rule applies to a transaction or event that involves an amount of foreign currency and occurs after the commencement date. However, the rule does not apply to a transaction or event involving an amount covered by subsections 775-110(1), (2) and (4) of the ITAA 1997. [Schedule 4, item 59, section 960-55]

3.90 Sections 20, 102AAX and 391 of the ITAA 1936 and section 103-20 of the ITAA 1997 continue to apply in relation to a transaction or event to which section 960-50 does not apply. [Schedule 4, item 78]

3.91 Sections 102AAW and 389 of the ITAA 1936 continue to apply in relation to section 20 of the ITAA 1936. [Schedule 4, item 79]

Consequential amendments

3.92 Section 20 of the ITAA 1936 is repealed to reflect the introduction of the core translation rule in section 960-50. [Schedule 4, item 21]

3.93 The reference to 'section 20' in subsection 102AAW(1) of the ITAA 1936 is removed to reflect the former provision's repeal. [Schedule 4, item 23]

3.94 Section 102AAX of the ITAA 1936 is repealed to reflect the introduction of the core translation rule in section 960-50. [Schedule 4, item 24]

3.95 Subsection 170(10) of the ITAA 1936 is amended to exclude references to subsections 82Z(3) and (4). [Schedule 4, item 25]

3.96 Subparagraphs 177C(2)(a)(i), (b)(i) and (c)(i) of the ITAA 1936 are amended in order to add a further exception to the tax benefit exclusion rule relating to functional currency elections. [Schedule 4, items 26 to 28]

3.97 The reference to 'section 20' in paragraph 389(a) of the ITAA 1936, is removed to reflect the former provision's repeal. [Schedule 4, item 29]

3.98 Section 391 of the ITAA 1936 is repealed to reflect the introduction of the core translation rule in section 960-50. [Schedule 4, item 30]

3.99 Sections 103-20 and 376-60 of the ITAA 1997 are repealed to reflect the insertion of Subdivisions 960-C and 960-D. [Schedule 4, items 48 and 57]

3.100 Sections 12-15 and 425-30 of Schedule 1 of the TAA 1953 are repealed to reflect the insertion of Subdivision 960-C into the ITAA 1997. [Schedule 4, items 75 and 76]

3.101 However, sections 20, 102AAX and 391 of the ITAA 1936, sections 103-20 and 376-60 of the ITAA 1997 and sections 12-15 and 425-30 in Schedule 1 of the TAA 1953 continue to apply in relation to amounts to which section 960-50 does not apply. [Schedule 4, items 78 and 79]

Chapter 4 - Regulation impact statement - Tax treatment of foreign exchange gains and losses

Policy objective

4.1 The policy objective of the proposed reforms to the taxation of foreign currency gains and losses is to:

•

restore the broad policy intention of the current taxation law (i.e. Division 3B of the ITAA 1936) which has been undermined by judicial decisions (FC of T v Energy Resources of Australia Ltd (1996)
185 CLR 66 and Victoria Co Ltd v DFC of T
2000 ATC 4755);

•

remove anomalies relating to tax treatment of foreign currency gains and losses; and

•

provide certainty as to how foreign currency gains and losses are brought to account for tax purposes.

Implementation options

4.2 The measure to reform taxation of foreign currency gains and losses includes the following elements.

•

A general translation rule is introduced into the income tax law that translates foreign currency denominated amounts into A$ so that Australian income tax liability is calculated by reference to a common unit of account.

•

A 'functional currency' rule is introduced. Under this rule, the net income or loss of an entity (or specified part of an entity) that functions predominantly in foreign currency can be determined in that currency, with the net amount being converted into A$. The functional currency rule is directed at lowering compliance costs associated with the general translation rule.

•

A core realisation principle is introduced into the income tax law which, together with the translation rule, ensures that foreign currency gains and losses are generally brought to account when realised, regardless of whether there is an actual conversion of foreign currency amounts into A$. This addresses a number of uncertainties and anomalies which arise under the current law's treatment of foreign currency gains and losses.

•

The amendments ensure that foreign currency gains and losses have a revenue character, subject to limited exceptions. This is done by including foreign currency gains in assessable income, and treating foreign currency losses as allowable deductions, when they are realised.

•

Exceptions to the timing and characterisation aspects of the realisation approach where the foreign currency gain or loss is closely linked to a capital asset, are introduced. This addresses anomalies between the proposed provisions dealing with the taxation treatment of foreign currency gains and losses and the capital gains and capital allowances provisions.

•

Roll-over relief is provided for foreign currency gains and losses of an issuer of short term discounted securities issued under certain finance facility agreements.

4.3 While not explicitly addressed in the recommendations made by A Tax System Redesigned, the proposed reforms are consistent with the recommendations made in this report to reform taxation of financial arrangements.

Assessment of impacts

4.4 The potential compliance, administrative and economic impacts of the measures in this bill have been carefully considered by the Government and through extensive consultation with the business sector. The final bill addresses a number of concerns raised in relation to compliance issues (see paragraph 4.12).

Impact group identification

4.5 The proposed reforms to the taxation of foreign currency gains and losses affects all taxable entities dealing in foreign currency, other than ADIs and non-ADI financial institutions. These entities have been excluded from the proposed foreign currency measures for the time being in view of the Government's proposal to introduce more extensive retranslation rules as part of further reform of taxation of financial arrangements. Deferring the application of the foreign currency measures of the bill will significantly reduce the compliance costs that these entities would have otherwise faced.

Analysis of costs/benefits

Compliance costs

4.6 The proposed foreign currency reforms address a number of uncertainties and anomalies under the current law's treatment of foreign currency gains and losses. Through roll-over relief, for example, the proposals better reflect commercial financing arrangements. Consequently, the reforms will improve neutrality, clarity and certainty in relation to the taxation of foreign currency gains and losses. In addition, the proposed reforms introduce a 'functional currency' approach that allows aggregation of foreign currency transactions to determine a net amount. These factors are expected to lower compliance costs relative to current law over the medium to long term.

4.7 Taxpayers are currently required to determine the income tax consequences of many foreign-currency-denominated transactions. To some degree, the principles contained in the proposed reforms are already present in the current law implying that, for many taxpayers, there is no or minimal change in compliance costs relative to the current position. However, there could be a small compliance impact for taxpayers in the short-term as they familiarise themselves with the new law.

4.8 In general, the impact of the proposed foreign currency reforms on individuals and small business is expected to be small to negligible, as these taxpayers rarely engage in complex foreign-currency-denominated transactions.

Administration costs

4.9 In terms of the impact on the ATO's administrative processes, no additional on-going costs are expected relative to the cost of administering the current law. However, there are likely to be some relatively small transitional costs associated with internal training, informing taxpayers of the new law and answering taxpayer questions on interpretation of the new law.

Government revenue

4.10 The impact on the Commonwealth's revenue collections is unquantifiable. However, the proposed reforms to the taxation of foreign currency gains and losses is expected to protect the Commonwealth's revenue base which is potentially at risk of being eroded due to the uncertainties of the current tax law.

Consultation

4.11 The proposed reforms have been subject to extensive consultation. Consultation occurred as part of the Review of Business Taxation over the period August 1998 to July 1999. Following the Government's plans to reform taxation of foreign currency gains and losses in the 2002-2003 Federal Budget, consultations were undertaken with industry representatives on the policy framework to implement this reform. Further consultations were undertaken based on exposure draft legislation that was released by the Government in December 2002.

4.12 Consultations on exposure draft legislation reveal some concerns about compliance costs associated with the transitional rules, the scope of the functional currency rules and how foreign currency denominated bank accounts are treated. The final bill addresses these concerns by:

•

providing taxpayers the option to elect existing transactions into the new rules and setting the commencement date at the beginning of the entity's income tax year commencing on or after 1 July 2003;

•

extending the functional currency election to cover Australian resident entities which are required to prepare financial accounts under the Corporations Act 2001, and which conduct their business and keep their accounts in a foreign currency, and to foreign investment funds; and

•

introducing a number of measures (namely, a FIFO rule, a retranslation rule and a de minimis rule) to lower compliance costs associated with calculating foreign currency gains and losses in respect of foreign currency denominated bank accounts.

Conclusion and recommended option

4.13 The proposed measure addresses a number of uncertainties and anomalies relating to the current taxation of foreign currency gains and losses. For these reasons, the proposed measure is expected to provide net benefits to the Australian economy.

Index

Schedule 1: Removal of taxing point on conversion or exchange of traditional securities

Schedule 2: Convertible interests

Schedule 3: Rights

Schedule 4: Foreign currency