Ruling Compendium

We assume that the RPS are debt interests under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997), as if they were equity interests Division 230 of the ITAA 1997 would generally not apply to them. This point should be clarified in the Example.

Example 1 needs more detailed analysis in relation to why an FX gain on redemption of the RPS would or would not be both 'incidental' and 'relevant' to gaining or producing section 23AJ of the Income Tax Assessment Act 1936 (ITAA 1936) NANE dividends.

This is needed because the alternative view is that any FX gain/loss realised on redemption would be treated as assessable/deductible on the basis that it is not 'relevant' to the derivation of any section 23AJ of the ITAA 1936 dividends.

The better view is that an FX gain or loss made on realisation of the RPS in Example 1 is assessable or deductible.

Example 1 should be removed because:

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that view is highly contentious and there is no clear technical basis for that view

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Example 1 involves a scenario that is very different from the other scenarios (with the exception of Example 2)

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it is unlikely to be relevant on a prospective basis, given the proposed changes to section 23AJ of the ITAA 1936.

The draft Ruling contemplates apportionment of a gain/loss in the context of Example 1 but does not provide any guidance as to the basis upon which such an apportionment would be made (paragraphs 23 and 83 of the draft Ruling).

No bifurcation or apportionment of a gain/loss in Example 1 should be required (see Rowdell Pty Ltd v FCT (1963) 111 CLR 106).

Apportionment in the manner suggested by the ATO would be extremely difficult from a practical and administrative perspective, particularly if the test is based on a taxpayer's intention/purpose in respect of an investment at different points in time.

Bifurcating gains/losses may also be difficult where exchange rates fluctuate.

Suggested action : The ATO should reconsider its comments on the apportionment of a gain/loss in the context of Example 1. If the ATO remains of the view, apportionment is required, the ATO needs to explain the precise basis on which the apportionment should be made (for example intention/purpose in respect of the financial arrangement - at inception/time of disposal) and illustrate this by way of additional examples.

The expression 'to the extent that' in subsections 230-30(2) and 230-30(3) indicate apportionment is required in applying these subsections.

Further, Rowdell is not relevant to the operation of subsection 230-30(2). Unlike subsection 230-30(2), the provision considered by the Court in that case (former section 50 of the ITAA 1936) did not contain the classic words of apportionment 'to the extent that', and did contain a test of 'relates directly'.

Where it is necessary to apportion a loss or outgoing, the appropriate method of apportionment will depend on the facts of each case.

This Ruling does not attempt to set out the only way in which a 'fair and reasonable' basis for apportionment might be found, or a basis that will be appropriate in all circumstances. However, further clarification of the principles has been provided in paragraphs 15 and 16 of the Ruling, and a possible apportionment basis at paragraphs 95 to 99.

The draft Ruling should comment on the implications of the foreign resident selling down the loan prior to maturity for an amount in excess of face value.

Ruling section should comment on the asymmetric treatment of FX gains and losses referable to interest expense on borrowings and relevant rules/principles should be illustrated as part of Example 3.

From a policy view point, suggested law should be amended so that FX gain is assessable if an FX loss is deductible. Paragraph 230-30(2)(b) of the ITAA 1997 should be amended to ensure that such FX gains are assessable in the future.

The ATO will analyse this issue and raise it with Treasury, if appropriate.

ATO should provide guidance on how gain or loss would be apportioned.

Additional examples suggested involving change in purpose of use of borrowed funds over period of loan, and change in character of income over period of loan.

Facts in Example 3 assume US subsidiary will pay dividends, ATO ID 2010/173 takes views that an FX gain on repayment of a loan to acquire preference shares is 'reasonably expected' to pay section 23AJ of the ITAA 1936 dividends and similar view adopted in ATO ID 2010/186.

Example 3 should clarify that the requisite nexus with NANE income will be satisfied if there is a reasonable expectation of section 23AJ dividends.

Draft Ruling does not adequately discuss the differences between Example 4 (declared dividend) and Example 5 (forecasted earnings). Not clear whether a dividend must actually be declared for any gain/loss on a related FX hedge to be NANE/non-deductible.

Suggested action: ATO should clarify its views on the treatment of FX hedges relating to anticipated or expected dividends as opposed to declared dividends and, to the extent possible, set out a 'bright-line' test in the Ruling (for example gains/losses on FX hedges over declared section 23AJ of the ITAA 1936 dividends would have the requisite nexus to NANE income).

ATO should provide further clarification on what it believes constitutes an 'expectation of making a gain.'

Suggested action:

1. ATO should amend paragraph 34 so:

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it is clear that comments about transactions entered into for speculative purposes do not apply where the FX hedge exactly matches the amount of the declared dividend

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it refers specifically to portfolio/pooled hedging arrangements and under or over hedging an FX exposure

2. ATO should amend paragraph 98 so:

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it refers to entering into the hedging arrangement for the purpose of making a speculative gain (as opposed to merely with the expectation of making a gain).

3. ATO should:

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include a specific example dealing with the entry into an FX forward contract for an amount other than the amount of the declared dividend.

1. Amendments have been made to paragraph 34 of the draft Ruling (paragraph 41 of the Ruling) so that it is clear that there is a distinction between the pursuit of a speculative gain and mitigation of risk. Purpose is a conclusion made from a close consideration of all of the relevant facts which means it cannot be said that under or over-hedging is determinative of a particular purpose. Pooled hedging arrangements raise complex issues that are beyond the scope of this Ruling but may be appropriate for a further guidance product.

Further, amendments have been made to make clear the distinction between a purpose of expecting a gain and expecting a gain as an incidental consequence of pursuing a different purpose (paragraph 116 of the Ruling).

2. Paragraph 98 of the draft Ruling (paragraph 119 of the Ruling) has been amended to refer to a speculative gain.

3. An additional example has not been included, given the additional detail added to paragraphs 41, 116 and 119 of the Ruling.

Conclusion in paragraph 37 of the draft Ruling is that a loss on the forward contract would not have the requisite nexus to the NANE income. However it then states 'Consequently, subsection 230-30(3) applies and the loss is not deductible under subsection 230-15(2).'

Draft Ruling does not adequately describe taxpayer's purpose in respect of the forward contract in Example 5.

Facts in Example 5 are ambiguous whether the foreign risk is:

1.

in respect of translating the sub's results to AUD; and/or

2.

the risk on repatriating the earnings as a dividend to Aust Co.

Suggested action:

Describe facts in Example 5 in greater detail so it is clear what Aust Co's purpose is in respect of the forward contract

Provide further clarification on what the ATO believes does and does not constitute the requisite nexus to NANE or exempt income.

Taxpayer's purpose in respect of the forward contract can be made clearer.

Although we agree with the conclusion in Example 6 (in relation to foreign exchange gains and losses), it is not entirely clear as to on precisely what basis the ATO was reaching this conclusion.

The reasoning in relation to why the FX loss would be deductible under section 230-15(2) of the ITAA 1997 (refer paragraph 105) should be clearly stated in the Ruling.

The statement in paragraph 40 of the draft Ruling that 'The change in fair value of an investment held on an ongoing basis does not affect the NANE income producing potential form that activity' should be clarified that the ATO is saying that any FX loss will not have the requisite nexus with either section 23AJ of the ITAA 1936 dividends or any potential Subdivision 768-G of the ITAA 1997 gain (as the loss is too remote from any such gain realised on disposal).

It is not clear whether Example 6 is consistent with the ATO's approach in ATO ID 2010/212.

The Ruling should discuss how the analysis in Example 6 would be applied to the fact pattern considered in ATO ID 2010/212 (and analogous fact patterns). Based on Example 6 the gain realised on the FX swap in ATO ID 2010/212 should be assessable.

The hypothetical loss on the FX swap had a sufficient nexus with the production of NANE income because the purpose of entering into the FX swap was to convert proceeds from an AUD borrowing to USD and on-lend to its foreign subsidiary. That is, the FX swap was an integral part of the funding arrangements.

This can be contrasted with the facts of Example 6 which involves a forward contract entered into in relation to the cost of the foreign shares and in circumstances removed from the funding arrangements.

The draft Ruling states that a gain or loss on the FX forward in Example 6 would not have the requisite nexus to NANE income '...even if the need for protection arises from the existence of an obligation to repay a borrowing used to acquire the investment'. This is an important point and should be made clear in the Ruling section.

There should be a clear statement that gains and losses from hedging arrangements are assessable/deductible when (i) the hedging arrangement relates to the principal amount of the investment (as per Example 6) and (ii) the hedging arrangement relates to borrowings used to fund the investment (as per paragraph 142 of the draft Ruling).

The determination of assessability and deductibility in these circumstances is very much dependent on all of the relevant facts.

The Ruling should state that the principles discussed 'are also applicable in the context of Division 775', rather than merely providing 'some guidance'.

Consideration could be given to raising the topic for inclusion on the Public Rulings Program.

Paragraph 7 states that the draft Ruling '...does not consider the tax treatment of a gain or loss made in relation to a hedge of a net investment in a foreign operation (within the meaning of the Australian accounting standards)'.

The ATO needs to clarify the intended meaning and significance of paragraph 7 of the draft Ruling. It is particularly odd given that Examples 5 and 6 seem to involve NIFO hedges (which should be made clear in the Ruling).

Nonetheless this Ruling does not address specifically issues arising from NIFO hedging, which often involve more complex fact patterns and complex accounting issues. Consideration of these specific matters should not delay the Ruling which has a wider and more general application.

Whether or not the hedges considered in Examples 5 and 6 are NIFO hedges within the meaning of the Australian accounting standards is not of itself relevant to the analysis of those examples.

The principles set out in the Ruling should apply to all FX derivatives (such as cross currency swaps). This should be made clear in the Ruling.

1. The draft Ruling deals with potential gains/losses realised on disposal of a NANE income producing asset (explanation for Example 6). The views expressed in paragraphs 103 and 106 of the draft Ruling should be reflected in the Ruling section and require further discussion/analysis.

2. In paragraph 56 of the draft Ruling the ATO states that a loss under a transaction may have a close connection with the (expected) gain under that transaction (rather than a connection with NANE dividends). In paragraph 57 of the draft Ruling, it is stated that examples of this could be:

(i)

a forward contract entered into for speculative purposes; and

(ii)

a foreign currency denominated investment entered into with the expectation of receiving low periodic returns and also a large foreign exchange gain on disposal or maturity.

This second example in relation to an FX gain on maturity appears to be at odds with the other comments in relation to gains/losses on disposal. We consider that this statement should be clarified.

2. As to paragraphs 57 of the draft Ruling, we have made it clear (at paragraph 68 of the Ruling) that where the activity is the pursuit of a total return comprising a low periodic return that is NANE income and a large foreign exchange gain then any foreign exchange loss in relation to the investment is not sufficiently connected with the gaining of the NANE income.

The ATO concludes that if an arrangement cannot give rise to a loss as a matter of fact, a gain from the arrangement will not be capable of being a hypothetical loss under the financial arrangement and therefore cannot be covered by subsection 230-30(2) of the ITAA 1997.

Clarification is required where a loss may be limited under the terms of the financial arrangement. As noted at paragraph 61 of the draft Ruling, a particular instrument may contain a feature which effectively eliminates the risk of making a loss, while retaining the ability to make the corresponding gain. If that instrument eliminates the risk of making a loss up to a specified amount only, the Ruling should clarify whether a gain could also be exempt or NANE income under subsection.230-30(2) of the ITAA 1997 up to the same amount.

However, the Ruling has been amended (see paragraphs 19 and 72 of the Ruling) to modify the scope of the observation in the draft Ruling.

The ATO should provide a definitive view in the Ruling that a gain or loss made on a financial arrangement is assessable/deductible unless there is a 'direct' nexus to the derivation of exempt or NANE income, and the Ruling requires a more detailed explanation of what constitutes such a 'direct' nexus supported by the type of additional examples suggested in the Professional Bodies' submission.