House of Representatives

Explanatory Memorandum

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

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].