House of Representatives

Explanatory Memorandum

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

Chapter 4 The compounding accruals and realisation methods

Outline of chapter

4.1 This chapter explains:

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the rationale for compounding accruals and realisation tax treatment;

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what compounding accruals and realisation are;

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the basis for determining when taxpayers apply the compounding accruals or the realisation method to a financial arrangement;

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the manner in which the compounding accruals and realisation methods are applied;

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when a re-assessment of the compounding accruals or realisation method should apply to a gain or loss arising from a financial arrangement; and

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the application of the re-estimation and running balancing adjustment provisions.

Overview of compounding accruals and realisation methods

4.2 The compounding accruals and realisation methods are the default methods of taxation under Division 230. These tax-timing methods will apply to those financial arrangements that are not subject to any of the elective tax-timing methods. The compounding accruals tax-timing method ('accruals method') will apply where there is a sufficiently certain overall gain or loss or a sufficiently certain particular gain or loss in respect of a financial arrangement. If there is neither a sufficiently certain overall gain or loss nor a sufficiently certain particular gain or loss in respect of a financial arrangement then it will be subject to the realisation tax-timing method ('realisation method').

4.3 An example of a sufficiently certain particular gain is where a contingency under an interest rate swap becomes settled, that is, it becomes certain that a payment is to be made that will give rise to a certain gain.

4.4 If neither a sufficiently certain overall gain or loss nor a sufficiently certain particular gain or loss arises in respect of a financial arrangement, the gains and losses in respect of that financial arrangement will be calculated using the realisation method.

Accruals method

4.5 There are two circumstances which require the spreading of gains and losses under the accruals method. The first applies where there is a sufficiently certain overall gain or loss. The second applies where there is a sufficiently certain particular gain or loss.

4.6 A sufficiently certain overall gain will only arise where the sufficiently certain financial benefits that the taxpayer is to receive exceed the cost of the financial arrangement, that is, the sufficiently certain financial benefits that a taxpayer is to provide (or vice versa for an overall loss), measured in nominal terms.

4.7 When a sufficiently certain overall gain or loss does not arise in respect of a financial arrangement, the accruals method will apply if there is a sufficiently certain particular gain or loss under that financial arrangement in respect of a particular financial benefit or financial benefits, measured in nominal terms.

4.8 A sufficiently certain particular gain or loss arises from a financial benefit that the taxpayer is to receive or provide under the arrangement, if it is sufficiently certain at a particular time before that financial benefit is to be received or provided that the taxpayer will make that gain or loss.

4.9 The accruals method is intended to bring to account sufficiently certain overall gains or losses and sufficiently certain particular gains or losses to prevent inappropriate tax deferral in relation to the recognition of that gain or loss.

Way in which gains and losses are to be spread

4.10 The core method for spreading sufficiently certain gains or losses uses compounding accruals. This is conceptually identical to the 'effective interest rate' method required by Australian Accounting Standard AASB 139 Financial Instruments: Recognition and Measurement (AASB 139) in so far as they both reflect the concept of interest on interest. The 'effective interest rate' method is a method of calculating the amortised cost of a financial instrument and of allocating the interest income or interest expense over the relevant time period (usually the term of the financial instrument). It is also the same as the internal rate of return.

4.11 There are specific rules in the accruals method with respect to certain gains or losses from fees and costs ('portfolio fees') and premiums and discounts ('portfolio premium/discount') arising from a financial arrangement that are part of a portfolio of similar financial arrangements. If eligible, a taxpayer can make an irrevocable election to spread the portfolio fees and portfolio premium/discount over a period that equals the expected life of the portfolio of which the financial arrangement is a part.

Spreading using other methods

4.12 It is possible to use another type of accruals for sufficiently certain gains or losses but the outcome under the alternative method (such as straight line spreading) must approximate the outcome under compounding accruals.

The realisation method

4.13 The realisation method brings to account gains or losses in the income year in which the gain or loss occurs. Generally, a gain or loss occurs when the last of the financial benefits is provided or is to be provided, that is, when the gain or loss comes home to the taxpayer.

Reassessment of application of accruals or realisation method

4.14 A taxpayer is only required to reassess whether the accruals or realisation method is appropriately applied to a gain or loss where there is a material change in the terms and conditions of the arrangement, or the circumstances affecting the arrangement. Whether a change is a material change depends on the facts and circumstances of the relevant arrangement.

Re-estimation of accrued gain or loss

4.15 Generally, for many financial arrangements, the accruals method will apply to the relevant gain or loss for the term of the financial arrangement. However, it may be necessary to re-estimate the accrued gain or loss during the term of the financial arrangement. An example is where circumstances change such that certain financial benefits are no longer contingent which changes the amount of the gain or loss that is sufficiently certain.

4.16 It will be necessary to re-estimate a gain or loss from a financial arrangement if:

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the compounding accruals method applies to that gain or loss; and

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there is a material change to the circumstances that affect the estimate in respect of an amount or value of a financial benefit or the timing of the provision of a financial benefit.

Running balancing adjustments

4.17 Running balancing adjustments are needed because the accruals method applies to estimated cash flows which may differ from the actual cash flows. The running balancing adjustments are to ensure that the correct amount of gain or loss is subject to tax over the life of the financial arrangement.

4.18 When a financial benefit is received or provided (or the time comes for the financial benefit to be received or provided), a balancing adjustment may be required. A running balancing adjustment is the difference between the estimated value of a financial benefit and the amount that a taxpayer receives or provides. The running balancing adjustment may be included in assessable income if the estimated value of the financial benefit is less than the actual financial benefit or may be allowed as a deduction if the estimated value of the financial benefit exceeds the actual financial benefit.

Context of amendments

4.19 Under the current law, the scope of accruals tax treatment has broadened through legislative and judicial developments over recent decades. However, the current accruals system is incomplete and has not adapted sufficiently to be able to deal effectively with the rapid pace of financial innovation. The application of the accruals method under Division 230 will further broaden the scope of accruals tax treatment. This further broadening mainly reflects the need to modernise the tax treatment of financial arrangements in order for it to appropriately apply to newer, innovative financial arrangements and also for it to operate in a generally consistent manner for both traditional arrangements and hybrid financial arrangements.

4.20 The realisation tax treatment has provided a basic treatment that applies when no other tax-timing treatment is appropriate. This role for realisation treatment is to remain essentially unchanged.

4.21 In general, the setting of the borderline between the realisation regime and the accruals regime in Division 230 takes into account the need to prevent manipulation and tax deferral, and the need to avoid the early and premature taxation of significant, unsystematic gains and losses that may not be realised.

What is accruals?

4.22 Compounding accruals in the context of the taxation of financial arrangements refers to the allocation or spreading of gains or losses over time, where the gain or loss is calculated by reference to known or estimated future amounts (represented by the financial benefits under the arrangement) and on the assumption that the entity will continue to have the arrangement for its remaining term.

4.23 Compounding accruals, in this sense, is in contrast to the concept of fair value, which calculates the gain or loss in each period by effectively assuming that the entity ceases to have the financial arrangement, which it holds, at the end of each income period and starts to have it at the beginning of the next period. This distinction between compounding accruals and fair value is important because it means that the volatility which can arise when gains and losses are accounted for on a fair value basis can be smoothed by spreading (using the compounding accruals method) the estimated gains or losses over a number of income periods.

4.24 This smoothing means that - relative to the outcomes from the fair value tax method - taxpayers will generally not be required to pay tax on unsystematic gains that may not be realised. The likelihood of this happening is further reduced by the principle which governs the circumstances in which the accruals method should apply. In principle, it should apply to spread estimated gains and losses that are sufficiently certain. The gains and losses that are so spread are then the subject of taxation.

4.25 The period over which the sufficiently certain gains or losses are intended to be spread is the period to which the gains or losses relate. The intended basis of allocation of the relevant gain or loss under this accruals (spreading) principle reflects the financial concept of interest on interest, or compound interest. For the purpose of Division 230, this form of accrual is referred to as 'compounding accruals'.

4.26 Insofar as they both incorporate the concept of interest on interest 'compounding accruals' allocation methodology is conceptually identical to the 'effective interest method' adopted by AASB 139 - that is, the financial accounting accruals methodology used to allocate gains and losses from loans, receivables, and held-to-maturity investments.

Why is compounding accruals important?

4.27 A compounding accruals principle is important for income tax purposes for two reasons. First, it moves tax outcomes closer to commercial (accounting) outcomes with attendant opportunities to reduce compliance costs. Second, and related to the first, it reduces tax deferral and tax arbitrage opportunities.

4.28 If the tax system relied only on a realisation tax method to tax all financial arrangements, opportunities would be created for taxpayers to delay the taxation of gains, and to bring forward losses and related tax deductions. This would undermine the revenue base and, over time, result in a distorted and inefficient allocation of investments and resources.

4.29 Compounding accruals methods generally recognise sufficiently certain (known or estimated) future gains and losses over the life of a financial arrangement. Such gains and losses, which are sufficiently certain to occur, can be subject to taxation on a compounding accruals (spreading) basis, rather than at realisation and will be brought to account under the compounding accruals method without significant unexpected, and potentially adverse, tax-based cash flow impacts on the taxpayer.

When does accruals treatment apply under the current income tax law?

4.30 Under the current income tax law, the main specific accruals rule is found in Division 16E of Part III of the Income Tax Assessment Act 1936 (ITAA 1936). As discussed below, Division 16E is limited in scope and is quite prescriptive in its operation.

4.31 Apart from Division 16E of the ITAA 1936, the question of whether accruals or realisation applies to a particular financial arrangement largely depends on the operation of the ordinary income and general deduction provisions in sections 6-5 and 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) respectively. For income, the issue turns on when the income is 'derived' and, for deductions, the issue turns on when a loss or outgoing is 'incurred'.

4.32 Whilst there is some authority for losses or outgoings to be incurred on an accruals basis in certain situations, there is very little clarity on whether, for example, interest or discount income is subject to accruals or realisation tax treatment. However, under Taxation Ruling TR 93/27, the Commissioner of Taxation has ruled that the interest income and expense of a financial institution may be brought to account on an accruals basis.

Division 16E of the ITAA 1936

4.33 Division 16E of the ITAA 1936 was introduced into the tax law in 1984 to remove the then existing distortions and tax deferral opportunities arising out of long term (more than 12 months) discounted and deferred interest securities. Before the introduction of Division 16E, a taxpayer (eg, a financial institution) could issue long term debt instruments, which deferred payment of interest until maturity, but could claim a deduction for interest on an accruals basis. However, a non-financial institution that held those instruments did not have to pay tax on the interest until the cash was received at maturity. The purpose of Division 16E was to remove such tax deferral opportunities by bringing the interest to tax on an accruals basis.

4.34 In general, Division 16E of the ITAA 1936 applies to qualifying securities where the non-periodic (ie, deferred) receipts are reasonably likely to exceed the payment needed to acquire the security. In broad terms, Division 16E spreads discount and deferred interest income to the holder, and corresponding expense to the issuer, of the security on a semi-annual compounding basis.

4.35 Division 16E of the ITAA 1936 has a relatively narrow scope. Where Division 16E does not apply, the tax-timing treatment of discount income and discount expense remains uncertain. There are gaps in the application of Division 16E - for instance in the case of premiums and market discounts that arise after issuance when the security is not a qualifying security.

4.36 There is general uncertainty over whether, and if so how, accruals tax treatment applies to various financial arrangements, including swaps, other derivatives, and hybrid arrangements.

4.37 The incomplete coverage of Division 16E of the ITAA 1936 creates complexity, anomalies and opportunities for tax deferral, avoidance and manipulation.

What is realisation?

4.38 Realisation tax treatment has been a common and traditional basis for recognising gains and losses from financial arrangements under the current law.

4.39 The realisation method applies in Division 230 to bring to account gains or losses in the income year in which the gain or loss occurs. Generally, a gain or loss occurs when the last of the financial benefits that are taken into account in calculating the relevant gain or loss is provided or is to be provided - that is when the gain or loss comes home to the taxpayer. Hence, if a gain or loss under a financial arrangement is subject to the realisation method, and a number of financial benefits are to be provided under the arrangement, there may be a number of separate gains or losses brought to account under that method at different points in time.

4.40 The application of the realisation method is distinguished from circumstances where the taxpayer must apply the balancing adjustment provisions in Subdivision 230-G. The balancing adjustment applies where the taxpayer ceases to have all of their rights or obligations under an arrangement or where the taxpayer transfers some or all of their rights and obligations under the arrangement - that is when the financial arrangement is disposed of or partly disposed of. The realisation method generally applies where particular rights or obligations come to an end through performance of those rights or obligations. Chapter 10 discusses the consequences of disposing of financial arrangements.

4.41 It is possible for both the compounding accruals method and the realisation method to apply to gains or losses arising from a single financial arrangement. This may occur because some of the financial benefits under the financial arrangement are sufficiently certain and others are not. The sufficiently certain financial benefits may give rise to either an overall, or a particular, gain or loss that will be subject to the compounding accruals method and the remaining financial benefits that are not sufficiently certain in regards to occurrence or as to at least some of the amount will, at the appropriate time, give rise to a gain or loss that is brought to account under the realisation method.

Summary of new law

4.42 Division 230 provides for a number of methods that can be applied to determine when gains or losses that a taxpayer makes from a financial arrangement should be brought to account for tax purposes. Where none of the elections available under Division 230 have been made, the compounding accruals method or the realisation method will apply.

4.43 The assessment of whether compounding accruals tax treatment is appropriate or not for any particular financial arrangement is to be based on an objective evaluation of the relevant considerations. In particular, regard must be had to the terms and conditions of the financial arrangement, accepted pricing and valuation techniques and the economic, or commercial, substance or effect of the financial arrangement.

The compounding accruals method

4.44 Under Subdivision 230-B, a taxpayer must apply the compounding accruals tax-timing method to a gain, or loss, from a financial arrangement when there is sufficient certainty that such a gain, or loss, will occur. The gain or loss may either be a gain or loss in respect of the entire financial arrangement (a 'sufficiently certain overall gain or loss') or a gain or loss made in respect of particular financial benefits (a 'sufficiently certain particular gain or loss').

4.45 The sufficiently certain overall gain or loss is determined by reference to the difference between the sum of all known and expected outlays (payments) and all known and expected inflows (receipts). These inflows and outflows are represented by the financial benefits to be received and provided under the relevant financial arrangement. A sufficiently certain overall gain will only arise if expected inflows under an arrangement will exceed all known and expected outlays such that there will be a gain of at least a specific amount. The converse is true for a sufficiently certain overall loss.

4.46 A sufficiently certain particular gain or loss can also arise under a financial arrangement in respect of a particular financial benefit or particular financial benefits. Such a gain or loss may arise where:

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it is sufficiently certain at the time when the taxpayer starts to have the arrangement, but before the taxpayer is to receive or provide the financial benefit or benefits; or

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it becomes sufficiently certain after the time the taxpayer starts to have the arrangement, but before the taxpayer is to receive or provide the financial benefit.

4.47 If there is a material change to circumstances, or to terms and conditions, adjustments may be required to be made to the amount of the gain or loss that is accrued during the term of the financial arrangement. Such material changes may also affect whether the compounding accruals method will continue to apply to a gain or loss, or if the realisation method becomes more appropriate.

4.48 Individuals and entities (other than an individual) which fall below the threshold test in section 230-455, will only be subject to Division 230 in respect of a financial arrangement that has a term of more than 12 months and is a 'qualifying security', within the meaning of that term in Division 16E of the ITAA 1936. However, such taxpayers can make an election for Division 230 to apply to all of their financial arrangements (see Chapter 2).

4.49 The spreading of the sufficiently certain gain or loss for tax purposes is done using a compounding accruals method, or a method whose results approximate those obtained using the prescribed method.

4.50 If the compounding accruals method does not apply to a financial arrangement, or to some of the financial benefits under the financial arrangement because the gain or loss in respect of those benefits is not sufficiently certain, then the realisation method applies to bring to account those gains or losses arising from that financial arrangement or part thereof.

The realisation method

4.51 A gain or loss from a financial arrangement is brought to account under the realisation method in Subdivision 230-B when no other tax-timing method is appropriate and:

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when a financial benefit is received or provided under the financial arrangement; or

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if a financial benefit is not received or provided at the time it is due, when the time comes for that financial benefit to be received or provided under the financial arrangement.

4.52 The gain or loss recognised under the realisation method is the difference between the amount received or provided, or the amount which is to be received or provided, and the cost of the financial arrangement which is attributable to that financial benefit. The general approach under Division 230 to determining whether realisation tax-timing treatment for a gain or loss is appropriate, and the basis of applying the realisation tax-timing treatment, is largely unchanged from the existing law (to the extent that the existing law operates in respect of gains and losses rather than receipts and outgoings). That is, the realisation tax-timing treatment applies where other tax-timing treatments are inappropriate. Gains and losses that are subject to the realisation method are recognised in the income year in which the time comes for the last of the financial benefits which are taken into account in calculating the gain or loss received or provided - or the income year in which the financial benefit is actually received or provided (that is, the time at which the gain or loss occurs for Division 230 purposes).

Accruals Diagram 1: Application

Comparison of key features of new law and current law

Detailed explanation of new law

4.53 The main object of the accruals and realisation methods is to properly recognise gains or losses from financial arrangements by allocating such gains or losses to appropriate periods of time [ Schedule 1, item 1, paragraph 230-95(a )]. The compounding accruals method provided for in Subdivision 230-B is also intended to reflect commercial accounting concepts, so as to reduce compliance costs for taxpayers [ Schedule 1, item 1, paragraph 230-95(b )].

4.54 The compounding accruals method is also intended to minimise tax deferral, which could occur under a realisation method [ Schedule 1, item 1, paragraph 230-95(c )]. This is reflected in the main object of Subdivision 230-B, as proper allocation of gains and losses to the periods to which they relate also reduces tax deferral.

4.55 The question of whether accruals or realisation treatment is applicable to a financial arrangement is determined by the nature of the terms, conditions, pricing and valuation techniques used; the nature of the financial benefits under the arrangement; and whether there is sufficient certainty in respect of the gain or loss.

Application of the accruals and realisation methods to individuals and certain entities

4.56 Generally, Division 230 does not apply to the financial arrangement gains or losses of individuals, or to entities that satisfy the relevant threshold tests in section 230-445, unless an election to have the Division apply has been made [ Schedule 1, item 1, subsection 230-455(7 )]. However, if such an individual or an entity which has not made an election under subsection 230-455(7) has a financial arrangement that is a 'qualifying security' within the meaning of Division 16E of the ITAA 1936, and that security has a remaining term after acquisition of more than 12 months, the accruals method under Division 230 may apply to that financial arrangement [ Schedule 1, item 1, subsection 230-455(1 )]. The application of Division 230 to individuals and to entities that satisfy the threshold test is further discussed in Chapter 2.

4.57 Where such an entity has a qualifying security that is a financial arrangement, the accruals method will apply to bring to account the gain or loss from the qualifying security only where the gain or loss satisfies the conditions for being a sufficiently certain overall gain or loss [ Schedule 1, item 1, subsection 230-105(1 )]. The compounding accruals method will not apply to a sufficiently certain particular gain or loss from a financial arrangement held by such an entity [ Schedule 1, item 1, subsection 230-100(4 )].

4.58 The exclusion of individuals and those relevant entities from the sufficiently certain particular gain or loss provisions is intended to provide a compliance cost saving in respect of such instruments. The requirement to have to attribute particular financial benefits that are provided, or that are expected to be provided (outlays), to those that are received, or that are expected to be received (inflows), is avoided by the application of the sufficiently certain overall gain or loss concept. A sufficiently certain overall gain can only arise where the sufficiently certain financial benefits that are to be received exceed the sufficiently certain financial benefits that are to be provided (or vice versa for a loss) [ Schedule 1, item 1, subsection 230-105(1 )]. Hence, under the overall gain or loss concept, all of the 'cost' of the financial benefits that are to be provided under the financial arrangement will be automatically attributed to those sufficiently certain financial benefits that are to be received at the start of the arrangement.

4.59 In cases where there is a sufficiently certain overall gain or loss under a qualifying security held by taxpayers which would not otherwise be subject to Division 230, and there are one or more financial benefits that become sufficiently certain after the start of the qualifying security, the realisation method will apply to gains or losses arising from those financial benefits. [ Schedule 1, item 1, subsection 230-100(5 )]

4.60 However, if the individual, or the entity that satisfies the threshold test, makes an election under subsection 230-455(7) to have Division 230 apply to its financial arrangements, then the compounding accruals method may apply to particular gains or losses made under the relevant qualifying security. [ Schedule 1, item 1, paragraph 230-100(4)(c )]

When to use the compounding accruals method?

4.61 If an entity does not opt for one of the elective tax-timing methods in Division 230 to apply to its relevant financial arrangements, or the entity does make such a choice but no elective method applies to a particular financial arrangement, the default tax-timing method will be either the compounding accruals or realisation method, or a combination of these methods, which will be applied to bring to account gains or losses made from the particular financial arrangement [ Schedule 1, item 1, subsection 230-40(4 )]. The compounding accruals method applies where there is a sufficiently certain gain or loss from the financial arrangement. A gain or loss arising from a financial arrangement will be sufficiently certain if the financial benefits used to calculate that gain or loss are themselves sufficiently certain (see paragraphs 4.97 to 4.117).

4.62 If the financial arrangement is denominated in a foreign currency, and a retranslation election has been made by the taxpayer, the accruals or realisation tax treatments may still apply to the gain or loss to the extent that it is not subject to the retranslation election. [ Schedule 1, item 1, paragraph 230-40(4)(b )]

4.63 If the hedging financial arrangement method applies to a financial arrangement, and that arrangement is a foreign currency hedge that is a 'debt interest' (as defined in Division 974 of the ITAA 1997), only the gain or loss that is attributable to movements in currency exchange rates, in respect of the outstanding balance in relation to the debt interest, is brought to account under the hedging financial arrangement election [ Schedule 1, item 1, subsections 230-300(7) and (8 )]. The gain or loss that may arise from the foreign currency hedge, other than that specified under the hedging rules and absent any other elections under Division 230, would then be subject to the accruals or realisation methods as appropriate [ Schedule 1, item 1, paragraph 230-40(4)(c )].

Sufficiently certain gain and loss - an overview

4.64 For the purposes of the accruals provisions, gains and losses which arise from financial arrangements may be an overall gain or loss or a particular gain or loss. That gain or loss is calculated with reference to sufficiently certain financial benefits which are to be received and provided under the financial arrangement.

4.65 Financial arrangements may incorporate financial benefits that are paid or received on a periodic and/or non-periodic basis. Most commonly, but not always, financial benefits are represented by cash inflows (for rights to receive) and cash outflows (for obligations to pay). For example, an annual interest payment on a bond would be a financial benefit that would be paid on a periodic basis. A non-periodic financial benefit would be represented by the end payment (return) of an initial outlay when a bond reaches full term, or by a partial return of the initial outlay. Hybrid financial arrangements may also comprise both periodic and non-periodic financial benefits - a convertible note, or an equity-linked bond, usually incorporates both periodic and non-periodic payments. If financial benefits are periodic, generally, subject to the facts and circumstances of each case, such benefits could be reasonably expected to be paid or received.

4.66 Both periodic and non-periodic financial benefits may be fixed in terms of amount and the time at which they will be paid or received (ie, they are completely certain) or they may be sufficiently certain, or they may not be sufficiently certain. Consequently, within the one financial arrangement there may be a mixture of different financial benefits some of which are sufficiently certain and some of which are not.

4.67 An overall gain or loss is that gain or loss generated by the entire financial arrangement. An overall gain, which is determined at inception, can only arise where all of the sufficiently certain financial benefits that are to be received will exceed the total of all of the sufficiently certain financial benefits that are to be provided (or vice versa for a loss). Hence, generally, an overall gain or loss will be calculated with reference to all of the financial benefits under the arrangement because those financial benefits are sufficiently certain at the start of the arrangement. There may be circumstances where an overall gain (or loss) arises from a financial arrangement, despite some of the financial benefits under the arrangement being not sufficiently certain. An example of this is where the total magnitude of an overall gain or loss may be unknown at inception, because of the existence of a contingent payment within the arrangement, but it may be known that an overall gain or loss of at least a specific amount will be made. This amount would be subject to the accruals method [ Schedule 1, item 1, subsection 230-105(1 )]. The compounding accruals method will apply to spread the sufficiently certain overall gain or loss over the life of the arrangement [ Schedule 1, item 1, subsection 230-130(1 )].

4.68 The concept of an overall gain or loss of at least a particular amount is important in the accruals provisions for two reasons:

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first, it is intended that where an overall gain or loss of at least a specific amount would be made from a financial arrangement, and that financial arrangement has an embedded option, none of the cost of the arrangement should be attributed to that embedded option; and

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second, the overall gain or loss concept is intended to deliver compliance cost savings by not requiring taxpayers to apply complex calculations to attribute the cost of the financial arrangement to expected financial benefits where it is clear that a gain or loss of at least a specific amount will be made from the financial arrangement.

4.69 A particular gain or loss is that gain or loss generated from a particular event under the arrangement (eg, the payment of a periodic return). As such, there could be several particular gains or losses arising under the one financial arrangement. For some financial arrangements (eg, hybrids) which may involve a mixture of both 'sufficiently certain' and 'not sufficiently certain' financial benefits, it may not be possible to determine at inception the expected overall gain or loss. It may, however, be possible to estimate a sufficiently certain particular gain or loss that will be made from such arrangements in advance of the time at which the relevant financial benefits will be received or provided. Those particular gains or losses would then be subject to compounding accruals treatment. Those periodic payments that may not become known in advance of payment or receipt with sufficient certainty will give rise to gains or losses that will be subject to realisation tax treatment.

4.70 The particular gain or loss concept encapsulates one of the key objects of the accruals methodology - that is, gains or losses are to be recognised as they become sufficiently certain and are to be attributed to the period to which that particular gain or loss relates [ Schedule 1, item 1, paragraph 230-95(a )]. By recognising gains and losses in this manner, inappropriate deferral of gains and bringing forward of losses is avoided.

Sufficiently certain overall gain and loss

4.71 A taxpayer must allocate a gain or loss from a financial arrangement using the compounding accruals method when there is sufficient certainty, at the time the taxpayer starts to have the arrangement, that the taxpayer will make an overall gain or loss under the arrangement [ Schedule 1, item 1, subsection 230-100(2 )]. An overall gain will only arise where the sufficiently certain financial benefits that the taxpayer is to receive exceed the cost of the financial arrangement, that is, the sufficiently certain financial benefits that a taxpayer is to provide (or vice versa for an overall loss) [ Schedule 1, item 1, note to paragraph 230-100(2)(b )].

4.72 In this sense, the overall gain or loss necessarily requires that the entire 'cost' (ie, the financial benefits that have been or are to be provided) of the financial arrangement be attributed to those sufficiently certain financial benefits that are to be received. This will be the case despite the fact that economically some of that cost may be attributable to other financial benefits that are not sufficiently certain at the start of the arrangement. [ Schedule 1, item 1, note to subsection 230-105(1 )]

4.73 In calculating the sufficiently certain overall gain or loss it must be assumed that the taxpayer will have the financial arrangement for the rest of its life [ Schedule 1, item 1, paragraph 230-105(2)(a )]. Generally, the life of a financial arrangement is dictated by the period between the time the arrangement is created or acquired and its maturity date. This could also be referred to as the 'estimated life' of the arrangement. If, for example, a financial arrangement has no defined maturity date (eg, because it may last in perpetuity) then the life of the arrangement is taken to span the period into perpetuity. This assumption is important because, as was noted above, an overall gain or loss is generally generated from the entire arrangement.

4.74 The accruals provisions dealing with overall gains and losses are modified in circumstances where the financial arrangement that gives rise to the overall gain or loss is part of a portfolio of similar financial arrangements. In order to access portfolio treatment the taxpayer will need to make an irrevocable election and meet certain eligibility requirements. [ Schedule 1, item 1, sections 230-150 and 230-155 ]. Where an irrevocable election is made, the portfolio fees from and the portfolio premium/discount on the financial arrangement are spread over the expected life of the portfolio rather than under the general accruals rules for overall gains and losses [ Schedule 1, item 1, subsections 230-160(3) to (5) and 230-165(3) to (5 )]. The portfolio treatment of fees and premiums/discounts is discussed in detail in paragraphs 4.153 to 4.167.

4.75 If there is a financial benefit that may reduce or eliminate an otherwise sufficiently certain overall gain or overall loss, it may be the case that it cannot be concluded with sufficient certainty that there will be an overall gain or overall loss of at least a particular amount [ Schedule 1, item 1, paragraph 230-105(2)(b )]. The overall gain or loss must be of at least a specific amount because it would be inappropriate to have a taxpayer accrue an amount of a gain or loss where there is insufficient certainty that it will be realised. If there is a sufficient risk that a financial benefit, that is itself not sufficiently certain at the start of the arrangement, may in fact reduce an amount of a gain or decrease an amount of a loss (such that part of the estimated gain or loss would never have been made), then it would be inappropriate to require an accrual of the otherwise sufficiently certain overall unrealised gain or unrealised loss. (At the same time, there may be a sufficiently certain particular gain or loss, as discussed in paragraphs 4.82 to 4.85.)

4.76 However, there may still be a sufficiently certain overall gain or loss which should be subject to the accruals method, despite the fact that there may be some financial benefits that are not sufficiently certain. Of particular relevance is the situation where the effect of those financial benefits which are not sufficiently certain will be to increase the amount of the sufficiently certain overall gain or loss. This is because, in such situations, there is sufficient certainty that the estimated overall gain or overall loss will be made, and the uncertainty generated by the financial benefit that is not sufficiently certain relates to whether the estimated gain or estimated loss will in fact be more than the specific amount of the overall gain or loss of at least a certain amount. In these circumstances, the accruals method is applied to the estimated overall gain or overall loss that is known with sufficient certainty at the start of the arrangement. In other situations, the financial benefits that are not sufficiently certain may be such that the likelihood of them reducing or eliminating an otherwise sufficiently certain overall gain or loss is artificial or 'immaterially remote'.

4.77 Once the contingency is resolved, in respect of those financial benefits which are not sufficiently certain at the start of the arrangement (as they become sufficiently certain), one of two outcomes may arise. First, the effect of those benefits becoming sufficiently certain may affect the amount of the previously estimated overall gain or loss so that a fresh determination of the overall gain or loss is required. If this is the case, then the implications of such an event are covered by the re-estimation provisions (see paragraphs 4.174 to 4.206).

4.78 Alternatively, the financial benefits that become sufficiently certain may themselves give rise to a gain or loss, separate to the estimated overall gain or overall loss. If the financial benefits give rise to a separate gain or loss, that gain or loss may be either:

•

accrued as a sufficiently certain particular gain or loss (where the financial benefit becomes sufficiently certain before it is received or provided) [ Schedule 1, item 1, subsection 230-100(3 )]; or

•

brought to account under the realisation method (where the uncertainty surrounding the financial benefit is resolved at the time it is received or paid, or the time comes for it to be received or paid) [ Schedule 1, item 1, subsection 230-100(5 )].

4.79 Broadly, arrangements which have the following characteristics may give rise to a sufficiently certain overall gain (for the holder) or overall loss (for the issuer):

•

periodic returns under the arrangement are determined and set in advance of the period to which they relate and are paid in arrears;

•

the initial outlay will be returned at maturity; and

•

if there are cash flows (financial benefits) that are not known at the start of the arrangement, those cash flows will not have the effect of reducing the estimated overall gain or loss.

4.80 Often periodic returns are calculated with reference to a variable (such as an interest rate) or the rate of change of a variable (such as the consumer price index (CPI)). This feature, which can affect the quantum of financial benefits arising under a financial arrangement, will not of itself affect whether there is an overall gain or overall loss from the arrangement. This is because in calculating the relevant gain or loss on a financial arrangement, the taxpayer is required to assume that the variable or the rate of change of the variable affecting the quantum of the financial benefit will remain constant for the period of the arrangement [ Schedule 1, item 1, subsections 230-115(4) and (5 )]. In this sense, the fact that the variable or the rate of change of the variable may vary, and hence may practically affect the amount of the gain or loss, is overcome by the required assumption. Any discrepancy between the assumed variable rate and the actual variable rate, provided the difference is insignificant, will be brought to account under the running balancing adjustment mechanism (see paragraphs 4.170 to 4.173).

4.81 Example 4.3 provides further guidance on when an overall gain or loss may arise.

Sufficiently certain particular gain or loss

4.82 The compounding accruals method will also apply to a particular gain or loss that arises from a financial benefit that the taxpayer is to receive or provide under the arrangement, if it is sufficiently certain at a particular time before that financial benefit is to be received or provided that the taxpayer will make that gain or loss [ Schedule 1, item 1, subsection 230-100(3 )]. The accruals method is intended to apply to bring to account sufficiently certain particular gains or losses so that there is no inappropriate deferral in relation to the recognition of that particular gain or loss [ Schedule 1, item 1, paragraphs 230-95(a) and (c )].

4.83 A sufficiently certain particular gain or loss arises where it is sufficiently certain at a particular time that a gain or loss of a particular amount, or at least a particular amount, will be made when:

•

the taxpayer receives a particular financial benefit or one of the taxpayer's rights ceases under the arrangement [ Schedule 1, item 1, paragraph 230-110(1)(c )]; or

•

the taxpayer provides a particular financial benefit or one of the taxpayer's obligations ceases under the arrangement [ Schedule 1, item 1, paragraph 230-110(1)(d )].

That is, the occurrence of one of the events listed above may give rise to a gain or loss. To calculate that gain or loss, which is a net concept for these purposes, there must be an offsetting of costs with proceeds. Depending on the circumstances, some part of the financial benefits the taxpayer has provided under the arrangement may be said to be reasonably attributable to the financial benefits that the taxpayer is to receive. This principle is encapsulated in sections 230-70 and 230-75 (about apportionment of financial benefits on receipt or payment of particular financial benefits), which will apply to calculate the amount of a sufficiently certain particular gain or loss [ Schedule 1, item 1, note to subsection 230-110(2 )]. Such apportionment must take into account the nature of the rights and obligations, risks associated with each of the rights, obligations and financial benefits and the time value of money (for further discussion see Chapter 3).

4.84 In order for the accruals method to apply, the amount of the sufficiently certain particular gain or loss will be a particular amount or at least a particular amount [ Schedule 1, item 1, paragraphs 230-110(1)(a) and (b )]. Therefore, in working out whether, at a particular time, there is a sufficiently certain particular gain or loss, the taxpayer must have regard to the risk that a particular financial benefit which is not sufficiently certain at that time will reduce or eliminate the amount of the gain or loss [ Schedule 1, item 1, paragraph 230-110(2)(a )]. For the same reasons as outlined in paragraph 4.75, this requirement ensures that taxpayers are not required to recognise gains or losses that may never be made, to the extent to which they are not sufficiently certain.

4.85 Further, under this attribution process, a financial benefit is not to be taken into account more than once in determining the gain or loss that will arise from a single financial arrangement [ Schedule 1, item 1, paragraphs 230-110(2)(b) and (c )]. This means that, to the extent to which a financial benefit that the taxpayer has or will provide under the arrangement has been allocated to a financial benefit that is to be received, that financial benefit that has or will be provided (or that part of the financial benefit that has or will be provided) is not to be taken into account (apportioned) to another financial benefit that is to be received. To recognise a particular financial benefit (or part thereof) more than once in respect of a single financial arrangement would result in the taxpayer recognising the same gain or loss more than once. Such an outcome is inappropriate, since economically the taxpayer has only made the gain or loss once.

Can there be more than one sufficiently certain gain or loss for a single financial arrangement?

4.86 It is possible for there to be more than one sufficiently certain gain or loss that is to be brought to account in respect of a single financial arrangement. Likewise, it is possible for there to be a number of separate sufficiently certain particular gains or losses under the same financial arrangement. Both a sufficiently certain overall gain or loss and sufficiently certain particular gains or losses can arise from a single financial arrangement.

4.87 This situation can arise because, despite the fact that some of the financial benefits under a financial arrangement are not sufficiently certain at the start of the arrangement, the financial benefits that are sufficiently certain at that time are such that they give rise to a sufficiently certain overall gain or loss (see discussion in paragraphs 4.71 to 4.81). When the other financial benefits under the financial arrangement not taken into account in determining the sufficiently certain overall gain or loss become sufficiently certain before they are due to be paid or received, a separate sufficiently certain particular gain or loss may arise. This sufficiently certain particular gain or loss is separate and distinct from the overall gain or loss calculated at the start of the arrangement and will be accrued separately from that overall gain or loss. The 'anti-overlap' provision in paragraphs 230-110(2)(b) and (c) - which requires that a particular financial benefit should not be taken into account more than once under a financial arrangement - operates to ensure that there is no double counting of gains or losses. [ Schedule 1, item 1, subsection 230-110(2 )]

Example 4.1 : A bond with contingent returns and guaranteed redemption value

Investor Co acquires from Issuer Co a 10-year bond for $100,000. The terms of the bond provide that Investor Co is entitled to annual interest payments of 8 per cent per annum, subject to Issuer Co agreeing to make the payment. At maturity, Investor Co is entitled to receive 120 per cent of the investment amount. Both entities exceed the threshold test in section 230-455.

Tax implications for Investor Co

When Investor Co starts to hold the financial arrangement, it must determine if it has a sufficiently certain gain or loss that would be subject to the accruals method. The relevant financial benefits are:

•

the payment of $120,000 at the end of 10 years (calculated with reference to the guaranteed payment of 120 per cent of the investment amount); and

•

each individual interest payment over the term of the bond (which is subject to Issuer Co agreeing to make the payment).

As discussed below, a sufficiently certain gain or loss is determined only by reference to financial benefits that are sufficiently certain (subsection 230-115(1)). A financial benefit is sufficiently certain if it is reasonably expected that the financial benefit will be received or provided (assuming the bond is held for its life - ie, until maturity) and that at least some of the amount or value of the financial benefit is fixed or determinable with reasonable accuracy (subsection 230-115(2)). Applying these criteria, it can be said that only the financial benefit represented by the payment of $120,000 due to be paid at the end of the 10 years can be said to be sufficiently certain at the start of the arrangement.

Hence, Investor Co has a sufficiently certain overall gain at the start of the arrangement because the financial benefit that it is sufficiently certain to receive exceeds the cost of the financial arrangement. The cost of the financial arrangement is represented by the $100,000 Investor Co paid to acquire the bond. That financial benefit is integral to calculating the overall gain or loss and hence is taken to be a financial benefit provided under the financial arrangement (subsection 230-60(2)). The amount of the difference between the sufficiently certain financial benefit provided and the financial benefit received is the sufficiently certain overall gain of $20,000 (ie, $120,000 less $100,000). The rights to the interest payments over the next 10 years, which are themselves subject to a contingency, such that it would not be reasonable to expect that those benefits will be received, will not have the effect of reducing this overall gain of $20,000. In fact, the contingent interest payments, if received, will have the effect of increasing the amount of the gain made on the financial arrangement as a whole. Hence, the compounding accruals method will apply to bring the overall sufficiently certain gain of $20,000, which is calculated at the start of the arrangement, to account over the life of the bond (subsection 230-130(1)).

If, some time after Investor Co acquires the bond, Issuer Co determines that it will make an interest payment two years before the payment is due, then once that determination is made, that financial benefit which represents the interest payment becomes sufficiently certain. From Investor Co's perspective, the amount of the gain is equal to the value of the entire interest payment (the relevant financial benefit) (subsection 230-75(3)). That gain is a sufficiently certain particular gain to which the compounding accruals method would apply to bring to account the amount of the gain over the next two years.

Tax implications for Issuer Co

From Issuer Co's perspective it has a sufficiently certain overall loss at the start of the arrangement of $20,000 (represented by the shortfall between the proceeds received from the issue of the bond and the payment required on redemption of the bond). The relevant financial benefits will be sufficiently certain at the start of the arrangement for the same reasons as outlined above. Provided the requirements of section 230-15 are satisfied, that overall loss is to be accrued over the life of the bond.

Further, on making the determination to pay interest, a sufficiently certain particular loss arises at the time of the determination. Provided the particular loss satisfies the requirements of section 230-15, Issuer Co will apply the compounding accruals method to that loss to determine the amount of the deduction for each income year over the next two years.

If Issuer Co were to make a further separate determination to pay interest, that determination may give rise to a third, and separate sufficiently particular certain gain (for Investor Co), or loss (for Issuer Co), that is taken to be made under the bond. Depending on the circumstances surrounding this further determination, that gain or loss may be subject to either the accruals or realisation methods.

Application of the accruals method to financial arrangements with a 'notional' principal

4.88 Subdivision 230-B applies so as to characterise and apply to notional principal arrangements in the following way.

4.89 A notional principal arrangement is a financial arrangement under which financial benefits to be provided or received are calculated by reference to a notional, rather than actual, principal amount, whether that amount is actually paid or received or not.

4.90 The notional principal amount, and the financial benefits that are calculated by reference to it, is referred to commercially as a 'leg' of the arrangement. There are two legs to such an arrangement.

4.91 A note explains that a swap contract is an example of a notional principal arrangement.

4.92 Subdivision 230-B applies to notional principal arrangements by calculating the gains and losses on each leg separately as if the notional principal amount is a financial benefit that is actually paid or received at a time, and in a manner, that properly reflects the way in which the other financial benefits in respect of that leg are calculated. [ Schedule 1, item 1, subsection 230-120(1) and subparagraph 230-120(3)(c)(i )]

4.93 A common example of a financial arrangement where sufficiently certain particular gains or losses may arise over the period of the arrangement is a swap. In general terms, a swap is an agreement between two parties under which they exchange cash flows over time. It is this exchange, as reflected in the mutual and corresponding rights to receive financial benefits and obligations to provide financial benefits over time, that makes opposite the separate gain or loss calculation for each leg of a swap. The value of the cash flows is often calculated based on a notional principal. Basic or 'plain vanilla' swaps will have no upfront or backend or other lumpy payments. Such payments, where they are present in a notional principal arrangement, will not be treated as a leg of the arrangement. Gains or losses in respect of these other things will also be calculated separately. [ Schedule 1, item 1, subparagraph 230-120(3)(b)(i )]

4.94 At a general level, as is the case with all financial arrangements, before it can be assessed which tax-timing method might apply to bring to account the relevant gain or loss under the swap, it is necessary to decide whether a taxpayer's rights and obligations under a swap constitutes a single, aggregate arrangement or two separate arrangements. [ Schedule 1, item 1, subsection 230-55(4 )]

4.95 Whether a number of rights or obligations constitute one or more arrangements is a question of fact and degree (see Chapter 2 for further discussion). Having regard to the factors outlined in subsection 230-55(4), a swap financial arrangement (comprising all of the taxpayer's rights and obligations) generally is to be considered as one arrangement. This flows from the general nature, terms and conditions of the financial arrangement and the purpose of most swap arrangements. The terms and conditions of many swap arrangements often require net settlement and, commercially, swaps generally derive their intended result when viewed as a whole arrangement - that is, considering both 'legs' in combination [ Schedule 1, item 1, section 230-55 ]. This conclusion is not, however, inconsistent with the notion of calculating the gains or losses from the two legs of a notional principal arrangement separately - in the same way that, as explained earlier, there can, at a particular time, be more than one sufficiently certain gain or loss in respect of the one financial arrangement. Chapter 14 contains a number of examples of swaps to illustrate how the separate calculation rules operate.

4.96 In standard interest rate swaps, the relevant fixed and floating rates are determined at the reset dates which occur at the beginning of each of the calculation periods. Commonly, the terms of 'standard' swap agreements require payment of the net difference between the fixed and floating payments at the end of the relevant period. Assuming that none of the elective tax-timing methods under Division 230 have been chosen, the question arises as to whether the gains or losses on the swap should be subject to the compounding accruals method or the realisation method.

When is a financial benefit sufficiently certain?

4.97 The compounding accruals method only applies to bring to account a sufficiently certain overall gain or loss or a sufficiently certain particular gain or loss. In deciding whether such a gain or loss is sufficiently certain at a particular time, the taxpayer can only have regard to those financial benefits that the taxpayer is sufficiently certain to receive or provide. That particular time includes the time when the taxpayer starts to have the arrangement [ Schedule 1, item 1, subsection 230-115(1 )]. In this sense, the borderline between the compounding accruals and realisation methods is encapsulated in the 'sufficiently certain' concept.

4.98 A financial benefit that is to be received or provided will be treated as being sufficiently certain only if both of the following requirements are met:

•

it is reasonably expected that the taxpayer will receive or provide the financial benefit. This analysis is to be done on the assumption that the taxpayer will have the financial arrangement for the remaining term of its life, or until maturity. For discussion on what the relevant life of a financial arrangement is, refer to paragraph 4.73 [ Schedule 1, item 1, paragraph 230-115(2)(a )]; and

•

at least some of the amount or value of the financial benefit is, at that time, fixed or determinable with reasonable accuracy [ Schedule 1, item 1, paragraph 230-115(2)(b )].

4.99 Both parts of the test are intended to ensure that the taxpayer will only accrue an estimated gain or loss made under a financial arrangement where there is more than a mere expectation that the estimated gain or loss will actually be made - the expectation must be quite firm.

4.100 Requiring the taxpayer to apply the accruals method would be inappropriate where a gain or loss can be estimated but there exists a real possibility that the taxpayer may never make the relevant estimated gain or loss because of the circumstances that may affect whether or not certain financial benefits will actually be received or provided. In this sense, the manner in which contingencies may affect such receipts or payments will need to be considered.

4.101 It would be equally inappropriate to require a taxpayer to accrue an estimated gain or loss where the payment of a particular financial benefit to be paid or received under the arrangement at a particular time was certain, but where none of the amount or the value of the financial benefit could not be estimated with reasonable accuracy. Note that it is not sufficient that the amount or value of the financial benefit be fixed or determinable. It must be fixed and determinable with reasonable accuracy .

4.102 Where all of the financial benefits under the financial arrangement are denominated in a particular foreign currency, the financial benefits are not to be translated into the taxpayer's functional currency (generally, the Australian dollar) for the purposes of applying the tests in subsection 230-120(2) [ Schedule 1, item 1, subsection 230-115(8 )]. This requirement is to ensure that, in those particular circumstances, uncertainties in relation to exchange rate movements are to be ignored in determining whether the relevant financial benefits are sufficiently certain. The special rule is required because the definition of 'special accrual amount' applies to amounts that are to be included in the taxpayer's assessable income or allowable as a deduction. The test as to whether financial benefits are sufficiently certain is applied prior to determining whether an amount should be included in the taxpayer's assessable income. Once a sufficiently certain gain or loss has been calculated, that amount is taken to be a special accrual amount for the purposes of applying the translation rules in Subdivision 960-C of the ITAA 1997 [ Schedule 1, item 28, subsection 995-1(1), definition of ' special accrual amount' ].

When is it reasonable to expect that a taxpayer will receive or provide a financial benefit?

4.103 The first limb of the sufficiently certain test is intended to encapsulate, in a principled way, the level of certainty of cash flows which are expected under the relevant financial arrangement. An analysis of this type involves an examination of the contingencies which particular financial benefits are subject to and the extent to which this may affect payment or receipt of these financial benefits under the arrangement. The analysis is focused on the probability of whether such benefits will be received or provided (if at all). This analysis will be different from the analysis of contingencies within the context of the debt/equity borderline. The design of the accruals/realisation borderline under Division 230 is distinct from that of the debt/equity borderline in Division 974 of the ITAA 1997. Illustrative of this, the accruals/realisation borderline addresses both derivatives and financing arrangements.

4.104 The term 'reasonably expected' is not defined in the legislation, although its meaning has been contemplated in a number of tax law cases. In FC of T v . Peabody (1994) 181 CLR 359 the court stated at 385 that:

'A reasonable expectation requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable.'

4.105 However, how much more likely than a 'possibility' is the expectation that a financial benefit will be provided or received is not clear from Peabody . In the context of accruals tax treatment, one key objective is to not accrue significant unsystematic gains and losses on an unrealised basis. Another objective is to prevent tax deferral. In the light of the context of these joint objectives, there must be quite a firm expectation that the financial benefit will be provided or received.

4.106 The basis on which this expectation is to be considered is not to be limited to the form of a particular financial arrangement. Rather, whether a particular financial benefit will be received or provided, based on the contingency which attaches to it or which it is subject to, is to be considered by reference to the circumstances surrounding the relevant financial arrangement. In particular, the taxpayer is to have regard to:

•

the terms and conditions of the financial arrangement;

•

accepted pricing and valuation techniques;

•

the economic and commercial substance and effect of the financial arrangement; and

•

contingencies that attach to other financial benefits that are to be provided or received under the arrangement and any interaction these contingencies may have with the financial benefits under consideration.

[ Schedule 1, item 1, paragraph 230-115(3)(a )]

4.107 Further, the expectation test is to be applied on an objective basis ( FC of T v Arklay (1989); 85 ALR 368; Eastern Nitrogen Ltd v FC of T (1999) FCA 1536).

4.108 The terms and conditions of the financial arrangement provide information on whether the right or obligation in relation to the financial benefit is subject to a contingency. The effect of the contingency, in relation to whether or not the financial benefit will actually be paid or received, can also be determined from an examination of the terms and conditions of the arrangement. For example, the terms and conditions of a financial arrangement may require a particular outcome upon which the satisfaction of a contingency depends. It may be argued that the terms and conditions of the financial arrangement constitute the 'legal form' of the arrangement.

4.109 However, if the determination of whether it is reasonable to expect that a financial benefit is to be received or provided under the arrangement were limited to an analysis of the legal form of the arrangement, this could lead to different tax-timing treatments being applied to financial arrangements that are equivalent in economic substance. This would encourage tax arbitrage and tax motivated practices. To address this issue, the taxpayer must look at the substance and effect of the terms and conditions and also have regard to factors external to the terms and conditions of the arrangement. Under paragraph 230-115(3)(a) this concept is to be applied on an objective basis. For example, in this context, if the terms and conditions of the arrangement include a contingency that is, in substance, artificial or contrived, then on an objective basis those contingencies would be effectively disregarded in determining whether it is reasonable to expect that the financial benefit will be received or provided.

4.110 Generally, subsection 230-115(2) requires that each financial benefit be individually tested to determine whether it is sufficiently certain. The situation may arise where a particular financial benefit, when tested in isolation to the other financial benefits under the arrangement, would not be considered to be sufficiently certain. However, when that financial benefit (the 'test financial benefit') is considered together with other financial benefits (the 'group financial benefits') under the financial arrangement, contingencies attaching to the test financial benefit may be nullified by the effect of the group financial benefits. Applying paragraph 230-115(3)(b), the combined effect of the financial benefits may be that a sufficiently certain gain or loss of at least a particular amount can be calculated in respect of the financial arrangement because the contingencies attaching to all the financial benefits under the financial arrangement may, in effect, create sufficiently certain rights to receive or obligations to provide. Consistent with the requirement that the substance and effect of the terms and conditions of a financial arrangement be taken into account, the test financial benefit is to be treated in such circumstances as if there were no contingency attaching to it (see Example 4.4 for further discussion). [ Schedule 1, item 1, subparagraph 230-115(3)(a)(iv), paragraph 230-115(3)(b )]

4.111 The economic or commercial substance and effect of the financial arrangement should also be taken into account [ Schedule 1, item 1, subparagraph 230-115(3)(a)(iii )]. This analysis would include consideration of the circumstances surrounding the financial arrangement which may involve the in-substance existence of a contingency (which is not present in the form of the terms and conditions of the arrangement) which may affect whether a financial benefit will be received or provided. In this context, regard could be had to a number of factors including:

•

prevailing market conditions at the time the financial arrangement was entered into or at subsequent material events;

•

the intended effect of the financial arrangement as determined by reference to the intention of the parties (determined objectively); and

•

the normal commercial understandings and practices in relation to similar instruments in the market.

4.112 Regard should also be had to generally accepted pricing and valuation techniques, and whether such techniques were used to establish the values (whether these be proceeds or cost) of the relevant financial benefits [ Schedule 1, item 1, subparagraph 230-115(3)(a)(ii )]. This is a necessary consideration when determining whether a financial benefit can be reasonably expected to be received or provided because, where appropriate and accepted pricing or valuation techniques have been used, the pricing, or valuation, of a financial benefit may be indicative of the nature of a contingency that affects the right to receive or the obligation to provide the relevant financial benefit.

4.113 For instance, where there is a right to receive, or the obligation to provide, a financial benefit, the existence or satisfaction of which is affected by a contingency (considered in the context of the other rights and obligations comprising the financial arrangement), and the cost of such a financial benefit is lower than may be expected for a comparable and certain financial benefit, this could indicate that a genuine contingency existed (the outcome of which was uncertain). Hence, it may not be able to be said that on an objective basis there is a reasonable expectation that the financial benefit will be received or provided, such that it could be considered sufficiently certain.

What is meant by 'fixed or determinable with reasonable accuracy'?

4.114 A financial benefit will only be treated as being sufficiently certain where there is a reasonable expectation that the financial benefit will be received or provided and at least some of the amount or value of the financial benefit is fixed or determinable with reasonable accuracy [ Schedule 1, item 1, paragraph 230-115(2)(b )]. The extent to which the value of the financial benefit can be estimated, or can be said to be fixed or determinable with reasonable accuracy, depends on a number of factors. Factors to which the taxpayer should have particular regard are:

•

the terms and conditions of the financial arrangement;

•

whether accepted pricing and valuation techniques were used or are relevant in determining the value of the financial benefits;

•

the economic or commercial substance and effect of the financial arrangement; and

•

the contingencies that attach to the other financial benefits that are to be provided or received under the arrangement.

[ Schedule 1, item 1, subsection 230-115(3 )]

4.115 The considerations taken into account in determining whether there is a reasonable expectation that a financial benefit will be received or provided under a financial arrangement, as outlined in paragraphs 4.103 to 4.113, may also be relevant in determining if the financial benefit is fixed or determinable with reasonable accuracy.

4.116 In an accounting context, a 'fixed or determinable' payment in respect of held-to-maturity instruments, and loans and receivables, means that a contractual arrangement defines the amounts and date of payments to the holder, such as interest and principal payments. Such payments would also be considered to be 'fixed or determinable with reasonable accuracy' for the purposes of Division 230.

4.117 Contingencies will not only affect whether it is sufficiently certain that a financial benefit will be received or provided - the amount or value of a financial benefit may also be the subject of a contingency or uncertainty. A contingency only in respect of value, in itself, will not always preclude the value of a financial benefit from being fixed or determinable with reasonable accuracy (particularly due to the application of the assumptions in subsections 230-115(4) and (5)). Additionally, if the value of a financial benefit is not specifically stated in the terms and conditions of the financial arrangement, but the taxpayer can nonetheless estimate with 'reasonable accuracy' the likely value of that financial benefit, (eg, by reference to other financial benefits) then the requirements of paragraph 230-115(2)(b) are satisfied.

Holding certain variables constant

4.118 In applying the 'sufficiently certain' test in subsection 230-115(2), certain assumptions are required to be made. The assumption is relevant to the second part of the test only - that is, whether a financial benefit can be said to be fixed or determinable with reasonable accuracy. Where calculation of a financial benefit relies on a certain type of variable (such as a floating interest rate) or a rate of change of a type of variable (such as a CPI), the taxpayer is required to assume that the variable will remain constant at the value it had at the particular time at which the test was applied. [ Schedule 1, item 1, subsections 230-115(4) and (5 )]

4.119 The inception of the financial arrangement is not necessarily the only time at which the value of a particular variable should be tested to determine whether it is fixed or determinable with reasonable accuracy under paragraph 230-115(2)(b). For instance, the relevant financial benefit may be subject to a contingency so that it is not reasonable to expect the financial benefit will be received or provided at the start of the arrangement - such a contingency may subsequently be resolved, so that at a later time, and by virtue of the assumptions in subsection 230-115(4) or (5), the financial benefit becomes sufficiently certain. The value the variable has at the time the financial benefit becomes sufficiently certain is the value that should be held constant for the purposes of calculating the amount of the sufficiently certain overall or sufficiently certain particular gain or loss. [ Schedule 1, item 1, subsection 230-115(6 )]

4.120 Further, if there is a material change in the variable which requires a re-estimation of the gain or loss previously estimated, the assumptions in relation to the variables to which subsections 230-115(4) and (5) applied must be re-examined. The value which is to be held constant for the purposes of a fresh determination of the gain or loss under the re-estimation provisions is the value of the variable at the time that the re-estimation is triggered.

4.121 Only those variables referred to in subsections 230-115(4) and (5) are required to be held constant. These variables should be held constant because:

•

the variables specifically referred to are considered to be relatively 'stable', in that their values are less likely to fluctuate over a large range, in the short to medium term;

•

the variables are considered to be those which generally increase over time, such that the value estimated at the relevant test time would generally be the minimum value for that variable over the life of the instrument; and

•

the variables can be reliably measured.

Further examples of sufficiently certain gains or losses

4.122 By way of further guidance, the following examples provide illustrations of the sufficiently certain overall gain or loss, and the sufficiently certain particular gain or loss, concepts and consider - for some of the more common type examples - whether the accruals or realisation methods are appropriate.

Example 4.2 : Sufficiently certain overall gain or loss - CPI-linked bond

On 1 July 2010, Hristina Co, a company with a turnover of $3 billion, purchases a five-year security with a face value of $100,000 from Jen Co. Hristina Co is entitled to receive an annual coupon of 7 per cent plus any percentage increase in the Australian CPI. As well, Jen Co is obliged to pay Hristina Co the face value of the bond ($100,000) at the end of the five years. The CPI increased by 2 per cent in 2010. The historical volatility of the CPI is very low. Based on history, and anticipated stable monetary policy settings, the CPI is expected to increase by between 2 and 3 per cent per annum over the next five years.

It was illustrated in Example 2.3 that a CPI-linked bond (that was similar to the one purchased by Hristina Co), is taken to be one arrangement - which satisfies the definition of 'cash settlable' financial arrangement. This is because the rights and obligations under an index-linked bond - being the right to receive the coupon payments, as adjusted for the index movement and the right to receive the face value of the bond on maturity - are all cash settlable (subsection 230-45(2)).

The accruals method will apply to gains or losses from the bond if there is a sufficiently certain overall gain or loss or a sufficiently certain particular gain or loss, made from the financial arrangement (section 230-100). The sufficiently certain gain or loss is calculated by reference only to financial benefits that are sufficiently certain (subsection 230-115(1)) (see paragraphs 4.97 to 4.102 for further discussion).

A financial benefit is sufficiently certain if:

•

it is reasonably expected that Hristina Co will receive the financial benefit (assuming Hristina Co will continue to have the CPI-linked bond until redemption - that is, for the life of the arrangement) (paragraph 230-115(2)(a)); and

•

the amount, or value, of the financial benefit is fixed or determinable with reasonable accuracy (paragraph 230-115(2)(b)).

Certain assumptions are required to be made in determining whether a particular financial benefit is sufficiently certain. In particular, if the financial benefit depends on the change in a variable that is based on the CPI then the rate of change of that variable is taken to continue to be the rate of change for the life of the financial arrangement (subsection 230-115(5)). Hence, for the purposes of determining if the coupon payments are financial benefits which are sufficiently certain, this assumption is applied to ensure that the coupons will satisfy the fixed or determinable with reasonable accuracy test in paragraph 230-115(2)(b).

Taking into account the terms and conditions of the arrangement, and the economic or commercial substance and effect of the arrangement, each of the financial benefits to be received under the arrangement are sufficiently certain (subsection 230-115(2)). This is because the financial benefit which is the coupon payment that is paid each year is taken to be 9 per cent - 7 per cent guaranteed, plus the 2 per cent increase in the CPI, which is assumed to continue to have the same rate of increase that it had at the time at which it is determined whether the financial benefits are sufficiently certain, as per subsection 230-115(5) - and Hristina Co is guaranteed to receive the face value of the bond at maturity. Hence, Hristina Co will make a sufficiently certain overall gain from the arrangement of at least a particular amount, under subsection 230-105(1).

Example 4.3 : Sufficiently certain particular gain or loss - exchangeable note

On 1 January 2011 Company A issues 2,000 exchangeable notes at par, each with a face value of $1,000, representing a total investment of $2 million to Company B. The terms and conditions of the exchangeable note provide for interest to be paid annually, at a fixed rate of 6 per cent per annum. At the end of year three, at the holder's option, either the issuer will be required to redeem the notes for their face value plus 5 per cent (ie, $2.1 million), or the notes could be exchanged for a specified number of shares in a third party company, Company C. Company C's shares are listed on the Australian Securities Exchange (ASX).

Company A has an annual aggregated turnover of $200 million and Company B has an annual aggregated turnover of $300 million. Neither Company A, nor Company B, has the sole or dominant purpose of entering into the exchangeable notes to deliver or receive the shares. Company B has not made any of the elections available under Division 230.

For the purposes of the illustration, the commentary below will focus on the tax consequences for Company B.

Is the exchangeable note a cash settlable financial arrangement?

The characteristics of the exchangeable note are very similar to those of the convertible note in Example 2.2. In that example, it was established that the convertible note was a single arrangement. The same reasoning would apply in this case - such that the exchangeable notes are also each a single arrangement. In particular:

•

the terms and conditions indicate that the arrangement, whilst having the same effect as its separate components, must be dealt with together, and contain no provision for the separate assignment of the various embedded rights and obligations (subsection 230-55(4));

•

the rights and obligations under the notes were created under the one arrangement, at the same time, and will extinguish together on maturity (subsection 230-55(4)); and

•

it would be reasonable to assume that Company B intends to deal with its rights and obligations under the note together, and not separately. (For the holder of such an exchangeable note, objectively it may be concluded that the general and principal purpose of entering into the exchangeable note is to benefit from both the annual interest payments and from holding a right to shares, the value of which may appreciate in the future, after the right is exercised and the shares are acquired) (subsection 230-55(4)).

Under this arrangement Company B has the right to receive cash coupon payments and, upon maturity, a right to the redemption amount - which is to be satisfied by receiving a payment of money. Both of these rights are cash settlable (paragraph 230-45(2)(a)). Company B also has a right to receive shares under the arrangement - that right is still a relevant right even though it is subject to a contingency. The right is the exercise of the option by Company B (paragraph 230-85(a)). The right to receive shares is a cash settlable right, because there is a market for the shares which has a high degree of liquidity and the shares constitute the right to receive the financial benefit. Company B also did not have as its sole or dominant purpose for entering into the arrangement its purchase or usage requirements in the ordinary course of its business (subsection 230-45(1) and paragraph 230-45(2)(g)).

Hence, each of the exchangeable notes is a cash settlable financial arrangement for the purposes of Division 230.

Is there a sufficiently certain gain or loss?

Given Company B has not made any of the elections under Division 230, the gains or losses from the exchangeable notes may be subject to either the accruals or realisation methods. The accruals method will apply to gains or losses from the exchangeable note if there is a sufficiently certain overall gain or loss or a sufficiently certain particular gain or loss made from the arrangement (section 230-100). The sufficiently certain gain or loss is calculated by reference only to financial benefits that are sufficiently certain (subsection 230-115(1)).

A financial benefit is sufficiently certain if:

•

it is reasonable to expect that Company B will receive or provide the financial benefit (assuming Company B will continue to have the exchangeable notes until redemption - ie, for the estimated life of the arrangement) (paragraph 230-115(2)(a)); and

•

the amount or value of the financial benefit is fixed or determinable with reasonable accuracy (paragraph 230-115(2)(b)).

Taking into account the terms and conditions of the arrangement, and the economic or commercial substance and effect of the arrangement, the interest payments can be said to be sufficiently certain (subsection 230-115(2)). This is because at the start of the arrangement, it is reasonable to expect that Company B will receive an amount of interest that is determinable with reasonable accuracy - this is because the amount of interest is able to be calculated as 6 per cent of the original amount invested.

The financial benefits which are represented by the shares in Company C, and the redemption amount, are not sufficiently certain when taken on an individual basis. However, Company B is required to have regard to contingencies which attach to other financial benefits under the arrangement (subparagraph 230-115(3)(a)(iv)). This means that, in determining whether the financial benefit represented by the redemption amount is sufficiently certain, Company B is required to take into account the effect of the right to the shares in Company C. When the effect of the contingencies attaching to each of the financial benefits is taken into account, it could be objectively concluded that at the end of the arrangement Company B would make a gain of at least $100,000 - this is the gain made where the redemption amount, as opposed to the shares, is taken.

This is because at the start of the arrangement, although the amount of the actual gain made by Company B cannot be calculated - because this would depend, amongst other things, on the value of Company C's shares at the time of redemption - Company B would not choose the shares if the market value of the shares gave rise to a gain that was less than $100,000.

For the purposes of determining whether the right to the redemption amount is sufficiently certain, it is appropriate to treat that financial benefit as if it were not contingent (paragraph 230-115(3)(b)). Therefore, it could be said, on the basis of this required assumption, that it is reasonable to expect that the redemption amount will be received at the end of the arrangement.

It is also reasonable to attribute the cost of the exchangeable notes to the final redemption amount. Hence, there will be a sufficiently certain overall gain made from the exchangeable notes of at least $100,000.

Further, the rule in subsection 230-70(3) applies to the interest payments. Under this rule, which applies in calculating a particular gain or loss under the accruals method, the receipt of an amount of, in the nature of, or in substitution for, interest, will represent a gain in its entirety (see Chapter 3 for further discussion of this rule). Were there no sufficiently certain gain, the interest payments would still be accrued because of the operation of subsection 230-70(4). However, in this situation as there is clearly an overall sufficiently certain gain the interest payments will form part of the overall sufficiently certain gain, which is required to be accrued.

Both the sufficiently certain overall gain of $100,000 and the sufficiently certain interest payments are to be brought to account over the three-year term of the notes on a compounding accruals basis.

4.123 Ordinary options and forwards over shares have relatively uncertain outcomes and a gain or loss in respect of them is not fixed or determinable with reasonable accuracy. The financial benefits under the financial arrangement may be the subject of a material contingency. Therefore, any gain or loss under the arrangement cannot be determined with sufficient certainty. Rather, any gains or losses should be subject to the realisation method.

4.124 Generally, for comparison and reference, consider the case of an ordinary share traded on a stock exchange. (Note that ordinary shares are 'equity interests' and generally are not subject to Division 230 except where the fair value or financial reports election applies [ Schedule 1, item 1, paragraph 230-40(4)(e )].) Typically, an ordinary share is subject to relatively high price volatility, and the value of their expected future financial benefits is relatively uncertain; the gains or losses from holding the share are similarly uncertain. Hence, a financial arrangement where the relevant financial benefits are directly linked to movements in an individual share price, or with returns (financial benefits) that are as uncertain as the returns on an ordinary share that is traded on the ASX, would ordinarily not be subject to the compounding accruals methodology.

4.125 Furthermore, in the case of a financial arrangement where the relevant values of the financial benefits are directly linked to movements in a broad-based share price index (such as the ASX All Ordinaries Index), or are as uncertain as are the returns based on that index, such gains or losses would not ordinarily be subject to compounding accruals treatment, but would instead be brought to account on a realisation basis.

Calculation of a gain or loss

4.126 As discussed in Chapter 3, to work out if there is a gain or loss arising from a financial arrangement, a taxpayer is generally required to compare:

•

the financial benefits which the taxpayer has provided, or which are to be provided, or the rights to financial benefits surrendered under the financial arrangement (the 'cost'); with

•

the financial benefits which are received, or which are to be received, or the obligations to transfer financial benefits under the financial arrangement (the 'proceeds').

4.127 The comparison recognises that a gain or loss, for the purposes of Division 230, is a net concept. As discussed in Chapter 3, there is a requirement that the taxpayer make a reasonable (in other words, an objectively supportable) allocation of costs to proceeds. In particular, subsection 230-115(1) requires that for the purposes of Division 230, to determine whether a gain or loss is sufficiently certain at a particular time, only those financial benefits that are sufficiently certain to be received or provided under the arrangement can be taken into account, unless gains or losses which are not sufficiently certain may lead to an over-accrual of a sufficiently certain gain or loss (see earlier discussion). In this sense, the test in subsection 230-115(1) is focused on those financial benefits that are yet to be received or provided. It does not necessarily preclude, in the calculation of the relevant gain or loss, the taxpayer from taking into account financial benefits already received or provided under the arrangement. Such financial benefits are, by the very fact that they have been provided or received, taken to be certain for the purposes of determining whether a gain or loss is sufficiently certain at a particular time - although such financial benefits, or part thereof, should not be attributed or included in the calculation of a sufficiently certain gain or loss more than once. [ Schedule 1, item 1, subsection 230-115(9 )]

4.128 As noted in paragraph 4.72, the calculation of a sufficiently certain overall gain or loss requires that the entire value of the costs of the arrangement be attributed to those financial benefits that are sufficiently certain at the start of the arrangement. The concept of a particular gain or loss necessarily requires that the financial benefits which represent the cost of the financial arrangement be reasonably attributed to the sufficiently certain financial benefit that will give rise to a gain or loss [ Schedule 1, item 1, sections 230-70 and 230-75 ]. Whether the attribution of those financial benefits provided is reasonable is determined by taking into account the factors listed in subsection 230-70(3). The attribution is to be calculated as at the time when a taxpayer respectively receives or provides the relevant financial benefit respectively. Chapter 3 further discusses the attribution process.

4.129 Financial benefits that have been taken into account in calculating a sufficiently certain overall gain or loss are required to be disregarded when calculating a sufficiently certain particular gain or loss [ Schedule 1, item 1, paragraph 230-110(2)(b )]. Practically this will mean that where there is a sufficiently certain overall gain or loss calculated for a financial arrangement with reference to some, but not all, of the financial benefits which are to be received (because some of those financial benefits are not sufficiently certain at the start of the arrangement), then once those financial benefits become sufficiently certain, the amount of the gain or loss on that financial benefit will reflect the entire value of the financial benefit. This is because all of the cost of the financial arrangement would have been attributed to the calculation of the sufficiently certain overall gain or loss.

The compounding accruals method

4.130 The compounding accruals method spreads gains or losses that are sufficiently certain to occur [ Schedule 1, item 1, section 230-100 ]. In order to 'spread' the sufficiently certain gain or loss, the taxpayer needs to establish:

•

a period over which the gain or loss should be spread;

•

the method used to allocate the gain or loss to particular intervals within the period established; and

•

how to work out an allocation of part of a gain or loss that is allocated to an interval that straddles two income years.

[ Schedule 1, item 1, section 230-125 ]

Period over which the gain or loss is to be spread

Relevant period for a sufficiently certain overall gain or loss

4.131 If it is established that there is a sufficiently certain overall gain or loss from a financial arrangement, that gain or loss is to be spread (recognised) over a period that starts when the taxpayer starts to have the financial arrangement and ends when the taxpayer ceases to have the financial arrangement. [ Schedule 1, item 1, subsection 230-130(1 )]

4.132 In some instances, the period over which the financial arrangement is held will not be known at the start of the arrangement - for example, in the case of financial arrangements that last in perpetuity. For the purposes of determining the start and the end of the arrangement, the taxpayer must assume that they will continue to have the financial arrangement for the rest of the life of the financial arrangement [ Schedule 1, item 1, subsection 230-130(1 )]. Hence, the life of such a financial arrangement starts at the time the taxpayer acquires or creates the arrangement and ends in perpetuity.

4.133 The period stated in paragraph 4.131 is the appropriate period over which the overall gain or loss should be spread because, consistent with the general policy underpinning the accruals method in Subdivision 230-B, this is the period to which that overall gain or loss relates. This policy is encapsulated in the principles stated in the sufficiently certain particular gain or loss case in subsection 230-130(2). However, where all financial benefits become sufficiently certain following the start of a financial arrangement, such that the overall gain or loss, or gain or loss of at least a particular amount, arising on the financial arrangement becomes known with sufficient certainty, that gain or loss should be treated as a sufficiently certain particular gain or loss and spread from the time at which it becomes certain to the time at which the arrangement matures, or for the rest of its life, as per paragraph 230-105(2)(a).

The relevant period for a sufficiently certain particular gain or loss that arises from a financial benefit

4.134 Where there is a sufficiently certain particular gain or loss that arises from a particular financial benefit, the relevant period over which that gain or loss is to be spread is the period to which the gain or loss relates. In determining the period to which that gain or loss relates, regard must be had to the pricing, terms and conditions of the financial arrangement [ Schedule 1, item 1, subsection 230-130(3 )]. The pricing, terms and conditions, amongst other considerations, will give an indication of what the financial benefit was provided for or received for, and hence a reference point to which period that financial benefit relates. Under the sufficiently certain particular gain or loss method, the gain or loss is taken to arise from that particular financial benefit, and so, generally, the period to which the financial benefit relates would also be the period to which the particular gain or loss relates, except in cases of deferral of payment where the time value of money may not be fully reflected.

4.135 Despite the general requirement to allocate the gain or loss to the period to which it relates, a specific boundary is placed on when that period can start and when that period can end. The period over which the sufficiently certain gain or loss is to be spread must not start earlier than the time at which the taxpayer starts to have the financial arrangement nor earlier than the beginning of the income year in which the gain or loss becomes sufficiently certain [ Schedule 1, item 1, subsection 230-130(3 )]. Additionally, the end of the period over which the gain or loss is to be spread must not end later than:

•

the time the taxpayer will cease to have the financial arrangement [ Schedule 1, item 1, paragraph 230-130(5)(a )];

•

the end of the income year in which the particular financial benefit that gives rise to the gain or loss is to be received or provided [ Schedule 1, item 1, subparagraph 230-130(5)(b)(i )]; or

•

the end of the income year during which the right or obligation (the cessation of which gives rise to the gain or loss) is to cease [ Schedule 1, item 1, subparagraph 230-130(5)(b)(ii )].

Example 4.4 : Calculation of relevant period for debt interest

Spices Ltd invests $1,000 into a three-year debt interest on 30 June 2011. The terms provide that if the profits in Tech Co are at a certain level on 30 June 2013, then on 30 June 2014, $2,000 is payable on redemption.

Assume that the profits of Tech Co achieve the levels required on 30 June 2013.

In the present case, there is a sufficiently certain gain for Spices Ltd under the financial arrangement determinable at 30 June 2013. On 30 June 2013, it is reasonably expected that Spices Ltd will receive a fixed and determinable amount of $2,000. This financial benefit is therefore sufficiently certain. It is reasonable to attribute the entire cost of the debt interest to the financial benefit that becomes sufficiently certain on 30 June 2013. Hence, at that time it is sufficiently certain that Spices Ltd will make a particular gain of $1,000.

Consistent with the period specified in subsection 230-130(5), the period will end on 30 June 2014 - the time at which Spices Ltd will redeem the investment and hence the time at which Spices Ltd will receive the financial benefit.

Having regard to the pricing, terms and conditions of the financial arrangement, the period over which the sufficiently certain particular gain of $1,000 is to be allocated will commence on 1 July 2012 (the start of the income year in which the gain becomes sufficiently certain (paragraph 230-130(4)(b)) and end on 30 June 2014 (paragraph 230-130(5)(b)).

Overall gain or loss may be spread in accordance with the particular gain or loss rule

4.136 Where the sufficiently certain gains or losses from the financial arrangement in effect represent both an overall gain or loss and a particular gain or loss, the taxpayer may choose to spread gains or losses as if they were the latter [ Schedule 1, item 1, subsection 230-130(2 )]. The choice must be applied consistently [ Schedule 1, item 1, subsection 230-80(3 )].

4.137 The purpose of this choice is to reduce complexity and compliance costs.

How the gain or loss is spread

4.138 Once the period over which the relevant gain or loss should be spread is determined, the method used to spread that gain or loss over that period must be established. Where the accruals method applies to gains or losses the taxpayer makes from a financial arrangement, the gain or loss is spread using:

•

compounding accruals [ Schedule 1, item 1, paragraph 230-135(2)(a )]; or

•

a different method, the results of which approximates those obtained using compounding accruals [ Schedule 1, item 1, paragraph 230-135(2)(b )].

Compounding accruals method

4.139 Under compounding accruals, the gain or loss must be allocated to intervals that are the same length and do not exceed 12 months. However, the first and last interval may be shorter than the other intervals. [ Schedule 1, item 1, subsection 230-135(4 )]

Fixing of amount and rate for interval

4.140 In allocating the gain or loss to an interval it is necessary to determine the rate of return and the amount to which the rate of return is to be applied for a given interval. [ Schedule 1, item 1, subsection 230-135(5 )]

4.141 The amount to which the rate of return is to be applied can be adjusted for reasons other than a fresh allocation of the gain or loss under paragraph 230-190(5)(a). In determining the amount it is necessary to have regard to both the amount (or value) and timing of the financial benefits that are to be taken into account in working out the gain or loss that is to be allocated to each interval and were provided or received by you during the interval [ Schedule 1, item 1, subsection 230-135(6 )]. An example of the application of this is rule is where a borrower has made an early repayment of part of the principal on a loan that has the effect of reducing the current outstanding amount to which the interest rate on the loan is to be applied in allocating the gain or loss for that interval.

4.142 Whichever method is chosen, the method is to be applied to spread the gain or loss on the assumption that the taxpayer will continue to have the financial arrangement for the rest of the arrangement's life [ Schedule 1, item 1, subsection 230-135(7 )]. An exception to this rule applies to 'portfolio fees' and 'portfolio premiums or discounts' as discussed in paragraphs 4.153 to 4.167.

4.143 Generally, to apply the compounding accruals method, a taxpayer estimates the rate of return (the discount rate) that equates the net present value of all relevant cash flows (financial benefits) to zero. A taxpayer applies that rate to the initial investment, to provide an estimated year-by-year gain which forms the basis for taxation. Although the discount rate is determined by reference to net present values, Division 230 applies to gains or losses so that the total nominal gains or losses are brought to account [ Schedule 1, item 1, subsections 230-70(1) and 230-75(1 )]. However, in making such an allocation of the gain or loss to the relevant intervals, regard must be had to the financial benefits that are to be provided or received in each of those intervals [ Schedule 1, item 1, subsection 230-135(8 )]. If there are a number of financial benefits that are to be provided at the start of the arrangement, and those financial benefits give rise to an overall gain, the allocation of parts of that overall gain to all of the relevant intervals should take into account the fact that these payments will be made in the intervals towards the start of the arrangement.

4.144 For the purposes of applying the compounding accruals method, the length of a particular compounding interval is not prescribed, but it cannot exceed 12 months [ Schedule 1, item 1, paragraph 230-135(4)(a )]. Each of the intervals must be of the same length, except for the first and last interval which may be shorter than the other intervals used [ Schedule 1, item 1, paragraph 230-135(4)(b )]. The first and last interval may be shorter than the other intervals during the accrual period because the financial arrangement may have been created or acquired part way through the financial year of the taxpayer, and not at a designated interval. Equally, the relevant financial arrangement may cease part way through an interval period. For example, a designated interval may be a three-month period, consistent with a financial quarter. That is, an interval might have otherwise started on 1 July and ended on 30 September. However, the financial arrangement may have been acquired on 10 August. The taxpayer could still use intervals that are consistent with a financial quarter, but the first interval will be from 10 August to 30 September - a lesser period that the other intervals in the accrual period.

Example 4.5 : Application of the compounding accruals method - a bond without a periodic payment

John Doe invests $100 in a zero coupon bond that will pay $120 at maturity in four years time. The bond satisfies the definition of 'qualifying security' in Division 16E of the ITAA 1936. The bond, by its terms, satisfies the definition of 'financial arrangement' for Division 230 purposes.

Figure 4.1: Zero coupon bond - representation of the holder's financial benefits

This is represented diagrammatically in Figure 4.1 by the return of the investment extending beyond the cost (shown as the small horizontal dash).

This bond would be subject to the compounding accruals method because there is a sufficiently certain overall gain that arises at the time the bond starts to be held by John Doe. The overall gain is sufficiently certain because it is reasonable to expect that, assuming John Doe holds the bond for its life (ie, until maturity) the financial benefits will be received under the arrangement and those benefits have a fixed value (section 230-115). For the purposes of accruing the gain, John Doe has chosen a 12-month compounding period.

To work out the part of the overall gain or loss that is to be recognised in each income year:

•

Estimate all cash flows as in column (c) of Table 4.1.

•

Calculate the discount rate at which the net present value of those cash flows is zero. This discount rate is also known as the internal rate of return, or the effective interest rate. In this example it is 4.66 per cent per year.

•

Apply the discount rate to the cost of the financial arrangement on a compounding basis to create column (b).

This is the gain or loss from the compounding accruals method each year. Effectively the gain of $20 is spread on a compounding accruals basis over the four-year period as shown in column (b).

Table 4.1 Accrual of sufficiently certain overall gain

Methods other than a compounding accruals method

4.145 A method other than the prescribed compounding accruals method may be used to spread a sufficiently certain gain or loss where the outcome under that method approximates the outcome under the compounding accruals method. The focus of the provision is in relation to the method used and not only the result from the application of that method. This means that taxpayer will not have to do two separate calculations - one under the prescribed method, and one under the alternative method - as long as the alternative method can be shown to have approximated what would have been the outcome under the compounding accruals method.

4.146 In determining whether a method gives rise to results which approximate those obtained under the compounding accruals method, regard must be had to the length of the period over which the gain or loss is to be spread. For example, the straight-line spreading method could be used for short-term financial arrangements, such as 90-day bills or arrangements which pay interest at least annually, and which have been acquired for face value. [ Schedule 1, item 1, paragraph 230-135(2)(b )]

Effective interest method

4.147 For the purposes of a method of spreading gains and losses that approximates the compounding accruals method, the effective interest method described in AASB 139 (or a comparable standard) will satisfy this requirement provided the financial arrangement does not have significant deferral characteristics and it is appropriately determined and reported in the taxpayer's audited financial accounts [ Schedule 1, item 1, section 230-140 ]. This 'safe harbour' method seeks to minimise compliance costs for taxpayers without opening up tax deferral opportunities.

4.148 The 'effective interest rate' method is a method of calculating the amortised cost of a financial instrument and of allocating the interest income or interest expense over the relevant time period (often the term of the financial instrument). In most cases, the financial instrument that is captured under AASB 139 will be the same as the financial arrangement that is subject to Division 230.

4.149 The 'effective interest rate' is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial arrangement, to the net carrying amount of the financial instrument.

4.150 For the effective interest rate method under AASB 139 to satisfy paragraph 230-135(2)(b) for a particular financial arrangement it must satisfy these requirements:

•

when the taxpayer starts to have the arrangement, the annually compounded rate of return applicable to any discount or premium under the arrangement does not exceed 1 per cent [ Schedule 1, item 1, paragraph 230-140(3)(a )];

•

neither the expected life nor the maximum life of the arrangement is more than 30 years when the taxpayer first starts to have the arrangement (or a different time as prescribed by regulations) [ Schedule 1, item 1, paragraph 230-140(3)(b )];

•

the financial benefits the taxpayer has an obligation to provide or right to receive - that give rise to a gain or loss from the arrangement not attributable to any discount or premium - relates to a period not exceeding 12 months and will be provided or received within that period [ Schedule 1, item 1, paragraph 230-140(3)(c )]; and

•

the gains or losses under the financial arrangement are spread in a way provided for under AASB 139 (or a comparable standard) in audited financial accounts of the taxpayer [ Schedule 1, item 1, paragraphs 230-140(3)(d) to (f )].

4.151 The taxpayer's accounts for the purposes of section 230-140 will be taken to be audited financial reports if they satisfy the requirement of subsection 230-210(2) in relation to, and in a way that is relevant to, the spreading.

4.152 If the financial arrangement that would otherwise satisfy the requirements of section 230-140 has features that require the interest rate on the arrangement to be re-set at least annually and the new rate applies no later than the reset date, the re-estimation requirements in section 230-190 permits the re-estimation to be done at the re-set date.

Election to spread portfolio fees/premium/discount

4.153 Generally, if it is established that there is a sufficiently certain overall gain or loss from a financial arrangement, that gain or loss is to be spread over a period that commences when the taxpayer starts to have the financial arrangement and ends when the taxpayer ceases to have the financial arrangement (as discussed in paragraphs 4.71 to 4.73). [ Schedule 1, item 1, subsections 230-105(1) and 230-130(1 )]

4.154 However, this rule is modified by way of an irrevocable election in circumstances where the overall gain or loss from the financial arrangement arises in part from fees referred to as 'portfolio fees', or from a discount/premium, in respect of a portfolio of similar financial arrangements and the financial arrangement is part of a portfolio of similar financial arrangements. [ Schedule 1, item 1, sections 230-150, 230-160 and 230-165 ]

4.155 In these cases, the portfolio fees from, and any premium or discount, in respect of the financial arrangement are spread over the expected life of the portfolio rather than from the period the financial arrangement started and ceased to be held [ Schedule 1, item 1, subsections 230-160(3) and (5) and 230-165(3) and (5 )]. An example of a portfolio of similar financial arrangements is a portfolio of similar home loans held by a bank. An application or establishment fee payable on the home loan is an example of a portfolio fee to which the modified accruals rule applies. A portfolio of loans purchased for an amount less than its face value may represent a portfolio discount to which the modified accruals rule may also apply. The election can only be made in the following circumstances:

•

where the taxpayer has prepared audited financial reports in accordance with the accounting standards (or comparable standards) [ Schedule 1, item 1, subsection 230-150(1 )]; or

•

all the following criteria are satisfied:

-

a connected entity of the taxpayer has prepared an audited financial report;

-

the report of the connected entity is a consolidated financial report that deals with both the taxpayer's affairs and the affairs of the connected entity; and

-

the report properly reflects the taxpayer's affairs (discussed below and in Chapter 5).

4.156 The election applies to financial arrangements that the taxpayer starts to have in the year of the election or subsequent years following the election [ Schedule 1, item 1, paragraphs 230-160(1)(a) and (b) and 230-165(1)(a) and (b )]. Once made an election it is irrevocable (subsection 230-150(2)).

4.157 The election applies only to portfolio fees or discount/premiums arising from a financial arrangement that is part of a portfolio of similar financial arrangements [ Schedule 1, item 1, subsections 230-160(3) and 230-165(3 )]. What is meant by 'similar' in the context of a portfolio of financial arrangements is to be determined by reference to the terms, conditions such as tenure, pricing and risk profile of the financial arrangements. An example could be a portfolio of similar home mortgages or credit card receivables held by a bank or financial institution.

4.158 The 'portfolio fees' are those fees that (in the absence of the 'portfolio fee' election) would form part of the gain or loss from the financial arrangement under subsection 230-105(1) [ Schedule 1, item 1, paragraph 230-160(1)(c )]. The discount/premium is that part of the gain or loss that arises as a result of the discount/premium on the loan portfolio. Specifically, for the purpose of the election, that part of the gain or loss arising from the fees, and the part relating to the discount/premium, are treated as separate gains or losses from the financial arrangement [ Schedule 1, item 1, subsection 230-160(2 )].

4.159 In the case of fees, in order for the election to apply they must play an integral role in determining the amount of the gain or loss from the financial arrangement. What is integral is determined by the nature and role of the fee in relation to the financial arrangement that gives rise to the overall gain or loss. [ Schedule 1, item 1, paragraph 230-160(1)(e )]

4.160 The net amount of these fees should not be significant relative to the gain or loss on the arrangement [ Schedule 1, item 1, paragraph 230-160(1)(f )]. In relation to the fee gain or loss, the net fee is used because portfolio fees include both fee (income) and costs (expenses). Examples of typical fees that would be included in a portfolio of fees are establishment fees, legal fees, search fees, brokerage commission (costs), and valuation (costs). In the case of discounts and premiums, the premium or discount should not be significant relative to the gain or loss on the portfolio of which the financial arrangement is a part [ Schedule 1, item 1, paragraph 230-165(1)(e )].

4.161 As the portfolio treatment of discounts/premiums will modify the general rule relating to the period over which the gain or loss is spread (in some cases shortening the 'spread' period) it is a requirement that the fees and the discount/premium must be insignificant relative to the gain or loss (that excludes the net portfolio fee) from the portfolio of which the financial arrangement is a part (which typically mainly consist of interest income).

4.162 What is not significant is determined on an objective basis depending on the facts and circumstances, for example it could be said that net fees of $1000 on a home loan which gives rise to interest income of $100,000 would not be significant relative to the overall gain on the loan. The testing time for determining whether the net fee is insignificant is at the start of the financial arrangement. [ Schedule 1, item 1, paragraphs 230-160(1)(f) and 230-165(1)(e )]

Example 4.6

An entity acquires from a vendor a portfolio of loans that include a right to receive $120 in two years time. However, the entity provided $110 to acquire this arrangement, notwithstanding that the market value of the right to receive $120 in two years time is $100.

The gain on the arrangement is $10. The gain of $10 is split into one gain and another loss. The part of the gain which relates to the premium is a loss of $10, and the part not relating to the premium is a $20 gain.

The entity spreads the $20 gain using the standard accruals/realisation method.

The entity spreads the $10 loss in accordance with the determination referred to below.

How is the expected life of the portfolio determined

4.163 The period over which the fees are spread is the expected life of the portfolio. In the case of fees, the period is to be determined before the fee is payable or receivable and must be reasonable and objective. Further, the period is to be determined prior to the entity starting to have the arrangement [ Schedule 1, item 1, paragraphs 230-165(3)(b) to (d) and 230-160(3)(b) to (d )]. What is considered reasonable and objective would depend on the facts and circumstances of each portfolio, and would include the assumptions made and methodology used to determine the average life of the portfolio, for example quantitative data or analysis (based on historical data) on the expected early repayment of similar financial arrangements.

4.164 The basis of determining the period over which to spread the portfolio must accord with the spreading of the discount premium for the purposes of the profit and loss statement in the audited financial reports of the taxpayer [ Schedule 1, item 1, paragraphs 230-160(3)(a) and 230-165(3)(a )]. It would be considered that the basis of determining the period for spreading the portfolio discount premium accords with the audited financial reports if the basis determined does not result in a qualification to the audited report of the taxpayer with respect to the period determined.

4.165 In the case of fees, the method of spreading the fee must also be reasonable and objective and be determined before the fee is payable or receivable [ Schedule 1, item 1, subsection 230-160(4 )]. In the case of portfolio premiums and discounts, the method of spreading the premium or discount must also be reasonable and objective and be determined before the entity starts to have the arrangement [ Schedule 1, item 1, subsection 230-165(4 )]. Further, the method of spreading the portfolio fees discounts or premiums must accord with the spreading of the fees in the profit and loss statement in the audited financial reports.

4.166 What is considered reasonable and objective would depend on the facts and circumstances of each type of fee, and would include the assumptions made or methodology used to determine what portion of the fee (income or expense) is to be spread. For example, it may be that expenses that relate in part to unsuccessful loans such as legal or valuations expenses may be spread on a percentage basis as determined by historic loan success rate data. It would be considered that the method of spreading of portfolio fee accords with the audited financial accounts if the method used does not result in a qualification of the audited accounts because of the manner in which the portfolio fees have been spread.

Transitional election to apply Division 230 to existing financial arrangements - application of portfolio treatment to existing financial arrangements

4.167 A taxpayer will not be prevented from applying the 'portfolio' treatment (to spread the fees) arising from a financial arrangement that existed prior to the first income year in which Division 230 applies to the taxpayer, and that the taxpayer still has at the time the Division first applies to the taxpayer. In these cases, the election in section 230-150 is able to be made despite the fact that the taxpayer started to have the financial arrangement before the first income year in which the Division applies to the taxpayer. [ Schedule 1, Part 3, subitem 104(7 )]

Allocating gain or loss to income years

4.168 That part of a gain or loss that has been allocated, pursuant to the compounding accruals or other acceptable method, to a particular interval must be brought to account under section 230-15 as:

•

assessable income; or

•

an allowable deduction, provided the loss requirements in section 230-15 are satisfied,

in the income year in which the interval falls. [ Schedule 1, item 1, subsection 230-170(1 )]

4.169 If the relevant interval straddles an income year, such that it starts in one income year and ends in the subsequent income year, the part of the gain or loss that relates to that interval must be allocated between the income years on a reasonable basis. The relevant amount that is brought to account under section 230-15 is so much of that part of the gain or loss that has been allocated to each income year. [ Schedule 1, item 1, subsection 230-170(2 )]

Running balancing adjustment

4.170 As noted above, the amount of a gain or loss that is subject to the compounding accruals provisions is calculated using sufficiently certain financial benefits, the values of which were fixed or determinable with reasonable accuracy at a particular point in time. That is, the values of the relevant financial benefits were estimated. Over time, the financial benefits that are to be received or provided under the financial arrangement will be received or paid. At the time a financial benefit is received or provided (or the time comes for the financial benefit to be received or provided), a balancing adjustment may be required.

4.171 The difference between the estimated value of a financial benefit and the amount that a taxpayer receives or provides will be brought to account by the application of the running balancing adjustment as either a gain or loss for the purposes of Division 230. This means that the taxpayer will recognise an amount of assessable income or, where the relevant loss requirements are satisfied, an allowable deduction which is equal to the relevant excess or shortfall. The excess or shortfall is brought to account for tax purposes in the income year in which the time for the financial benefit to be received or provided occurs, or at the time the financial benefit is actually received or provided if this is earlier. [ Schedule 1, item 1, section 230-175 ]

4.172 More specifically, by virtue of the running balancing adjustment, an amount of a loss may be recognised where the compounding accruals method applied to the financial arrangement at a particular time and the taxpayer:

•

was sufficiently certain that they would receive a financial benefit of at least a particular amount and, at the time when the financial benefit is received or is to be received, the amount received is a nil amount or an amount that was less than the estimated amount of the financial benefit [ Schedule 1, item 1, subsection 230-175(1 )]; or

•

was sufficiently certain that they would provide a financial benefit of at least a particular amount and, at the time when the financial benefit is provided or is to be provided, the amount provided is more than the estimated value of the financial benefit [ Schedule 1, item 1, subsection 230-175(4 )].

4.173 Equally, the running balancing adjustment will apply in cases where an amount of a gain is recognised where the compounding accruals method applied to the financial arrangement and, at a particular time, the taxpayer:

•

was sufficiently certain that they would receive a financial benefit of at least a particular amount and, at the time when the financial benefit is received or is to be received, the amount received is more than the estimated amount of the financial benefit [ Schedule 1, item 1, subsection 230-175(2 )]; or

•

was sufficiently certain that they would provide a financial benefit of at least a particular amount and, at the time when the financial benefit is provided or is to be provided, the amount provided is nil or less than the estimated value of the financial benefit [ Schedule 1, item 1, subsection 230-175(3 )].

Re-estimation of gain or loss

4.174 Whether a financial arrangement will be subject to the compounding accruals method is to be determined initially at the time when the taxpayer starts to have the financial arrangement or when specific financial benefits become sufficiently certain so as to give rise to a sufficiently certain particular gain or loss. Generally, for many financial arrangements, the taxpayer will apply the compounding accruals method to the relevant gain or loss for the term of the financial arrangement. However, some circumstances may arise where, during the term of the financial arrangement, the calculation of the gain or loss to be accrued must be re-estimated. For example, previously contingent amounts that are no longer contingent may affect the amount of the gain or loss that is sufficiently certain to occur under the financial arrangement.

When is re-estimation necessary?

4.175 A taxpayer is required to re-estimate a gain or loss from a financial arrangement if:

•

the compounding accruals method applies to that gain or loss; and

•

there is a material change to the circumstances that affect the estimate, in respect of an amount or value of a financial benefit or the timing of the provision of a financial benefit.

The taxpayer is required to make that re-estimation as soon as practicable after they become aware of the relevant material changes to the circumstances. [ Schedule 1, item 1, subsection 230-190(2 )]

4.176 Relevant circumstances which would require a re-estimation include, but are not limited to:

•

a material change in market conditions which is relevant to the amount or value of financial benefits that are to be received or provided under the financial arrangement [ Schedule 1, item 1, paragraph 230-190(3)(a )];

•

the cash flow or flows which were previously estimated become known [ Schedule 1, item 1, paragraph 230-190(3)(b )];

•

the right to, or part of a right to, a financial benefit under the financial arrangement is written off as a bad debt [ Schedule 1, item 1, paragraph 230-190(3)(c )]; and

•

a re-assessment of the gains or losses to which the compounding accruals method should apply (pursuant to section 230-185) being undertaken and it being determined that the compounding accruals method was still the appropriate method to apply to those gains or losses [ Schedule 1, item 1, paragraph 230-190(3)(d )].

4.177 A taxpayer is not required to re-estimate the amount of the gain or loss if the change in the value or amount of the financial benefit or the timing of the financial benefit is not significant. The requirement is that a change to those circumstances affecting a financial benefit is a material change . Whether there has been a material change is a question of fact which depends on the relevant circumstances of each situation. An example is where there is a change to circumstances such that a cash flow which was previously estimated becomes known, but where the difference between the estimated value of the cash flow and the actual value of the cash flow is small or negligible in nominal terms. In such an instance, the change would not be material. Hence, a re-estimation is not required in such a situation and the taxpayer will continue to accrue the originally calculated sufficiently certain gain or loss. In such cases the small differences between the estimated values and the actual values of the relevant financial benefits will be brought to account by way of the running balancing adjustment in section 230-175.

4.178 Under section 230-190, a re-estimation is only done where a change in the circumstances will materially affect the amount or value or timing of a financial benefit that was used to calculate a gain or loss made from the financial arrangement. However, if, consistent with a taxpayer's accounting systems, a re-estimation is still required where there is a change in circumstances which gives rise to an insignificant difference between the value of estimated cash flows and the value when those cash flows become known, a taxpayer may still apply the re-estimation provisions to the relevant financial arrangement. That re-estimation can be done where the method used in the taxpayer's accounting systems approximates the results under the compounding accruals method. Generally, if the changes are insignificant, then it may be considered that the results are a reasonable approximation of the method under Subdivision 230-B. Such a practice must be adopted consistently - that is, if a re-estimation is to be done for insignificant differences between estimated and actual values for financial benefits in relation to a particular financial arrangement, that re-estimation must be done for all similar financial arrangements.

4.179 A re-estimation of a gain or loss is not done where there has been a change in the credit rating or creditworthiness of a party or parties to the financial arrangement. [ Schedule 1, item 1, subsection 230-190(3 )]

4.180 The case of impairment is to be distinguished from cases where rights to financial benefits have been written-off as a bad debt. The taxpayer will re-estimate the relevant gain from the financial arrangement only where such rights have been written-off as a bad debt. Taxation Ruling TR 92/18 provides guidance as to when a debt is a bad debt. A debt will not be a bad debt if it is simply doubtful that the debt will be recovered [ Schedule 1, item 1, paragraph 230-190(3)(c )]. Further, the amount of the loss that is available where a bad debt is written-off is limited to the extent provided for in the legislation.

Annual or more frequent reset date

4.181 Where the gain or loss qualifies for spreading under the above rule and:

•

the financial arrangement has an interest reset date or dates which occur at least annually; and

•

a new interest rate (if any) applies to the arrangement from no later than the date at which the rate is set,

the re-estimation of the gain or loss may be done at the reset date instead of at the time at which the taxpayer becomes aware of the relevant change in circumstances referred to in paragraph 230-190(1)(b). [ Schedule 1, item 1, subsection 230-190(2 )]

Re-estimation where there is a partial disposal

4.182 A re-estimation is also required where the accruals method applies to gains or losses made from the financial arrangement, and the balancing adjustment under Subdivision 230-G is made in relation to the same financial arrangement. The re-estimation is made where the balancing adjustment in Subdivision 230-G applied because a proportionate share of the rights or obligations or particular rights or obligations under the arrangement were transferred to another person [ Schedule 1, item 1, subsection 230-200(1 )]. In such a situation, only the method prescribed under section 230-200 should be used to re-estimate the relevant gain or loss that will be made from the financial arrangement.

4.183 The balancing adjustment under Subdivision 230-G should bring to account, at the time of disposal of the relevant rights and obligations, a gain or loss referable to those rights and obligations. The re-estimation provisions are triggered because the transfer of one or more rights and/or obligations would be expected to materially affect the amount or value and timing of financial benefits that were taken into account in calculating the amount of the originally determined sufficiently certain gain or loss. It would be inappropriate then to allow that same amount of gain or loss to be recognised under the re-estimation. This would have been the outcome if the provisions in section 230-190 were to apply without adjustment.

4.184 Further, where the part of the financial arrangement disposed of was a right to an interest stream, Subdivision 230-G will have appropriately allocated a cost to that interest income stream disposed of, and calculated a gain or loss with reference to that cost and the proceeds received for the disposal. The requirement to disregard the special rules in relation to interest or things in the nature of interest in subsections 230-70(4) and 230-75(4) is intended to ensure that the remaining gain or loss to be accrued can appropriately take account of that part of the cost of the financial arrangement that has been attributed to the portion disposed of. [ Schedule 1, item 1, subsection 230-200(2 )]

Nature of a re-estimation

4.185 A re-estimation for the purposes of Division 230 involves two parts - first, a fresh determination of the amount of the gain or loss and a reallocation of the remaining part of that revised amount over the remaining part of the accrual period. [ Schedule 1, item 1, subsection 230-190(5 )]

4.186 The calculation of the re-estimated gain or loss will require a comparison of the values of the relevant sufficiently certain financial benefits that are to be received and provided by the taxpayer using the re-estimated values where relevant (see paragraphs 4.126 to 4.129 for a discussion on the calculation of gains and losses). A 'balancing adjustment' is recognised at the time the re-estimation is done if the method in subsection 230-195(5) is used. This balancing adjustment will ensure that, at the time of re-estimation, there is a correction made such that only the value of the actual gain or loss which is made by the taxpayer is brought to account under Division 230 during the life of the arrangement, so that a large adjustment will not be required at the end of arrangement.

4.187 In situations where there is a partial disposal of a financial arrangement by way of a transfer of one or more rights and/or obligations in relation to financial benefits, a fresh determination of the amount of the gain or loss is also required. In making a fresh determination, the taxpayer is required to disregard those financial benefits to the extent to which they are reasonably attributable to the proportionate share or right or obligation that were transferred [ Schedule 1, item 1, subparagraph 230-200(2)(a)(i )]. The taxpayer is also required to disregard amounts of the gain or loss that have already been allocated to intervals ending before the re-estimation is made, to the extent to which that part of the gain or loss is reasonably attributable to the part of the financial arrangement that was transferred [ Schedule 1, item 1, subparagraph 230-200(2)(a)(ii )]. Disregarding such financial benefits and proportionate amounts of the relevant gain or loss will ensure that there is no double recognition of amounts in the recalculated gain or loss.

Basis for re-estimation - method used for fresh allocation

4.188 As noted in paragraph 4.185, the nature of a re-estimation involves two parts. The first part is a fresh determination of the gain or loss that is estimated to be made under the financial arrangement. The second part of the re-estimation process requires that a taxpayer make a fresh allocation of the part of the recalculated gain or loss to the remaining part of the accrual period. One of two methods can be used to make a fresh allocation:

•

the first method is to maintain the rate of return which was used prior to the re-estimation and adjust the amount to which that rate of return is applied; or

•

the second method is to maintain the amount to which the rate of return was applied prior to the re-estimation and adjust the rate of return that is applied to that amount.

[ Schedule 1, item 1, subsection 230-190(6 )]

4.189 The amount to which the rate of return is applied depends on the method used. The first method involves adjusting the amount to which the rate of return is applied to equal the present value of the estimated future (revised) cash flows, discounted at the rate of return that is being maintained. This adjusted amount becomes the amortised cost to which the maintained rate of return will be applied to calculate the amount of the remaining gain or loss that is to be accrued. [ Schedule 1, item 1, paragraph 230-190(6)(a )]

4.190 The second method requires an adjustment of the rate of return and maintaining the amount to which that rate of return will be applied. That amount is the amortised cost of the arrangement at the time of the re-estimation. The adjusted rate of return is calculated by reference to the amortised cost and the present value of the (revised) estimated future cash flows at the time of re-estimation [ Schedule 1, item 1, paragraph 230-190(6)(b )]. The application of these methods is demonstrated in Example 4.7.

4.191 It is arguable that in accordance with paragraph 230-190(6)(b) - under which the fresh allocation can be made on the basis that the rate of return is adjusted while the amount to which that rate is to be applied is maintained - there is an implication that the amount cannot be changed other than under the alternative basis of fresh allocation found in paragraph 230-190(6)(a). That will not be the case.

4.192 The amount can be adjusted for reasons other than a fresh allocation under paragraph 230-190(6)(a)). Indeed, this adjustment is often an essential element of working out, under section 230-135, the compounding accruals gain or loss for a given interval. Subsection 230-135(6) in particular clarifies that the amount to which the rate of return is applied should have regard to financial benefits provided or received during the interval. Accordingly, this amount can change because of, for example, a partial repayment of a loan or the non-payment of interest during the interval.

4.193 The object of the two methods is to bring the re-estimated gain or loss to account on an appropriate basis such that the gain or loss is properly accounted for over the whole period over which the gain or loss is spread. Compliance cost issues would arise if the taxpayer is required to amend prior year's returns each time a re-estimation of an amount is required. Hence, the object of the fresh allocation is to ensure that the remaining part of the re-estimated gain or loss is allocated to the remaining intervals under the financial arrangement. That is, the fresh allocation of the remaining gain or loss applies from the income year in which the taxpayer makes the re-estimation until the end of the relevant accrual period. A wash-up of over-accrued or under-accrued amounts is achieved by way of a specific balancing adjustment where the first method above is used [ Schedule 1, item 1, section 230-195 ]. The balancing adjustment that is made on a re-estimation is to be distinguished from the running balancing adjustment, which applies during the life of the arrangement as financial benefits which were estimated become known (see discussion at paragraphs 4.170 to 4.173). Any amounts previously recognised under the running balancing adjustment rule in section 230-175 are taken to have been allocated to intervals ending before the re-estimation was done.

4.194 Taxpayers who prepare audited financial reports in accordance with the Australian accounting standards, or comparable standards, may apply the methods under paragraph 230-190(6)(a) or (6)(b), so long as the taxpayer continually and consistently applies the methods in accordance with the accounting standards. Taxpayers who do not prepare audited financial reports in accordance with the Australian accounting standards, or comparable standards, may only apply paragraph 230-190(6)(b). However, where a taxpayer's application of paragraph 230-190(6)(b) - due to the rule for impaired financial arrangements in subsection 230-190(9) - is in conflict with the requirements of the accounting standards, this does not cause the taxpayer to fail to satisfy the requirements of subsection 230-190(7). [ Schedule 1, item 1, subsection 230-190(7 )]

4.195 The same consistency rule is not relevant where there has been a partial disposal of a financial arrangement by way of a transfer of one or more rights and/or obligations under the arrangement to another person. In such situations, the taxpayer is required to re-allocate the remaining part of the recalculated gain or loss (that has not already been allocated to intervals occurring before the time of re-estimation) over the remaining part of the accrual period by maintaining the relevant rate of return and adjusting the amount to which that rate is applied. The adjusted amount is equal to the present value of the estimated future cash flows discounted at the maintained rate of return. [ Schedule 1, item 1, subsection 230-200(3 )]

4.196 If there is an impairment (within the meaning of the accounting standards) of the financial arrangement or financial asset or financial liability that forms part of the financial arrangement, a re-estimation is required to be made in accordance with paragraph 230-190(6)(b) [ Schedule 1, item 1, subsections 230-190(8) and (9 )]. A loss that arises because of the impairment is not deductible for that income year nor able to be accrued in a later interval [ Schedule 1, item 1, subsection 230-190(10 )].

Balancing adjustment if the rate of return maintained

4.197 Where a taxpayer has chosen to make a fresh allocation of the re-estimated gain or loss by maintaining the original rate of return and adjusting the amount to which the rate of return is applied, other than in the case of a partial disposal, an amount is brought to account in the income year in which the re-estimation is made [ Schedule 1, item 1, subsection 230-195(1 )]. The adjustment is intended to capture the amount of the difference between the amount of the re-estimated gain or loss which should have been brought to account up until the time of re-estimation and the amount of the previously estimated gain or loss which had been brought to account. A similar adjustment is made under the accounting standard AASB 139, where a financial instrument is subject to the effective interest rate method (eg, see paragraph AG 8 of AASB 139).

4.198 On applying the balancing adjustment provisions, a gain will arise in the income year in which the re-estimation is made if:

•

the re-estimated amount is a gain and the amount to which the maintained rate of return is applied increases in value as a result of the re-estimation. The amount of the gain is equal to that increase [ Schedule 1, item 1, paragraph 230-195(1)(a )]; or

•

the re-estimated amount is a loss and the amount to which the maintained rate of return is applied decreases in value as a result of the re-estimation. The amount of the gain is equal to that decrease [ Schedule 1, item 1, paragraph 230-195(1)(d )].

4.199 On applying the balancing adjustment provisions, a loss will arise in the income year in which the re-estimation is made if:

•

the re-estimated amount is a gain and the amount to which the maintained rate of return is applied decreases in value as a result of the re-estimation. The amount of the loss is equal to that decrease [ Schedule 1, item 1, paragraph 230-195(1)(b )]; or

•

the re-estimated amount is a loss and the amount to which the maintained rate of return is applied increases in value as a result of the re-estimation. The amount of the loss is equal to that increase [ Schedule 1, item 1, paragraph 230-195(1)(c )].

4.200 The gain or loss that is made on applying the balancing adjustment provision in subsection 230-195(1) is brought to account as assessable income or an allowable deduction (provided the loss requirements of section 230-15 are satisfied) in the income year in which the re-estimation is made.

4.201 Where there has been a partial disposal of some of the rights and/or obligations under the arrangement, no balancing adjustment, other than that under Subdivision 230-G, is available for the reasons provided in paragraph 4.182.

Example 4.7 : Application of the re-estimation provisions: income security with non-periodic cash flows

FLD Finance Co buys a four-year security for $1,000 at the beginning of the income year (year 1). FLD Finance Co has an annual turnover of $40 million and has not made any elections under Division 230.

Under the security, FLD Finance Co is entitled to fixed cash flows at the end of years 1, 2, 3 and 4 as outlined in Table 4.2. FLD Finance Co is also entitled to additional contingent amounts payable at the end of each of these years; the contingency does not relate to credit risk. Assume that the contingent amounts are sufficiently certain (because despite the contingency, it is reasonable to expect that the financial benefits will be received) and that, as a result, the following amounts will be added to the fixed payments at the ends of years 1, 2, 3 and 4: $20, $30, $60 and $100. A summary of expected cash flows from the arrangement are outlined in Table 4.2.

Table 4.2 : Summary of cash flows

Year	Fixed cash flows	Estimated cash flows	Total cash flow for the year
0	-$1,000.00	$0.00	-$1,000.00
1	$20.00	$20.00	$40.00
2	$20.00	$30.00	$50.00
3	$20.00	$60.00	$80.00
4	$1,000.00	$100.00	$1,100.00

This will mean that FLD Finance Co will have an overall gain of $270 from the arrangement that must be accrued over the life of the arrangement.

Based on the estimated values of the financial benefits, the internal rate of return of the security is 6.58 per cent per annum ^[1] .

Assume that in income years 1 and 2, FLD Finance Co receives the amounts that it estimated it would receive. However, at the beginning of income year 3, FLD Finance Co determines that the contingent amounts in that year and income year 4 will be fixed at $40 and $70 respectively because the contingency that relates to that part of those payments has been resolved. Hence, for those years, the entire amount of the fixed cash flows will instead be $60 and $70 respectively.

This is a situation in which there would be a requirement to re-estimate the amount of gain that FLD Finance Co will make under the arrangement because the previously estimated cash flows have become known (paragraph 230-190(3)(b)).

If there was no re-estimation during the term of the security, the tax calculations would have been as shown in Table 4.3.

Table 4.3 : The amounts that would have been accrued if there was no re-estimation

Year	Amortised cost (year start )	Gain	Cash flows	Amortised cost (year end )
	( a )	( b )	( c )	( a ) + ( b ) - ( c )
0	$0.00	$0.00	-$1,000.00	$1,000.00
1	$1,000.00	$65.83	$40.00	$1,025.83
2	$1,025.83	$67.53	$50.00	$1,043.36
3	$1,043.37	$68.69	$80.00	$1,032.06
4	$1,032.06	$67.94	$1,100.00	$0.00

Application of the re-estimation provisions

Making a re-estimation in such circumstances involves:

•

a fresh determination of the amount of the gain (subsection 230-190(5)); and

•

a reapplication of the accruals method to the re-determined gain to make a fresh allocation of that re-determined gain. The reallocation of the re-determined gain applies only to that part of the gain that has not already been allocated to intervals ending before the re-estimation is made (subsection 230-190(5)).

FLD Finance Co chooses to apply the first method - maintaining the original rate of return and adjusting the amount to which that rate is to be applied (paragraph 230-190(6)(a)).

Making a fresh determination of the amount of the gain

The fresh determination of the gain would be calculated with reference to the revised values of the financial benefits under the financial arrangement. That amount would be:

-$1,000 principal paid at the start of the arrangement;

plus

$220 representing the value of cash flows over the period of the arrangement;

plus

$1,000 return of the principal at the end of the arrangement.

The re-determined gain would therefore be $220.

FLD Finance Co must reapply the accruals method to the gain or loss to make a fresh allocation of that part of the re-determined gain that has not already been allocated to intervals ending before the re-estimation is made. An amount of $133.36 has already been brought to account in intervals ending before the re-estimation is made. Hence the remaining amount of the re-determined gain is $86.64 (ie, $220 less $133.36).

FLD Finance Co makes that fresh allocation by maintaining the rate of return being used and adjusting the amount to which the rate of return is applied. The adjusted amount comprises the present value of the estimated future cash flows, discounted at the maintained rate of return (ie, 6.58 per cent per annum). This results in an adjusted tax cost of $998.19.

Assuming that there are no further re-estimations, and that FLD Finance Co receives the revised cash flows, the tax calculations for income years 3 and 4 would - based on applying the originally determined rate of return to the adjusted (amortised cost) amount - be as follows.

Table 4.4 : Amounts to be accrued using the method in paragraph 230-190(6)(a)

Year	Amortised cost (year start )	Gain	Cash flows	Amortised cost (year end )
	( a )	( b )	( c )	( a ) + ( b ) - ( c )
3	$998.19	$65.71	$60.00	$1,003.90
4	$1,003.91	$66.09	$1,070.00	$0.00

Under this method, FLD Finance Co is also required to make a balancing adjustment at the time of the re-estimation (subsection 230-195(1)). The amount of the balancing adjustment is equal to the difference between the amount which FLD Finance Co applied to the maintained rate of return, and the adjusted amount to which the maintained rate of return is to be applied. The amount to which FLD Finance Co would have, instead, applied the original rate of return is $1,043.36. The balancing adjustment that is to be applied in these circumstances will bring to account the difference between that amount and the adjusted tax cost of $998.19. That difference, $45.18, is a loss that would be recognised in income year 3 - the income year in which the re-estimation is made (paragraph 230-195(1)(b)).

Calculation required where method under paragraph 230-195(5)(b) is applied

If, instead, FLD Finance Co had chosen to apply the second method of adjusting the rate of return and maintaining the amount to which that rate is to be applied, the following calculation would be done. Firstly, the relevant gain or loss must be re-estimated. This calculation would be no different from the method under paragraph 230-190(5)(a). Hence, the re-estimated gain will be $220.

FLD Finance Co must reapply the accruals method to the gain or loss to make a fresh allocation of that part of the re-determined gain that has not already been allocated to intervals ending before the re-estimation is made. Hence the remaining amount of the re-determined gain is $86.64.

FLD Finance Co makes that fresh allocation by adjusting the rate of return and maintaining the amount to which the recalculated rate of return is applied. FLD Finance Co does this by calculating a new internal rate of return, based on the amortised cost of $1,043.37, and the expected future cash flows of $60 in year 3 and $1,070 in year 4. The adjusted rate of return for these future cash flows will be 4.18 per cent ^[2] .

Assuming that there are no further re-estimations and that FLD Finance Co receives the revised cash flows, the tax calculations for income years 3 and 4 would, under the method in paragraph 230-190(6)(b), be:

Table 4.5 : Amounts to be accrued using method in paragraph 230-190(6)(b)

Year	Amortised cost (year start )	Gain	Cash flows	Amortised cost (year end )
	( a )	( b )	( c )	( a ) + ( b ) - ( c )
3	$1,043.37	$43.65	$60.00	$1,027.02
4	$1,027.02	$42.98	$1,070	$0.00

The amount that is brought to account under this method over the remaining two years is equal to the amount of the remaining part of the re-determined gain - that is, a gain of $86.63.

Limit on balancing adjustment amount where the re-estimation is triggered by a bad debt write-off

4.202 The accruals method applies to gains or losses which are calculated on a net basis. If a debt or part of the debt (which is a financial arrangement) goes bad, difficulties arise as to how to identify the effect that the financial benefits, which have become bad should have, in respect of the amount of the estimated gain which should now be accrued. This is because the effect of some of the financial benefits going bad is that the overall or particular gain which was previously sufficiently certain would have been a lesser amount, had it been known at that time that the relevant financial benefits were going to go bad - hence, the value which should have been allocated to each of the intervals, in the entire accrual period, would have been a different amount.

4.203 The policy intent of this provision is to provide a deduction, by way of a balancing adjustment, which is limited to an amount that is referable to that part of the gain or loss which was previously bought to account in respect of the financial arrangement and which is reasonably attributable to the right, or part of the right, to the financial benefit that has been written off as bad. It is not intended that the balancing adjustment under section 230-195 apply to effectively allow a deduction for doubtful debts, or of an amount of capital (eg, the principal investment provided under the debt). This policy intent is also reflected in the specific exclusion from the re-estimation provisions, where the re-estimation is triggered by an impairment of the financial arrangement (within the meaning of that term in the Australian accounting standards). [ Schedule 1, item 1, paragraph 230-190(8)(b )]

4.204 A 'bad debt' for the purposes of Division 230 is intended to be the same concept as that encompassed in section 25-35 of the ITAA 1997. Where the re-estimation is triggered by a bad debt write-off, the amount of the balancing adjustment deduction, which would have otherwise been calculated under subsection 230-190(5), is instead limited to the amount of the gain that has already been assessed under Division 230, to the extent that the gain was reasonably attributable to the financial benefit which was written off as bad [ Schedule 1, item 1, subsection 230-195(3 )]. The limit to the deduction allowed under subsection 230-195(1) applies where:

•

the taxpayer has written off, as a bad debt, a right to receive a financial benefit or part of a financial benefit. Generally, provided a bona fide commercial decision is taken by a taxpayer as to the likelihood of the non-recovery of a debt, it will be accepted that the debt is bad for these purposes (see Taxation Ruling TR 92/18 for guidelines); and

•

the right is not one of the following:

-

a right in respect of money which the taxpayer lent in the ordinary course of their business of lending money (note that the term 'business' is defined in subsection 995-1(1) of the ITAA 1997); or

-

a right which is one that the taxpayer bought in the ordinary course of their business of lending money.

[ Schedule 1, item 1, subsection 230-195(2 )]

4.205 In situations where the taxpayer has lent money in the course of their business of lending money, the full amount of the adjustment under subsection 230-195(1) is available. Further, if the taxpayer has bought a right to receive a financial benefit in the ordinary course of their business of lending money (ie, the taxpayer bought a debt) the intention is to provide a deduction, limited to the cost of acquiring the right [ Schedule 1, item 1, subsection 230-195(5 )]. This reflects the policy in section 25-35 of the ITAA 1997, which is intended to be replicated for the purposes of Subdivision 230-B. Further, an exception to the anti-overlap rule in section 230-25 is specifically included - to allow a deduction for a bad debt write-off where the amount of a financial benefit was included in a taxpayer's assessable income under a provision outside of Division 230 (see Chapter 3 for further discussion).

4.206 There are special rules contained in subsection 25-35(5) of the ITAA 1997 which affect a taxpayer's entitlement to a bad debt deduction under section 25-35 or which may result in deductions under that section being reversed. It is intended that the same adjustments apply to bad debt deductions which are allowable under Division 230, as opposed to section 25-35. The fact that the deduction for the bad debt is recognised under section 230-15, rather than section 25-35, should not result in such adjustments being ignored for the purposes of the ITAA 1997. This is achieved by requiring that the deduction allowable under Division 230, in respect of the balancing adjustment, be treated as a deduction of a bad debt for the purposes of the ITAA 1936 and the ITAA 1997. [ Schedule 1, item 1, subsection 230-195(6 )]

When to use the realisation method

4.207 The realisation tax-timing treatment applies to financial arrangements which are not the subject of the elective fair value method or where:

•

the taxpayer has elected to rely on their financial accounts under Subdivision 230-F; or

•

the financial arrangement is an equity interest for the purposes of Division 974 of the ITAA 1997.

4.208 The realisation method may have residual application in relation to a financial arrangement, to the extent to which the following methods do not apply to that financial arrangement:

•

the compounding accruals method;

•

the elective fair value method;

•

the elective retranslation method - in respect of foreign currency gains and losses;

•

the elective financial reports method; and

•

the elective hedging regime.

[ Schedule 1, item 1, subsection 230-40(4 )]

4.209 Generally, the realisation method will apply to those financial benefits where it is not sufficiently certain that they will occur because, for example, they are the subject of a contingency, or where the value or amount of the financial benefit is not fixed or determinable with reasonable accuracy. A discussion as to whether a financial benefit will be sufficiently certain is contained in paragraphs 4.97 to 4.125.

4.210 For example, the realisation method may apply to vanilla option and forward contracts that are entered into at market rates. Under such arrangements it would be improbable to conclude that the financial benefits are sufficiently certain so as to give rise to a sufficiently certain gain or loss from the derivative. This assumes that there are no payments fixed in advance for more than the normal settlement period for such contracts (approximately three days).

4.211 The realisation method can be distinguished from the balancing adjustment provisions in Subdivision 230-G. Under Subdivision 230-G a gain or loss is recognised only where the taxpayer either transfers some or all of the rights and obligations under the arrangement to another person, or all of the rights or obligations under the arrangement otherwise cease [ Schedule 1, item 1, subsection 230-435(1 )]. In contrast, the realisation method applies where a financial benefit under a financial arrangement which is not sufficiently certain is paid, or received, or the time comes for it to be paid or received. Although the payment or receipt of a financial benefit will result in the right or obligation to that financial benefit ceasing, other rights and/or obligations to financial benefits under the arrangement may still be held by the taxpayer.

Realisation treatment and hybrid financial arrangements

4.212 Generally, for the purposes of Division 230, hybrid financial arrangements will be assessed on a stand-alone (whole of hybrid) basis. However, hybrid financial arrangements that are bifurcated by taxpayers applying the relevant accounting standards, where part of that hybrid is subject to a fair value tax-timing election, will also be bifurcated for tax purposes [ Schedule 1, item 1, section 230-235 ]. Further discussion in relation to this bifurcation rule is contained in Chapter 6.

4.213 Therefore, gains or losses that are made under a hybrid financial arrangement which do not become sufficiently certain before they are due to be paid or received would be subject to the realisation method if none of the other elective methods apply.

4.214 It should be noted that a hybrid financing arrangement which is an 'equity interest' under Division 974 of the ITAA 1997 is excluded from the realisation method applied under Division 230. [ Schedule 1, item 1, paragraph 230-40(4)(e )]

How is a gain or loss calculated under the realisation method

4.215 As was explained in Chapter 3, a gain or loss for the purposes of Division 230 is a net concept. For the purposes of the realisation method, the gain or loss is calculated as the difference between the value of financial benefits received or that are to be received (the proceeds), and the financial benefits provided or which are to be provided which are attributable to those proceeds (the cost of the financial benefit). Details, as to the application of the attribution rules in calculating a gain or loss, are contained in Chapter 3. Further, if those financial benefits are denominated in a foreign currency, each element of the calculation (ie, each financial benefit that is integral to calculating the relevant gain or loss) is to be translated into the taxpayer's applicable functional currency - and then the gain or loss for realisation purposes is to be calculated. The provisions in Subdivision 960-C of the ITAA 1997 will apply to determine the exchange rate at which to translate the relevant financial benefits.

When to recognise a gain or loss under the realisation method

4.216 Where the realisation method applies to a gain or loss, that gain or loss is brought to account for tax purposes in the income year in which the gain or loss occurs [ Schedule 1, item 1, section 230-180 ]. For the purposes of applying the realisation method, a gain or loss 'occurs' at the time the last of the financial benefits which are to be taken into account in calculating a gain or loss from the arrangement:

•

are provided [ Schedule 1, item 1, paragraph 230-180(2)(a )]; or

•

are due to be provided, if the financial benefit was not provided at that time and it is reasonable to expect that the financial benefit will be provided [ Schedule 1, item 1, paragraph 230-180(2)(b )]. Similar considerations in respect of the test in section 230-115, in respect of whether a financial benefit is sufficiently certain are relevant here. In particular, whether it would be reasonable to expect that the financial benefit will actually be provided is determined on an objective basis.

4.217 The time at which the last of the financial benefits is to be provided is based on an objective analysis of the timing of the rights and obligations under the financial arrangement, rather than an analysis from the point of view of a particular party to the arrangement. This means that the time at which the last financial benefit is to be provided - regardless of which party to the arrangement is under an obligation to provide that benefit - is taken to be the time at which that gain or loss occurs. This will ensure that the timing of the recognition of the gains by one party to the arrangement will correspond accordingly with the loss that will be made by the counterparty to the arrangement.

4.218 Further, the rules in relation to the apportionment of financial benefits in sections 230-70 and 230-75 are relevant to determining whether a gain or loss occurs for realisation purposes. In this sense, there could be several gains or losses that are made from a single financial arrangement - which could arise from a number of different payments or receipts made under the arrangement. Such gains or losses might each separately represent a gain or loss which is subject to the realisation method.

Deductions for bad debts

4.219 The time at which a financial benefit is due to be provided may arise before that benefit is actually provided. The realisation rule requires recognition for tax purposes of the gain or loss at the earlier time - where there is a reasonable expectation that the financial benefits will be provided [ Schedule 1, item 1, subsection 230-180(3 )]. Circumstances may arise where a financial benefit that was taken into account in calculating a gain or loss under the realisation method is not subsequently provided. This may be due to a change of circumstances which happens after the gain or loss is taken to have occurred for Division 230 purposes - such that the relevant right to receive the financial benefit is written off as a bad debt. In such cases, where certain requirements are met, the taxpayer is taken to have made a loss for Division 230 purposes.

4.220 The realisation method principle is contained in subsection 230-180(1) - that is, a taxpayer is required to recognise a gain or loss under the realisation method, when that gain or loss occurs. Where the circumstances required for a deduction for a bad debt write-off are satisfied, the loss which arises is taken to occur when the taxpayer writes off the right to receive a financial benefit as a bad debt [ Schedule 1, item 1, subsection 230-180(6 )]. This is a separate and distinct rule as to the time a loss occurs for realisation purposes, when compared to the primary test contained in subsection 230-180(2).

4.221 In order for such a loss to be recognised, the loss must be made from the writing off a right to receive a financial benefit as a bad debt:

•

where that benefit was taken into account in working out the amount of a gain that was worked out under the realisation method and has been included in the taxpayer's assessable income under Division 230 [ Schedule 1, item 1, paragraph 230-180(3)(a )]. The amount of the loss is equal to so much of the gain which was attributable to the right to the financial benefit which was written off as bad [ Schedule 1, item 1, paragraph 230-180(5)(a )]; or

•

where the right is in respect of money lent in the ordinary course of the taxpayer's business of lending money [ Schedule 1, item 1, paragraph 230-180(3)(b )]. The amount of the loss is equal to the amount of the financial benefit in respect of which the relevant right was written off as bad [ Schedule 1, item 1, paragraph 230-180(5)(b )]; or

•

where the right is one that the taxpayer bought in the ordinary course of their business of lending money [ Schedule 1, item 1, paragraph 230-180(3)(c )]. The amount of the loss is equal to the cost, to the taxpayer, of the right to the financial benefit [ Schedule 1, item 1, paragraph 230-180(5)(c )].

4.222 As was stated in paragraph 4.206, it is intended that the same adjustments, which are contained in subsection 25-35(5) of the ITAA 1997 apply to bad debt deductions as are allowable under Division 230 (rather than under section 25-35). This is achieved by requiring that the deduction allowable under Division 230, in respect of the balancing adjustment, be treated as a deduction of a bad debt for the purposes of the ITAA 1936 and the ITAA 1997 [ Schedule 1, item 1, subsection 230-180(6 )]. Further, an exception to the anti-overlap rule in section 230-25 is specifically included - to allow a deduction for a bad debt write-off where the amount of a financial benefit was included in the taxpayer's assessable income, under a provision outside of Division 230 (see Chapter 3 for further discussion).

Reassessment of whether to apply an accruals or realisation method

4.223 A gain or loss under a financial arrangement which is not subject to any of the elective methods under Division 230, must be assessed when the taxpayer starts to have the arrangement - to determine whether the gains or losses should be brought to account using the accruals or realisation method. After that point, the taxpayer is only required to reassess whether the accruals or realisation method is appropriately applied to a gain or loss where there is a material change in the terms and conditions of the arrangement, or the circumstances affecting the arrangement. [ Schedule 1, item 1, subsection 230-185(1 )]

What constitutes a material change that triggers a reassessment?

4.224 Whether a change is a material change depends on the facts and circumstances of the relevant arrangement. A change to the circumstances external to the terms and conditions of the arrangement, but which nonetheless affect the gains or losses that arise under the arrangement, may trigger a reassessment. Also, not every change to the terms and conditions, or the circumstances affecting the financial arrangement, will be of a material nature. The legislation specifically states a number of changes which are considered to be material changes and which trigger a reassessment. This is not an exclusive list, and other changes may constitute a relevant, material change sufficient to trigger a reassessment under section 230-185.

However, a mere change in the fair value of the financial benefits under the financial arrangement will not, of itself, be considered to be a material change sufficient to require a reassessment. [ Schedule 1, item 1, subsection 230-185(3 )]

Change to the terms or conditions that alters the essential nature of an interest

4.225 A material change to the terms and conditions of the financial arrangement in a way which alters the essential nature of the arrangement will trigger a reassessment. One example is where a debt interest becomes an equity interest for the purposes of Division 974 of the ITAA 1997 [ Schedule 1, item 1, paragraph 230-185(2)(a )]. The test for reassessment under section 230-185 is slightly different from the material change test under the debt and equity provisions in Division 974 - in particular the provisions in section 974-110 of the ITAA 1997. Under section 974-110, the issuer of an interest is required to re-test the instrument every time there is a change to an existing scheme, to ensure it is not a material change that changes its classification under Division 974 from debt to equity or vice versa. In contrast, a material change under section 230-185 is one which has, in fact, affected the classification of an instrument and triggers a reassessment.

Change to the terms and conditions that materially affects the contingencies in respect of significant rights or obligations

4.226 A material change requiring reassessment would be a change to the terms and conditions of the arrangement in a way which materially affects the contingencies on which significant obligations, or rights, under the arrangement are dependent [ Schedule 1, item 1, paragraph 230-185(2)(b )]. The relevant obligations or rights which are affected must be significant, in the context of the financial arrangement.

4.227 The compounding accruals method only applies to gains or losses that are sufficiently certain. A contingency may affect whether a financial benefit, in respect of which certain rights or obligations relate, is sufficiently certain. If a contingency in relation to such a right or obligation is removed, or is resolved, then an amount of a gain or loss which was not previously sufficiently certain, and as a result subject to the realisation method, may become sufficiently certain, such that it would be more appropriate to apply the compounding accruals method.

4.228 Likewise, if a financial benefit was taken into account in working out a sufficiently certain gain or loss, but the right or obligation to which it relates is made subject to a contingency, then that gain or loss may no longer be sufficiently certain and should be subject to the realisation provisions.

4.229 A change in relation to a contingency may trigger a reassessment but the conclusion may be that the compounding accruals method should still apply to the relevant gain or loss. However, the effect of the change in the contingency may be that the amount of the gain or loss will need to be re-estimated. [ Schedule 1, item 1, paragraph 230-190(3)(d )]

A change in circumstances that materially affects the contingencies in respect of significant rights or obligations

4.230 A change that materially affects a pre-existing contingency does not necessarily have to be affected by a change to the terms and conditions of an arrangement. A pre-existing contingency affecting significant rights or obligations under the arrangement may be removed by circumstances surrounding the financial arrangement [ Schedule 1, item 1, paragraph 230-185(2)(c )]. An example of this may be that a number of contingencies may apply to a significant obligation, or right, and the obligation or right becomes no longer subject to the contingencies - or becomes effectively non-contingent - when only one of the contingencies is satisfied.

A change to the terms on which credit is provided to a third party

4.231 A reassessment is required where there is a change to the terms on which credit is to be provided to, or a change to the credit rating of, a person that is not a party to the arrangement, where significant obligations or rights under the arrangement depend on that other person's credit profile. [ Schedule 1, item 1, paragraph 230-185(2)(d )]

4.232 In one sense, if the significant right or obligation is dependent on the other person's ability to obtain credit, or maintain a rating, a change to either of those circumstances will introduce contingencies which will affect whether the relevant financial benefits to which the significant rights and obligations relate will be sufficiently certain.

A change to the terms or conditions or circumstances that are sufficient to treat a financial arrangement, or a part of the arrangement that is a financial asset or financial liability as impaired

4.233 A reassessment is required if the financial arrangement is, or includes, a financial asset or financial liability and the taxpayer prepares financial reports in accordance with the Australian accounting standards, or comparable standards and there is a change to the terms and conditions or the circumstances affecting the financial arrangement - such that it would be treated as impaired for the purposes of those standards [ Schedule 1, item 1, paragraph 230-185(2)(e )]. The outcome of the reassessment can result in either the accrual method no longer applying to the financial arrangement and instead the realisation method applying from the time of reassessment, or the impairment requiring a re-estimation of the gain from the financial arrangement. However, a taxpayer cannot deduct a loss because of impairment when it occurs nor accrue a deduction for the loss in a later interval [ Schedule 1, item 1, subsections 230-190(8) to (10 )].

4.234 This particular trigger for a reassessment will not apply to individuals or entities which satisfy the threshold test in section 230-455. It may apply to entities satisfying that threshold test which have made an election to have Division 230 apply to them, and who prepare financial reports in accordance with the Australian accounting standards.

4.235 'Impairment' for accounting purposes relates to financial assets where the carrying amount of the asset exceeds its estimated recoverable amount (see paragraphs 58 to 70 of the AASB 139). Objective evidence of impairment is required under AASB 139 before a financial asset is considered to be impaired.

4.236 For tax purposes, under the current law, Taxation Ruling TR 94/32 ( Income Tax: non-accrual loans ) specifies what would constitute a non-accrual loan for tax purposes. In particular, the taxation ruling refers to indicators which would provide support for a bona fide assessment based on sound commercial considerations, that interest which was previously accrued is not likely to be received (in particular refer to paragraph 47 of the TR 94/32). Such indicators may be relevant in determining if impairment of a loan has occurred, for the purposes of the accounting standards.

4.237 The effect of impairment for the purposes of the reassessment provisions would be that the future gains (represented by interest payments on the loan) would no longer be accrued but instead would be brought to account under the realisation method.