Edited version of private advice

Authorisation Number: 1051867519738

Date of advice: 15 July 2021

Ruling

Subject:Taxation of financial arrangements

Question 1

Will each interest rate swap entered by the Company with an existing bank counter-party, that is novated to another bank counter-party, constitute a single arrangement for the Company for the purposes of Division 230 of the Income Tax Assessment Act 1997 (ITAA 1997), having regard to the relevant matters contained in subsection 230-55(4)?

Answer

No

Question 2

Will the novation of interest rate swaps from one bank counter-party to another bank counter-party result in a balancing adjustment for the Company under section 230-245 of the ITAA 1997?

Answer

Yes

This ruling applies for the following period:

Income year ended 30 June 2021

The scheme commences on:

During the income year ended 30 June 2021

Relevant facts and circumstances

The Company borrows funds from various financial institutions as part of its ordinary business. In order to hedge its exposure to interest rates, it also enters interest rate derivative contracts with the same financial institutions.

The Company is changing its lending arrangements to remove one financial institution as a lender. Consequently, the Company plans to remove Entity X from connected interest rate swap agreements via a Novated Swap arrangement.

The Company and Entity X entered into a Master Swap Agreement (the Original Master Agreement) to undertake interest rate swap transactions (each known as a "Transaction").

Similarly, the Company and Entity Z had also entered into a Master Swap Agreement (the New Master Agreement) to undertake interest rate swap transactions.

The arrangement to novate interest rate swaps (Novated Swap) requires Entity X to novate the swaps to Entity Z which is a continuing lender with the Company, continuing to have its existing rights and obligations under the swaps, and with no material changes to the terms of the swaps.

The Company would not make or receive any payment in respect of the novation.

The Novated Swap arrangement was facilitated when Entity X (as the Retiring Party), Entity Z (as the Substitute Party) and the Company (as the Continuing Party) signed a Novation Deed (the Deed).

Under the Deed, the Retiring Party and the Continuing Party are parties to the transactions evidenced by the attachments, each being referred to in this agreement as a "Transaction".

The Deed's states that the parties have agreed to a novation of the Transactions on the terms set out in this deed under which the Retiring Party is to surrender its rights and be released and discharged from its obligations under the Transactions and the Substitute Party is to become entitled to equivalent rights and assume equivalent obligations under the Transactions.

The Deed states that reference to the "same" rights or obligations is a reference to rights or obligations which are the same in nature and character as those rights or obligations rather than the same as to the person entitled to them or obliged to perform them.

The Deed states that the Transactions cease to be governed by the Original Master Agreement and instead are deemed to have been and are governed at all times by the New Master Agreement.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 section 230-10

Income Tax Assessment Act 1997 section 230-45

Income Tax Assessment Act 1997 subsection 230-45(1)

Income Tax Assessment Act 1997 section 230-55

Income Tax Assessment Act 1997 subsection 230-55(4)

Income Tax Assessment Act 1997 paragraph230-55(4)(a)

Income Tax Assessment Act 1997 paragraph230-55(4)(b)

Income Tax Assessment Act 1997 paragraph230-55(4)(c)

Income Tax Assessment Act 1997 paragraph230-55(4)(d)

Income Tax Assessment Act 1997 paragraph230-55(4)(e)

Income Tax Assessment Act 1997 paragraph230-55(4)(f)

Income Tax Assessment Act 1997 Subdivision 230-G

Income Tax Assessment Act 1997 section 230-435

Income Tax Assessment Act 1997 subsection 230-435(1)

Income Tax Assessment Act 1997 paragraph 230-435(1)(b)

Income Tax Assessment Act 1997 section 230-440

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise stated.

The Novated Swap will not constitute a single arrangement for the purposes of Division 230.

Having regard to the factors in subsection 230-55(4), the Novated Swap will constitute two or more separate arrangements.

Detailed reasoning

Division 230 deals with the tax treatment of gains and losses from financial arrangements. The Division provides for the recognition of gains and losses, as appropriate, over the life of a financial arrangement.

The term, 'financial arrangement' is defined in subsection 995-1(1) to be the meaning given by sections 230-45 to 230-55.

Under subsection 230-45(1), an arrangement is a financial arrangement if under that arrangement there is:

(a) a cash settlable legal or equitable right to receive a financial benefit; or

(b) a cash settlable legal or equitable obligation to provide a financial benefit; or

(c) a combination of one or more such rights and/or one or more such obligations;...

From the facts provided in this case, the Novated Swap meets the definition of financial arrangement under section 230-45(1).

Subsection 230-55(4) lists the matters that are relevant to identifying whether a number of rights and/or obligations are themselves an arrangement or are 2 or more separate arrangements for the purposes of Division 230. It is a question of fact and degree that is determined having regard to the following:

(a) the nature of the rights and/or obligations;

(b) their terms and conditions (including those relating to any payment or other consideration for them);

(c) the circumstances surrounding their creation and their proposed exercise or performance (including what can reasonably be seen as the purposes of one or more of the entities involved);

(d) whether they can be dealt with separately or must be dealt with together;

(e) normal commercial understandings and practices in relation to them (including whether they are regarded commercially as separate things or as a group or series that forms a whole);

(f) the objects of this Division.

In applying subsection 230-55(4), regard must be had to the matters referred to in paragraphs (a) to (f) both in relation to the rights and/or obligations separately and in relation to the rights and/or obligations in combination with each other.

Taxation Ruling 2012/4 Income tax: the operation of subsection 230-55(4) of the Income Tax Assessment Act 1997 (ITAA 1997) in determining what is an 'arrangement' for the purposes of the taxation of financial arrangements under Division 230 of the ITAA 1997 (TR 2012/4) outlines the Commissioner's view on the matters in subsection 230-55(4) in determining whether a number or rights and/or obligations are themselves an arrangement or are two or more separate arrangements for the purposes of Division 230.

Paragraph 230-55(4)(a) - nature of the rights and/or obligations

This factor includes a consideration of the substance of the rights and/or obligations (paragraph 15 of TR 2012/4).

Regarding paragraph 230-55(4)(a), paragraph 154 of TR 2012/4 states that:

This paragraph also requires consideration of whether the rights and/or obligations are intrinsically linked, or, in substance, form part of a larger thing. In this assessment, links or interactions between them, such as contingencies on other rights and/or obligations, or conversion or redemption can be relevant. When consideration is given to the nature of the rights and/or obligations in combination with each other, an assessment is required of what is effected in substance.

In respect to rights and obligations arising from more than one contract, TR 2012/4 relevantly states:

156. Where the rights and/or obligations arise under more than one contract, it would typically be the case that each contract gives rise to a separate arrangement, but again, it will not necessarily be so.

157. The mere fact that one contract refers to another does not indicate that the rights and/or obligations under the contracts are to be combined. It is necessary to understand the nature of the relationship between the contracts. For example, mere incorporation by reference of generic terms as a means of drafting efficiency would not tend to suggest aggregation.

158. On the other hand, where the nature of the rights and obligations under individual contracts would make no sense on their own, but would only make sense if they operated together, this factor would point towards aggregation of the contracts.

The facts and circumstances of this case involve a novation of interest rate swaps in which the Company remains the continuing party and Entity Z (as the Substitute Party) replaces Entity X (as the Retiring Party).

The parties have agreed to a novation of the Transactions on the terms set out in the Deed under which the Retiring Party is to surrender its rights and be released and discharged from its obligations under the Transactions and the Substitute Party is to become entitled to equivalent rights and assume equivalent obligations under the Transactions.

Novation is relevantly discussed in Taxation Determination TD 2006/11[1]. Paragraphs 13 to 15 and 17 of TD 2006/11 states that:

13. Novation is the process whereby with the consent of all parties, including the creditor, a new contract is entered into in substitution for an existing contract. Often one party to the original contract is substituted by another party under the new contract (Olsson v. Dyson (1969) 120 CLR 365 at 388, 389 per Windeyer J).

14. The effect of a novation is to discharge, by agreement, the existing contractual rights and obligations or part of them and create new obligations and rights in substitution (Re United Railways of Havana and Regla Warehouses Limited [1960] 1 Ch 52 at 84, 85 and 88; [1959] 1 All ER 214 at 229 and 233).

15. A novation can effect the substitution of a new debtor for the original debtor, with the intention of releasing the latter. Similarly, a novation can effect the substitution of a new creditor for the original creditor, with the intention of effectively transferring the rights of the latter to the former. In either case, the novation of a debt results in the discharge of the original debt and creation of a new debt.

17. The creation of substituted rights and obligations in place of the original rights and obligations does not alter the fact that those original rights and obligations have ceased.

A similar view is also expressed in ATO ID 2006/195[2] which relevantly states:

Novation according to Windeyer J in Olsson v. Dyson (1969) 120 CLR 365, at p 388 is:

the making of a new contract between a creditor and his debtor in consideration of the extinguishment of the obligations of the old contract: if the new contract is to be fully effective to give enforceable rights or obligations to a third person, he, the third person, must be a party to the novated contract... In that sense "novation" means simply a new contract standing in the place of the old

In this case, the Deed stipulates that the Transactions cease to be governed by the Original Master Agreement and instead are deemed to have been governed at all times by the New Master Agreement.

Under the novation, Entity X will surrender its rights and be released and discharged from its obligations. The rights and obligations under the new contract with Entity Z will be 'of the same nature' but not, in fact, the same rights or obligations under the original contract.

The Novated Swap ceases the financial arrangement between Entity X and the Company and gives rise to a new financial arrangement between Entity Z and the Company.

Hence, the legal effect of the novation is that the former swap contract with Entity X ceases and there is a new swap contract with Entity Z.

Entering into a new obligation (the Novated Swap) under different contractual frameworks and with different counterparties is not the same arrangement or a continuation of the same arrangement.

Therefore, there are fundamental differences between the rights and obligations of the Novated Swap as a result of the different counterparties and contractual agreements that set out the respective rights and obligations.

As such, the form and substance indicate that the Novated Swap does not form part of a single financial arrangement.

Paragraph 230-55(4)(b) - their terms and conditions (including those relating to any payment or other consideration for them)

This factor requires assessment of the legal expression of the arrangement (paragraph 160 of TR 2012/4).

As set out in paragraph 16 of TR 2012/4, this factor includes a consideration of the terms and conditions relating to payment and/or consideration. Where one amount is calculated and paid as consideration for a number of rights, it will tend to suggest aggregation of such rights. Where the consideration is calculated and paid separately for different rights, it will tend to suggest such rights are separate.

The Novated Swap contains the same Transaction details with respect to principal amount, interest rate, effective date, termination date and payment dates. This aspect could support the conclusion that the Novated Swap would constitute a single financial arrangement.

However, the terms and conditions for the Transactions under the novation are set out in the New Master Agreement (between Entity Z and the Company). This is a separate agreement to the Original Master Agreement (between Entity X and the Company) which had previously set the terms and conditions for the Transactions.

The New Master Agreement entered contains similarities to the Original Master Agreement, however the novation was not subject to the terms and conditions of the Original Master Agreement. There are also some differences between the New Master Agreement and the Original Master Agreement.

Paragraph 118 of TR 2012/4 relevantly states:

Where a facility arrangement is in substance a contractual framework under which functionally separate financing contracts can be established, each borrowing is likely to be a separate arrangement...

Further, paragraph 160 of TR 2012/4 states:

This requires assessment of the legal expression of the arrangement. In combination with paragraph 230-55(4)(a), this requires a comparison of the substance of the rights and/or obligations with their legal form.

On the whole, whilst there are some aspects of the consideration under paragraph 230-55(4)(b) which indicate that the Novated Swap are part of a single financial arrangement, the contractual framework under which functionally separate financing contracts can be established post novation differs from the terms and conditions of the Transactions prior to novation.

As such, the terms and conditions indicate that the Novated Swap does not form part of a single financial arrangement.

Paragraph 230-55(4)(c) - the circumstances surrounding their creation and their proposed exercise or performance (including what can reasonably be seen as the purposes of the entities involved)

Paragraph 230-55(4)(c) requires consideration of the context surrounding the life cycle of the rights and/or obligations from creation to what is proposed as exercise or performance (paragraph 17 of TR 2012/4). The relevant circumstances can include the commercial, regulatory and financial imperatives that shaped the transaction (paragraph 168 of TR 2012/4). This is an objective assessment of the purposes of the entities involved. In such assessment, evidence of the subjective purpose of such entities may be relevant, though not determinative (paragraph 18 of TR 2012/4).

In this regard, the intention and purpose the purpose of the interest rate swap arrangement for the Company was to hedge an underlying loan arrangement. The Company entered into the Deed to retain the same objective purpose of the interest rate swap arrangement.

While Entity X was aware of the commercial rationale for the Novated Swap, however there was no obligation on Entity X to enter into the Novated Swaps when the Original Master Agreement was entered into with the Company. When Entity X entered into the Deed, it surrendered its rights and was released and discharged from its obligations for the Transactions.

Entity Z was aware of the commercial rationale for the Novated Swap and entered into the Deed under the terms and conditions of the New Master Agreement. In doing so, Entity Z become entitled to equivalent rights and assumed equivalent obligations for the Transactions.

Therefore, the intention and purpose of the creation of the Novated Swap for each of the entities involved differs between each entity.

As such, the circumstances surrounding the creation of the Novated Swap indicates that it does not form part of a single financial arrangement.

Paragraph 230-55(4)(d) - whether they can be dealt with separately or must be dealt with together

Paragraph 230-55(4)(d) requires the consideration of whether the rights and/or obligations can be dealt with separately or must be dealt with together in accordance with the term and conditions of the arrangement (paragraph 19 of TR 2012/4). Where the rights and/or obligations must be dealt with together, it will tend to suggest aggregation. The enquiry under this paragraph is as to legal, rather than commercial, constraint.

As previously discussed in the above reasoning, the legal effect of the novation is that the former swap contract ceases and there is a new swap contract.

Accordingly, the rights and obligations will be equivalent under the Novated Swap, but not the same.

The Original Master Agreement and the New Master Agreement were entered into with different counterparties. They have been created at different times and there is no suggestion that they could be dealt with together.

As the rights and obligations for the Company and Entity Z under the Novated Swap is determined by the New Master Agreement, it follows that the rights and obligations will be separate post novation from the rights and obligations prior to novation.

Therefore, this factor indicates that the Novated Swap does not form part of a single financial arrangement.

Paragraph 230-55(4)(e) - normal commercial understandings and practices (including whether they are regarded commercially as separate things or as a group or series that forms a whole)

Paragraph 230-55(4)(e) requires the consideration of normal commercial understandings and practices in relation to rights and/or obligations (including whether they are regarded commercially as separate things or as a group or series that forms a whole) (paragraph 20 of TR 2012/4). Where normal commercial understandings and practices are to regard a number of rights and/or obligations as one aggregated whole, it will tend to suggest aggregation. Where normal commercial understandings and practices are to regard a number of rights and/or obligations as separate things, it will tend to suggest that they are separate.

Commercially, two swap transactions entered into with a different counterparty would generally be regarded as separate arrangements, each of which could be dealt with or assigned separately.

It is arguable that treating the Novated Swap as a continuation reflects the commercial and economic substance of the Transactions.

Economically, the Company would be in the same position under the Novated Swap.

From an accounting perspective, there is no recognition of a new swap transaction on novation, nor any gain or loss in the accounts for the Company.

However, as noted in TR 2012/4 that accounting treatment is an important commercial information source as to how things are recognised and measured, however, accounting treatment may not always be very helpful and the legislation under Division 230 has an explicit choice to use the broader (and different) term 'commercial' rather than 'accounting' (at paragraph 188).

As previously discussed in the above reasoning, the legal effect of the novation is that the former swap contract ceases and there is a new swap contract.

The commercial reasons for each of the entities involved in the Novated Swap differs between each entity.

Paragraph 188 of TR 2012/4 relevantly states:

The term 'commercial' includes the notion of how entities engage in commerce - what they are transacting - what they are, put very broadly, buying and selling. Normal commercial understandings and practices in relation to rights and obligations include what is normally understood to be being transacted and the normal practices followed to transact in relation to them.

The normal commercial practices and understandings for the Company under the Novated Swap will treat the swap as a continuing right and obligation for the Company.

The normal commercial practices and understandings for Entity X under the Novated Swap is that Entity X surrendered its rights and was released and discharged from its obligations for the Transactions.

The normal commercial practices and understandings for Entity Z under the Novated Swap is that Entity Z become entitled to equivalent rights and assumed equivalent obligations for the Transactions.

Accordingly, normal commercial understandings and practices for each entity under the Novated Swap are to regard the rights and/or obligations as separate things.

Therefore, this factor, on balance, indicates that the Novated Swap does not form part of a single financial arrangement.

Paragraph 230-55(4)(f) - the objects of Division 230

Paragraph 230-55(4)(f) requires the consideration of the objects of Division 230 as set out in section 230-10 (paragraph 21 of TR 2012/4). Broadly, the objects of Division 230 are:

•        to minimise tax distortions on commercial decision-making by, for gains and losses from financial arrangements, aligning tax recognition of such gains and losses with the reality of what gains and losses occur and when they occur;

•        to align tax and commercial recognition of gains and losses from financial arrangements by ensuring the time of recognition of those gains and losses is reasonable, and by generally recognising such gains and losses on revenue account; and

•        to appropriately take account of, and minimise, compliance costs.

In this case, the Company continues to have the same rights and obligations in respect of the swaps and is not making or receiving any payment for the novation of the swaps to the new substitute party. From an accounting perspective, there is no recognition of a new swap transaction on novation, nor any gain or loss in the accounts for the Company.

However, in this regard it is noted that taking account of and minimising compliance costs is a goal that does not override or ignore the choices that the legislation makes to not have a direct link with accounting. That is, where the legislation expressly requires a treatment different from that in accounting, the compliance costs object cannot result in the express legislative requirement being ignored.

As noted in TR 2012/4, in having regard to the objects of Division 230 of the ITAA 1997, it may be necessary to consider how Division 230 would apply if the rights/obligations were aggregated, and if they were treated separately (paragraph 22 of TR 2012/4).

If the Novated Swap was treated as a separate arrangement, a balancing adjustment on ceasing to have a financial arrangement would be made and the Company would be entitled to a TOFA gain or loss.

Conversely, if the Novated Swap is treated as a single arrangement, then no balancing adjustment would be made under Subdivision 230-G as the rights and obligations under the arrangement have not ceased.

From this perspective, it may suggest that treating the Novated Swap as a single arrangement would align tax recognition of gains and losses with the reality of what gains and losses occur and when they occur.

However, in applying subsection 230-55(4), regard must be had to all of the matters referred to in paragraphs (a) to (f) and must include a consideration of how the matters interact (paragraph 13 of TR 2012/4).

In regard to all the factors discussed above, the gains/losses under the Novated Swap may be realised for the Company by the termination of the Old Master Agreement with Entity X. Entering into a new obligation (the Novated Swap) under different contractual frameworks and with different counterparties is not the same arrangement or a continuation of the same arrangement such that the gains/losses on the terminated agreement should not be realised.

Therefore, treating the Novated Swap as a single financial arrangement could potentially lead towards tax distortions on future commercial decision-making and fail to deliver tax neutral and consistent outcomes which are the objectives of Division 230. As such, this factor, on balance, indicates that the Novated Swap does not form part of a single financial arrangement.

Overall conclusion

The factors in paragraphs 230-55(4)(a) to (f) point away from the Novated Swap forming part of a single arrangement. Therefore, having regard to those factors, the Novated Swap does not form part of a single arrangement.

Question 2

Summary

The Novated Swap will result in a balancing adjustment for the Company in accordance with section 230-435.

Detailed reasoning

Section 230-435 provides for when a balancing adjustment is made on ceasing to have a financial arrangement. Subsection 230-435(1) states:

(1) A balancing adjustment is made under this Subdivision if:

(a) you transfer to another entity all of your rights and/or obligations under a financial arrangement; or

(b) all of your rights and/or obligations under a financial arrangement otherwise cease; or

(c) you transfer to another entity:

(i) a proportionate share of all of your rights and/or obligations under a financial arrangement; or

(ii) a right or obligation that you have under a financial arrangement to a specifically identified *financial benefit; or

(iii) a proportionate share of a right or obligation that you have under a financial arrangement to a specifically identified financial benefit; or

(d) an arrangement that is a Division 230 financial arrangement ceases to be a financial arrangement.

For there to be a balancing adjustment event, there either needs to be a transfer to another entity or all of the Company's rights and/or obligations under a financial arrangement must otherwise cease.

In the case of a 'substitution' of banks under the Novated Swap, this will not be transferred to another entity, rather they will remain obligations of the Company. Accordingly, for a balancing adjustment event to happen, all of the Company's rights and/or obligations under a financial arrangement must otherwise cease. Whether the 'substitution' results in all of the Company's rights and obligations under afinancial arrangementceasing will depend upon what is the financial arrangement.

Under the terms of the Deed, the financial arrangement for the Company under the Old Master Agreement with Entity X has ceased.

The legal effect of the Novated Swap is that the former swap contract with Entity X ceases and there is a new swap contract with Entity Z.

Accordingly, the Novated Swap ceases the financial arrangement between Entity X and the Company and gives rise to a new financial arrangement between Entity Z and the Company.

Paragraph 230-435(1)(b) provides that a balancing adjustment is made under Subdivision 230-G if all of your rights and/or obligations under a financial arrangement otherwise cease.

As the Novated Swap has caused the financial arrangement between Entity X and the Company under the Old Master Agreement to cease, this has resulted in a balancing adjustment pursuant to paragraph 230-435(1)(b) and the exceptions in section 230-440 will not apply.

[1] Taxation Determination TD 2006/11 Income tax: for the purposes of Division 775 of the Income Tax Assessment Act 1997, does forex realisation event 2 and forex realisation event 4 occur when, on novation, a foreign currency-denominated debt is ended and a new party becomes either the creditor or debtor in the substituted debt?

[2] ATO Interpretative Decision ATO ID 2006/195 Income Tax: Interest Withholding Tax Exemption: novation of revolving credit facility - public offer test

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