House of Representatives

Explanatory Memorandum

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

Chapter 3 Tax treatment of gains and losses from financial arrangements

Outline of chapter

3.1 This chapter explains:

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why Division 230 recognises gains and losses rather than, for example, receipts and outgoings;

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the revenue character of those gains and losses;

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the elements of a gain or loss; and

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which gains and losses are disregarded.

Overview of taxation of financial arrangements gains and losses

3.2 This overview summarises the tax treatment of gains and losses from financial arrangements.

3.3 Gains and losses from financial arrangements are important for the purposes of Division 230 because the tax treatment of financial arrangements depends on gains and losses made from them and not, for example, on receipts and outgoings. Thus, a taxpayer subject to Division 230 may be required to include a gain in their assessable income and may be allowed a deduction for a loss where it is made in deriving or producing assessable income or in carrying on business for the purpose of deriving assessable income.

3.4 This means that a net amount, for example, the money received (the proceeds) minus the money provided (the cost) under a financial arrangement may be included as assessable income when that net amount is a gain and claimed as an allowable deduction when that net amount is a loss.

3.5 Basically, the cost of a financial arrangement will be the total of the financial benefits provided, or to be provided, to acquire such an arrangement. Conversely, the proceeds from a financial arrangement will be the total of the financial benefits received from having such an arrangement including those at maturity of the arrangement or the disposal of the arrangement.

3.6 There are special rules that ensure that where a financial arrangement is received as consideration or provided as consideration for the provision of a thing (eg, this could be trading stock or a capital gains tax (CGT) asset) the thing is taken to have been received or provided for its market value. These special rules are intended to provide an appropriate value for determining the tax consequences of transactions relating to the thing under provisions of the Income Tax Assessment Act 1936 (ITAA 1936) and the Income Tax Assessment Act 1997 (ITAA 1997) (including Division 230).

3.7 Division 230 will not apply to all gains and losses from financial arrangements. In particular, Division 230 will not apply to gains and losses in respect of financial arrangements that are not subject to Division 230 nor to the gains and losses of financial arrangements held by taxpayers that are not subject to Division 230.

3.8 Some of these specific exceptions are to put it beyond doubt that Division 230 will not apply to those financial arrangements while others have been included to ensure that Division 230 does not apply to taxpayers with relatively simple tax affairs for reasons of compliance costs, or for other administrative or policy reasons.

3.9 Division 230 will not contain a definition of a 'gain' or a 'loss'. However, as a general rule a 'gain' or a 'loss' from a financial arrangement may be calculated as follows:

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Step 1 - calculate the money received from a financial arrangement including that received at maturity or upon disposal.

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Step 2 - calculate the cost of the financial arrangement including those expenses at maturity or upon disposal.

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Step 3 - deduct the amount at step 2 from the amount at step 1.

3.10 There will be a gain from a financial arrangement if the amount at step 3 is positive. On the other hand, there will be a loss from a financial arrangement if the amount at step 3 is negative.

3.11 Division 230 will contain rules for determining the amount at step 2 and allocating it to the amount in step 1 so as to ensure that the appropriate amount of gain or loss is subject to Division 230.

3.12 The amount of this gain or loss that is assessable or deductible in a particular income tax year will be determined by the tax-timing treatment (accruals/realisation, fair value, hedging, retranslation or financial reports) and the balancing adjustment, where applicable, that applies to a particular financial arrangement.

3.13 Some losses made from a Division 230 financial arrangement are not deductible. Examples are losses made to the extent they are in gaining or producing exempt income or non-assessable non-exempt income. Other non-deductible losses are those of a private or domestic in nature. These losses are not deductible for any income tax purposes.

3.14 A gain made from a Division 230 financial arrangement will continue to be exempt income or non-assessable non-exempt income to the extent the gain would have been exempt income or non-assessable non-exempt income by a provision outside Division 230 on the assumption Division 230 was not enacted. Also, a gain made on a Division 230 financial arrangement will be exempt income if, instead, the gain had been a loss and the loss would have been made gaining or producing exempt income. A similar rule is provided in respect of gains that are to be treated as non-assessable non-exempt income. For example, if a taxpayer subject to Division 230 makes a loss on a financial arrangement where the arrangement was entered into in gaining or producing exempt income, that loss would not be deductible; paragraph 230-30(3)(a). Therefore, to provide symmetry, if a taxpayer had made a gain from a financial arrangement, such as a forward contract, as part of an activity that produces exempt income, and instead had that gain had been a loss that would have been denied deductibility under paragraph 230-30(3)(a), the gain is taken to be exempt income: paragraph 230-30(2)(a).

3.15 Finally, Division 230 will not apply to gains in the form of franked distributions or rights to franked distributions. This allows the existing tax law to apply in respect of such franked distributions. Also, Division 230 does not apply to gains that are of a private and domestic nature made from a financial arrangement.

3.16 Under Division 230 the general rule is that gains and losses from financial arrangements will be on revenue account. This treatment will simplify the law by removing the need to determine the revenue or capital nature of such gains and losses.

3.17 Division 230 will contain anti-overlap rules to ensure that gains and losses from financial arrangements are not double-counted for income tax purposes. However, these rules will not prevent Division 230 gains and losses being used to calculate other amounts for income tax purposes. For instance, such amounts may be used in calculating thresholds where appropriate.

Context of amendments

Gains and losses from financial arrangements

3.18 Under current income tax law, the taxation of financial arrangements is based on an amalgam of provisions, including the ordinary income provision (section 6-5 of the ITAA 1997), the general deduction provision (section 8-1 of the ITAA 1997) and various specific provisions.

3.19 The application of the ordinary income and general deduction provisions to financial arrangements may not always produce appropriate results. Because of the complexity in the structure of many financial arrangements, greater clarity, consistency and coherency can be obtained by only recognising gains and losses from relevant financial arrangements for income tax purposes.

3.20 The concept of gain or loss connotes the appropriate offsetting of the cost (broadly, financial benefits provided under the financial arrangement) against proceeds (broadly, financial benefits received under the financial arrangement). However, in recognising that a gain or loss is a net concept, it is important to note that:

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the gain or loss may be recognised despite not all offsetting amounts being fully known (eg, a gain or loss will be recognised under the accruals method if it is known with sufficient certainty to be of at least a certain amount);

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whilst an overall gain or loss will often be able to be determined for a financial arrangement as a whole, more than one gain or loss may be made from a financial arrangement;

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a mere receipt of a financial benefit or payment of a financial benefit may itself represent a gain or loss if no offsetting financial benefits are reasonably attributable to that particular receipt or payment;

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a payment need not be received in order to make a gain (eg, the receipt of a financial benefit includes the reduction or saving of an amount of a liability);

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gains and losses can be made from holding a financial arrangement, as well as on the cessation or disposal of that financial arrangement; and

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the gain or loss is to be calculated in nominal, rather than present value, terms. Therefore, in determining the gain or loss from the financial arrangement, the financial benefits to be received or provided under the arrangement should be taken into account at the value they have at the time they are received or provided, and should not be discounted to their present values when a taxpayer first starts to have the arrangement.

Example 3.1 : Gain or loss from an option

A typical option requires the payment of a premium at the time the arrangement is entered into.

However, the mere payment of the premium does not represent a loss for the purchaser of the option (the option holder). While the premium is an outgoing of the option holder, it is an outgoing which is reasonably attributable to any financial benefits that may be received under the option agreement. Likewise, the mere receipt of the option premium does not yet produce a gain for the issuer of the option.

That is, the gain or loss on a typical option is calculated by offsetting the cost or proceeds represented by the premium against the net amounts, if any, received or paid from disposal or exercise of that option.

For example, as part of its speculative activities, U-mine Co acquires an option to purchase US$100,000 in 18 months time for a set amount of Australian dollars, by paying a A$2,000 option premium. U-mine Co will not make a gain or loss from its option arrangement until its rights under the option agreement cease (eg, through being disposed of, exercised or expiring). Note, however, that some of the tax-timing methods in Division 230 may apply to calculate a gain or a loss from the arrangement before this time.

Character of gains and losses from financial arrangements

3.21 If the tax framework in Division 230 did not clarify that gains and losses from financial arrangements are to be on revenue account unless subject to a specific rule, existing tests and factors would need to be considered in determining the character of gains and losses from a particular financial arrangement. The revenue/capital distinction in the income tax law is often a very difficult distinction to make, relying on factors such as purpose, the degree of periodicity, and the circumstances in which the relevant amount is found in the hands of the particular taxpayer. Determining the character of the gains and losses against factors such as these can be very demanding and complex and the outcome may be uncertain.

3.22 In this regard, certainty as to the character of some gains and losses from financial arrangements has been provided by a number of existing specific provisions. Specifically, revenue treatment has been provided by:

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sections 26BB and 70B of the ITAA 1936, in relation to the disposal of traditional securities;

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Division 3B of Part III of the ITAA 1936, in relation to foreign currency gains and losses; and

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Division 775 of the ITAA 1997, in relation to foreign currency denominated arrangements (with limited exceptions).

3.23 Complexity will be further reduced by removing the capital/revenue distinction in respect of financial arrangements by taxing all gains and losses on revenue account under Division 230. An exception to the requirement that a gain or loss from a financial arrangement will always be on revenue account is contained within the hedging financial arrangements election, and is applicable to certain hedging financial arrangements. Under this exception, the tax characterisation of a hedging financial arrangement may be based on the characterisation already given to the hedged item under the taxation law, and to that extent will not of itself increase complexity to any significant extent.

3.24 In addition, any gains and losses to which Division 230 expressly does not apply (such as through an exception as set out in Subdivision 230-H as explained in Chapter 2) will fall for consideration under the existing tax law. This means their tax treatment, including their character, is to be determined by any residual operation of the ITAA 1936 and the ITAA 1997.

Nexus test for losses

3.25 To be deductible, the current income tax law requires a sufficient nexus between losses and the gaining or producing of assessable income. This concept is preserved under Division 230.

Summary of new law

3.26 Unless otherwise specified, gains and losses from financial arrangements are on revenue account. Unless specifically provided for:

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gains from financial arrangements are included in assessable income; and

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losses from financial arrangements made in gaining or producing assessable income, or necessarily made in carrying on a business for the purpose of gaining or producing such income, are deductible.

3.27 Losses from financial arrangements made in gaining or producing exempt or non-assessable non-exempt income are not deductible. Gains made from financial arrangements will be exempt income or non-assessable non-exempt income to the extent that they reflect amounts that would be treated or would reasonably be expected to be treated as exempt or non-assessable non-exempt income under a provision outside Division 230 if Division 230 were not enacted. Division 230 does not apply to gains to the extent they are gains in the form of a franked distribution or a right to receive a franked distribution.

3.28 Losses made from borrowings used for private or domestic purposes or by individuals from derivative financial arrangements held or used for private or domestic purposes are not deductible while Division 230 does not apply to gains made from such borrowings.

3.29 Gains and losses from financial arrangements are recognised only once for tax purposes.

Comparison of key features of new law and current law

Detailed explanation of new law

Determining the gain or loss from a financial arrangement

3.30 The various tax-timing methods available under Division 230, discussed in detail in later chapters of this explanatory memorandum, are used to determine the timing and quantum of gains and losses made from a financial arrangement. [ Schedule 1, item 1, section 230-40 ]

3.31 Unless otherwise specified, the gain or loss recognised over the life of the financial arrangement is the total gain or loss. In some cases, recognition of the total gain or loss may come about through a combination of provisions in Division 230 (eg, the compounding accruals method in Subdivision 230-B and the balancing adjustment required when the taxpayer ceases to have a financial arrangement in Subdivision 230-G). [ Schedule 1, item 1, section 230-40 ]

3.32 The concept of gain or loss connotes the appropriate offsetting of the cost (financial benefits provided or to be provided, or rights to financial benefits forgone under the financial arrangement) against proceeds (financial benefits received or to be received, or obligations to pay financial benefits saved under the financial arrangement). [ Schedule 1, item 1, sections 230-70 and 230-75 ]

3.33 In recognising that a gain or loss is a net concept, it is important to note that the gain or loss is generally determined by making a reasonable allocation of:

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the costs of the financial arrangement (financial benefits provided or to be provided, either under the financial arrangement or which are integral to the calculation of a gain or loss from the arrangement); and

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the proceeds from the financial arrangement (financial benefits received or to be received, either under the financial arrangement or which are integral to the calculation of a gain or loss from the arrangement or the amount of such gain or loss).

[ Schedule 1, item 1, sections 230-60, 230-70 and 230-75 ]

Costs and proceeds of a financial arrangement

3.34 The costs of, and proceeds from, the financial arrangement naturally include financial benefits provided and/or received in satisfaction of the obligations and/or rights that comprise the relevant financial arrangement. These will be financial benefits received and/or provided under the relevant financial arrangement.

3.35 Notably, the costs of, and proceeds from, the financial arrangement also include financial benefits in addition to those financial benefits provided or received under the financial arrangement. Specifically, the costs of, and proceeds from, the financial arrangement will also include other financial benefits received or provided (or those which the taxpayer is entitled to receive or obliged to provide) that play an integral role in determining whether the taxpayer will make a gain or loss (or a gain or loss of a particular amount) from the financial arrangement.

3.36 For this purpose, a financial benefit received or provided (or a financial benefit which the taxpayer is entitled to receive or obliged to provide) will be integral to determining whether the taxpayer will make a relevant gain or loss from the financial arrangement if it is an essential part of determining that gain or loss or the amount of such a gain or loss. What is considered essential or integral will be determined by the nature or purpose of the financial benefit that is taken to be provided or received under the financial arrangement. The quantum of the particular financial benefit in this respect is not determinative as to whether it is considered 'integral'. For example an application fee paid on a home loan provided by a bank may be 'integral' to determining whether the bank makes a gain or loss from the home loan even though it would be a much smaller amount than the interest income that is to be received by the bank from the borrower.

3.37 Such integral financial benefits may include the costs incurred to acquire the financial arrangement (including, for example, any application or processing charges, in addition to the specific consideration for the relevant rights and obligations under the arrangement) and amounts received on transfer or cessation of all or part of the financial arrangement. [ Schedule 1, item 1, section 230-60 ]

Example 3.2 : Continuation of Example 2.16, scenario 2

In this scenario, Steam Co has a financial arrangement consisting entirely of its obligation to pay $1 million to Big Co, which it started to have as consideration for, and at the time of, receiving delivery of the train from Big Co.

The proceeds Steam Co receives (the train that was delivered) for starting to have this obligation, is integral to the calculation of the gain or loss that is made from its financial arrangement constituted by Steam Co's outstanding obligation. Accordingly, the train (valued at the time it is received by Steam Co), is a financial benefit that Steam Co is taken to have had the right to receive under its financial arrangement, broadly for the purpose of determining any gains and losses Steam Co makes from that arrangement (subsection 230-60(2)).

Note, however, the amount taken to have been provided for the train for the purposes of this Act (eg, determining a deduction for a depreciating unit) may be affected by section 230-505. Section 230-505 will treat the amount of the benefit provided for the train as the market value of the train at the time it was acquired.

3.38 More generally, what is considered to be integral or essential to determining whether the taxpayer makes a relevant gain or loss from the financial arrangement can be determined by commercially accepted principles and the relevant facts and circumstances of each arrangement. However, the costs of, or proceeds from, the financial arrangement, where they are integral to the calculation of a gain or loss from the arrangement, need not necessarily be provided or received from parties to the particular financial arrangement. [ Schedule 1, item 1, section 230-60 ]

3.39 It is possible that a financial benefit could be considered integral to more than one financial arrangement. An example would be where a fixed and indivisible fee is to be provided to acquire either one or more financial arrangements. In this circumstance, it will be necessary to apportion on a reasonable basis the actual amount of the financial benefit between the financial arrangements. This will ensure that the gain and loss from each financial arrangement reflects the proper apportionment of the financial benefit. [ Schedule 1, item 1, section 230-65 ]

3.40 Also a financial benefit may be provided or received as consideration for starting or ceasing to have one or more things which themselves are not financial arrangements. Where this occurs the amount of financial benefit needs to be apportioned, between the financial arrangement and other things on a reasonable basis. This means that only that part of the amount of the financial benefit that plays an integral role to the financial arrangement is taken to be received or provided under the arrangement. [ Schedule 1, item 1, section 230-65 ]

Example 3.3 : Financial benefit provided as consideration for a financial arrangement and services

Deb Co enters into an arrangement where it agrees to provide a train worth $1 million in return for a bond worth $700,000 and services worth $300,000. The financial benefits provided, the train, is integral to determining Deb Co's gain or loss from the bond. Section 230-65 therefore applies for the purpose of Division 230 causing the $1 million financial benefit provided to be apportioned and the services on a reasonable basis. Therefore, Deb Co is taken to have provided $700,000 worth of financial benefits under the financial arrangement to acquire the bond.

3.41 The above paragraphs have outlined the basic case of how the cost and proceeds from a financial arrangement are determined. It can be seen that the gain or loss from a cash settlable financial arrangement can therefore be determined by comparing:

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the financial benefits provided, or to be provided, as consideration for (or that are integral to) obtaining a cash settlable right to receive a financial benefit, with the financial benefits received, or to be received, as consideration for (or that are integral to) the satisfaction or other cessation of that right; and

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the financial benefits received, or to be received, as consideration for (or that are integral to) assuming a cash settlable obligation to provide a financial benefit, with the financial benefits provided, or to be provided, in consideration for (or that are integral to) the satisfaction or other cessation of that obligation.

Cost or proceeds where a financial arrangement starts or ceases to be held as consideration for providing or acquiring something else

3.42 As mentioned in paragraph 3.37, the costs or proceeds of a financial arrangement include financial benefits provided or received in satisfaction of the obligations or rights comprising the financial arrangement. If a financial arrangement is started or ceased as consideration for the provision or acquisition of something else (whether money or not) the financial benefits may include that thing but, if they do not, section 230-60 would operate to deem the thing (the something else) to be provided or received under the financial arrangement. The costs of, or proceeds from, a financial arrangement that started or ceased to be held as consideration for providing or acquiring something is (or includes) the market value of the relevant thing when it is provided or acquired.

Example 3.4 : Cost of widgets

White Co manufactures widgets. The cost to White Co of manufacturing each widget is $80, and they retail for their market value of $90. White Co enters into a deferred payment arrangement to sell a widget to Black Co for $100, to be paid in 18 months. The cost to White Co of the financial arrangement represented by the deferred payment arrangement is the market value of the widget provided $90, rather than the cost to it of the widget ($80).

3.43 The primary function of section 230-505 is to provide appropriate interaction between the provisions of Division 230 and the other provisions of the ITAA 1936 and the ITAA 1997 (including Division 230 if the thing is also a financial arrangement) where a financial arrangement (or part of a financial arrangement) whose gains and losses are subject to Division 230 is provided or received as consideration for a thing. In a broad sense, the provision ensures that the amount of the benefit taken to be obtained or provided for the thing is, for the purposes of this Act, the market value of the thing at the time it is provided or acquired. This will result in symmetry between the cost or proceeds of the financial arrangement started or ceased and the amount for which the thing is taken to have been acquired or disposed of. [ Schedule 1, item 1, section 230-505 ]

3.44 Section 230-505 will not apply where gains and losses from the relevant financial arrangement which is consideration for the thing are not subject to Division 230. For example, where a taxpayer provides an asset to another party as consideration for a right to receive a payment of money from that party in the future (a cash settlable financial arrangement), in circumstances where gains and losses from that right are not subject to Division 230 (eg, under section 230-455 because of the taxpayer's traits, or under section 230-450 because of the period for which the right will be outstanding), section 230-505 will have no application in resetting the amount taken to have been received for that asset for tax purposes. Section 230-505 only applies in respect of dealings with financial arrangements that are themselves dealt with under Division 230. [ Schedule 1, item 1, subsection 230-505(1 )]

3.45 The impact of the operation of section 230-505 upon the tax treatment of a thing for which a relevant financial arrangement is consideration is discussed in detail in Chapter 11.

3.46 Section 230-505 ensures that there is symmetry between the cost or proceeds of the financial arrangement and the acquisition or disposal consideration for the thing. In other words, section 230-505 ensures symmetry between the following two amounts for tax purposes:

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the cost or proceeds of the financial arrangement that is either started or ceased as consideration for the thing acquired or provided under the relevant transaction (these costs or proceeds are used to determine the amount of the gain or loss on the financial arrangement); and

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the amount for which the thing is taken to have been acquired or disposed of (eg, the cost base of, or capital proceeds for, a CGT asset, used to determine the amount of the capital gain or loss on that asset).

3.47 This symmetry is required to ensure that, where both Division 230 and another provision of the income tax law apply to a particular transaction, there is no overlap or gap between the operation of the Division and the operation of that other provision. Symmetry is also required to ensure that, where Division 230 applies to a financial arrangement whose acquisition or disposal is part of another financial arrangement also taxed under Division 230, each financial arrangement is (separately and cumulatively with the other financial arrangement) treated appropriately: see the discussion below under the heading Things that are financial arrangements .

3.48 The effect of section 230-505 is that, for all income tax purposes, the cost of the financial arrangement is taken to be the market value of the thing provided. Similarly, the proceeds of the financial arrangement is taken to be the market value of the thing acquired. [ Schedule 1, item 1, subsection 230-505(2 )]

Example 3.5 : Sale of a CGT asset for a bond

Saint Co purchased a factory in 2000 for $1.1 million.

In April 2011 it sells the factory to Moore Co in exchange for receiving a five-year zero coupon bond, with a face value of $3 million. At the date of sale, Saint Co's factory has an estimated market value of $2.5 million. Assume that any gain on sale of the factory would be subject to CGT.

The bond is a cash settlable financial arrangement.

In terms of subsection 230-505(1), Saint Co starts to have the bond (a Division 230 financial arrangement) as consideration for providing the factory.

Because of the operation of section 230-505, for the purposes of the ITAA 1936 and the ITAA 1997, the proceeds Saint Co receives for the sale of the factory will be taken to be the market value of the factory, that is, $2.5 million (subsection 230-505(2)).

As a result the difference between Saint Co's cost of the factory ($1.1 million) and the market value of the factory that was received ($2.5 million) will be taken into account under Parts 3-1 and 3-3 of the ITAA 1997 (a $1.4 million capital gain). In accordance with the general principles for determining the cost of a financial arrangement, the market value of the factory (financial benefit provided) would be included as the cost of the financial arrangement (the bond). As a result the difference between the market value of the factory ($2.5 million) and the proceeds Saint Co receives from the bond on redemption ($3 million), that is, a $500,000 gain, will be taken into account under Division 230.

3.49 In the example above, section 230-505 has ensured symmetry between the proceeds received for the sale of the factory and the cost of the financial arrangement such that the appropriate amount is recognised for the purposes of CGT and Division 230.

Example 3.6 : Deferred settlement

Bill Co had an agreement to sell land to Jim Co for $100,000 and agreed to allow Jim Co 18 months from the settlement date to pay.

In the hands of Bill Co, the land (a CGT asset), is held on capital account with CGT tax treatment.

At the settlement date, the market value of the land is $87,000.

Bill Co will start to have a financial arrangement on the settlement date consisting of its cash settlable right to receive $100,000 from Jim Co (section 230-45). The financial benefit provided under the financial arrangement is the land, whose value is $87,000 (subsection 230-60(1)).

For the purpose of calculating a capital gain or loss on disposal of the land, Bill Co is taken to have received capital proceeds from disposal of the land equal to the market value of the land, being $87,000 (subsection 230-505(2)).

Assuming the cost base of the land is $50,000, Bill Co will make a $37,000 capital gain. Given that the cost of the financial arrangement (being the market value of the land) is $87,000 and the proceeds of the financial arrangement are $100,000, Bill Co will make a $13,000 gain on the financial arrangement.

In the absence of the rule in section 230-505, assuming the whole of the deferred settlement amount is included as capital proceeds, the capital gain would have been $50,000 ($100,000 capital proceeds less $50,000 cost base) in addition to the $13,000 gain made on the financial arrangement. As a result, section 230-505 will ensure there is no duplication of gains or losses in respect of the transaction for all tax purposes.

Things that are financial arrangements

3.50 Section 230-505 will apply where the relevant thing that starts, or ceases, to be held as consideration for starting or ceasing to have all or part of a financial arrangement is also a financial arrangement. The effect of section 230-505 is to treat this financial arrangement (which is the relevant thing for the purposes of the section) as having been dealt with for its market value. [Schedule 1, item 1, subsection 230-505(2)]

Example 3.7 : Exchange of bonds under a forward contract

On 1 July 2010 Money Co enters into a forward contract with Option Co to exchange its Bond A for Options Co's Bond B on 30 June 2012 (the date on which the exchange takes place). At the time of exchange, Bond A has a market value of $100 and Bond B has a market value of $110. Assume that Money Co acquired Bond A for $80 and Bond B has a face value of $130 with maturity at 30 June 2013.

In this bond swap there are three financial arrangements: the two financial arrangements being exchanged as consideration for each other, and an overarching financial arrangement, being the forward contract (a financial arrangement under section 230-45). Each bond is also a thing for whose acquisition or disposal the relevant part of the forward contract (ie, the obligation to deliver, or right to receive, the other bond) is started as consideration. (Alternatively, the consideration for each bond is the bond for which it is exchanged: in other words, starting to hold the other bond is the consideration for the provision of the bonds as things to which section 230-505 applies.) Because Division 230 applies to the overarching financial arrangement, the exclusion in subsection 230-505(3) does not apply. Therefore, subsection 230-505(2) ensures that the amount of the proceeds received by Money Co for disposing of Bond A is its $100 market value (which is also the cost provided by Option Co for acquiring Bond A) while the cost provided by Money Co for acquiring Bond B is taken to be its $110 market value (which would also be the proceeds by Option Co for disposing of Bond B).

When the exchange occurs two balancing adjustment events arise for Money Co:

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- Rights/obligations under the forward contract ceases

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The general financial arrangement cost and proceeds principles apply to determine the gains or losses made from the forward contract ceasing.

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Financial benefit provided: Bond A with market value of $100.

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Financial benefit received: Bond B with market value of $110.

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Division 230 gain under section 230-445: $10.

2

- Bond A is transferred

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Financial benefit provided: $80.

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Financial benefit received: $100 (deemed amount under section 230-505).

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Division 230 gain under section 230-445: $20.

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At 30 June 2012 Money Co has a total Division 230 gain of $30.

Assuming that Money Co holds Bond B until 30 June 2013 when Bond B matures, a balancing adjustment event will arise:

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Financial benefit provided: $110 (deemed amount under section 230-505).

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Financial benefit received: $130.

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Division 230 gain under section 230-445: $20.

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At 30 June 2013 Money Co has a Division 230 gain of $20.

Overall, Money Co has made a Division 230 gain of $50. This matches the economic outcome because Money Co provided $80 (for Bond A) and received $130 (on maturity of Bond B).

3.51 The following example shows the symmetry between the proceeds received for Bond A (paragraph 230-505(2)(a)) and the cost of the forward contract being the financial benefits provided in satisfaction of the obligation under the forward contract. Similarly the example shows the symmetry between the cost of Bond B (paragraph 230-505(2)(b)) and the proceeds received under the forward contract being the financial benefits received in satisfaction of the right to receive $120.

Example 3.8 : Forward sale of a bond

On 1 July 2010 Share Co enters into a forward contract with Delta Co to sell its Bond A for $120 on 30 June 2012. At the time of the sale, Bond A has a market value of $130. Share Co acquired Bond A for $100.

For the purposes of applying Divisions 230 to Share Co, there are two financial arrangements being the forward contract and Bond A.

Forward contract financial arrangement

For the purposes of determining Share Co's gain or loss on the forward contract, Division 230 picks up the financial benefits provided and received in satisfaction of the obligation and right under the forward contract. In this example, the financial benefits provided and received are Bond A and $120 respectively. The value of these financial benefits is determined by the general financial arrangement cost and proceeds principles. Therefore Share Co will make a $10 loss on the forward contract comprising the financial benefits provided (being the market value of the bond at the time it was provided) and the financial benefit received (being $120).

Bond financial arrangement

Section 230-505 applies to Bond A as a thing because Share Co starts to have part of the forward contract (the right to receive $120) as consideration for providing Bond A (subsection 230-505(1)). Share Co will be taken to have obtained an amount for providing Bond A equal to the market value of Bond A at the time it is provided (ie, $130) (subsection 230-505(2)). Therefore Share Co makes a $30 gain on Bond A.

Overall, Share Co has made a net gain of $20. This gain is consistent with the economic substance of the two financial arrangements. That is, Share Co provided $100 for acquiring Bond A and received $120 for ceasing to hold Bond A.

Where an overarching financial arrangement is not a Division 230 financial arrangement

3.52 The purpose of section 230-505 is to ensure appropriate interactions through symmetry between the cost and proceeds of both the relevant thing and the financial arrangement started or ceased as consideration. A thing for the purposes of section 230-505 may be a financial arrangement whose gains and losses are the subject of Division 230. The value of this thing may not be reflected in either the cost of, or the proceeds from, an overarching arrangement that is itself a financial arrangement whose gains and losses are the subject of Division 230. In such a case, no symmetrical outcome is required and section 230-505 is prevented from applying to the thing. [ Schedule 1, item 1, subsection 230-505(3 )]

Example 3.9 : Exchange of shares

On 1 July 2010 Finance Co enters into an arrangement with Business Co to exchange its Share A with Business Co's Share B on 30 June 2012. Finance Co fair values both Share A and Share B, but not the agreement (the overarching financial arrangement).

Both Share A and Share B are financial arrangements to which Division 230 applies pursuant to subsection 230-50(1). However, the exchange contract is not a Division 230 financial arrangement because it is not fair valued nor subject to the financial reports election (and the shares are not cash settlable). In other words, the overarching financial arrangement is not subject to Division 230.

Here there is no overarching financial arrangement to which section 230-505 needs to apply to ensure appropriate interaction between the arrangements. Therefore, subsection 230-505(3) operates to prevent the application of subsection 230-505(2) to Share A and Share B. Instead the ordinary cost and proceeds rules in the income tax law will apply so that, absent unusual features of the arrangement, the value of Share B will constitute the proceeds for the disposal of Share A, and vice versa.

3.53 Sometimes a financial arrangement may be started or ceased not as consideration (in a direct or contractual sense) for a thing, but nevertheless in circumstances where it is necessary to provide symmetry between the cost/proceeds of both the financial arrangement and the thing. If section 230-505 is not triggered in such circumstances, the gains or losses that arise under other provisions of the Act in relation to the thing may duplicate the gains or losses generated from the financial arrangement.

3.54 An example of this type of situation is an entity acquiring a right to do something (which is the 'thing' for section 230-505 purposes) as consideration for a payment (deductible under section 8-1 of the ITAA 1997) and that payment obligation being subsequently satisfied by the issue of a financial arrangement. Although the financial arrangement is issued as consideration for satisfaction of the payment (or the extinguishment of an obligation) there is a clear causal connection between the acquisition of the thing and the issue of the financial arrangement. This is because the payment is consideration for the thing and this payment is satisfied by the issue of the financial arrangement. In terms of the substance or effect, the financial arrangement is issued in exchange for the acquisition of the thing.

3.55 Subsection 230-505(8) applies to ensure that, in this situation, the deduction available for the payment and the gain or loss available under Division 230 properly reflects the economic gain or loss on the total transaction. In this example, the benefit deemed to have been provided for the thing (the deductible payment) will be taken by subsection 230-505(2) to be the market value of the thing at the time it is acquired. Subsection 230-505(8) requires a determination of what, in effect, the entity acquiring the thing starts or ceases to have the financial arrangement for.

Allocation of costs to proceeds

3.56 As mentioned above, the determination of a gain or a loss from a financial arrangement involves an allocation of the cost of that arrangement to any proceeds taken to be from that arrangement (or, more specifically, an allocation of the financial benefits taken to be received and provided under that financial arrangement). Where there is more than one gain or loss made from the financial arrangement over its lifetime (eg, where an overall gain or loss cannot be determined from the financial arrangement at its inception, but there are several particular gains and losses made from the arrangement over its lifetime (see Chapter 4)) it is particularly important that the financial benefits provided, or to be provided, under the financial arrangement are appropriately allocated to the relevant financial benefits received, or to be received, under that financial arrangement.

3.57 The attribution of the costs of the financial arrangement to the proceeds from the financial arrangement is reasonable only if it reflects appropriate and commercially accepted valuation techniques. The cost and proceeds allocation, in reflecting such techniques, must properly take into account:

•

the nature of the rights and obligations under the financial arrangement;

•

the risks associated with each of the rights, obligations and financial benefits under the arrangement; and

•

the time value of money.

[ Schedule 1, item 1, subsections 230-70(3) and 230-75(3 )]

3.58 Requiring that the attribution of cost and proceeds reflect valuation principles that take into account the time value of money does not mean that the value of the financial benefits used to determine the overall gain or loss from the arrangement can be discounted. Rather, a relevant cost amount is to be appropriately spread, taking into account the time value of money, when being allocated in its entirety to relevant proceed amounts. It does not go so far as to say that the cost and proceeds (and the corresponding calculation of gain or loss) can be discounted to present value. The calculation of the gain or loss from the financial arrangement is specifically to be conducted in nominal (and not present value) terms. [ Schedule 1, item 1, sections 230-70 and 230-75 ]

3.59 Importantly, this requires that the value of the relevant financial benefit must be determined as at the time when it is (or is to be) received or provided.

Example 3.10 : Valuing financial benefits integral to gain or loss

Under an arrangement, Cat Co receives $100 from Dog Co, in return for assuming an obligation to pay Dog Co $150 in three years time. Cat Co has a financial arrangement consisting of its cash settlable obligation to pay $150. At the time of assuming this obligation, Cat Co's obligation to pay Dog Co has a present value of $100.

From the start of the arrangement, Cat Co's obligation is not valued in present value terms but is taken for the purposes of Division 230 to be an obligation to pay $150.

As the proceeds for assuming this obligation are integral to calculating Cat Co's gain or loss from the financial arrangement, Cat Co is taken to have received the $100 financial benefit it received in relation to this arrangement, under the arrangement (section 230-60).

At the time of entering the arrangement, then, Cat Co is sufficiently certain that it will make a $50 loss (calculated in nominal terms) from the arrangement.

However, after one year, Cat Co novates its obligation to Bird Co, in return for providing a bond to Bird Co. The value of both the outstanding obligation and the bond at the time of novation is $130. The bond is due to mature several years after the time of novation, for its face value of $200.

Being integral to calculating the gain or loss Cat Co makes on its financial arrangement, Cat Co is taken to have provided the bond under its financial arrangement with Dog Co. It does not matter that Cat Co provided the bond to an entity (Bird Co) that is a third party to its arrangement with Dog Co (subsection 230-60(1)).

The financial benefit that Cat Co in fact provides (the bond) is taken to be $130. This is the value of the financial benefits that Cat Co, at the time it provides them, has given to Bird Co and therefore the amount taken to have been provided by Cat Co under the arrangement pursuant to section 230-60. Subsection 230-75(1) makes it clear that it is the gain or loss, and not the individual financial benefits that are in fact provided or in fact received, that must be calculated in nominal terms. It would be an anomaly if Cat Co were taken to have provided $200 to extinguish its obligation to Dog Co.

Cat Co will therefore make a $30 loss from its financial arrangement rather than its expected $50 loss.

The requirement that the gain or loss must be calculated in nominal terms is designed to ensure that the outcome is not that Cat Co makes no loss from the arrangement. Without such a requirement, it may be argued that, as the present value of Cat Co's obligation to pay $150 under the financial arrangement was, when it was incurred, only $100, no gain or loss is made as Cat Co also received $100 under the arrangement. Such an approach is not permissible under sections 230-70 and 230-75.

3.60 Example 3.10 illustrates that if a financial benefit received or provided under an arrangement is, for example, an asset that itself consists of a series of future cash flows, the financial benefit being the asset is to be taken into account in determining a gain or loss from the financial arrangement at its market value when received or provided. The cash flows it represents are not amounts provided under the relevant financial arrangement, or that are integral to calculating the gain or loss from the relevant financial arrangement. The requirement that a gain or loss from the financial arrangement be calculated in nominal terms does not go so far as to suggest that where the financial benefit provided under the arrangement is such an asset, its value must be represented by the dollar sum of its expected cash flows.

3.61 If a right to a financial benefit is received in the form of an obligation being waived, or an obligation to provide a financial benefit is provided in the form of waiving a right to receive a financial benefit from someone else, the amount of those financial benefits is taken to be the market value of the debt waived, as determined at the time of the waiver.

3.62 The following example provides an illustration of the valuation rule where a financial benefit is received or provided in the form of a waiver.

Example 3.11 : Value of a financial benefit in the form of a waiver

LA Co has an outstanding debt owing to AH Co of $200 which is to be paid in two years time. The debt has a current market value of $150. At the same time it holds a bond (a separate financial arrangement) issued by AH Co that has a market value of $150 (and face value of $250). In an agreement between the parties LA Co agrees to waive its right to receive payment under the bond in full satisfaction of the amounts it owes on the outstanding debt of $200.

In determining any gain or loss on the extinguishment of the debt owed by LA Co, it will be taken to have provided a financial benefit (being the waiving of its right to receive payment on the bond of $250 in the future) which is equal to the market value of the bond at the time of the waiver (see note at end of subsection 230-60(2)). The valuation rule will ensure that LA Co takes into account the market value of the waived bond ($150) and not its nominal value ($250) when calculating the gain or loss it makes on the extinguishment of the debt.

Allocation of cost and proceeds may also occur within a particular tax-timing method

3.63 Under some of the tax-timing methods, the allocation of costs and proceeds is required for determining particular gains and losses from a financial arrangement over the period for which it is held. Note that other tax-timing methods have their own methodology for determining gains and losses from the financial arrangement over this period. It is therefore critical to refer to the relevant tax-timing method to determine the timing and quantum of relevant gains and losses from a financial arrangement.

A special rule for interest for particular gains and losses, and realised gains and losses

3.64 As mentioned above, many of the tax-timing methods have their own methodology for determining what is the gain or loss that is made from a financial arrangement, and under these methods, together with the balancing adjustment in Subdivision 230-G where relevant, the entire gain or loss from the financial arrangement will be brought to account under Division 230. However, the methodologies in Subdivision 230-B (accruals and realisation methods) will largely rely on the core provisions in Subdivision 230-A to determine what is the relevant gain or loss in the appropriate circumstance. The allocation of financial benefits received, to those provided in order to determine the quantum of the relevant gain or loss, will be particularly important where there is more than one gain or loss from the financial arrangement. In an accruals and realisation sense, this will be relevant for determining particular gains and losses, and in determining gains and losses made under the realisation method.

3.65 When a financial benefit is received or provided as an interest receipt or payment (or where it is in the nature of interest or can reasonably be regarded as a substitute for interest or are returns in the form of dividends paid or provided on a debt interest) it is intended that this financial benefit (or cash flow) itself be a gain or a loss. These cash flows under the current law are typically treated on a gross basis. It is therefore intended that in a broad sense the current treatment of these cash flows not be disturbed in these circumstances. Special rules are contained in sections 230-70 and 230-75 to clarify this point. These rules provide that no costs (or proceeds) are allocated to the receipt (or payment) of interest (or an amount in the nature of, or in substitution for, interest or are returns in the form of dividends paid or provided on a debt interest) when determining the relevant gain or loss on such a receipt (or payment). Under these rules, which apply only in calculating a particular gain or loss under the accruals methodology, or a gain or loss that occurs under the realisation method, the receipt of an amount of, in the nature of, or in substitution for, interest, will represent a gain in its entirety. Likewise, the payment of an amount that is interest, interest in nature, or in substitution for interest, will be a loss made under a financial arrangement in its entirety for the purpose of these methods. [ Schedule 1, item 1, sections 230-70 and 230-75 ]

3.66 [0]As these rules only apply for the purpose of determining a particular gain or loss under the accruals methodology or for determining a gain or loss that occurs under the realisation method, they will not apply, for example, to prohibit a cost being attributed to an interest income stream disposed of, or proceeds being allocated to interest obligations that are assigned, novated or that otherwise cease. When a financial arrangement ceases, or is partially transferred, any financial benefits reasonably attributable to a right or obligation to an amount in the nature of interest under that arrangement continues to be appropriately allocated. This ensures that an appropriate gain or loss can be calculated upon the cessation or relevant partial disposal of a financial arrangement. [ Schedule 1, item 1, sections 230-70, 230-75, 230-200 and 230-445 ]

3.67 In addition, the acquisition of an interest stream of itself will not invoke these rules so as to deny that income stream from having any cost. This is because in the hands of the acquirer, the 'interest' income is a series of cash flows that it has simply acquired. Not being connected with any loan, provision of credit or borrowing of the relevant taxpayer, these payments in isolation are not interest, interest in nature, or in substitution for interest. [ Schedule 1, item 1, section 230-70 ]

General rule for the taxation of gains and losses made from financial arrangements

3.68 Under Division 230, gains from financial arrangements are assessable income unless otherwise specified. [ Schedule 1, item 1, subsection 230-15(1 )]

3.69 Gains from financial arrangements included in assessable income pursuant to subsection 230-15(1) will still retain their character as either statutory or ordinary income (see note 2 to subsection 6-10(2) of the ITAA 1997). Apart from some specific rules for determining a gain or loss on a financial arrangement where there is a change of residence during an income year (see Chapter 11), Division 230 does not disturb the general rules relating to foreign residents contained within Division 6 of the ITAA 1997. The structure of that Division (and, in particular, subsections 6-5(3) and 6-10(5) of the ITAA 1997) ensures that foreign residents are only taxed on their gains from financial arrangements that have an Australian source. [ Schedule 1, item 1, subsection 230-15(7 )]

3.70 Under Division 230, losses from financial arrangements are deductible to the extent that they are made in gaining or producing assessable income or are necessarily made in carrying on a business for the purpose of gaining or producing assessable income, unless otherwise specified. [ Schedule 1, item 1, subsection 230-15(2 )]

3.71 This rule reflects the current general deduction rule in section 8-1 of the ITAA 1997 with the exception that it generally does not deny deductions for a loss of a capital nature. This is consistent with an object of Division 230, which is to generally ignore distinctions between capital and revenue. [ Schedule 1, item 1, subparagraph 230-10(b)(ii )]

Dividends paid on debt interests

3.72 As noted above, the rule in subsection 230-15(2) reflects the current general deduction rule in section 8-1 of the ITAA 1997 - in particular the 'nexus' aspects of section 8-1. Hence, the case law in respect of the nexus aspects would also apply in determining whether losses made from a financial arrangement will satisfy the test for deductibility in subsection 230-15(2). Given the nexus requirements, deductions may not be allowable where a loss is made from interests (including debt/equity hybrids) that satisfy the debt test under Division 974 of the ITAA 1997 (eg, an interest that would be an equity interest but for the fact that it satisfies the debt test, such as a mandatory redeemable preference share) where the loss represents the application of income derived (ie, a post-derivation outlay). Such outlays may be dividends paid in respect of the relevant interest (see Commissioner of Taxation v Boulder Perseverance (1937) 58 CLR 223).

3.73 Further, although the rule in subsection 230-15(2) generally will not deny deductions for losses of a capital nature (which may otherwise have denied deductibility for dividends paid on debt interests because they could be said to be of a capital nature), there is case law that suggests that such dividend payments are not made for the purpose of gaining or producing assessable income (see Macquarie Finance Limited v Commissioner of Taxation [2005] FCAFC 205). Rather, these dividend payments may be said to be outgoings relevant to the raising of permanent additional capital. This means that such payments, which are themselves the losses made on financial arrangements that are debt interests, could be prevented from deductibility under subsection 230-15(2) because it could be said that they were not made in gaining or producing assessable income or necessarily made in carrying on a business for the purpose of gaining or producing assessable income.

3.74 In respect of section 8-1 of the ITAA 1997, in order to address these issues, section 25-85 of the ITAA 1997 specifically provides for deductibility in respect of dividends (subject to certain restrictions). Section 25-85 will not apply to financial benefits paid or received in respect of financial arrangements that are debt interests due to the operation of the anti-overlap rule in section 230-25 (which is explained further below). However, the effect of section 25-85 is reflected in subsections 230-15(4) to (6). That is, if the financial arrangement is a debt interest (as determined under Division 974 of the ITAA 1997), the loss made at the time a dividend is paid on that debt interest is not denied deductibility merely because the financial benefit (ie, the dividend) is contingent on the economic performance of the taxpayer or a connected entity of the taxpayer; or that the dividend is considered to secure a permanent or enduring benefit for the taxpayer. [ Schedule 1, item 1, subsection 230-15(4 )]

3.75 As a revenue safeguard it is necessary to prevent excessive deductible payments on debt/equity hybrids that satisfy the debt test. The same risk to the revenue identified in respect of section 25-85 of the ITAA 1997 exists under Division 230 - that is, that a company could distribute its profits as deductible payments in lieu of frankable dividends by making the distribution in respect of a hybrid that has been artificially characterised as debt. The artificiality of the characterisation would be indicated by a return on the interest considerably in excess of the interest payable on an equivalent interest without any equity component (ie, straight debt). The deduction allowable in these circumstances is capped by reference to the rate of return on an equivalent straight debt interest, increased by a margin to recognise the premium paid for the increased risk of non-payment because of the contingency. That rate of return is referred to as the 'benchmark rate of return', and the margin is 150 basis points [ Schedule 1, item 1, subsection 230-15(5 )]. The margin may be increased or decreased by reference to regulations made under subsection 25-85(6) of the ITAA 1997 [ Schedule 1, item 1, subsection 230-15(6 )].

Gains and losses relating to exempt and non-assessable non-exempt income

Gains

3.76 To the extent that a gain made from a financial arrangement is reflected by an amount which a provision in the income tax law outside Division 230 would have considered as exempt income or non-assessable non-exempt income, if Division 230 were not enacted, the gain, or that part of the gain, will maintain its status as either exempt income or non-assessable non-exempt income (as the case may be). The gain will also be either exempt income or non-assessable non-exempt income to the extent that, if it had instead been a loss, the loss would have been denied deductibility on the basis it would have been made in gaining or producing exempt income or non-assessable non-exempt income. [ Schedule 1, item 1, section 230-30 ]

Losses

3.77 A Division 230 loss from a financial arrangement will not be deductible if it is made in gaining or producing exempt income or non-assessable non-exempt income. [ Schedule 1, item 1, subsection 230-30(3 )]

3.78 An exception to this general rule is losses from financial arrangements made by Australian entities in deriving foreign source income that is non-assessable non-exempt under section 23AI, 23AJ or 23AK of the ITAA 1936, where the loss is a cost in relation to a debt interest covered by paragraph (a) of the definition of 'debt deduction' in subsection 820-40(1) of the ITAA 1997 (the 'thin capitalisation' provisions) [ Schedule 1, item 1, subsection 230-15(3 )]. This treatment maintains the current treatment of such costs under section 25-90 of the ITAA 1997.

Gains and losses of a private or domestic nature

3.79 Under Division 230, losses from certain financial arrangements having a private or domestic purpose will not be deductible. Division 230 will not apply to gains from such arrangements that are private or domestic in nature.

3.80 The specific arrangements subject to this exclusion are:

•

a borrowing or provision of credit under an arrangement where the taxpayer is the borrower, or is provided with the credit, to the extent that the borrowing or provision of credit is used for private or domestic purposes; and

•

derivative financial arrangements of individuals, to the extent they are held or used for private or domestic purposes.

[ Schedule 1, item 1, section 230-35 ]

Private or domestic borrowings

3.81 A loss made from an arrangement under which finance is raised by the taxpayer (ie, where the taxpayer has borrowed funds or has been provided with credit) will not be deductible to the extent the finance is used for a private or domestic purpose. Division 230 will not apply to gains made from such an arrangement. [ Schedule 1, item 1, section 230-35 ]

3.82 The intended operation of this exception is to exclude gains and losses from assessable Division 230 gains or deductible Division 230 losses where they are made in respect of borrowings and other forms of raising finance used to fund private or domestic arrangements. It does not include an arrangement under which the taxpayer is the provider, rather than the recipient, of the finance.

3.83 A borrowing is broadly defined in subsection 995-1(1) of the ITAA 1997 to cover any form of borrowing, whether secured or unsecured. The provision of credit is a similarly broad concept, entailing a financial contribution to the taxpayer in respect of which the taxpayer pays a return.

3.84 In determining whether borrowed funds, or credit provided, have been used for a private or domestic purpose, it is important to consider all the relevant circumstances and features of the particular arrangement, in addition to the taxpayer's intention.

Example 3.12 : A loss made where finance is raised for a private purpose

Hoa's Haulage, a truck importing business, is conducted by Hoa as a sole trader.

As an individual, Division 230 does not apply to Hoa's gains and losses from financial arrangements on a mandatory basis (section 230-455). However, Hoa makes an election to have all financial arrangements subjected to Division 230 (subsection 230-455(7)).

After making this election, Hoa then borrows $50,000. $30,000 of the borrowed funds are to acquire a second-hand prime-mover truck as part of the trading stock of Hoa's Haulage, and the remaining $20,000 funds Hoa's personal overseas travels.

The interest payments Hoa makes on repayment of the loan are losses made from a financial arrangement (see Chapter 2). However, 40 per cent of the losses made relate to a borrowing that was used for a private purpose. Accordingly, despite being losses made from a financial arrangement to which Division 230 applies, 40 per cent of Hoa's interest payments will be denied deductibility under section 230-35.

(Note that it is not necessary for Hoa to make a subsection 230-455(7) election in order to obtain a deduction for the cost of that part of the borrowed funds used to acquire the prime-mover truck under other provisions of the Act.)

Derivatives held for private or domestic purposes

3.85 Division 230 will not apply to a gain made by an individual from a derivative financial arrangement, to the extent that it is held or used for private or domestic purposes. Losses from such an arrangement will not be deductible. [ Schedule 1, item 1, section 230-35 ]

3.86 Whilst individuals will not be compulsorily subject to Division 230 except in relation to their qualifying securities, they may elect to have all of their financial arrangements subject to the Division (see Chapter 2). [ Schedule 1, item 1, subsection 230-455(7 )]

3.87 Derivative financial arrangements are financial arrangements that:

•

change in value in response to a change in a specified variable or variables; and

•

require little or no net investment, in that the net investment is smaller than that required for other types of financial arrangements, except other derivative financial arrangements, that would be expected to have similar results to changes in market factors (see Chapter 8).

[ Schedule 1, item 1, subsection 230-350(1 )]

3.88 Where a derivative financial arrangement (such as an interest rate option) is used or held by an individual for private or domestic purposes (eg, to hedge the risk associated with a private underlying transaction), any gain or loss made on it will in effect be disregarded under Division 230.

Gains and losses to which Division 230 does not apply

3.89 Division 230 will not apply to gains from financial arrangements to the extent that they are in the form of a franked distribution, or a right to a franked distribution, whether received directly by the taxpayer or indirectly through a partnership or trust. [ Schedule 1, item 1, section 230-480 ]

3.90 Division 230 will also not apply to certain gains and losses from specified financial arrangements or where specific provisions operate to reduce gains and losses from particular financial arrangements. [ Schedule 1, item 1, note to subsections 230-15(1) and (2 )]

3.91 These specified exceptions to the general scope of the Division have the effect of limiting the application of the general taxing provisions in section 230-15. They are discussed in detail in Chapter 2.

Gains and losses from financial arrangements generally on revenue account

3.92 As the above paragraphs have illustrated, by being generally assessable or deductible, gains and losses from financial arrangements are typically taxed on revenue account under Division 230.

3.93 Under existing legislation, not only are there questions of fact and law in determining the appropriate character of gains and losses, but also potentially difficult apportionment issues because gains and losses can be attributable to both periodic and non-periodic cash flows.

3.94 Putting all gains and losses on revenue account, other than where an exception or exclusion applies, simplifies the determination of the tax treatment. It is also consistent with the operation of some existing tax provisions relating to financial arrangements (eg, see the provisions listed in paragraph 3.22).

3.95 However, a different character may be attributed to the gains and losses from a financial arrangement that is a hedging financial arrangement, if the hedging financial arrangement method is applied to take account of those gains and losses from a financial arrangement. Under this method, the gain or loss from the hedging financial arrangement will in most instances be aligned with the tax treatment of the underlying hedged item. [ Schedule 1, item 1, section 230-310 ]

3.96 If the hedging financial arrangement method specifically provides that a gain or loss on a hedging financial arrangement is to be dealt with in a particular way (whether or not by providing that it be on capital account), this takes priority over the treatment provided for in the general rule for the taxation of gains and losses from financial arrangements. [ Schedule 1, item 1, subsections 230-300(1) and 230-310(3), section 230-40 ]

3.97 For a more comprehensive discussion of the hedging financial arrangement method (including what are hedging financial arrangements and hedged items), refer to Chapter 8.

3.98 Financial arrangements which have their gains and losses specifically excluded from the operation of Division 230 may also be taxed on capital account.

Anti-overlap rule

3.99 Sections 230-20 and 230-25 contain rules to ensure that:

•

a gain or loss from a financial arrangement that is, or will be, taken into account under Division 230; and

•

any associated financial benefits making up the calculation of that gain or loss,

are not taken into account more than once under Division 230, and are not included in assessable income or allowable as a deduction under a provision of the ITAA 1936 or the ITAA 1997 outside of Division 230. [ Schedule 1, item 1, sections 230-20 and 230-25 ]

3.100 These anti-overlap rules ensure that:

•

gains and losses from financial arrangements are recognised only once for tax purposes;

•

to the extent that a gain or loss from a financial arrangement is, or will be, assessable or deductible under Division 230, or dealt with under the hedging rules, this takes priority over other provisions of the ITAA 1936 or the ITAA 1997; and

•

to the extent to which Division 230 does not deal with a gain or loss from a financial arrangement the other provisions of the ITAA 1936 or the ITAA 1997 will have residual operation unless otherwise specified (ie, Division 230 does not represent an exclusive code for the taxation of gains and losses from financial arrangements).

[ Schedule 1, item 1, sections 230-20 and 230-25, item 76, section 118-27 ]

3.101 The operation of the anti-overlap rules in sections 230-20 and 230-25 require that if a gain or loss from a financial arrangement is, or is to be, included in assessable income or allowable as a deduction under Division 230, or dealt with in accordance with subsection 230-310(4) (which, as explained in Chapter 8, sets out particular tax classifications for gains and losses from certain hedging financial arrangements), then no part of that gain or loss can be:

•

included in assessable income;

•

allowable as a deduction; or

•

dealt with in accordance with subsection 230-310(4),

again under Division 230, or under any other provision of the ITAA 1936 or the ITAA 1997, in any income year. [ Schedule 1, item 1, section 230-20 ]

3.102 For example, this means for foreign residents that where a hedged item is ordinary or statutory income from an Australian source the hedge gain or loss will be subject to tax in Australia. On the other hand, where a hedged item is ordinary or statutory income from a non-Australian source, the hedge gain or loss will not be subject to tax in Australia.

3.103 In addition, no part of the amount or value of any financial benefits taken into account in determining an assessable gain or deductible loss under Division 230, or a gain or loss dealt with in accordance with subsection 230-310(4), can be either included in assessable income or allowable as a deduction under any other provision of the ITAA 1936 or the ITAA 1997 in any income year. [ Schedule 1, item 1, subsection 230-25(2 )]

Relevance for other parts of the Act

3.104 The intention of the anti-overlap rule is to ensure that gains and losses from financial arrangements (including any component parts of such gains and losses) are only recognised once for tax purposes. It is not intended to restrict the other workings of the ITAA 1936 or the ITAA 1997. In this regard, the anti-overlap rule does not prevent such gains and losses (or any financial benefits taken into account in determining them) from being used to work out other tax-relevant amounts, as long as no part of any gain or loss from a financial arrangement is dealt with more than once. [ Schedule 1, item 1, subsection 230-20(2 )]

3.105 Further, the rules do not prevent the application of the provisions of Division 13 of Part III of the ITAA 1936 to financial arrangements and/or their financial benefits where they are, or are used as consideration for, the supply of property or services in cross-border transactions/dealings. In the relevant circumstances, the Commissioner may adjust the amount of the consideration (if any) given or received to an arm's length amount. Such an adjustment might be made to the amount of a financial benefit provided or received under a financial arrangement. If an adjustment is made, the adjusted amount would then be used to determine the amount of a gain or loss that would be brought to account under Division 230. Section 230-15 remains the only provision under which the gain is assessable or the loss is deductible or, if relevant, the arm's length gain or loss remains to be dealt with by subsection 230-310(4).

Financial arrangements used as consideration in other dealings

3.106 In keeping with this intention, the anti-overlap rule does not go so far as to provide that where a taxpayer is taken to have received or provided a financial benefit as the cost or proceeds for a particular financial arrangement, that a financial benefit of an equal value cannot be assessable or deductible elsewhere. For instance, in Example 3.6, Bill Co is taken to have received capital proceeds on disposal of its land equal to the market value of the financial arrangement it starts to have. Bill Co is also taken to have started to have that financial arrangement by providing an amount of that same value. In this example, even though the values are the same, they are in respect of different financial benefits (one being the financial benefit received for the land and the other being the financial benefit provided for starting to have the financial arrangement). Section 230-25 clarifies this point for the avoidance of doubt. [ Schedule 1, item 1, section 230-25 ]

Bad debts

3.107 Where a financial arrangement arises in respect of the provision of goods, services or other property on deferred payment terms (and section 230-450, dealing with certain short-term arrangements, does not apply), a special rule is required to allow a deduction under section 25-35 of the ITAA 1997 if the relevant debt that arises on provision of those goods, services or other property goes bad. This is because, despite the amount taken to have been received for the provision of such property or services being a different financial benefit from that taken to have been provided for starting to have the financial arrangement, in these circumstances, the debt that arises at the time the goods, services or other property is provided is in fact satisfied by the acquisition of the financial arrangement.

3.108 The value that is included in assessable income in respect of the provision of the goods, services or other property is determined under section 230-505. For the special rule to apply, the financial benefit (as determined under section 230-505) must have been brought to account as assessable income under a provision outside of Division 230 [ Schedule 1, item 1, paragraph 230-25(3)(a )]. Where this amount is written-off as a bad debt by the taxpayer, a deduction for the value of the financial benefit the taxpayer is taken to have provided to acquire the financial arrangement is to be claimed under section 25-35 of the ITAA 1997 (subject to the relevant restrictions in that section) [ Schedule 1, item 1, subsection 230-25(3 )].

3.109 If a gain has been included in the taxpayer's assessable income under Division 230, and an amount that includes or represents that gain has been written off as a bad debt, specific provisions in Subdivision 230-B will apply to recognise a loss under Division 230 to the extent of the gain previously brought to account.

3.110 Further, if the taxpayer ceases to have the relevant financial arrangement (eg, by disposing of the debt to a third party), after it has written-off the relevant debt as bad and claimed the deduction available under section 25-35 of the ITAA 1997, the balancing adjustment under Subdivision 230-G is adjusted to take this previously claimed deduction into account. Therefore, in calculating an amount of a gain or loss on the relevant ceased financial arrangement, the amount of any deduction that has been claimed under section 25-35 is to be taken into account under step 1(b) in the method statement in section 230-445 (see Chapter 10) [ Schedule 1, item 1, subsection 230-445(7 )]. This rule is consistent with the underlying policy in sections 230-20 and 230-25: that amounts are not to be included in assessable income or allowable as a deduction more than once under the ITAA 1936 or the ITAA 1997.

Exempt income

3.111 Subsection 6-20(2) of the ITAA 1997 provides that amounts of ordinary income that are excluded from being assessable income, are exempt income. However, merely because a provision in Division 230 prevents a gain or part of a gain from being assessable under Division 230 (in order to avoid that gain or part of that gain from being included in assessable income more than once under the tax law) the carving out of the gain from being assessable under Division 230 does not of itself cause the gain to be exempt income. This is because the gain, while not included in assessable income under Division 230, is ultimately included in assessable income under another provision of the tax law. Subsections 230-20(5) and 230-25(4) put it beyond doubt that such a gain excluded from being assessable under Division 230 is not exempt income merely because of that exclusion. [ Schedule 1, item 1, subsections 230-20(5) and 230-25(4 )]

Threshold calculations

3.112 By only requiring that gains and losses from financial arrangements (or any financial benefits taken into account in determining them) not be taken into account more than once in working out a taxpayer's taxable income, the anti-overlap rules do not prevent these amounts from being included in other calculations.