House of Representatives

Explanatory Memorandum

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

Chapter 6 The elective fair value method

Outline of chapter

6.1 This chapter outlines how the elective fair value method operates. The chapter explains:

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when the taxpayer can apply the elective fair value tax-timing method;

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the effect of the elective fair value tax-timing method; and

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what valuations are used for the purposes of the elective fair value tax-timing method.

Overview of the elective fair value method

The fair value tax-timing method

6.2 The elective fair value method is a tax-timing method that measures gain or loss as the change in the value of a financial arrangement between two points in time. Under this tax-timing method the gain or loss from a financial arrangement for a particular period is the increase or decrease in its fair value between the beginning and end of the period, adjusted for amounts paid or received during the period. For example, assuming there are no amounts paid or received during the period, if the value of a financial arrangement is $100 on 1 July 2010 and $125 on 30 June 2011, there is a fair value gain of $25 for that particular period.

6.3 Where a fair value election applies, the gains or losses for an income year will be determined by relevant accounting standards. Accordingly, where the Australian accounting standards, or comparable foreign accounting standards, require that a fair value measurement through profit or loss be used to determine accounting profits or losses on financial arrangements for an income year, these gains and losses shall be used to determine the taxpayer's gain or loss for an income year from those financial arrangements.

6.4 Distributions, to the degree that they are franked (received either directly by the taxpayer or indirectly through a partnership or trust), and rights to receive distributions, to the degree that they are franked (either directly or indirectly), are not to be included as a gain or loss under the fair value method.

Valuations

6.5 The term fair value is defined in Australian Accounting Standard AASB 139 Financial Instruments: Recognition and Measurement (AASB 139) as '...the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in arm's length transactions'. The valuation methods used for the elective fair value method ought to generally be the same as those used for the fair value valuation in relevant accounting standards.

Election to apply fair value tax-timing method

6.6 Broadly, the fair value tax-timing method will apply to a financial arrangement where a taxpayer makes a valid election to use the fair value election in respect of a Division 230 financial arrangement.

6.7 Generally, for a taxpayer to make a valid election to apply the fair value tax-timing method, the taxpayer must prepare financial reports in accordance with relevant accounting standards and have those financial reports audited in accordance with relevant auditing standards.

6.8 The taxpayer must also:

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classify the financial arrangement in the financial report as an asset or liability at fair value through profit or loss, except for intra-group financial arrangements not required to be recognised in the financial reports referred to above because of the application of the relevant accounting standard dealing with consolidated and separate financial statements; and

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treat the asset or liability (or that part of the asset or liability) that is classified at fair value through profit or loss as if it is the whole of the relevant financial arrangement (with any balance being treated as a separate financial arrangement).

6.9 Once the fair value election is made a taxpayer must apply the fair value tax-timing method to financial arrangements described in the previous paragraph that start to be held in that income year and any subsequent income year.

Balancing adjustment if a fair value election ceases to apply

6.10 Where a fair value election ceases to have effect, or ceases to apply to a particular financial arrangement, a balancing adjustment is made in respect of any financial arrangement that is no longer subject to the election. This balancing adjustment has the effect of a disposal of that financial arrangement for its fair value at the start of the income year in which the election ceases to apply, followed by an immediate reacquisition for that fair value.

Context of amendments

6.11 The current income tax law does not specifically provide for gains and losses to be recognised using a fair value tax-timing method. The current trading stock provisions provide the closest proxy by allowing taxpayers to revalue trading stock on-hand by reference to changes in market value. However, these provisions have limited application to many financial arrangements.

6.12 The absence of an elective fair value method for the recognition of gains and losses from a trading portfolio of financial arrangements could mean that, while the portfolio is largely hedged in value terms, the tax-timing method applying to the individual financial arrangements may produce significant gains or losses that do not reflect the manner in which those portfolio gains or losses are earned. This tax result is inconsistent with the way that the gains and losses from the portfolio are recognised for financial accounting purposes and managed for risk management purposes. Where the portfolio is integral to the price-making function in a financial market, the potentially significant difference between the tax and financial accounting results would be distortionary.

6.13 The elective fair value method is a tax-timing methodology that measures gain or loss for tax purposes as the change in the value of a financial arrangement between two points in time. Under fair value tax accounting the gain or loss from a financial arrangement for a particular period is the increase or decrease in its fair value between the beginning and end of the period, adjusted for amounts paid or received during the period.

6.14 While the elective fair value method has a number of potential advantages, mandatory application to all financial arrangements and all taxpayers could potentially result in excessive volatility in reported profits/losses and tax liabilities, creating adverse cash flow and liquidity issues for some taxpayers. Imposing the elective fair value method could also create substantial compliance costs for taxpayers where they are not required to use the fair value method for accounting purposes. For these reasons the fair value tax treatment is elective.

6.15 The elective fair value method requires integrity measures to ensure that the elective treatment is not tax motivated. It is against this background that the accounting and auditing requirements are necessary. That is, the accounting and auditing requirements, which the taxpayer must meet to make the fair value election and apply it to the financial arrangements which they have, provide a level of integrity around facilitating the elective fair value method in the appropriate circumstances and minimising tax motivated accounting or selection practices. These requirements, with other common requirements and conditions, are discussed in more detail in Chapter 5.

Summary of new law

6.16 Relevant taxpayers may irrevocably elect to use the elective fair value method to determine gains and losses on financial arrangements including equity interests (other than equity interests that they issue) for the income year. The fair value gain or loss for an income year will be the same as that recorded on a fair value basis in the entity's audited profit or loss account under relevant Australian accounting standards or their comparable foreign equivalents.

6.17 When the requirements for making the election cease to be satisfied, the fair value election ceases to have effect and a balancing adjustment is required to be made.

Comparison of key features of new law and current law

Detailed explanation of new law

6.18 To apply the elective fair value method to a financial arrangement, the taxpayer must:

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elect the method [ Schedule 1, item 1, subsection 230-210(1 )];

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meet the common requirements for a valid election - that is, prepare financial reports in accordance with the relevant accounting standards and have those financial reports audited in accordance with the relevant auditing standards (for more detail on the common requirements for the elective Subdivisions refer to Chapter 5) [ Schedule 1, item 1, subsection 230-210(2 )];

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classify the financial arrangement in the financial report, pursuant to the operation of the relevant accounting standards, as an asset or liability at fair value through profit or loss - noting the exception for financial arrangements that are not recognised in a set of financial reports because of the application of accounting standard Australian Accounting Standard AASB 127 Consolidated and Separate Financial Statements (AASB 127) (or comparable) [ Schedule 1, item 1, paragraph 230-220(1)(c) and subsection 230-220(2 )];

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treat the asset or liability that is classified at fair value through profit or loss (or that part of the asset or liability) as comprising the whole of the relevant financial arrangement (with any balance of the 'financial arrangement' as defined in Division 230 being treated as a separate financial arrangement) [ Schedule 1, item 1, section 230-235 ]; and

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apply the fair value tax-timing election to the financial arrangement if:

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it starts to be held in the income year in which the election is made or any subsequent income year [ Schedule 1, item 1, paragraph 230-220(1)(d )]; and

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it is not subject to certain exceptions [ Schedule 1, item 1, section 230-225 ].

Which entities can elect the fair value tax-timing method?

6.19 Any entity that prepares audited financial reports is able to make a fair value election [ Schedule 1, item 1, section 230-210 ]. However, only certain taxpayers may want to elect to use the fair value tax-timing method. For instance, traders holding instruments or commodities for relatively short times, and buying and selling commodities or financial instruments primarily for market-making purposes, might elect fair value tax treatment. 'Traders' generally have fully or largely hedged exposures.

6.20 Traders are often financial institutions that have separate trading books. These institutions usually have large portfolios of financial arrangements which are fair valued through profit or loss for financial accounting purposes. If such institutions are able to elect fair value tax treatment for such financial arrangements both their accounting and tax treatments would be on the same fair value basis, and they would benefit from substantial economies in record-keeping and data management. Overall compliance costs are expected to be reduced as a result.

6.21 Some other entities, outside the financial sector, may also have relatively sophisticated risk management systems which would allow them to cope with any price risk and tax volatility that may arise from using the fair value tax-timing method. Such entities may also want to elect fair value tax treatment. Furthermore, entities that record gains and losses on a fair value basis in their audited profit or loss accounts may also want to elect fair value tax treatment to reduce overall compliance costs.

Making the election

6.22 Broadly speaking, a taxpayer whose financial arrangement gains and losses Division 230 applies to may make a fair value election, but an election will only be valid for those taxpayers who meet the requirements of Subdivision 230-C.

6.23 In the case of a tax consolidated group or a multiple entry consolidated group (MEC group), elections are made by the head company of the group. Generally, an election under Division 230 will apply to all the relevant transactions of all members of the consolidated group or MEC group. However, there is an exception to this where a tax consolidated group or MEC group includes a member that carries on a 'life insurance business'. Where a member of the group carries on a life insurance business the head company can specify whether or not the election will apply to the life insurance business carried on by that member of the group. [ Schedule 1, item 1, subsection 230-225(3 )]

6.24 A regulation-making power allows for regulations to be made specifying other types of businesses for which a fair value election made by the head company of a consolidated group or MEC group will not apply. [ Schedule 1, item 1, subsection 230-225(4 )]

6.25 The making of a valid election and its application to a member of a consolidated group that carries on life insurance business is discussed in more detail in Chapter 5.

The elective fair value tax-timing requirements

6.26 For the elective fair value method to apply to the financial arrangements of a taxpayer for the bringing to account of gains and losses, a taxpayer must elect that the elective fair value method apply. An election will only be valid if the accounting and audit requirements listed in subsection 230-210(2) are met. There are elective requirements common to the elective Subdivisions (Subdivisions 230-C, 230-D, 230-E and 230-F). These accounting and audit elective requirements are discussed in detail in Chapter 5. There are also a number of requirements which a particular financial arrangement must meet in order for the election to validly apply, which are discussed below.

Financial arrangements fair valued through profit or loss

6.27 Once a fair value election has been made, the election applies to all financial arrangements which are first held in the income year in which the election is made and in later income years and which are fair valued through profit or loss [ Schedule 1, item 1, paragraphs 230-220(1)(c) and (d )]. In addition, a transitional election may be made to apply the elective fair value method to financial arrangements being fair valued through profit or loss that existed at the time of commencement of the Division [ Schedule 1, Part 3, subitems 104(8) and (11 )]. The transitional election requirements are discussed in Chapter 13.

6.28 Where a financial arrangement is an intra-group transaction for the purposes of accounting standard AASB 127 (or comparable), the financial arrangement is deemed to be an arrangement that is recognised in a set of audited financial reports and classified as at fair value through profit or loss [ Schedule 1, item 1, subsection 230-220(2 )]. For further discussion of this, see Chapter 5.

6.29 Arrangements that fall within the extended operation of Division 230, as set out in section 230-530 (eg, foreign currency, non-equity shares, and commodities and offsetting commodity contracts held by traders), which are fair valued for the purpose of the profit or loss statement can also be fair valued for tax purposes. [ Schedule 1, item 1, section 230-530 ]

6.30 Financial arrangements which are fair valued, and which are not classified as at fair value through profit or loss because the change in fair value is initially taken to equity , cannot be fair valued for the purposes of Division 230. This means that a company cannot apply the fair value method to an equity issued by that company. [ Schedule 1, item 1, subsection 230-220(1 )]

Financial assets and liabilities that comprise the whole or part of the financial arrangement

6.31 The application of the elective fair value tax method is limited to those financial arrangements which, in whole or in part, comprise assets or liabilities classified in the relevant accounts as at fair value through profit or loss [ Schedule 1, item 1, paragraph 230-220(1)(c )]. Where only part of a financial arrangement is subject to fair value (eg, the financial arrangement may comprise a financial asset or liability that is fair valued through the profit or loss and another financial asset or liability which is not), that part of the arrangement is treated as a separate financial arrangement that is subject to this Subdivision. The remaining part of the financial arrangement will be treated as a separate financial arrangement and will be subject to the other provisions of the Division [ Schedule 1, item 1, section 230-235 ].

6.32 Where a hybrid financial arrangement (comprising a host instrument and an embedded derivative) is bifurcated (separated) under the relevant accounting standards (Australian Accounting Standard AASB 132 Financial Instruments: Disclosure and Presentation and AASB 139) the derivative may be fair valued for accounting purposes. However, such a hybrid arrangement may be a single arrangement for the purpose of Division 230 [ Schedule 1, item 1, section 230-55 ]. If the taxpayer has made a fair value tax-timing election in relation to such a hybrid arrangement that is a financial arrangement, it is the intention that such derivatives, which are part of the hybrid arrangement, would be fair valued for tax purposes [ Schedule 1, item 1, section 230-235 ].

Consequences of making a fair value election

6.33 A fair value tax-timing election requires the taxpayer to apply the elective fair value method to all financial arrangements that are required by the relevant accounting standards to be fair valued through profit or loss, and that are not subject to an exception. The fair value election, once made, applies from the beginning of the income year in which the election is made. The election will apply to all financial arrangements which start to be held in the income year in which the election is made (including arrangements subject to a transitional election - see Chapter 13) or a later income year so long as the election remains valid and continues to apply. [ Schedule 1, item 1, paragraph 230-220(1)(d )]

6.34 An election will continue to be valid as long as the requirements which a taxpayer must meet in order to make the election, including the accounting and auditing requirements, continue to be met [ Schedule 1, item 1, subsection 230-240(1 )]. Chapter 5 discusses these common requirements and the making of an election. In the income year in which one or more of these requirements ceases to be met, the election will cease to be valid and the elective fair value method may not be applied to financial arrangements then held by the taxpayer (see paragraphs 6.43 to 6.45). For those financial arrangements which were previously being fair valued, a balancing adjustment is required to be made (see paragraphs 6.46 to 6.49 and Chapter 10) when the election ceases to be valid.

The application of fair value to financial arrangements that are equity interests

6.35 The elective fair value method may apply to all financial arrangements, including financial arrangements which are equity interests under Division 974 of the Income Tax Assessment Act 1997 , subject to the satisfaction of the fair value tax-timing requirements and the exclusion set out below.

6.36 A taxpayer that has issued its own equity interests is not permitted to fair value those equity interests [ Schedule 1, item 1, subsection 230-225(1 )]. This rule is directed at ensuring, for example, that an entity does not obtain a tax deduction for dividends paid.

Gains and losses taken into account where a fair value election is made

6.37 Where a fair value election applies to a financial arrangement, the gains or losses for an income year will be determined by relevant accounting standards. Where the Australian accounting standards, or comparable foreign accounting standards, require that a fair value measurement through profit or loss be used to determine accounting profits or losses on financial arrangements for an income year, these gains and losses shall be used to determine the taxpayer's gain or loss for an income year from those financial arrangements, should the taxpayer make the fair value election that validly applies to those financial arrangements. Chapter 11 explains how this applies in respect of fair value gains or losses that are made from a financial arrangement arising from intra-entity/group dealings that are recognised by Part IIIB (foreign bank branches) of the Income Tax Assessment Act 1936 (ITAA 1936) or Division 9A of the ITAA 1936 (offshore banking units). [ Schedule 1, item 1, subsection 230-230(1 )]

Franked distributions

6.38 Franked distributions (received either directly by the taxpayer or indirectly through a partnership or trust) and rights to receive franked distributions (either directly or indirectly) are not to be included as a gain or loss that is brought to account in accordance with Subdivision 230-C. The effect of excluding franked distributions from the scope of the fair value election is to ensure that these distributions will remain assessable in accordance with section 44 of the ITAA 1936. Assessing the distribution under section 44 of the ITAA 1936 rather than under Division 230 will ensure that the imputation system works appropriately in respect of distributions such that franking credits allocated to such distributions are available to the recipient in the income year in which the distribution is taxed to the recipient.

6.39 Without a specific rule, a dividend (distribution) may be declared in favour of a shareholder and the accounting standards (eg, Australian Accounting Standard AASB 118 Revenue ) would have required the taxpayer to recognise revenue (ie, a gain) in respect of the declared distribution based on the individual facts and circumstances relating to that dividend declaration. At this time, however, the dividend could not be franked. Later, when the dividend is actually paid, that payment would not be assessed to the taxpayer because of the operation of the anti-overlap rule (section 230-20) and, accordingly, franking benefits would not be allowed to the shareholder.

6.40 The exclusion of distributions to the extent that they are franked will apply equally to distributions received directly by the taxpayer from a corporate tax entity or received indirectly by the taxpayer as a beneficiary of a trust or through a partnership. In these cases, a beneficiary of a trust (and equally a taxpayer that will receive franked distributions through a partnership) will only recognise a dividend either when it is received through the trust or when the dividend is declared but not paid and the beneficiary knows how much it will actually receive. If this cannot be determined by the beneficiary, then the exclusion will not apply. [ Schedule 1, item 1, section 230-480 ]

Example 6.1 : Dividend payment

On 1 July 2010 Company A acquires ordinary shares in Company B for $50 million and makes the fair value election in respect of all its financial arrangements. At 30 June 2011 the shares in Company B have a market value of $65 million. On 1 May 2011 Company B pays dividends of $6 million. Company A's taxable income for the 2010-11 year includes the fair value gain of $15 million ($65 million - $50 million) and a dividend of $6 million (ignoring grossing-up for franking credits). However, Division 230 will only assess the fair value gain of $15 million. The dividend paid by Company B will be assessed under section 44 of the ITAA 1936.

At 30 June 2012 the shares in Company B have a market value of $90 million. No dividends have been paid for this income year. Company A's taxable income for the 2010-12 income year includes the fair value gain of $25 million ($90 million - $65 million).

Valuation issues

6.41 The term fair value is not defined in Division 230. The term should take its ordinary commercial meaning. In this regard, AASB 139 defines fair value as '...the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in arm's length transactions'.

6.42 The valuation methods used, and the guidance, definitions and requirements for the elective fair value method ought to generally be the same as those used for the fair value valuation in relevant accounting standards. Therefore, if taxpayers use fair value estimates in their profit or loss accounts that accord with commercially acceptable valuation techniques, they can generally use the same estimates for the purpose of the elective fair value method.

Where requirements for election are no longer satisfied

6.43 Although an election under the elective Subdivisions is irrevocable, the election may cease to apply, depending on the circumstances of either:

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all of a taxpayer's financial arrangements; or

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one or more particular financial arrangements of the taxpayer.

6.44 If an election under any of the elective Subdivisions ceases to apply to a particular financial arrangement, that election cannot subsequently apply to it again. [ Schedule 1, item 1, subsection 230-240(4 )]

6.45 Refer to Chapter 5 for further information as to when an election will cease to apply.

Balancing adjustment if election ceases to apply

6.46 Where an election made under an elective Subdivision ceases to have effect, or ceases to apply to a particular financial arrangement, from the start of a particular income year, a balancing adjustment is made at that time in respect of any financial arrangement that is no longer subject to the election. [ Schedule 1, item 1, subsections 230-245(1) and (3 )]

6.47 The balancing adjustment is to be made in accordance with the balancing adjustment requirements set out in Subdivision 230-G (see Chapter 10). The balancing adjustment when applied to a financial arrangement has the effect of a disposal of that financial arrangement - for its market value at the start of the income year in which the election ceases to apply - followed by an immediate reacquisition for that market value. [ Schedule 1, item 1, section 230-245 ]

6.48 Chapter 5, in respect of the elective Subdivisions, and Chapter 10 more generally, provide further detail as to the operation of the balancing adjustment rules contained in Subdivision 230-G.

Example 6.2 : Balancing adjustment when fair value ends

On 22 April 2010 Spice Co makes a fair value election under section 230-210. Assume Spice Co has a balance date for tax purposes of 30 June.

After the financial year ending 30 June 2011, Spice Co ceases to have its financial reports audited.

From the financial year beginning 1 July 2013, Spice Co again satisfies all the requirements for making a fair value election (including the requirement that its accounts are audited). Spice Co makes a new fair value election under section 230-210.

The consequences of Spice Co ceasing to maintain audited financial reports from 1 July 2011 results in Spice Co not being able to apply the elective fair value method to the financial arrangements it holds at 1 July 2011, as its election ceases to apply from this time. A balancing adjustment will be required to be made on 1 July 2011 for those financial arrangements which were being fair valued through profit or loss subject to the fair value election.

On 1 July 2013, Spice Co again makes a valid fair value tax-timing election. From this time, the elective fair value method will apply to any new assets and liabilities that comprise a financial arrangement (or part thereof) that start to be held on or after this time by Spice Co, which are fair valued through profit or loss in accordance with the relevant accounting standards.

6.49 Once a financial arrangement is taken to be reacquired and no longer subject to the elective fair value method, a taxpayer will need to assess which other relevant tax-timing method under Division 230, is to be applied to the financial arrangement. For example, where the taxpayer ceases to have financial reports prepared in accordance with Australian accounting standards, the default tax-timing methods under Division 230 (accruals or realisation) will typically apply.

Making a new election

6.50 Where a taxpayer has made an election which ceases to have effect, they may later make a new election where the conditions for making an election are once more satisfied (refer Chapter 5). [ Schedule 1, item 1, subsection 230-240(2 )]