House of Representatives

Explanatory Memorandum

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

Chapter 8 The elective hedging financial arrangements method

Outline of chapter

8.1 This chapter outlines the elective tax-hedge rules. The chapter explains:

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the eligibility requirements that entities need to satisfy if they wish to make use of the elective tax-hedge rules; and

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the rationale, structure and operation of the tax-hedge rules.

Overview of the elective hedging method

8.2 Broadly, a financial arrangement is hedged to offset an adverse financial impact arising out of a movement in a price or other financial variable.

8.3 The hedging financial arrangements method is intended to facilitate, subject to safeguarding requirements, pre-tax hedging decisions.

8.4 The approach used to achieve this is to more closely align the tax treatment of the hedging financial arrangement with that of the item it hedges, thereby improving the degree of post-tax matching compared to that under the current tax law.

8.5 The elective hedging method seeks to remove distorting tax mismatch effects on pre-tax hedging activity by changing the tax-timing and tax-status of the hedging financial arrangement and more closely matching it with that of the hedged item.

8.6 Broadly, the tax hedge rules reduce post-tax mismatch by ensuring that gains and losses from hedging financial arrangements are included in taxable income at the same time that the gains or losses made from the hedged item or items are included in taxable income.

8.7 Similarly, the tax classification or status of a hedging financial arrangement gain or loss is matched to that of the hedged item. For example, if the hedged item is subject to capital gains tax (CGT) the hedging financial arrangement will also be subject to CGT rather than being on revenue account.

Context of amendments

8.8 Hedging activity is ordinarily conducted by businesses on a pre-tax basis and is designed to manage, reduce or eliminate risk and uncertainty associated with the taxpayer's financial exposures created when anticipating the purchase, sale or production of commodities and other items, or when having financial assets or liabilities. Derivative instruments (such as swaps, options or forward contracts) are often the means used to hedge such exposures.

8.9 A hedging transaction undertaken in respect of the financial risk arising from an underlying item is effective to the extent that it offsets the movements in an underlying transaction. Generally, a hedging transaction will offset an adverse financial impact, in respect of a hedged item, arising out of a movement in a price or other financial variable.

8.10 Subdivision 230-E (hedging financial arrangements method) seeks to appropriately facilitate, subject to safeguarding requirements, pre-tax hedging decisions. The approach used to achieve this is to more closely align the tax treatment of the hedging financial arrangement with that of the items they hedge, thereby improving the degree of post-tax matching. Under current tax law, comprehensive tax-hedge rules do not exist, and there has been considerable uncertainty about when gains and losses from specific hedging instruments are recognised. For instance, uncertainty occurs in situations where rolling hedges are used as hedging instruments. In such situations, taxpayers have not known whether the point of termination of one hedging instrument is, or is not, to be regarded as a taxing point for the gain or loss on that particular hedging instrument.

8.11 The tax system is differentiated as to tax treatments. For instance, some financial arrangements are taxed on a realisation basis and some are taxed on an accruals basis. If a financial arrangement that is subject to the former basis is used to hedge a risk in relation to an arrangement that is subject to the latter, a tax mismatch may arise. A tax mismatch could also occur where a gain or loss in respect of the financial arrangement is brought to account as assessable income or an allowable deduction (ie, taxed on 'revenue account') but the gain or loss on the underlying item (referred to as a 'hedged item') is brought to account as a capital gain or a capital loss (ie, taxed on capital account).

8.12 The outcome of a tax mismatch is that the effectiveness of pre-tax hedging activity is reduced on an after-tax basis. Such mismatches may produce anomalous tax outcomes, distort decision-making, disrupt the ability of taxpayers to reduce or manage risk and, in general, impede efficiency of risk allocation and management.

8.13 In appropriate circumstances, tax-hedge rules remove distorting tax mismatch effects on pre-tax hedging activity by changing the way that the hedging financial arrangement would have been taxed, to a way that is consistent with the tax treatment of the hedged item. That is, reducing the post-tax mismatch is achieved by altering the tax-timing and tax-status of the hedging financial arrangement and more closely matching it with that of the hedged item.

8.14 The tax-hedge rules broadly align with the purpose of the hedging activity. At the same time, if the tax treatment of a hedging financial arrangement depends only on the purpose of the taxpayer without safeguards, there is the potential for an inappropriate level of selectivity of tax treatment. It appears that the rigorous hedge criteria set out in Australian Accounting Standard AASB 139 Financial Instruments: Recognition and Measurement (AASB 139) also reflect a concern about selectivity. Similarly, tax-hedge rules based solely on purpose have the potential to create administrative difficulties. Without adequate safeguards, the ability to administer tax-hedge rules would be severely constrained.

8.15 Tax-hedge rules that draw heavily on financial accounting concepts will provide greater clarity and neutrality for the taxation of gains or losses arising from arrangements that are part of hedging relationships and will contribute to lower overall compliance costs. Existing uncertainties over relevant tax treatments will be reduced, risk management will be enhanced, and there will be less scope for deferral possibilities arising from adverse selection.

8.16 Greater matching between the taxation of the hedging financial arrangement and the underlying or hedged item may, however, not always lead to greater consistency between the taxation and financial accounting treatment of the hedging financial arrangement. The reason is that taxation treatment of the hedged item may be different to the financial accounting treatment of the item. In this circumstance, the matching process may give rise to a different tax allocation of hedge gains and losses over time, to the financial accounting allocation.

8.17 Further, financial accounting does not have some of the distinctions found in the income tax law, such as:

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the different treatment of capital and revenue gains and losses;

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income which is assessable in some cases and not in others; and

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expenses which are deductible in some cases and not in others.

8.18 The tax-hedge provisions nevertheless are designed to reduce the degree of tax mismatches which might otherwise occur in a tax, albeit not in a financial accounting, context. Reducing tax mismatches that go beyond what financial accounting does (ie, principally matching the time at which the hedging instrument and hedged item are recognised), increases the amount of rules, the level of complexity and the need for integrity requirements. The proposed tax-hedge rules represent a balancing of these factors.

Summary of new law

8.19 The proposed tax-hedge rules are designed to facilitate efficient management of financial risk by reducing post-tax mismatches where hedging takes place. At the same time, the rules seek to minimise tax deferral and tax motivated practices.

8.20 These objectives are given effect by allowing entities, subject to proposed Division 230, to elect tax-hedge treatment in respect of all their financial arrangements whose purpose is to hedge against risk. The election can be made if certain requirements are met. In broad terms these requirements are that:

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each financial arrangement must either be a 'derivative financial arrangement' or a 'foreign currency hedge' (as defined);

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the entity must satisfy documentation requirements that build on those contained in AASB 139;

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the entity prepares a financial report in accordance with appropriate accounting standards and the report is appropriately audited;

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the hedging of the relevant risk must meet specified tests of effectiveness; and

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subject to the satisfaction of certain additional requirements, the taxpayer can adopt hedge tax treatment in respect of a limited number of specific hedging financial arrangements that do not meet the financial accounting standard hedge requirements.

8.21 Once a valid hedging financial arrangement election is made, an entity is generally able to allocate gains and losses from a hedging financial arrangement on an objective, fair and reasonable basis. The allocation must correspond with the basis on which gains, losses or other amounts in relation to the hedged item or items are allocated for tax purposes (referred to as 'tax-timing matching'). The entity will, in many cases, also be able to align the tax classification of the hedging financial arrangement with that of the hedged item (referred to as 'tax-status matching').

8.22 The tax-hedge rules also provide that, under certain circumstances, the hedging financial arrangement ceases to be held and is reacquired for its then fair value. Proposed Division 230, other than the tax-hedge rules, is then applied to bring to account gains or losses made from the reacquired financial arrangement.

Comparison of key features of new law and current law

Detailed explanation of new law

8.23 Tax-hedge treatment is limited to 'hedging financial arrangements' to which the hedging financial arrangement election apply [ Schedule 1, item 1, sections 230-300 and 230-325 ]. A 'hedging financial arrangement' is defined as a financial arrangement that is a 'derivative financial arrangement' or a 'foreign currency hedge' and meets certain purposive and other tests [ Schedule 1, item 1, subsections 230-335(1) and (3 )].

8.24 Generally, to be a hedging financial arrangement, the arrangement must be a hedging instrument for financial accounting purposes [ Schedule 1, item 1, subsection 230-335(1 )]. However, a hedging financial arrangement can exist, in limited circumstances, even if particular aspects of the financial accounting tests are not satisfied [ Schedule 1, item 1, subsection 230-335(3 )], provided that the taxpayer meets certain record-keeping requirements [ Schedule 1, item 1, subsection 230-355(5 )] or, in limited circumstances, where the Commissioner of Taxation (Commissioner) exercises a discretion to treat a financial arrangement as a hedging financial arrangement [ Schedule 1, item 1, section 230-345 ] or to treat certain requirements as having been met [ Schedule 1, item 1, section 230-380 ].

8.25 The hedged item does not have to be a financial arrangement. Neither does it have to be a current transaction. It can be an existing asset or liability, a firm commitment, a highly probable future transaction or a net investment in a foreign operation. It can also be a part of one of these things. [ Schedule 1, item 1, subsection 230-335(10 )]

8.26 In addition, an anticipated dividend from a connected entity that is non-assessable non-exempt income under section 23AJ of the Income Tax Assessment Act 1936 (ITAA 1936), can be a hedged item [ Schedule 1, item 1, subsection 230-335(11 )] and the regulations may prescribe something to be a hedged item [ Schedule 1, item 1, paragraph 230-335(10)(f )].

8.27 Tax-hedge treatment is obtained by making a 'hedging financial arrangement election' which will apply to all the entity's hedging financial arrangements [ Schedule 1, item 1, sections 230-315 and 230-325 ]. As the election requirements are common to various elective regimes in Division 230, Chapter 5 explains these requirements in more detail.

8.28 As a major objective for tax-hedge rules is to reduce tax mismatches, there may be numerous hedging financial arrangements for which entities seek tax-hedge treatment. The 'one-in, all-in' election means that an entity does not have to make a separate election for each of the arrangements. It also means that there is less opportunity for picking and choosing the situations in which the tax-hedge rules will be applied (so as to access the changed tax treatment that hedge tax rules allow); without the requirement to apply the tax-hedge rules on a one-in, all-in basis, administration of the rules would potentially be more difficult.

Accounting and auditing requirement

8.29 There are two basic requirements that have to be satisfied before being able to make a valid hedging financial arrangement election [ Schedule 1, item 1, subsection 230-315(2 )]:

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the entity, or a connected entity of that entity, must prepare a financial report for the relevant income year in accordance with Australian or comparable accounting standards; and

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the report is either required by Australian or comparable foreign law to be audited in accordance with relevant auditing standards or, where there is no requirement to apply the auditing standards, the report is in fact audited in accordance with those standards.

These requirements are common to all elective regimes in Division 230. Chapter 5 explains in more detail the generic requirements and operation of the hedging financial arrangement election and other elections that may be made under Division 230.

Arrangements to which the election applies

8.30 Once a valid hedging financial arrangement election has been made, it applies to relevant hedging financial arrangements which are first held in the income year in which the election is made or in later income years. [ Schedule 1, item 1, section 230-325 ]

8.31 For the hedging financial arrangement method to apply, the hedging financial arrangement must also satisfy requirements in relation to the following three matters:

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documentation of the hedging relationship [ Schedule 1, item 1, section 230-355 ];

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determining the basis of the tax allocation of the gains and losses from the hedging financial arrangement [ Schedule 1, item 1, section 230-360 ]; and

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effectiveness of the hedge [ Schedule 1, item 1, section 230-365 ].

Arrangements to which the election does not apply

8.32 Generally, the election will not apply to financial arrangements that are equity interests or rights to receive or provide such equity interests [ Schedule 1, item 1, subsection 230-330(1 )]. However, there is an exception to this rule, namely where the taxpayer is the issuer of a hedging financial arrangement that is an equity interest and a foreign currency hedge [ Schedule 1, item 1, subsection 230-330(2 )].

8.33 Further, if no election is made under subsection 230-455(7) (about electing to have Division 230 apply to all the taxpayer's financial arrangements), the hedging financial arrangement election will not apply to a financial arrangement if the taxpayer is an individual or an entity that satisfies the relevant threshold test in subsections 230-455(2), (3) or (4) and the arrangement is a qualifying security that has a remaining term, after acquisition, of more than 12 months [ Schedule 1, item 1, subsection 230-330(3 )].

8.34 Where a hedging financial arrangement election is made by a head company of a consolidated group or multiple entry consolidated group (MEC group), the election can specify that it does not apply to financial arrangements in relation to the life insurance business carried on by a member of the consolidated or MEC group [ Schedule 1, item 1, subsection 230-330(4 )]. Nor will the election apply to financial arrangements associated with a business of a kind which may be specified by regulation [ Schedule 1, item 1, subsection 230-330(5 )]. See Chapter 5 for further discussion on this.

Allocating gains or losses

8.35 If the hedging financial arrangement election applies, the gain or loss from the hedging financial arrangement is (subject to any disqualifying condition) recognised for income tax purposes on the following basis:

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the gain or loss is allocated over income years according to the basis determined and set out in the record [ Schedule 1, item 1, subsections 230-300(3), 230-360(1) and (2 )]; and

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where the tax classification of the hedged item is listed in the table in subsection 230-310(4), the gain or loss is treated in accordance with that table [ Schedule 1, item 1, subsection 230-310(4 )].

8.36 This tax allocation and tax classification is subject to certain exceptions. In particular, the treatment specified above may not continue to apply where there is an event within the allocation period that has the effect of treating the hedging financial arrangement as ceasing to be held and being reacquired for its then fair value. [ Schedule 1, item 1, subsection 230-300(5) and section 230-305 ]

Transitional election

8.37 Transitional election rules are explained in Chapter 13. Essentially, the elective hedging financial arrangements method is only available for hedging arrangements that the taxpayer has at the time of commencement of Division 230 where a transitional election is made and where specific record-keeping requirements are met. However, tax-status matching is not available to hedging arrangements that the taxpayer has at the time of commencement of Division 230. What this means is that section 230-310 does not apply to hedging financial arrangements that exist at the time the taxpayer first commences to apply the Division. [ Schedule 1, subitems 104(9) and (10 )]

8.38 The rest of this chapter explains the tax-hedge method in more detail.

Hedging financial arrangements

8.39 To be a 'hedging financial arrangement', the arrangement has to be either a 'derivative financial arrangement' or a 'foreign currency hedge'. [ Schedule 1, item 1, section 230-335 ]

What is a derivative financial arrangement?

8.40 A derivative financial arrangement is a financial arrangement that has the following characteristics:

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its value changes in response to changes in a specified variable or variables; and

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it requires no net investment, or it requires a subsequent net investment that is smaller than would be required for other types of financial arrangements that would be expected to have a similar response to changes in market factors.

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

8.41 The note to paragraph 230-350(1)(a) includes as specified variables (without limiting the term) an interest rate, credit rating, a financial instrument or commodity price, a foreign exchange rate and an index.

8.42 The Division 230 definition of a derivative financial arrangement is very similar to the definition of 'derivative' in AASB 139. However, the tax definition of 'derivative financial arrangement' also explicitly caters for the situation where there is a subsequent net investment in relation to the financial arrangement. If there is a substantial net investment after the financial arrangement has been entered into, it will not be a derivative financial arrangement for the purposes of Division 230. This is different to the AASB 139 definition of a derivative where a subsequent (substantial) investment made after the start of the arrangement is not a disentitling matter. The accounting definition of derivative focuses on whether there is an initial net investment that is of a particular magnitude, rather than any subsequent investments.

8.43 Where there is a requirement for a net investment, the financial arrangement will be a derivative financial arrangement only where the amount of the net investment is smaller than that required for other types of financial arrangements that are expected to have similar responses to changes in market forces. This means that the particular comparison is to be done in relation to the financial arrangement being tested under the definition in subsection 230-350(1) and contracts or arrangements of a type other than derivative financial arrangements.

8.44 Typical derivative financial arrangements that are used as hedging financial arrangements are swaps, options, futures and forward contracts.

What is a foreign currency hedge?

8.45 A foreign currency hedge for the purposes of Division 230 is a financial arrangement:

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whose value changes in response to changes in a specified variable or variables;

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in respect of which there is a requirement for a net investment (whether this be an initial or subsequent net investment) that is not smaller than would be required for other types of financial arrangement that would be expected to have a similar response to changes in market factors (ie, paragraph 230-350(1)(b) is not satisfied); and

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that hedges a risk in relation to movements in currency exchange rates.

[ Schedule 1, item 1, subsection 230-350(2 )]

8.46 To be a hedging financial arrangement, a foreign currency hedge, amongst other requirements, must have been created, acquired or applied for the purpose of hedging a risk or risks in relation to a hedged item. [ Schedule 1, item 1, paragraph 230-335(1)(a )]

8.47 However, the financial arrangement is not disqualified from being a hedging financial arrangement if it is also used for an investment or borrowing purpose (ie, for the purpose of financing). Thus, unlike derivative financial arrangements, a foreign currency hedge can be a financing arrangement and, reflecting AASB 139, represents an exception to the general position that only derivatives can obtain hedge tax treatment.

When will a derivative financial arrangement or foreign currency hedge be treated as a hedging financial arrangement?

8.48 There are two ways in which a derivative financial arrangement or foreign currency hedge can be a hedging financial arrangement. The first is by the financial accounting route, that is, essentially by being a hedging instrument for financial accounting purposes [ Schedule 1, item 1, subsection 230-335(1 )]. The second is where the financial arrangement is not a hedging instrument for financial accounting purposes but meets certain other requirements [ Schedule 1, item 1, subsection 230-335(3 )] (explained in paragraphs 8.72 to 8.78).

8.49 A derivative financial arrangement or foreign currency hedge is to be treated as a hedging financial arrangement if, in the income year in which the rights and/or obligations that comprise the relevant financial arrangement are created, acquired or applied:

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the financial arrangement is created, acquired or applied for the purpose of hedging a risk or risks in relation to all or part of an existing asset or liability or, in terms of the accounting standards, a firm commitment, a highly probable forecast transaction or a net investment in a foreign operation [ Schedule 1, item 1, paragraph 230-335(1)(a )];

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at the time it is created, acquired or applied the financial arrangement satisfies the requirements of a hedging instrument for the purposes of Australian accounting standards or applicable comparable foreign financial accounting standards [ Schedule 1, item 1, paragraph 230-335(1)(b )]; and

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it is recorded as a hedging instrument in the financial report of the entity unless it is a foreign currency hedge, in which case it is recorded in the financial report of a financial accounting consolidated entity in which the entity is included [ Schedule 1, item 1, paragraph 230-335(1)(c )].

8.50 The requirement that a financial arrangement must have been created, acquired or applied for the purpose of hedging a risk, or risks, in relation to a hedged item, or items, in order to be a hedging financial arrangement underpins the hedging relationship and the link between the financial arrangement and the hedged item or items. At the same time, this purpose test may be met notwithstanding that there is a more important purpose for the entity in entering into the arrangement, for example, to manage risk at the entity level.

8.51 It is also important to note that the link between the hedging financial arrangement and the hedged item is at the centre of determining effectiveness and the basis of the allocation of the hedge gain or loss, as well as of the integrity of hedge accounting for tax purposes (and perhaps financial accounting purposes as well).

8.52 Where, in terms of paragraph 230-335(1)(b) or (c) (or both), the accounting requirements relating to a hedging financial arrangement are not satisfied through an honest mistake or inadvertence, the Commissioner may nevertheless exercise a discretion to treat the arrangement as a hedging financial arrangement. In deciding whether to exercise the discretion, the Commissioner shall have regard to the entity's documented risk management practices and policies, its record-keeping practices, its accounting systems and controls, its internal governance processes, the circumstances surrounding the mistake or inadvertence, the extent to which the accounting standards and the recording requirements are met, and the objects of Subdivision 230-E. [ Schedule 1, item 1, section 230-345 ]

8.53 Because the scope of this discretion is limited to circumstances where there an honest mistake or inadvertence, if a financial arrangement is not a hedging instrument for financial accounting purposes it can only obtain tax-hedge treatment if it falls within the list set out in subsection 230-335(3) (including the possibility of inclusion by regulation).

What constitutes the hedging financial arrangement?

8.54 Generally, it is the whole of a derivative financial arrangement, or a foreign currency hedge, considered in its entirety, that must satisfy the requirements for an arrangement to be a hedging financial arrangement [ Schedule 1, item 1, section 230-340 ]. However, reflecting various hedging relationships that can be designated for the purposes of AASB 139, Subdivision 230-E permits a number of variations to this general rule. In broad terms, to the extent that parts of the hedging financial arrangement (represented by the relevant financial benefits) satisfy the requirements in subsections 230-335(1) or (3), the variations are:

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the intrinsic value of an options contract can be designated as the hedging financial arrangement ('partial hedges') [ Schedule 1, item 1, subsection 230-340(2 )];

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the spot price element of a forward contract that also has an interest element can be designated as the hedging financial arrangement [ Schedule 1, item 1, subsection 230-340(3 )]; or

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a specified proportion of a financial arrangement can be designated as the hedging financial arrangement ('proportionate hedges') [ Schedule 1, item 1, subsection 230-340(4 )].

8.55 Where one of the above variations leads to a part or a proportion of a financial arrangement being treated as a hedging financial arrangement, it is taken to be a separate financial arrangement for the purposes of Division 230 and the remaining part or proportion is also taken to be a separate financial arrangement [ Schedule 1, item 1, subsections 230-335(5) and (6 )]. It is therefore possible, for example, for the remaining proportion itself to be a hedging financial arrangement that hedges a hedged item that is separate and distinct to the hedged item being hedged by the other proportion.

Example 8.1 : Proportion of a hedging financial arrangement

Serendipity Co has a highly probable forecast transaction under which it is to borrow $90 million in five months. Serendipity Co also has a forward rate agreement that would be highly effective in offsetting its exposure to an increase in interest rates in the next five months. However, the notional principal on the forward rate agreement is $120 million.

Serendipity Co may treat $90 million or 75 per cent of the forward rate agreement as a hedging financial arrangement in relation to the anticipated borrowing, provided that that proportion meets the requirements of subsection 230-335(1) or (3) in accordance with subsection 230-340(4). In the event that that proportion of the forward rate agreement is a hedging financial arrangement, the remaining proportion (ie, $30 million or 25 per cent) of the agreement is taken to be a separate financial arrangement for the purposes of Division 230 (subsection 230-340(5)).

Further, the remaining proportion could qualify as a hedging financial arrangement in relation to another hedged item, provided it satisfied the necessary tax-hedge criteria.

8.56 It is possible for a financial arrangement to hedge more than one type of risk. However, for Subdivision 230-E purposes, it can only qualify as a hedging financial arrangement if the applicable financial accounting standards allow the arrangement to be designated as a hedge of those risks. [ Schedule 1, item 1, subsection 230-335(8 )]

8.57 It is also possible for two or more financial arrangements to hedge the same risk or risks. However, for Subdivision 230-E purposes, they may only qualify as hedging financial arrangements if the applicable financial accounting standards allow them to be viewed in combination and jointly designated as hedging that risk or those risks. [ Schedule 1, item 1, subsection 230-335(9 )]

8.58 It should be noted that the conditions in subsections 230-335(8) and (9) must be satisfied whether the financial arrangement is one that satisfies the financial accounting hedge requirements or is one which satisfies the extended rules in subsection 230-335(3). [ Schedule 1, item 1, subsections 230-335(8) and (9 )]

The hedged item

8.59 The hedged item may be an existing asset or liability, a firm commitment, a highly probable future transaction or a net investment in a foreign operation whose risk is being hedged by the particular hedging financial arrangement. It can also be a part of one of these things. A hedged item can also be prescribed by regulations. [ Schedule 1, item 1, subsection 230-335(10 )]

8.60 The terms 'firm commitment', 'highly probable forecast transaction' and 'net investment in a foreign operation' all take their meaning from the equivalent terms in the Australian accounting standards. A firm commitment or highly probable future transaction might, for example, be in regard to prospective crops (eg, in future crop years) or prospective resources or output (eg, expected gold production in a future year).

8.61 An anticipated dividend from a connected entity that is non-assessable non-exempt income under section 23AJ of the ITAA 1936 can also be a hedged item. [ Schedule 1, item 1, subsection 230-335(11 )]

Record-keeping requirements

8.62 The following are record-keeping requirements that the taxpayer must meet in order for a hedging financial arrangement to be eligible for tax-hedge treatment:

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There is a formal designation and documentation of the hedging relationship. The documentation must include designation of the hedging financial arrangement in respect of which the hedging financial arrangement election applies, and identification of the hedged item or items. It must also set out the nature of the risk or risks being hedged and how the entity will assess the hedging financial arrangement's effectiveness in offsetting the exposure to changes in the hedged item's fair value, cash flows or foreign currency exposure attributable to the hedged risk or risks. Further, the record must state the risk management objective and strategy to be followed in acquiring, creating or applying the hedging financial arrangement [ Schedule 1, item 1, subsection 230-355(1 )].

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In addition, the record must contain any details that the accounting standards require, by way of documentation, for an arrangement to be recorded in the financial report as a hedging instrument [ Schedule 1, item 1, paragraph 230-355(1)(b )]. This is irrespective of whether the hedging financial arrangement is in fact recorded in the financial report as a hedging instrument [ Schedule 1, item 1, subsection 230-355(1 )]. An example is where a hedging arrangement occurs within a financial reporting period and which is not captured in the financial reports as a hedging arrangement. The record must contain details for that arrangement that would be required had it been recorded in the financial reports for the relevant period as a hedging arrangement.

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The record must set out the terms of the determination made about the allocation of the hedging financial arrangement gain or loss over income years [ Schedule 1, item 1, paragraph 230-355(1)(c )]. This determination forms the basis of the tax-timing and tax classification of the hedging financial arrangement gains and losses, as discussed in further detail below.

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The record must set out the risk in respect of the hedged item with sufficient precision and detail that it is clear:

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that the risk was hedged by the particular hedging financial arrangement [ Schedule 1, item 1, paragraph 230-355(4)(a )];

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the extent to which the risk was hedged [ Schedule 1, item 1, paragraph 230-355(4)(b )]; and

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that the rights and/or obligations that comprise the hedging financial arrangement were in fact created, acquired or applied for the purpose of hedging the risk [ Schedule 1, item 1, paragraph 230-355(4)(c )].

8.63 This record must be made or be in place at, or soon after, the time that the entity creates, acquires or applies the hedging financial arrangement [ Schedule 1, item 1, subsection 230-355(3 )] unless regulations provide otherwise [ Schedule 1, item 1, paragraph 230-355(3)(b )]. For the integrity of the tax-hedge rules, it is important that the relevant record in relation to a hedging relationship either be in place at the inception of the relationship or be made in a reasonably contemporaneous manner. Subsection 230-355(3) permits the record to be made soon after the relationship starts. The reason for this short period is to take into account administrative and systems processes of the particular entity and not to allow designation of the financial arrangement to be determined, with the benefit of hindsight, by reference to whether it creates a favourable outcome.

8.64 The record may consist of one or more documents [ Schedule 1, item 1, subsection 230-355(2 )]. One of those documents may have been brought into existence before the hedging financial arrangement is created, acquired or applied. This allows the record to be based on an amalgamation of a hedging policy document that covers a number of the details of a type of class of hedging financial arrangements that have similar characteristics (eg, swap contracts relating to interest rate risk in relation to housing loans) and an associated document that contains details of the specific arrangement (eg, date, notional principal, currency, term, counterparty, transaction number, and hedged item details). It is likely that such an amalgamation would be consistent with record-keeping practices with respect to routine or high volume hedges. The policy document and associated specific document must together meet the record-keeping requirements in section 230-355.

Hedge effectiveness requirement

8.65 To maintain tax-hedge treatment while the derivative financial arrangement or foreign currency hedge (in relation to a non-derivative financial arrangement) is held, the following conditions must be met:

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for the period the hedging financial arrangement is expected to be held, the entity must expect the arrangement to be highly effective (within the meaning of the relevant accounting standards) in achieving offsetting changes in fair value or cash flows attributable to the hedged risk [ Schedule 1, item 1, paragraph 230-365(a )];

•

the effectiveness of the hedge can be reliably measured, that is, the fair value or cash flows of the hedged item that are attributable to the hedged risk and the fair value of the hedging instrument can be reliably measured [ Schedule 1, item 1, paragraph 230-365(b )]; and

•

the hedge is assessed on a regular basis in accordance with the relevant accounting standards - at least once in each 12-month period. The assessment is directed at determining that the hedge will be highly effective in reducing fair value or cash flow exposure in respect of the hedged item or items attributable to the hedged risk for the remainder of the period for which the entity expects to have the hedging financial arrangement [ Schedule 1, item 1, paragraph 230-365(c )].

8.66 The last test does not preclude risk management in relation to a particular item or particular portfolio of items. However, it does require an assessment of effective risk reduction in relation to an identified item or items for the purposes of helping to establish upfront the basis of allocation of gains or losses from the hedging financial arrangement.

8.67 Where a hedging financial arrangement ceases to be a highly effective hedging financial arrangement then, consistent with paragraph AG113 of AASB 139, the taxpayer will discontinue hedging the hedged item from the last date on which compliance with hedge effectiveness was last demonstrated. Consistent with paragraph AG113, in circumstances where a taxpayer is able to identify an event or change in circumstance that caused the hedging relationship to fail the effectiveness test, and demonstrate that the hedge was effective before the event or change in circumstance occurred, the taxpayer may discontinue hedging the hedged item from the date of the event or change in circumstance.

8.68 What is 'highly effective' for the purposes of section 230-365 depends on the meaning of this term in AASB 139. Thus, the hedge effectiveness must be within the range of 80 per cent to 125 per cent, as set out in paragraph AG105 of AASB 139.

8.69 If the hedge is not highly effective, item 1(c) in the table in section 230-305 will operate in conjunction with section 230-300 to provide that:

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the arrangement ceases to be held for its fair value when the taxpayer makes the assessment that the effectiveness requirement is no longer met;

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the gain or loss is allocated over income years according to the basis set out in the determination required by subsection 230-360(1); and

•

Division 230 is re-applied to any future gain or loss made from the arrangement as if it had been acquired for its fair value at that time.

8.70 Note, however, that if the hedge is highly effective but not 100 per cent effective, the ineffective portion is not treated differently by Subdivision 230-E. That is, unlike financial accounting, the ineffective portion of an otherwise highly effective hedging financial arrangement is not disqualified from hedge tax treatment under Subdivision 230-E.

8.71 Although the effectiveness test can be satisfied for tax purposes by reference to compliance with the effectiveness test in the relevant accounting standards, there will be times when this will not be sufficient. One example is where the taxpayer accounting and income tax years do not align. Where this is the case taxpayers will be required to undertake additional effectiveness testing so as to satisfy the effectiveness test in section 230-365.

Can a financial arrangement be a hedging financial arrangement if it is not an accounting hedging instrument?

8.72 The purposive nature of hedging rules and the volume of hedging transactions makes the administration of the rules relatively difficult. As indicated above, the existing income tax law does not contain comprehensive tax-hedge rules. Further, the tax-hedge rules will cover not just commodity hedging (as recommended by the Review of Business Taxation (the Ralph Review)) but all sectors of the economy. Also, they extend beyond tax-timing hedging to tax-status hedging. Thus, the introduction of tax-hedge rules raises potentially significant administrative implications.

8.73 Against this background, the requirements that the derivative financial arrangement satisfies the hedging requirements of the financial accounting standards, and is recorded as a hedging instrument for the purposes of the standards, represents an important administrative safeguard.

8.74 At the same time, it is understood that some entities' hedging practices will not satisfy the financial accounting hedge rules in AASB 139 because of some technical aspect of those rules and notwithstanding that the substance of the requirements - particularly the risk management purpose, the nature of the hedge transaction and appropriate record-keeping and other safeguards - is met.

8.75 Accordingly, Subdivision 230-E contains a list of situations in which those practices may, subject to certain requirements, nevertheless attract tax-hedge treatment. In particular, a derivative financial arrangement or foreign currency hedge may, in the circumstances listed below, qualify as a hedging financial arrangement even though it does not qualify, or it is not recorded, as a hedging instrument under the applicable financial accounting standards. In these circumstances, certain additional record-keeping requirements have to be met (see paragraphs 8.79 and 8.80).

8.76 The only circumstances in which the tax-hedge rules may apply, despite such financial arrangements being denied hedging instrument status for accounting purposes are:

•

the hedging of a foreign currency risk relating to an anticipated dividend from a connected entity where the dividend is non-assessable non-exempt income under section 23AJ of the ITAA 1936 [ Schedule 1, item 1, subsection 230-335(4 )];

•

entering into a financial arrangement with a connected entity that is not part of the same tax consolidated group but is part of the same financial accounting consolidated group for which the accounting standards require a consolidated financial report (even though that report ignores the arrangement), provided that the arrangement is created, applied or acquired for the purpose of hedging a risk or risks in relation to a hedged item and would satisfy the accounting hedge requirements but for the consolidated financial report ignoring it [ Schedule 1, item 1, subsection 230-335(5 )]; and

•

the period for which the risk or risks are hedged does not straddle two or more income years, that is, the hedge is an intra-income year hedge, provided that the arrangement is created, applied or acquired for the purpose of hedging a risk or risks in relation to a hedged item and would be recorded as a hedging instrument in a relevant financial report if it had straddled two or more income years [ Schedule 1, item 1, subsection 230-335(6 )].

8.77 The list of circumstances in which a financial arrangement may be treated as a hedging financial arrangement - and thus potentially be able to attract tax-hedge treatment - even though it does not qualify as a hedging instrument, or is not recorded as a hedging instrument for financial accounting purposes, can be added to by regulations [ Schedule 1, item 1, subsection 230-335(7 )]. Those regulations can require that particular conditions be met before the financial arrangement can qualify as a hedging financial arrangement.

8.78 Where the derivative financial arrangement or foreign currency hedge is not an accounting hedging instrument, neither the financial accounting nor external audit systems provide a platform for recognition of the financial arrangements as hedges for tax purposes. The tax system therefore has to provide a separate platform, with its separate requirements. These are that:

•

meeting the requirements of accounting standards for obtaining hedge treatment, or the recording as a hedging instrument for accounting purposes, is not possible due to requirements of the relevant accounting standards, rather than any act or omission on the entity's part to deliberately fail these requirements [ Schedule 1, item 1, paragraph 230-335(3)(c )];

•

certain additional record-keeping requirements are met (see paragraphs 8.79 and 8.80) [ Schedule 1, item 1, subsection 230-355(5 )]; and

•

any requirements prescribed by the regulations are met [ Schedule 1, item 1, paragraph 230-335(3)(e )].

Additional record-keeping requirements if a financial arrangement is not an accounting hedging instrument

8.79 As noted above, there are circumstances in which a financial arrangement can qualify as a hedging financial arrangement even where the arrangement cannot be a hedging instrument for financial accounting purposes or is not classified as a hedging instrument in the entity's financial report. Because there is no requirement to create a financial accounting record of the arrangement as a hedging instrument, the entity's financial records cannot be relied upon to demonstrate, for example, the purpose of the arrangement. Accordingly, separate tax requirements need to be met. The requirements, which are important administrative safeguards, are in addition to those in respect of financial arrangements that are hedging instruments for financial accounting purposes. [ Schedule 1, item 1, section 230-335 and subsection 230-355(5 )]

8.80 The additional requirements are:

•

that the entity make or have in place at, or soon before or after, the time that it creates, acquires or applies the hedging financial arrangement, a 'record' (as defined in the Acts Interpretation Act 1901 ) that explains why and how the financial arrangement operates commercially or economically, as a hedge of the hedged item or items [ Schedule 1, item 1, subparagraph 230-355(5)(a)(i )]. This requirement has regard to those situations in which it appears that the strict requirements of AASB 139 prevent a derivative (or non-derivative hedging a foreign currency risk) from being classified as a hedging instrument, even though commercially or economically the instrument reduces the entity's exposure to financial risk;

•

that the entity make a record of the reasons why the financial arrangement cannot qualify as a hedging instrument for financial accounting purposes [ Schedule 1, item 1, subparagraph 230-355(5)(a)(ii )]. It is envisaged that the normal situation in which a financial arrangement is a hedging financial arrangement is when it is a hedging instrument for financial accounting purposes. The financial accounting record may provide support in establishing the purpose of the financial arrangement in question. It is important that, when the arrangement is not a hedging instrument for financial accounting purposes, hedge tax treatment is only applied when there are sound and appropriate reasons why such financial accounting treatment could not be obtained. A purpose of this requirement, in conjunction with the requirements in paragraph 230-355(3)(a), is to establish that there are such reasons. For example, as indicated above, it should not be because the entity deliberately failed to meet the requirements of AASB 139;

•

that the entity have a record that sets out its risk management policies and practices at the time the financial arrangement in question is created, acquired or applied [ Schedule 1, item 1, paragraph 230-355(5)(c )];

•

that, at the time the entity creates, acquires or applies the financial arrangement, it has in place internal risk management systems and controls that record the arrangement and the hedged item or items. This additional requirement is intended to link the arrangement and the hedged item or items together in terms of the former hedging the risk in respect of the latter. It will assist in confirming that the financial arrangement is created, acquired or applied for commercial risk management purposes and not for tax reasons [ Schedule 1, item 1, paragraph 230-355(5)(d )]; and

•

that where a financial arrangement that qualifies for tax-hedge treatment under subsection 230-335(3), the taxpayer keeps a record of the accumulated hedge gain or loss that is yet to be allocated in accordance with that of the hedged item(s). This requirement is intended to be an analogue of the financial accounting equity reserve. This is in the sense that, for financial accounting purposes, even though the hedge gain or loss may not be reflected in that period in the income statement, there is a record in an equity reserve of the balance sheet of an amount that has been deferred and is yet to be recognised in profit or loss. It also reflects the fact that the matching of a gain or loss on a hedged item can mean that a gain or loss from a hedging financial arrangement can be deferred for a long time. The requirement is for an ongoing record of the accumulated gain or loss, whether realised or unrealised, that is yet to be matched for income tax purposes to a hedged item or items [ Schedule 1, item 1, paragraph 230-355(5)(b )]. When recording the accumulated gains and losses at the end of each income year, taxpayers must assume that all gains from the hedging financial arrangement would be assessable income and that all losses from the hedging financial arrangement would be allowable deductions [ Schedule 1, item 1, subsection 230-355(6 )].

Example 8.2 : Accumulation of gains and losses

Gold Coast Co, which has an Australian dollar functional currency, has a firm commitment to sell a fixed quantity of gold in four years for a fixed amount of United States of America (US) dollars. To hedge its exposure to unfavourable movements in the A$/US$ currency exchange rate, Gold Coast Co enters into a series of four rolling one year forward foreign currency contracts. Gold Coast Co has made a valid hedging financial arrangement election under subsection 230-315(1).

Assume that the forward foreign currency contracts qualify as hedging financial arrangements to which the hedging financial arrangement election applies. The hedging financial arrangements hedge the foreign currency risks in relation to the firm commitment to sell gold in four years time. Accordingly, Gold Coast Co is able to defer the gains and/or losses from the arrangements until the sale of gold is due to take place.

Assume that the gains or losses that are made on a year-by-year basis in relation to each of the forward contracts are as set out in Table 8.1.

Table 8.1 : Gains and losses made on a year-by-year basis

Year	A $ gain /( loss )
1	150,000
2	(200,000)
3	70,000
4	(50,000)

For the purposes of paragraph 230-355(5)(b), Gold Coast Co must make a record of the accumulated gains/losses as at the end of each income year from each of the arrangements relating to the hedged item, namely the firm commitment to sell the gold. Thus the record would be along the lines of that in Table 8.2.

Table 8.2: Accumulated gain/loss

Year	A $ accumulated gain /( loss )
1	150,000
2	(50,000)
3	20,000
4	(30,000)

Allocation of gains and losses from hedging financial arrangements

8.81 Tax-hedge rules reduce post-tax mismatch by allocating gains and losses from hedging financial arrangements on a timing basis that is consistent with the tax recognition time for the gains or losses made from the hedged item or items. The way that Subdivision 230-E does this is to require the entity to determine the basis of allocation when the various hedging requirements are met.

8.82 The allocation basis must be objective. That is, the basis cannot be subjective. Objectivity should be read to be consistent with the matching objective of hedging.

8.83 The basis must also fairly and reasonably correspond with the basis on which the gains, losses or other amounts from the hedged item or items are allocated or recognised for income tax purposes [ Schedule 1, item 1, paragraph 230-360(2)(a )]. Further, the basis must be sufficiently precise and detailed so that it can be determined from the record the taxpayer makes under section 230-355 the time at which the gain or loss from the hedging financial arrangement is to be taken into account for the purposes of Division 230, and the way in which the gain or loss will be classified for tax purposes [ Schedule 1, item 1, paragraph 230-360(2)(c )]. These requirements are designed to be both consistent with the commercial purpose of hedging and to support the integrity of the recording process.

Example 8.3 : A forward foreign currency contract hedging forward purchase

Assume that Southern Exposure Co, which has an Australian dollar functional currency, has a firm commitment to buy an item of machinery for US$10 million, which at that time is equal to A$14 million. The company wants to hedge against the US$/A$ exchange rate by buying under a forward contract US$10 million. The forward contract will be delivered at the settlement date for the machinery which is six months hence.

The effective life of the machinery is 10 years. When Southern Exposure Co enters into the forward foreign currency contract, in relation to the timing of when the relevant gains or losses from that contract will be recognised, it records that it determines that the gain or loss on the contract is to be allocated over 10 years. This allocation fairly and reasonably corresponds with the basis on which the cost of the machinery is to be recognised for income tax purposes. It is also an objective basis of allocation which, from the record, clearly and precisely determines how the hedging gain or loss is to be treated for income tax purposes.

If Southern Exposure Co makes an A$1 million gain on the forward foreign currency contract and the machinery is acquired as planned, it could allocate the gain over 10 years on a basis that effectively meant that the cost of the machinery was A$13 million. This outcome enables the gain on the hedging financial arrangement to be allocated on a similar timing basis as that used for capital allowances purposes. It should be noted that the gain itself is not part of the cost of the machinery for capital allowance purposes; however, the outcome of the allocation of the hedge gain under section 230-360 effectively achieves this.

Example 8.4 : Basis of the allocation: re-estimation of the effective life

Assume that in Example 8.3 the hedging arrangement is in respect of machinery that is not subject to accelerated depreciation rates. Accordingly, its effective life is able to be re-estimated for income tax purposes (section 40-110 of the Income Tax Assessment Act 1997 (ITAA 1997)).

Is it permissible, if Southern Exposure Co anticipates that it may re-estimate the effective life of the machinery, for it to provide in the record for the allocation of the hedging financial arrangement gain or loss to be either 10 years, or the period corresponding to the effective life of the machinery as re-estimated in terms of section 40-110 of the ITAA 1997?

The allocation on the basis of the re-estimation of the effective life would be fair, objective and reasonable if its purpose is to continue to effectively integrate the hedging financial arrangement gain or loss into the cost of the machinery for capital allowance purposes.

However, paragraph 230-355(1)(c) and section 230-360 require that the record must contain a determination of the allocation basis which is precise and detailed enough that, when the gain or loss or other amount from the hedged item is taken into account for tax purposes, it will be clear from the record the time at which the hedging financial arrangement gain or loss is to be taken into account under Division 230. To satisfy this requirement, there must be a mechanism for the hedge record to be appropriately linked to the choice Southern Exposure Co makes to re-estimate the effective life of the machinery. In this regard, it would be permissible for the company to append, at the time it makes this choice, a record of the choice to the hedge record.

Example 8.5 : Hedging future mineral production

Cienna Co uses sold futures contracts to hedge against future sales of the mineral it produces (a highly probable forecast transaction). However, because the futures contracts are for a shorter period than the period to the projected sale date, a series of futures contracts are used as part of a 'rollover strategy'.

Provided the futures contracts are otherwise the subject of a hedging financial arrangement election - which includes the documentation of an objective, fair and reasonable basis for allocating the gains and losses from the particular hedging financial arrangement, and sufficient linking between the contracts and the hedged item(s) - the gains and losses from each contract can be deferred and allocated to the income year in which the underlying mineral sale is made.

Example 8.6 : Hedging the forward purchase of trading stock

On 1 May 2010, Green Co enters into a firm commitment to acquire solar panels worth US$1 million for delivery on 1 June 2010. The solar panels to be acquired by Green Co will be trading stock from the time of acquisition.

On 1 May 2010, Green Co enters into a forward exchange contract to hedge its foreign currency risk exposure. The terms of the forward contract provide that Green Co will purchase US$1 million in exchange for Australian dollars on 1 June 2010 at an agreed forward rate.

Green Co is eligible to make a hedging financial arrangement election and has complied with all hedging and documentation requirements under Subdivision 230-E. Green Co designates the forward contract as the hedging financial arrangement in respect of the firm commitment to acquire the solar panels. The hedged item is the firm commitment to acquire the solar panels (paragraph 230-335(10)(c)).

Green Co determines at the inception of the hedge to allocate any gain or loss on the hedging financial arrangement to the time of sale of the solar panels. The gain or loss should be allocated equally over the solar panels acquired by Green Co. Any gain or loss on the forward contract will be aligned with the treatment of the trading stock. While the gain or loss is not integrated into the cost of the trading stock for tax purposes (ie, Division 70 of the ITAA 1997), this basis of allocation effectively enables the gains or losses on the hedge to be allocated so as to achieve the same tax outcome as if the gain was integrated into the tax cost of the panels sold.

On 1 June 2010 Green Co receives and pays for the solar panels in full. On that day it realises a US$43,000 loss on the forward contract. Despite the fact that the forward contract is settled on that day, the loss on the arrangement will be deferred and allocated for tax purposes to the income year in which the solar panels are sold.

8.84 The allocation will not be fair and reasonable unless, in terms of the overall nominal gain or loss, it produces the same outcome as, for example, the accruals/realisation Subdivision and the balancing adjustment Subdivision of Division 230 would produce. This is particularly important as the other Subdivisions of Division 230 do not apply to the extent that the hedging Subdivision does. [ Schedule 1, item 1, subsections 230-300(1) and (2 )]

8.85 The treatment of the overall gain or loss discussed in the preceding paragraph is subject to the situations covered by subsections 230-300(4) and (7). The first situation is with respect to a hedging financial arrangement that is a foreign currency hedge that is a debt interest. In this situation, only that part of the gain or loss from the arrangement - that represents a currency exchange rate effect attributable to the outstanding balance in respect of a debt interest - can be allocated under the hedging financial arrangement Subdivision [ Schedule 1, item 1, paragraph 230-300(4)(a )]. Therefore, the difference between this amount and the entire gain or loss made from the financial arrangement is to be brought to account under other provisions of Division 230 - namely, the accruals or realisation method, the election to rely on financial reports or the balancing adjustment under Subdivision 230-G [ Schedule 1, item 1, paragraph 230-300(4)(b )].

8.86 The second situation is with respect to a hedging financial arrangement that is an equity interest issued by the taxpayer, is covered by section 230-50, and is a foreign currency hedge. Only that part of the gain or loss from the arrangement that represents a currency exchange rate effect can be allocated under the hedging financial arrangement Subdivision. The remainder will not be dealt with under Division 230 as none of the Subdivisions apply to equity interests of which the taxpayer is the issuer. [ Schedule 1, item 1, subsection 230-300(7 )]

Tax classification of a hedging financial arrangement

8.87 As well as determining the basis on which gains and losses from a hedging financial arrangement are allocated on a timing basis, in certain circumstances Subdivision 230-E provides for the gain or loss to be classified in a way for income tax purposes that corresponds with the way that the hedged item is classified for tax purposes. In this situation, the tax classification (or status) of the hedging financial arrangement gain or loss is matched to that of the associated hedged item. Tax classification matching is available only for hedging financial arrangements to which a hedging financial arrangement election applies [ Schedule 1, item 1, sections 230-300 and 230-310 ]. It is not possible to obtain tax classification matching without tax-timing matching. While tax-status matching is available under section 230-310 (subject to meeting the requirements of the section) the allocation of the hedging financial arrangement gain or loss to an income year or years is determined by reference to section 230-300.

8.88 To facilitate tax classification matching, the table in section 230-310 sets out the treatment of a gain or loss on a hedging financial arrangement. To the extent the gain or loss is reasonably attributable to a hedged item referred to in the table, it is broadly given the same classification. [ Schedule 1, item 1, subsection 230-310(4 )]

8.89 In the absence of tax-status matching, there may be a mismatch between the treatment of the hedging financial arrangement and the hedged item. For example, a hedged item may be a CGT asset in relation to which there is a CGT event and, if it turns out that there is a net capital gain in respect of the asset, the net gain would be assessable under Parts 3-1 and 3-3 of the ITAA 1997. Without tax-status matching, it is possible that a tax mismatch will arise because the gain or loss on a hedging financial arrangement, which hedges the asset will be on revenue account. Based on the table in subsection 230-310(4), the gain or loss on the hedging financial arrangement may be treated as a capital gain or capital loss respectively, where the requisite conditions are met. [ Schedule 1, item 1, subsection 230-310(4), item 1 in the table ]

8.90 Similarly, a hedged item may produce non-assessable non-exempt income. If the tax-hedge criteria are met, a gain on a hedging financial arrangement hedging that item would also be treated as non-assessable non-exempt income. Any loss would not be deductible. [ Schedule 1, item 1, subsection 230-310(4), item 5 in the table ]

8.91 Other items in the table in subsection 230-310(4) facilitate tax classification matching by setting out the tax classification of a gain or loss on a hedging financial arrangement which is reasonably attributable to a hedged item that is, or that produces:

•

a CGT asset that is a taxable Australian property [ Schedule 1, item 1, subsection 230-310(4), item 2 in the table ];

•

a CGT asset in respect of which the capital gains and losses are disregarded, or reduced by a particular percentage under Division 855 of the ITAA 1997 [ Schedule 1, item 1, subsection 230-310(4), item 3 in the table ];

•

exempt income [ Schedule 1, item 1, subsection 230-310(4), item 4 in the table ];

•

non-assessable non-exempt income of an Australian resident [ Schedule 1, item 1, subsection 230-310(4), item 5 in the table ];

•

a share in a company that is a foreign resident if the capital gain or loss made from a CGT event that happens to the share is reduced by a particular percentage under Subdivision 768-G of the ITAA 1997 [ Schedule 1, item 1, subsection 230-310(4), item 6 in the table ];

•

ordinary or statutory income from an Australian source, and losses or outgoings incurred in earning that income [ Schedule 1, item 1, subsection 230-310(4), items 7 and 10 in the table ];

•

ordinary income or statutory income from a source out of Australia, and a loss or outgoing incurred in gaining or producing that income from a source out of Australia [ Schedule 1, item 1, subsection 230-310(4), items 8 and 9 in the table ];

•

a loss or outgoing that is not allowed as a deduction [ Schedule 1, item 1, subsection 230-310(4), item 11 in the table ];

•

a net investment in a foreign operation (within the meaning of the accounting standards) that is not carried on through a subsidiary or a company in which the taxpayer has shares (ie, a foreign branch or permanent establishment), but only to the extent that the hedge gain or loss does not relate to a hedged item covered by another item in the table [ Schedule 1, item 1, subsection 230-310(4), item 12 in the table ]; and

•

a net investment in a foreign operation (within the meaning in the accounting standards) that is carried on through a subsidiary or a company in which the taxpayer has shares. (This item arises because the hedged item will be taken to be (or deemed to be) the interest the taxpayer has in the shares of the foreign subsidiary or company for the purpose of applying the table in subsection 230-310(4) only [ Schedule 1, item 1, subsection 230-310(5 )]. This does not, however, affect hedge effectiveness testing of the net investment in the foreign operation being in respect of the underlying carrying value of the net assets in the subsidiary. Typically, the relevant item in the table will be item 6, but this will depend on the particular circumstances.

8.92 The items in the table relate to both the type of gain or loss made (ie, a capital gain or loss or an amount of assessable income or an allowable deduction) and the source of the gain or loss. Accordingly, more than one item in the table may be relevant to the hedged item identified in the record.

8.93 Where alternative items in the table can apply to the hedging financial arrangement, the taxpayer must apply that item to which the gain or loss on the hedging financial arrangement is most relevant.

8.94 Where no item in the table applies, subsection 230-310(3), together with subsection 230-15(1), has the effect of including any gain on the hedge in assessable income. Any loss may be deductible in accordance with subsections 230-15(2) and (3).

8.95 Unlike the situation with respect to tax-timing matching, a determination is not required for tax classification matching that pre-specifies the tax classification treatment of the hedging financial arrangement. Importantly, though, the record must still show, at inception of the hedging financial arrangement, the relevant hedged item in respect of which the hedging financial arrangement relates. An up-front specification of the tax classification of gains or losses from the hedging financial arrangement is not required because the tax classification treatment of gains or losses made from the hedged item may change between the time that the hedging relationship starts and the time that those gains or losses from the hedged item are recognised for income tax purposes. Accordingly, where a hedging financial arrangement election applies, a gain or loss made from the hedging financial arrangement, to the extent to which it is reasonably attributable to a hedged item listed in the table in subsection 230-310(4), is dealt with in the way indicated by that table.

8.96 At the same time, the recorded determination must be sufficiently precise and detailed such that, when the hedged item is recognised for income tax purposes, it will be clear from the record how the hedge gain or loss will be dealt with under section 230-310 [ Schedule 1, item 1, subparagraph 230-360(2)(c)(ii )]. The purpose of this requirement, like that of the tax-timing aspect of the recorded determination, is to prevent determination of the tax treatment of the hedging financial arrangement gains and losses in hindsight. It is therefore a central requirement of the tax-hedge rules. Establishing the tax classification of the hedging gains or losses with the benefit of hindsight is prevented by requiring that the hedged item, to which the hedging financial arrangement relates, be specified in the record up-front. Hence, the tax classification of the hedged item will then automatically apply to the gains or losses made from the hedging financial arrangement. Hence, if the tax classification of the former changes, so too will the latter.

Example 8.7 : Cross currency interest rate swap

AGM Co uses a cross currency interest rate swap to hedge its exposure to currency exchange rates in respect of a net investment in a foreign operation consisting of shares in a foreign subsidiary (SA Co). Assume that all the hedge tax criteria are met. AGM Co designates the notional principal on the swap, which is exchanged at the beginning and end of the arrangement, as the hedge of the foreign currency risk in respect of the capital value of the shares.

AGM Co determines that an objective, fair and reasonable basis on which to allocate any gain or loss on the hedge is to allocate the gain or loss to the time when it ceases to have the net investment in SA Co. AGM Co also sets out in the record at the inception of the hedging relationship that the interest in the shares in SA Co is the relevant hedged item (subsection 230-310(5)).

Assume that AGM Co sells the shares in SA Co in three years and at that time the gain or loss on the sale of the shares turns out to be subject to Subdivision 768-G of the ITAA 1997; accordingly item 6 in the table would govern the tax classification of the hedge gain or loss on the notional principal on the swap.

Example 8.8 : Net investment in a foreign operation

Oz Co has a New Zealand subsidiary, Fern Co. At 1 January 2012, Oz Co has a net investment of NZ$20 million in Fern Co and Oz Co expects that the value of the investment will not fall below that amount. The net investment satisfies the definition of 'net investment in a foreign operation' as per the accounting standards. On that date, Oz Co borrows NZ$20 million and designates the borrowing as a hedge of the net investment in Fern Co. The borrowing satisfies the definition of a 'foreign currency hedge'.

Oz Co determines that the basis on which it seeks to allocate any gain or loss on the hedge of the principal component of the borrowing is to allocate the gain or loss to the time when it ceases to have the net investment in Fern Co. Oz Co sets out in the record at the inception of the hedging relationship that the interest in the shares in Fern Co is the relevant hedged item (subsection 230-310(5)).

Assume that Oz Co meets all the tax-hedge tests required by Division 230, that subsection 230-335(1) is satisfied and that Oz Co's shares in Fern Co are CGT assets subject to Subdivision 768-G of the ITAA 1997.

The tax deductibility of the interest on the borrowing, together with any foreign currency gains and losses attributable to that interest, is determined by section 230-15 and Division 960 of the ITAA 1997 and not under the hedging tax rules (subsection 230-300(4)).

The taxation of any accumulated foreign currency gain or loss attributable to the principal component of the borrowing is deferred until Oz Co ceases to have its net investment in Fern Co (whether by, for example, disposal of the shares in Fern Co or disposal of the assets and liabilities comprising the net investment in Fern Co). This deferral would occur even if the borrowing was repaid before then.

Oz Co disposes of the shares on 1 January 2013. At that time (for the purposes of determining the tax classification of any accumulated foreign currency gain or loss attributable to the principal component of the borrowing) Oz Co will have regard to the tax treatment of the shares it holds in Fern Co. At the time of disposal the shares are CGT assets subject to Subdivision 768-G of the ITAA 1997. Therefore the gains or losses on the hedging financial arrangement are treated (ie, classified) as a capital gain or a capital loss made from a CGT event to the extent to which the gain or loss is reasonably attributable to the CGT event that would have happened in respect of its shares in Fern Co (subsection 230-310(4), item 1 in the table). Further, pursuant to item 6 in the table in subsection 230-310(4), that capital gain or capital loss (on the hedging financial arrangement) that was made on the borrowing is reduced by the same percentage which the capital gain or capital loss on net investment is reduced.

The Commissioner's discretion in relation to 'tax tests'

8.97 The Commissioner can make a determination to treat the record-keeping requirements in section 230-355, the requirements in section 230-360 about tax allocation of the gains and losses, and the requirements about hedge effectiveness in section 230-365, as having been met notwithstanding that the hedging financial arrangement does not meet the tests. [ Schedule 1, item 1, section 230-380 ]

8.98 In deciding whether the Commissioner should exercise this discretion to make this determination, he or she must have regard to the respects in which the requirements would not be met, the extent to which they would not be met, the reasons why they would not be met, and the objects of Subdivision 230-E. As indicated, the objects are to facilitate the efficient management of financial risk by reducing after-tax mismatches where hedging takes place, and to minimise tax deferral. [ Schedule 1, item 1, section 230-295 ]

8.99 The requirements in sections 230-355 to 230-365 seek to prevent after-the-event selectivity of tax allocation and/or tax classification of gains and losses from hedging financial arrangements. The requirements are particularly important given the potentially wide differences in timing and tax-status for the particular hedging financial arrangement. The requirements promote robust audit trails and hedging activity that is objectively consistent with the aim of reducing after-tax mismatches. The discretion should be considered against this background.

8.100 The Commissioner can make the determination that the requirements of sections 230-355 to 230-365 have been met, conditional on the taxpayer keeping records in addition to those required by section 230-355 [ Schedule 1, item 1, subsection 230-380(2 )]. If those further record-keeping requirements are breached, the determination ceases to have effect. The Commissioner can, in certain circumstances, make a further determination that has the effect that the original determination is reinstated, by determining that the cessation provision not apply. In making the further determination, the Commissioner is to have regard to the taxpayer's record-keeping practices, compliance history, changes to the taxpayer's record-keeping and governance procedures, and other relevant matters [ Schedule 1, item 1, subsections 230-380(3) to (5 )].

8.101 Where the Commissioner does make a determination under subsection 230-355(1), the basis for allocating the gains or losses from the hedging financial arrangement may be determined by the taxpayer. However, if the taxpayer fails to do this, or if the basis on which the taxpayer determines the gains or losses are to be allocated is not in accordance with the requirements of subsection 230-360(2), the Commissioner may make a further determination as to that matter. [ Schedule 1, item 1, subsection 230-380(6 )]

The relevant entity

8.102 In a tax consolidation context, the tax-hedge rules are intended to be limited to the risk of the tax consolidated group of which the entity carrying out the hedging activity is part. This is consistent with the single entity rule in section 701-1 of the ITAA 1997, where all the subsidiaries of the consolidated tax group are taken to be parts of the one entity - the head company of the tax consolidated group. That is, the tax-hedge rules do not extend to financial arrangements entered into between members of the same consolidated tax group. At the same time, the head entity of a tax consolidated group can enter into a hedging financial arrangement with an external party to the consolidated tax group in relation to the risks of another entity within the same tax consolidated group.

Consequences if the hedging financial arrangement is disposed of early

8.103 To the extent that the hedging financial arrangement is disposed of, or ceases, before the gains and losses in respect of the hedged item or items are recognised for income tax purposes, the gains or losses on the hedging financial arrangement should be allocated to the income year in which the gains or losses on the hedged item or items are recognised [ Schedule 1, item 1, subsection 230-300(5 )]. The fact that the hedging financial arrangement ceases before the gains or losses on the hedged item are recognised does not prevent a deferral of the recognition of the gains or losses made from the hedging financial arrangement until a later time.

Consequences if the hedged item is disposed of before the hedging financial arrangement is disposed of, or is not likely to occur

8.104 To the extent that the hedged item or one or more of the hedged items are disposed of before the hedging financial arrangement is disposed of, or there is a forecast transaction that is no longer expected to occur, or the entity ceases to expect that it will have the hedged item(s), the hedging financial arrangement is deemed to have been disposed of at that time for its then fair value and, to the extent that it would otherwise not have been disposed of, is deemed to have been reacquired or re-entered into at that fair value. [ Schedule 1, item 1, subsection 230-300(5) and section 230-305, item 2 in the table ]

Consequences if the entity revokes the designation of, redesignates or disposes of, the hedging financial arrangement

8.105 After an entity has a hedging financial arrangement to which the hedging financial arrangement election applies, the entity may decide that it should no longer be treated as such (ie, a revocation occurs), but the entity does not actually terminate or otherwise dispose of the financial arrangement. One reason for this may be that the entity wants to classify the financial arrangement as a hedge of another hedged item.

8.106 Where there is a revocation or redesignation of a hedging financial arrangement, any realised or unrealised gain or loss on the hedging financial arrangement, as at the time of revocation or redesignation, is allocated to the income year or years in which the gains or losses on the hedged item are recognised.

8.107 Any gain or loss on the hedging financial arrangement from the time of revocation or redesignation is to be treated in accordance with the classification of the financial arrangement. For example, if it meets the hedge tax criteria in respect of another hedged item or transaction, there should be a corresponding allocation. [ Schedule 1, item 1, section 230-305, subitems 1(a) and (b) in the table ]

8.108 A bona fide revocation of a hedging financial arrangement will not constitute a deliberate failure to meet a record-keeping requirement or allocation determination under subsection 230-385(1).

Example 8.9 : Firm commitment to purchase trading stock on deferred settlement

On 1 July 2009, Green Co enters into a firm commitment to acquire solar panels worth US$1.5 million for delivery on 1 August 2009 with full payment deferred until 1 September 2009. The solar panels to be acquired by Green Co will represent trading stock from the time of delivery.

On 1 July 2009, Green Co enters into a forward contract to hedge its foreign currency US dollar exposure. The terms of the forward contract provide that Green Co will purchase US$1.5 million in exchange for A$2 million on 1 September 2009.

For accounting purposes Green Co designates the forward contract as a hedge of the firm commitment to acquire the solar panels and the resulting accounts payable of US$1.5 million.

Assume that for the scenarios discussed below, Green Co complies with all hedging and documentation requirements in Subdivision 230-E.

It determines at the inception of the hedging relationship to allocate any gains or losses from the hedging financial arrangement (the forward contract) measured at the time the solar panels are delivered to the income year in which the panels are sold. Any subsequent gain or loss on the forward contract will be brought to account on settlement of the accounts payable.

The solar panels are delivered on 1 August 2009. At that date, the fair value of the forward contract is $5,000. The gain will be allocated to the income year in which the solar panels are sold. The gain should be allocated equally over the acquired panels. The effect of this allocation is to effectively 'integrate' the hedge gain into the cost of the panels sold.

Green Co makes full payment for the trade liability on 1 September 2009 and realises the forward contract. At that time, it has made a gain on the contract of $15,000. The gain that is assessable to Green Co at that time is $10,000. The gain at that time is calculated by deducting $5,000, being the value of the forward contract at the time of delivery of the trading stock, from the gain of $15,000 at settlement of the accounts payable. The gain brought to account for tax purposes on settlement of the accounts payable reflects the gain arising from the change in value of the forward contract following delivery of the solar panels.

Note that if the trade liability were a financial arrangement - the gains or losses in respect of which Division 230 applied on a fair value basis - Green Co could determine that the gains or losses in respect of the forward contract from the time of delivery of the solar panels could also be allocated on a fair value basis for Division 230 purposes.

As an alternative to the above separate allocation in respect of delivery and accounts payable, Green Co may determine that the manner in which the gain or loss on the hedging financial arrangement is to be determined and allocated as at the accounts payable date with deferral until the solar panels are sold.

Whichever manner Green Co chooses, it must apply it consistently to all of its arrangements that hedge the purchase of its trading stock (section 230-80).

Consequences if the hedging financial arrangement no longer meets the hedge tax criteria even though it was originally met

8.109 The outcome where a hedging financial arrangement no longer meets the hedge tax criteria (eg, if the revenue hedge becomes ineffective) is similar to that of a revocation of a designation or a redesignation of the hedging financial arrangement.

8.110 That is, any gain or loss on the hedging financial arrangement up to the time of the non-compliance (in the case of tax-hedge ineffectiveness) or the event (in the case of a revocation of the designation or redesignation) is allocated to the income year (or years) in which the hedged item's gains or losses are recognised. Any gain or loss on the hedging financial arrangement from the time of non-compliance or event is to be treated in accordance with the classification of the financial arrangement at that time. [ Schedule 1, item 1, section 230-305, item 1 in the table ]

Consequences if the hedged item(s) or risk arising from the hedged item(s) ceases to exist

8.111 In certain circumstances cessation of a hedging relationship may occur where the entity ceases to have the hedged item, or one or more of the hedged items, or the risk that was being hedged in relation to the hedged item or items (eg, terms of a variable rate loan are altered to a fixed rate loan) no longer exists or you no longer expect to hold the hedged item. In these circumstances as the hedged item or items or hedged risk no longer exist, hedging from that time would not be appropriate. As a result gains and losses on the hedging financial arrangement are to be bought to account at that time [ Schedule 1, item 1, section 230-305, items 2(a) to (c) and (3) in the table ]. Regulations may also be made to determine the treatment of gains and losses up to the time that the taxpayer ceases to have some, but not all, of the hedged items or item under a hedging financial arrangement [ Schedule 1, item 1, subsection 230-300(6 )].

Where requirements for election are no longer satisfied

8.112 Although an election under the hedging financial arrangement election is irrevocable [ Schedule 1, item 1, subsection 230-315(3 )], the election will cease to apply from the start of the income year in which the taxpayer ceases to meet the eligibility requirements under subsection 230-315(2) [ Schedule 1, item 1, subsection 230-370(1 )].

The making of a new election

8.113 The taxpayer is not prevented from making a new election at a later time if the conditions in subsection 230-315(2) are satisfied for an income year. [ Schedule 1, item 1, subsection 230-370(2 )]

8.114 The new election, however, will only apply to new financial arrangements you start to have after the start of the income year in which the new election is made. Refer to Chapter 5 for further discussion as to when an election will cease to apply.

Balancing adjustment if an election ceases to apply

8.115 Where a hedging financial arrangement election ceases to apply the taxpayer is taken to have disposed of each hedging financial arrangement for its fair value, immediately before an election ceases to apply (ie, at the start of the relevant income year) and to have been reacquired for its fair value immediately after the election ceases to have effect [ Schedule 1, item 1, section 230-375 ]. The gain or loss arising from the disposal (ie, the 'balancing adjustment') is brought to account in the year of income according to the record made under section 230-375 and not under Subdivision 230-G [ Schedule 1, item 1, subsections 230-375(3), 230-300(1), 230-300(2) and 230-440(2 )].

Consequences of deliberate failure to meet the hedge tax requirements

8.116 Tax-hedge treatment introduces the potential for considerable selectivity of tax-timing and/or tax classification if the requirements relating to the making of determinations or recording are not met. For example, the hedging financial arrangement method could effectively become an arrangement-by-arrangement election, making the administration of the hedging rules more difficult, if there was a deliberate failure - perhaps of a minor or technical nature - to meet one or more of the requirements.

8.117 Accordingly, a deliberate failure to meet one of these requirements leads to the result that hedge tax treatment does not apply to hedging financial arrangements that start to be held after the failure. [ Schedule 1, item 1, subsection 230-385(2 )]

8.118 Despite subsection 230-385(2), the Commissioner may determine that, after a specified date, this cessation no longer applies, that is that the hedging financial arrangements Subdivision reapplies to the particular entity [ Schedule 1, item 1, subsection 230-385(3 )]. To make this determination, the Commissioner must be satisfied that the taxpayer is unlikely to deliberately fail again to meet the abovementioned requirements [ Schedule 1, item 1, subsection 230-385(4 )] and must take into account various factors. Specific factors relate to the entity's record-keeping practices, its compliance history and whether there have been appropriate changes to its accounting systems, controls and governance processes [ Schedule 1, item 1, subsection 230-385(5 )].

Hedging requirements process

8.119 Diagram 8.1 summaries in schematic form the hedging financial arrangement election.

Diagram 8.1