House of Representatives

Explanatory Memorandum

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

Chapter 14 Case studies

Outline of chapter

14.1 This chapter includes case studies which illustrate how Division 230 will apply to:

•

a deferred settlement;

•

a financial arrangement where the retranslation method has been elected;

•

financial arrangements over which the parties have agreed to a forward swap;

•

a securitisation arrangement;

•

a basic interest rate swap;

•

an interest rate swap with an upfront payment;

•

a cross currency swap; and

•

a total return swap.

Case study 1: A deferred settlement

Deferred settlement scenario

Go Co is a transport company with an aggregated turnover of over $100 million. Go Co has not made any of the elections available under Subdivision 230-C, 230-D, 230-E or 230-F.

Big Rig Co is a heavy vehicle retail company with an aggregated turnover of over $100 million. Big Rig Co has not made any of the elections available under Subdivision 230-C, 230-D, 230-E or 230-F.

On 1 May 2011, Go Co enters into an agreement with Big Rig Co to purchase a refrigerated truck for its fleet, with the payment of $100,000 for the vehicle to occur on 30 June 2014. Under the arrangement, Go Co will take delivery of the vehicle from Big Rig Co on 1 June 2011.

1. Application of Division 230 to Go Co

Does Go Co have a financial arrangement under the agreement to purchase the truck?

Under the agreement to purchase the truck Go Co has a right to receive a financial benefit (the truck) on 1 June 2011 and an obligation to provide a financial benefit (the payment of $100,000) on 30 June 2014. For the purpose of Division 230 the right and the obligation are one arrangement (subsection 230-55(4)).

At the inception of the arrangement (1 May 2011), Go Co does not have a financial arrangement as:

•

although the $100,000 payment is a cash settlable financial benefit (paragraph 230-45(2)(a)) and an obligation to provide such a benefit can constitute a financial arrangement (paragraph 230-45(1)(b));

•

the right to receive the truck, which is under the same arrangement, is:

-

not a cash settlable financial benefit; and

-

not insignificant in comparison with the obligation to pay the $100,000 (paragraphs 230-45(1)(d) to (f)).

However, from 1 June 2011, assuming the vehicle is delivered on time, Go Co will have a financial arrangement as the only right or obligation existing under the arrangement from that time is to a cash settlable financial benefit, that is the obligation to provide $100,000 on 30 June 2014 (paragraph 230-45(1)(b) and section 230-45, note 1).

What are the gains and losses under the financial arrangement?

For the purposes of Division 230 Go Co is taken to have received financial benefits equal to the market value of the truck when it is delivered. This financial benefit which Go Co is taken to have received under the financial arrangement is taken into account in calculating any gain or loss from the financial arrangement. Suppose the truck has a market value of $73,561 at 1 June 2011. This amount is the value of the financial benefit taken to be received by Go Co.

Taking into account the financial benefit of $73,561 which is taken to be received and the financial benefit of $100,000 which is to be provided under the financial arrangement, Go Co will have a loss of $26,439 from the financial arrangement.

As it is reasonable to expect that Go Co will provide a financial benefit on 30 June 2014 (paragraph 230-115(2)(a)) and the amount of that financial benefit is fixed at $100,000 (paragraph 230-115(2)(b)), there is a sufficiently certain overall loss (subsection 230-105(1)) which is required to be accrued (subsection 230-100(2)).

As the loss of $26,439 is required to be accrued, the loss will be spread:

•

over the period starting when Go Co starts to have the financial arrangement, that is 1 June 2011, and ending when Go Co will cease to have the arrangement assuming that it will be held for the rest of its life, that is, until 30 June 2014 (subsection 230-130(1)); and

•

using a compounding accruals method with compounding intervals of not more than 12 months (subsections 230-135(2) and (3)).

In spreading the loss Go Co uses compounding periods (or intervals) of one month.

As each of the compounding intervals fall wholly within one income year the accrued loss from each interval is taken to have been made in the income year in which the interval falls (section 230-170).

Table 14.1 : Loss for each compounding interval

What is the cost of the truck?

In addition to the loss on the financial arrangement, and on the assumption that Go Co uses the truck for the purpose of producing assessable income, the company is also entitled to claim a deduction for the decline in value on the truck acquired under the agreement.

Although Go Co pays $100,000 under the purchase contract, the cost of the truck for the purposes of calculating the deduction under Division 40 of the Income Tax Assessment Act 1997 (ITAA 1997) is the market value of the truck (the 'thing' in terms of section 230-505) at the time it is acquired (paragraph 230-505(2)(b)). Therefore, the cost of the truck is $73,561.

2. Application of Division 230 to Big Rig Co

Does Big Rig Co have a financial arrangement under the agreement to purchase the truck?

Under the agreement to sell the truck, Big Rig Co has an obligation to provide a financial benefit (the truck) and a right to receive a financial benefit (the payment of $100,000). For the purpose of Division 230, the right and the obligation are one arrangement (subsection 230-55(4)).

At the inception of the arrangement (1 May 2011), Big Rig Co does not have a financial arrangement as:

•

although the $100,000 payment is a cash settlable financial benefit (paragraph 230-45(2)(a)) and a right to receive such a benefit can constitute a financial arrangement (paragraph 230-45(1)(a)); and

•

the obligation to provide the vehicle which is under the same arrangement is:

-

not a cash settlable financial benefit; and

-

not insignificant in comparison with the right to receive the $100,000 (paragraphs 230-45(1)(d) to (f)).

However, from 1 June 2011 when the vehicle is delivered, Big Rig Co will have a financial arrangement as the only right or obligation existing under the arrangement from that time is to a cash settlable financial benefit, that is the right to receive $100,000 on 30 June 2014 (paragraph 230-45(1)(a) and section 230-45, note 1).

What are the gains and losses under the financial arrangement?

As Big Rig Co has started to have a financial arrangement at 1 July 2011 in relation to the delayed consideration for providing the vehicle, for the purposes of Division 230 Big Rig Co is taken to have provided financial benefits equal to the market value of the truck (the 'thing') at the time when Big Rig Co provided it (1 July 2011) (subsection 230-505(2)). This financial benefit which Big Rig Co has provided under the financial arrangement is taken into account in calculating any gain or loss from the financial arrangement. As stated above, the market value of the truck is $73,561 at 1 June 2011. This amount is the value of the financial benefit taken to have been provided by Big Rig Co.

Taking into account the financial benefit of $73,561 which is taken to be provided and the financial benefit of $100,000 which is to be received under the financial arrangement, Big Rig Co will have a gain of $26,439 from the financial arrangement.

As it is reasonable to expect that Big Rig Co will receive a financial benefit on 30 June 2014 (paragraph 230-115(2)(a)) and the amount of that financial benefit is fixed (at $100,000) (paragraph 230-115(2)(b)), there is a sufficiently certain overall gain (subsection 230-105(1)) which is required to be accrued (subsection 230-100(2)).

As the gain of $26,439 is required to be accrued, the gain will be spread:

•

over the period starting when Big Rig Co starts to have the arrangement, that is 1 June 2011, and ending when Big Rig Co will cease to have the arrangement assuming that it will be held until maturity, that is 30 June 2014 (subsection 230-130(1));

•

using a compounding accruals method with compounding intervals of not more than 12 months (subsections 230-135(2) and (3)).

In spreading the gain Big Rig Co uses compounding periods (or intervals) of one month.

As each of the remaining compounding intervals fall wholly within one income year the accrued gain from each interval is taken to have been made in the income year in which the interval falls (section 230-170).

What are the proceeds of the sale of the truck?

In addition to the gain on the financial arrangement, Big Rig Co has also sold a truck. Although Big Rig Co is entitled to $100,000 under the sale contract, the amount of the benefit that Big Rig Co is taken to have obtained for the truck is the market value of the truck (the 'thing' in terms of section 230-505) at the time it started to have the financial arrangement (paragraph 230-505(2)(a)).

Accordingly, if the truck is trading stock in Big Rig Co's hands, the amount for which it is treated as having sold trading stock is $73,561.

Table 14.2 : The gain for each compounding interval

Case study 2: Balancing adjustment for the qualifying foreign exchange account

Qualifying foreign exchange account scenario

Kwala Co is a toy company, with an annual turnover of over $100 million. Kwala Co is subject to Division 230 on an elective basis from 1 July 2009 and chooses not to make a transitional election to bring existing financial arrangements which it holds within the operation of Division 230.

Kwala Co has an account denominated in US dollars (US$) which it elects to retranslate under the qualifying foreign exchange accounts election (subsection 230-255(5)). Kwala Co does not elect to make the general retranslation election. If it had, Kwala Co would not have been able to make a separate qualifying foreign exchange accounts election because the relevant qualifying foreign exchange account is a foreign currency denominated financial arrangement and would have been subject to the operation of the general election. The qualifying foreign exchange accounts election applies from 1 July 2009, the beginning of the income year in which the election is made. The account was opened on 7 July 2008.

In order for the qualifying foreign exchange accounts election to apply, Kwala Co must apply a balancing adjustment calculation under Subdivision 230-G to capture the foreign exchange gain or loss not already brought to account under another method available in the Income Tax Assessment Act 1936 or the ITAA 1997 for bringing to account foreign exchange gains and losses. Prior to making the qualifying foreign exchange accounts election, Kwala Co was bringing foreign exchange gains and losses to account under Division 775 of the ITAA 1997. Kwala Co was using the weighted average rate to determine the foreign currency gain or loss.

Table 14.3 : Qualifying foreign exchange account in US$

Table 14.4 : US$/AUD exchange rates

Table 14.5: Division 775 weighted average

Using the weighted average method available under the Division 775 income tax regulations, Kwala Co brings to account a foreign currency loss of $3.93 for the 2008-09 income year.

Table 14.6 : Subdivision 775-E foreign exchange gain or loss (retranslation election)

The foreign currency gain or loss which would have been brought to account using a retranslation method would have been $102.64.

Table 14.7 : Balancing adjustment required on qualifying foreign exchange election commencement

The additional foreign currency gain required to be brought to account under the balancing adjustment provisions in Subdivision 230-G (section 230-445) is therefore $106.57.

Case study 3: Forward contract to swap bonds

Forward contract scenario

PV Enterprises is an Australian resident company with an annual aggregated turnover in excess of $100 million. It has not made any elections under Division 230. It currently holds a number of bonds which, due to its business practices, it typically accrues gains and losses over intervals equal to its income years.

For both taxation and accounting purposes, the functional currency for PV Enterprises is Australian dollars.

PV Enterprises enters into the following transactions.

Acquisition of an Aussie bond

On 1 July 2010 PV Enterprises acquires a zero coupon bond with a face value of $1,600 on the secondary market for $1,000 (the Aussie bond). At the time of acquisition, the Aussie bond has five years remaining of its term (ie, it is due to mature on 30 June 2015).

Forward contract to swap the Aussie bond for a US bond

On 1 July 2011 PV Enterprises enters into a forward contract under which it agrees to exchange its Aussie bond on 1 July 2014 for a bond with a face value of US$1,300 due to mature on 30 June 2016 (the US bond).

At the time of entering into this contract, prevailing market rates have fallen somewhat so the value of the Aussie bond is $1,164.

A US bond carrying a right to receive US$1,300 on 30 June 2016 has a market value at 1 July 2011 of US$850. Also at this time, the prevailing US$/AUD exchange rate is 0.73, so that in Australian dollar terms the US bond has a market value of $1,164.

Settlement of the forward contract

On 1 July 2014 PV Enterprises disposes of its Aussie bond under the forward contract in exchange for receiving the US bond.

At this time its Aussie bond is worth AUD 1,500.

The US bond at this time is worth US$1,100. The US$/AUD exchange rate prevailing at this time is 0.80. Accordingly, at this time the US bond has a market value of AUD 1,375.

Redemption of the US bond

On 30 June 2015 PV Enterprises is still holding the US bond. The prevailing US$/AUD exchange rate at this time is 0.625.

On 30 June 2016 PV Enterprises redeems the US bond for its face value of US$1,300. At this time the US$/AUD exchange rate has fallen to 0.75, so PV Enterprises is taken to have received AUD 2,080 on redemption of the US bond.

Economic summary

Under the entirety of this arrangement, PV Enterprises has paid out $1,000 for the Aussie bond and is taken to have received AUD 2,080 under the US bond, making an overall economic gain of AUD 1,080.

PV Enterprises' Aussie bond

Financial arrangement

The Aussie bond held by PV Enterprises is a financial arrangement consisting of a cash settlable right to receive a financial benefit (the AUD 1,600 on redemption) (section 230-45). Moreover, as the amount PV Enterprises paid for the bond (AUD 1,000) is integral to calculating any gain or loss on the financial arrangement, it is taken to be an amount PV Enterprises provided under its Aussie bond financial arrangement (subsection 230-60(1)).

Application of accruals methodology

As outlined above, the only financial benefits under the arrangement are PV Enterprises' $1,000 payment for the Aussie bond (taken to be provided under the arrangement pursuant to section 230-60), and the $1,600 it has a right to receive on maturity. The $1,000 acquisition cost, having already been provided by PV Enterprises, and the right to receive $1,600 on maturity, being reasonably expected and for a fixed amount, are both sufficiently certain (subsections 230-115(2) and (9)). Therefore, PV Enterprises has, from the time it acquires the Aussie bond, a sufficiently certain overall gain from the financial arrangement of $600 (subsection 230-105(1) and paragraph 230-105(2)(a)). This $600 overall gain is subject to the accruals method in Subdivision 230-B (subsection 230-100(2)).

Under the accruals method, PV Enterprises will spread the $600 over the entire five-year remaining term of the bond using a compounding accruals method, or a method whose results reasonably approximate this method (subsection 230-80(1) and section 230-135).

Because of the circumstances of its business and how it treats its other bonds for tax purposes, PV Enterprises will accrue any gains and losses it makes on its Aussie bond over 12-month intervals ending on 30 June each year (subsections 230-80(3) and 230-135(3)).

The gain or loss from PV Enterprises' Aussie bond under a compounding accruals method can therefore be calculated as follows (this calculation reveals a 9.86 per cent effective interest rate for the Aussie bond).

Table 14.8 : Gain for each compounding interval

The accrual amounts will be assessable to PV Enterprises under section 230-15 in the year they are accrued (sections 230-15 and 230-170).

Year ended 30 June 2011

Based on the accrual calculation in Table 13.19, on 30 June 2011, PV Enterprises will accrue a $98.56 gain in respect of the Aussie bond.

Year ended 30 June 2012

At the start of the year ending 30 June 2012 PV Enterprises entered into the forward contract to dispose of the Aussie bond (on 1 July 2011).

On 1 July 2011, the elements of subsection 230-505(1) are satisfied because PV Enterprises starts to have part of a financial arrangement (being the right to receive the US bond under the forward contract) as consideration for the Aussie bond to be provided.

Therefore subsection 230-505(2) will apply to deem the benefit obtained for providing the Aussie bond to be the market value of the Aussie bond when it is provided (ie, 1 July 2014).

Also on 1 July 2011, PV Enterprises now knows it will only hold the Aussie bond until 1 July 2014. However, it will continue to accrue the overall gain it has calculated on the Aussie bond (as set out in Table 13.19) as if it will continue to hold the Aussie bond for the rest of its life, that is, until 30 June 2015 (subsection 230-135(4)).

At the time of entering into the forward contract, PV Enterprises' outstanding rights and obligations under the Aussie bond are still the same. That is, entering into the forward contract has not changed the terms and conditions of the Aussie bond.

Further, the fact that PV Enterprises has entered into the forward contract does not of itself necessarily cause a material change to the circumstances affecting the Aussie bond at the time the forward contract is entered into. Although subsection 230-185(2) does not limit the scope of what is considered to be a material change in these circumstances, it provides further context as to the types of changes that would be considered to be material . Entering into the forward contract does not, for example, (taking into account the requirement under paragraph 230-115(2)(a) for PV Enterprises to assume it will hold the Aussie bond for the rest of its life) cause a contingency to arise in respect of the financial benefits under the Aussie bond, such that would cause those financial benefits to cease to be sufficiently certain.

Because of this, it is also relevant to note that even if entering into the forward contract was to be considered to materially alter the circumstances affecting the Aussie bond, and materially affect the amount and timing of the financial benefits PV Enterprises will receive under the Aussie bond (thus triggering a reassessment under section 230-185 and, assuming the Aussie bond is still subject to accruals, a re-estimation of the gain or loss to be accrued under section 230-190), there will be no difference in outcome. As mentioned above, the rights and obligations under the Aussie bond have not changed. In determining whether the financial benefits under such rights and obligations are sufficiently certain to be received or provided, PV Enterprises must continue to assume that it will have the Aussie bond for the rest of its life, that is, until 30 June 2015 (paragraph 230-115(2)(a)). This means that following entry into the forward contract, PV Enterprises is still sufficiently certain to receive AUD 1,600 on 30 June 2015. The same gain or loss, even following a re-estimation, would continue to have to be accrued (subsection 230-190(4)).

This means that based on the accrual calculation in Table 13.19, on 30 June 2012, PV Enterprises will still accrue a $108.27 gain in respect of the Aussie bond.

Year ended 30 June 2013

Based on the accrual calculation in Table 13.19, on 30 June 2013, PV Enterprises will accrue a $118.95 gain in respect of the Aussie bond.

Year ended 30 June 2014

Based on the accrual calculation in Table 13.19, on 30 June 2014, PV Enterprises will accrue a $130.67 gain in respect of the Aussie bond.

Year ended 30 June 2015

The balancing adjustment on disposal of the Aussie bond

Upon settlement of the forward contract on 1 July 2014, PV Enterprises transfers the Aussie bond to the counterparty in exchange for receiving the US bond. As a result of this transfer, the balancing adjustment in Subdivision 230-G applies (paragraph 230-435(1)(a)).

The method statement in section 230-445 results in the following balancing adjustment (under the relevant steps):

•

step 1 (a) (amounts received): PV Enterprises is taken to have obtained for disposing of its Aussie bond AUD 1,500 (its market value when it is provided) (paragraph 230-505(2)(a));

less the sum of

•

step 2 (a) (amounts paid): PV Enterprises is taken to have provided the $1,000 cost of the Aussie bond under the Aussie bond (subsection 230-65(1));

and

•

step 2 (b) (amounts previously taken into account): the amounts previously accrued and included in PV Enterprises' assessable income in respect of the reacquired Aussie bond total $456.45 ($98.56 + $108.27 + $118.95 + $130.67) (subsection 230-445(1), sections 230-15 and 230-170),

which results in a balancing adjustment of a $43.55 gain being made from the Aussie bond (paid $1,456.45 and received $1,500).

Note: On 1 July 2014 the elements of subsection 230-505(1) are satisfied again because PV Enterprises starts to have the US bond as consideration for ceasing to have the Aussie bond. However, this will give rise to the same outcome, being an amount deemed to have been obtained for providing the Aussie bond equal to the market value of the Aussie bond at the time this bond was provided.

Total gains and losses made by PV Enterprises from the Aussie bond

Under the Aussie bond, the following amounts will be assessable under Division 230:

•

$456.45 accrued over the years ended 30 June 2011 to 30 June 2014 ($98.56 + $108.27 + $118.95 + $130.67) (accrual amount); and

•

$43.55 gain assessable in the year ended 30 June 2015 (gain on actual disposal).

This amounts to a total gain on the Aussie bond of exactly $500.

PV Enterprises' forward contract

Financial arrangement

The forward contract is a financial arrangement in the hands of PV Enterprises consisting of a cash settlable right to receive the US bond (being a right to receive a 'money equivalent' as defined), and a cash settlable obligation to provide the Aussie bond (being an obligation to provide a 'money equivalent' as defined) (section 230-45, definition of 'money equivalent' in subsection 995-1(1) of the ITAA 1997).

Application of accruals methodology

The US bond that PV Enterprises has a right to receive under the forward contract arrangement is not a financial benefit that it is sufficiently certain to receive for the purpose of applying the accruals methodology. This is because, whilst PV Enterprises may reasonably expect to receive the US bond under the forward contract, the amount or value of the US bond is not fixed or determinable with reasonable accuracy (paragraph 230-115(2)(b)).

The reason for this is because the financial benefits to be provided and received under the forward contract are not all denominated in the same currency - the value of the US bond must be translated into Australian dollars using the rules in section 960-50 of the ITAA 1997 (subsection 230-115(8) and paragraph (aa) of the definition of 'special accrual amount' in subsection 995-1(1) of the ITAA 1997). The value of the US bond in Australian dollar terms, determined at the time it is to be translated, cannot be known until such time as it is received. As such, it is not sufficiently certain that PV Enterprises will make either an overall or a particular gain or loss under the forward contract, so it does not have a sufficiently certain gain or loss under its forward contract that can be subject to the accruals methodology (sections 230-100, 230-105, 230-110 and 230-115).

Balancing adjustment on settlement

In the year a financial arrangement ceases to be held, a gain or loss made in that year can only be determined under Subdivision 230-G (subsection 230-40(1)). On settlement of the forward contract, a balancing adjustment will therefore be made (paragraph 230-435(1)(b)).

The method statement in section 230-445 results in the following balancing adjustment (under the relevant steps):

•

step 1 (a) (amounts received): PV Enterprises received the US bond, worth AUD 1,375, under its financial arrangement comprising its cash settlable rights and obligations under the forward contract;

less

•

step 2 (a) (amounts paid): PV Enterprises paid the Aussie bond, worth AUD 1,500 under its forward contract financial arrangement,

which results in a balancing adjustment of a $125 loss being made by PV Enterprises from the forward contract (paid $1,500 and received $1,375).

This loss will be deductible to PV Enterprises in the income year ended 30 June 2013.

PV Enterprises' US bond

Financial arrangement

The US bond is a financial arrangement consisting of a cash settlable right to receive a financial benefit (the US$1,300 on redemption) (section 230-45).

In addition, the amount PV Enterprises paid for the US bond is integral to calculating the gain or loss on the financial arrangement, and thus is taken to be an amount PV Enterprises provided under the arrangement (subsection 230-60(1)).

On 1 July 2011, the elements of subsection 230-505(1) are satisfied because PV Enterprises starts to have a part of a financial arrangement (being the obligation to provide Aussie bond under the forward contract) as consideration for the US bond to be acquired.

Therefore subsection 230-505(2) will apply to deem the benefit obtained for acquiring US bond to be the market value of the US bond when it is acquired.

Upon settlement of the forward contract on 1 July 2014, PV Enterprises transfers the Aussie bond to the counterparty in exchange for receiving the US bond. Because of the operation of subsection 230-505(2), PV Enterprises will be taken to have paid US$1,100 (or AUD 1,375) for the US bond, being its market value on 1 July 2014.

Note: On 1 July 2012 the elements of subsection 230-505(1) are satisfied again because PV Enterprises ceases to have the Aussie bond as consideration for acquiring the US bond. However, this will give rise to the same outcome, being an amount deemed to have been provided for acquiring the US bond equal to the market value of the US bond at the time this bond is acquired.

Application of the accruals methodology

PV Enterprises' financial benefits under its US bond financial arrangement are known. As they are all in a particular foreign currency (US$), they are not to be translated into Australian currency before the relevant gain or loss is determined for the purpose of applying the accruals methodology (subsection 230-115(8) and paragraph (aa) of the definition of 'special accrual amount' in subsection 995-1(1) of the ITAA 1997).

As outlined above, the only financial benefits under the US bond arrangement are the US$1,100 PV Enterprises' is taken to have paid to start to have the US bond on 1 July 2014 (subsection 230-60(1) and section 230-505), and the US$1,300 it has a right to receive on maturity. The acquisition cost, having been provided by PV Enterprises, and the right to receive payment on maturity, being reasonably expected and for a fixed amount (in the relevant particular foreign currency), are both sufficiently certain (subsections 230-115(2), (8) and (9)). Therefore, PV Enterprises has, from the time it acquires the US bond, a sufficiently certain overall gain from the financial arrangement of US$200 (subsection 230-105(1) and paragraph 230-105(2)(a)). This US$200 overall gain is subject to the accruals method in Subdivision 230-B (subsection 230-100(2)).

Under the accruals method, PV Enterprises will spread the US$200 over the two-year remaining term of the US bond using a compounding accruals method, or a method whose results reasonably approximate this method (subsection 230-130(1) and section 230-135).

Because of the circumstances of its business and how it treats its other bonds for tax purposes, PV Enterprises will accrue any gains and losses it makes on its US bond over 12 month intervals ending on 30 June each year (subsections 230-80(3) and 230-135(3)).

The gain or loss from PV Enterprises' US bond under a compounding accruals method can therefore be calculated as follows (this calculation reveals a 8.71 per cent annually compounded effective interest rate for the US bond).

Table 14.9 : Gain for each compounding interval

The accrual amounts will be assessable to PV Enterprises under section 230-15 in the year they are accrued, and translated into Australian dollars at that time (sections 230-15 and 230-170 and paragraph (aa) of the definition of 'special accrual amount' in subsection 995-1(1) of the ITAA 1997).

Year ended 30 June 2015

Based on the accrual calculation in Table 13.20, on 30 June 2015, PV Enterprises will accrue a US$95.83 gain in respect of the Aussie bond. Based on prevailing exchange rates, the gain that is included in PV Enterprises' assessable income under section 230-15, will be AUD 153.33.

Year ending 30 June 2016

Balancing adjustment

On maturity of the US bond, PV Enterprises will be paid US$1,300 and all of its rights and obligations under this arrangement will cease. This will trigger a balancing adjustment under Subdivision 230-G (paragraph 230-435(1)(b)). The method statement in section 230-445 results in the following balancing adjustment (under the relevant steps):

•

step 1 (a) (amounts received): PV Enterprises will receive US$1,300 under the bond, which translates under the translation rules in section 960-50 (and as set out in the facts) to AUD 2,080;

less the sum of

•

step 2 (a) (amounts paid): as set out in the analysis for the financial arrangement that is the US bond, PV Enterprises is taken to have paid AUD 1,375 to acquire the US bond (paragraph 230-505(2)(b));

and

•

step 2 (b) (amounts previously taken into account): the AUD 153.33 previously accrued and included in PV Enterprises' assessable income (subsection 230-445(1), sections 230-15 and 230-170 and the definition of 'special accrual amount' in paragraph (aa) of the definition of 'special accrual amount' in subsection 995-1(1) of the ITAA 1997),

which results in a balancing adjustment of a $551.67 gain being made from the US bond (paid $1,375, assessed on $153.33 and received $2,080).

Total amount brought to tax from the US bond

The total amount brought to tax from the US bond is a $705 gain ($153.33 accrual amount and $551.67 gain on maturity).

Summary of gains and losses for PV Enterprises under its arrangement to swap bonds

Under the entirety of this arrangement, PV Enterprises has made the following gains and losses under Division 230:

•

a $500 gain made from the Aussie bond ($456.45 accrued over the years ended 30 June 2009 to 30 June 2014, and a $43.55 gain on disposal, assessable in the year ended 30 June 2015);

•

a $125 loss made from the forward contract (deductible in the year ended 30 June 2015); and

•

a $705 gain made from the US bond ($153.33 accrual gain at 30 June 2015 and $551.67 gain on maturity in the year ended 30 June 2016).

This amounts to a total overall gain on the entirety of the arrangements of $1,080. This equals the overall economic gain PV Enterprises made on the entirety of these arrangements.

Case Study 4: Securitisation

The purpose of this case study is to consider issues related to the application of Division 230 to a residential mortgage-backed securitisation (RMBS) structure. The Division 230 treatment will depend on the facts and circumstances of the particular securitisation structure.

In this case study, the Originator consolidates the special purpose entity (SPE) into the Originator's consolidated financial accounts; the assets in the form of the mortgages are recognised in the financial statements of the Originator's accounts and for tax purposes the Originator and the SPE do not form part of the same consolidated tax group. In this case study, the term 'Originator' refers to the Head Co and its subsidiaries.

The securitisation structure can be illustrated diagrammatically as follows.

Securitisation fact pattern

An authorised deposit-taking institution (the 'Originator') provides fixed and variable rate residential home loans to Australian borrowers backed by mortgages over residential properties.

On 1 July 2011, to fund its on-going lending activities the Originator equitably assigns the mortgages and rights to cash flows from the mortgages to an SPE. The SPE issues securities to finance the transfer of these mortgages from the Originator to the SPE. Specifically, the SPE issues a series of securities (featuring senior and subordinated tranches) with a total face value of AUD 5 billion to investors backed by the pool of residential mortgages.

The SPE is in the form of a trust (the 'Trust'). The residual income unit in the Trust is issued to the Originator. This entitles the Originator to income of the Trust that is in excess of what is paid to the holders of the Securities of the Trust and other parties. In this particular securitisation arrangement the residual capital units are issued to the Originator and Charitable Trust. The Originator is appointed manager of the securitisation. A floating charge is attached to the assets of the Trust and administered by a Security Trustee.

A series of credit enhancements are put in place including subscription by the Originator in the subordinated tranche of the notes, external mortgage insurance and mortgage insurance policies (effected via an equitable assignment of its interest in mortgage insurance policies to the Trust).

Servicing is provided by the Originator whose role is to collect interest and principal payments and any other amounts to which the investors are entitled from the borrowing pool, pass those amounts on to the investors and pursue collection of delinquent accounts. Liquidity support is also provided by the Originator.

The Trust enters into a range of hedging arrangements including interest rate swaps with the Originator.

The structure is a revolving one where the mortgage pool of AUD 5 billion is topped up with substitute mortgages funded through repayments of principal.

The Trust issues clean-up call options to the Originator to facilitate winding up the securitisation structure when an agreed trigger event occurs.

Securitisation assumptions

Accounting

The Trust is consolidated with the Originator in accordance with Australian Accounting Standard AASB 127 Consolidation and Separate Financial Statements and Urgent Issues Group 112 Consolidation - Special Purpose Entities . There is no de-recognition of the transferred mortgages under Australian Accounting Standard AASB 139 Financial Instruments: Recognition and Measurement (AASB 139) as the Originator has retained, notwithstanding the transfer, substantially all of the risk and rewards of the home loans through the holding of the residual income unit and the Originator's exposure (incorporating features such as credit enhancement mechanisms, liquidity support and interest rate swaps) to expected variability in the future net cash flows from the home loans.

Tax

The Originator and the Trust are not tax consolidated.

The Originator's aggregated turnover for the 2011 year is in excess of AUD 20 million.

The Originator has not chosen to use any of the elective tax-timing methods under Division 230.

1. Application of Division 230

Securitisation agreements

The securitisation shown above comprises a number of agreements including those entered into by the Originator:

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equitable assignment of home loans;

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equitable assignment of home loan mortgage insurance;

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issuance of RMBS securities;

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residual income unit subscription;

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residual capital unit subscription;

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management agreement;

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service agreement;

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subordinated note subscription;

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liquidity facility;

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interest rate swaps; and

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management of the trust.

Does the Originator have one or more arrangements under the securitisation?

Under the securitisation the Originator has a number of rights to receive, and/or obligations to provide, financial benefits by virtue of the agreements listed above.

The question that arises is whether the Originator's rights and/or obligations under each agreement constitute a single, aggregate arrangement or two or more separate arrangements.

In accordance with subsection 230-55(4) the answer to this question is a matter of fact and degree that is determined having regard to the:

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nature of the rights and/or obligations;

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terms and conditions of the rights and/or obligations;

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circumstances surrounding the creation of the rights and/or obligations and their proposed exercise or performance (including the purpose of the relevant parties);

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rights and obligations and whether the rights and/or obligations must be dealt with separately or together;

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normal commercial understandings and practices in relation to the rights and obligations (including whether they are viewed commercially as separate things or as a group or as a whole); and

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objects of Division 230.

Depending on the particular structure, all or a majority of the rights and obligations under the separate agreements could be interdependent and related to each other.

The creation of these rights and obligations and their proposed exercise or performance predominantly occur at the same time.

The common purpose of the Originator and the Trust is to raise and provide cost-effective finance for the Originator with the timing and pricing of the rights, obligations and consideration all structured to meet that objective.

Commercial practice indicates that such a securitisation, or at least most of the components of such a securitisation, is treated as one arrangement. Depending on the particular situation, the service agreement could be treated as part of a loan or treated on a stand-alone basis.

The position under AASB 139 regarding grouping of financial instruments is not clear. However, specific implementation guidance provided in item B6 in Implementation Guidance IAS 39 indicates that separate instruments may be bundled into one transaction provided that they meet certain criteria.

In the context of this particular case study, where the Trust is consolidated and assets recognised for accounting purposes, it appears that for accounting purposes this type of securitisation structure is treated as equivalent to that of a loan to the Originator from the note holders.

Taking these factors into account indicates that at least a majority of the rights and obligations that arise from this type of structure could, in particular circumstances, be viewed in combination as constituting one arrangement.

Is the securitisation arrangement a 'financial arrangement'?

The Originator will have a financial arrangement if, under the securitisation, there is a combination of one or more cash settlable rights to receive and cash settlable obligations to provide financial benefits. However, in accordance with subsection 230-45(1), the securitisation will not be a financial arrangement if there are rights and obligations that are not cash settable and those rights and obligations are not insignificant in comparison with the cash settlable rights and obligations.

A right to receive, or an obligation to provide, a financial benefit is cash settlable if one of the requirements in subsection 230-45(2) is satisfied. In the case of this securitisation most, if not all, of the rights and obligations are in relation to benefits that are money or a money equivalent (rights and/or obligations under a service agreement may not be cash settlable, and may therefore not be part of the financial arrangement). Hence, at least a majority of the various agreements comprising the relevant securitisation arrangement could satisfy the definition of 'financial arrangement' for the purposes of Division 230.

Is a balancing adjustment required?

Whether there would be a balancing adjustment under Subdivision 230-G for securitisation structures of this type will depend on the particular facts and circumstances of the particular structure.

Nevertheless, subsection 230-435(3), by design, provides that a transfer for the purposes of this Subdivision does not arise unless there is, in effect, a transfer of substantially all the risks and rewards of ownership of the interest in question. Thus, it would be possible, depending on factors such as the nature of the holding of the residual income unit and the credit enhancements, for there not to be a Subdivision 230-G transfer in respect of typical securitisation arrangements.

Case study 5: A basic interest rate swap

Vanilla Co enters into a five-year interest rate swap contract with a counterparty on 7 March 2010. Vanilla is to receive annual floating rate payments, set one year in advance of the date due for payment, based on the Bank Bill Swap Rate (BBSW) and is to make annual payments at the fixed rate of 8 per cent per annum, also set one year in advance of the due date for payment. Accordingly, the first floating and fixed rate payments are to be made on 7 March 2011. Payments are calculated by reference to a notional principal of $100 million.

Vanilla Co has a 30 June income year and makes an election to have Division 230 apply from 1 July 2009. However, it does not make any of the Division 230 tax-timing elections.

Assume that the swap contract is a financial arrangement. This arrangement consists of a floating rate leg and a fixed rate leg. Further, the financial benefits to be provided or received in respect of each leg of the arrangement are calculated by reference to a notional principal amount (which, in this case, is not paid or received). The value of the notional principal in relation to both legs is $100 million, that is, they are equal in value. When viewed separately, the substance, effect and pricing of each leg of the swap (particularly having regard to the financial benefits to be provided or received in respect of it) is such that the notional principal in relation to it is provided or received at a time. Accordingly, the swap contract is a financial arrangement to which section 230-120 applies.

In accordance with subsection 230-120(3), the financial benefits and gains or losses from the swap contract are to be worked out separately for each leg. Then the gains or losses from the swap contract are worked out by calculating them in respect of the floating rate leg separately to those in respect of the fixed rate leg, before combining them to work out the gains or losses from the arrangement.

In the case of the fixed rate leg, the fixed rate payments are calculated as if the notional principal amount of $100 million is received by Vanilla Co on 7 March 2010, and is to be repaid by Vanilla Co on 7 March 2015. The fixed rate payments are calculated thus:

$100m x 8% per annum = $8m

Similarly, in the case of the floating rate leg, the floating rate payments are calculated as if the notional principal amount of $100 million is paid by Vanilla Co on 7 March 2010, and is to be received by Vanilla Co on 7 March 2015. Assume that BBSW on 7 March 2010 is 7.7 per cent per annum. Then the first floating rate payment, to be made on 7 March 2011, is calculated thus:

$100m x 7.7% per annum = $7.7m

Assume the following BBSW rates:

Table 14.10 : BBSW rates over the term of the interest rate swap

Based on the above BBSW rates, Vanilla Co's financial benefits (cash flows) including notional financial benefits (cash flows) for the notional principal in respect of each leg are as follows, bearing in mind that the notional principal in respect of the two legs of the swap is viewed as having been provided or received, and that these rates are set one year in advance.

Table 14.11 : Vanilla Co's cash flows under the interest rate swap

The negative sign for the cash flows signifies a cash outflow while the remaining figures signify a cash inflow.

As at 7 March 2010, Vanilla Co has a sufficiently certain:

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particular gain in respect of the floating leg of $7.7 million, which relates to the period 7 March 2010 to 7 March 2011; and

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particular loss in respect of the fixed leg of $8 million, which also relates to the period 7 March 2010 to 7 March 2011.

Vanilla Co applies the accruals method under on a compounding accruals basis to this and subsequent gains/losses in respect of the two legs of the swap contract using a 12-month compounding period and yearly intervals starting from 7 March 2010. Each interval straddles more than one income year, so Vanilla Co uses fractional compounding to allocate gains and losses from intervals to income years: this is a reasonable allocation for the purposes of subsection 230-170(2). The results of this application of the accruals method are as follows:

Table 14.12 : Fractional compounding to allocate gains and losses

Straight line accruals for this swap would have produced the following results:

Table 14.13 : Straight line accruals to allocate gains and losses

Comparing the compounding accruals result with the straight line accruals result on a year-by-year basis illustrates that, in this swap, the difference is relatively small: see Table 14.14. Vanilla Co could have used straight line accruals (as long as it applied this on a consistent basis) to spread the swap gains and losses because in this situation it provides a result that approximates the compounding accruals result.

In this situation, it is to be noted that the notional principal for the two legs of the swap are the same, do not change during the term of the swap, there are no upfront or backend or other lumpy payments under the swap, and the swap payments are periodic in nature.

Table 14.14 : Compounding accruals versus straight line accruals ^[5]

Case study 6: An interest rate swap with upfront payment

Neapolitan Co enters into a swap contract on the same terms and conditions as those entered into by Vanilla Co (and based on the same assumptions) except that Neapolitan Co prepays its obligation to make fixed rate payments under the contract. This upfront payment, assumed to be $31,941,680, is the present value of all the payments that Neapolitan Co would otherwise have had to make under the fixed leg of the swap contract.

The upfront payment is not a leg or part of the leg of the swap. Subsection 230-120(1) is designed on the basis of a notional principal arrangement with two legs of equal value when the entity starts to have the arrangement, with the possibility of one or more other things. Further, there is a requirement for the financial benefits to be provided or received in respect of each leg of the arrangement to be calculated by reference to, or to be reasonably related to, a notional principal. However, the upfront payment has the characteristics of actual rather than notional principal as it serves a financing function, namely to finance the financial benefits that would otherwise have had to be provided by Neapolitan Co under the swap contract.

In these circumstances, the upfront payment is, instead, another thing: see subparagraph 230-120(1)(a)(iii). Accordingly, the $31,941,680 payment needs to be taken into account in working out the gain or loss from that thing (subparagraph 230-120(3)(b)(i)) which, in turn, is used to work out the gain or loss from the financial arrangement comprising the swap contract (subparagraph 230-120(3)(b)(ii)).

The role of the subparagraph 230-120(1)(a)(iii) thing is to provide a mechanism for reconciling the actual financial benefit profile of the financial arrangement with its economic and commercial substance, including the time value of money. Thus, for the Neapolitan Co swap:

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The financial benefits from the financial arrangement are worked out by working out the financial benefits of each thing separately, namely:

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the two legs of the swap as if there were no other thing; and

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the other thing, namely the upfront payment.

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The gain or loss from the financial arrangement is worked out by working out the gains or losses from each of the three things separately:

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The gains and losses from each of the two legs are worked out in the way described in the previous (Vanilla Co) example.

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Working out the gains and losses from the upfront payment needs to take into account the fact that it is calculated to finance the annual $8 million amounts which Neapolitan Co, by making the upfront payment, is discharged from having to make to meet its mutual obligations under the swap contract. In effect, Neapolitan Co makes the $31,941,680 payment as an investment at 8 per cent per annum annually compounded, receiving $8 million annually in arrears. The gains from this, which are set out below, are part of the gains and losses from the swap financial arrangement (subparagraph 230-120(3)(b)(ii)).

Table 14.15 : Gains and losses allocated using compounding accruals

If straight line accruals were used for this swap, it would produce the following results:

Table 14.16 : Straight line accruals to allocate gains and losses

In this case, a comparison between the results of compounding accruals and straight line accruals shows that there is a relatively large year-by-year difference. Neapolitan Co could not use straight line accruals for all of the things in respect of this swap, although it could use straight line accruals solely for the two legs. The upfront payment would have to be accrued as a sufficiently certain particular gain or loss using compounding accruals.

Table 14.17 : Compounding accruals versus straight line accruals

Case study 7: A cross currency interest rate swap

Gelato Co, which has an Australian dollar functional currency and a 30 June end of income year, enters into a three-year cross currency interest rate swap under which:

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it will pay a counterparty annual Australian dollar fixed amounts calculated by reference to a notional principal of AUD 10 million (6 per cent per annum);

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it will receive from the counterparty annual foreign currency (FC) fixed amounts calculated by reference to a notional principal of FC 8 million (5 per cent per annum);

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on 1 January 2012, it will exchange (by receiving) AUD 10 million for (by paying) FC 8 million (at the time AUD 1 = FC 0.8 and the two amounts are equivalent in value to each other); and

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on 1 January 2015, it will reverse the above exchange by paying AUD 10 million and receiving FC 8 million.

Assuming that this swap is on arm's length terms, and having regard to the swap contract as a whole being the relevant financial arrangement, the exchange and re-exchange amounts are notional principal rather than actual principal. The exchange of amounts of equivalent value at 1 January 2012 do not involve financing, given that each leg is not a separate financial arrangement (even though each is viewed separately to work out the gains and losses on the whole swap contract).

Gelato Co has not made the hedging financial arrangement election, the retranslation election or the fair value election. Assume that it has decided to use spot exchange rates to translate foreign currency amounts into Australian dollars for the purposes of Subdivision 960-C.

Assume that the periodic swap payments are made on 1 January 2013, 1 January 2014 and 1 January 2015 and that the exchange rates on those dates and 30 June 2012, 30 June 2013 and 30 June 2014 are as follows:

Table 14.18 : Assumed exchange rates

In terms of section 230-120, the swap contract consists of two legs only:

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There is a foreign currency denominated leg which consists of paying FC 8 million on 1 January 2012 and being entitled to receive that same amount on 1 January 2015; and being entitled to receive FC 400,000 on 1 January 2013, 1 January 2014 and 1 January 2015.

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There is an Australian dollar denominated leg which consists of receiving AUD 10 million on 1 January 2012 and having to pay that same amount on 1 January 2015; and having to pay AUD 600,000 on 1 January 2013, 1 January 2014 and 1 January 2015.

The gains and losses from the swap contract are to be worked out by working out the gains and losses from each of these legs separately and then aggregating them (paragraph 230-120(3)(b)). In effect, the gains and losses from this swap contract are worked out by treating the foreign currency denominated leg as a foreign currency denominated bond and the Australian dollar denominated leg as an Australian dollar denominated bond, and then combining these results.

The application of the compounding accruals rules to each of the legs of the swap - using annual compounding, annual intervals commencing 1 January 2012 and fractional compounding to spread gains and losses over intervals that straddle the end of the income year - is worked out in the following way.

Foreign currency denominated leg

In respect of the first receipt under the foreign currency denominated leg:

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At 30 June 2012, the accrued gain is FC 197,561. Under Subdivision 960-C, this is translated using the spot rate of AUD 1 = FC 0.92 to give an accrued gain of AUD 214,740 (see the definition of 'special accrual amount') (Schedule 1, item 28, section 995-1 of the ITAA 1997).

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The accrued gain for the 2013 income year up to the date of receipt (1 January 2013) of the FC 400,000 is FC 202,439. Translated at the spot rate of AUD 1 = FC 0.86 produces an accrued gain of AUD 235,394.

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Because the exchange rate changed between 30 June 2012 and 1 January 2013, the amount accrued up until 30 June 2012 may be different to the amount actually received. In this case, there is an under-accrual of AUD 14,982 (reflecting the fact that FC 197,561 at an exchange rate of AUD 1 = FC 0.92 is worth less than that amount at an exchange rate of AUD 1 = FC 0.86). Under subsection 230-175(2), this underestimate is a gain made by Gelato Co in the 2013 income year.

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On 1 January 2013, Gelato Co receives FC 400,000. Translated at the spot rate of AUD 1 = FC 0.86 produces an Australian dollar equivalent of AUD 465,116. Note that this is the sum of the accrued amounts for the period that the FC 400,000 relates to (1 January 2012 to 31 December 2013) and the subsection 230-175(2) running balance adjustment (AUD 214,740 + AUD 235,394 + AUD 14,982).

The gains and losses in respect of the other periodic payments under the foreign currency leg of the swap contract are worked out in a similar way.

On 1 January 2015, Gelato Co receives FC 8 million from the counterparty, being the re-exchange of the notional principal. The exchange rate at this date is AUD 1 = FC 0.78. Therefore, the foreign currency has an Australian dollar value of AUD 10,256,410. In the circumstances of this swap contract, this amount is attributable to the FC 8 million Gelato Co paid on 1 January 2012 (which had an Australian dollar value of AUD 10 million) and it could not be said that the gain of AUD 256,410 was sufficiently certain at the time the swap contract was entered into. Accordingly, Gelato Co makes a realisation gain of AUD 256,410 in the income year ended 30 June 2015 in relation to the notional principal exchange.

Accordingly, the Australian dollar compounding accruals gains and losses in respect of the foreign currency leg of the swap contract are as follows:

Table 14.19 : Compounding accruals gains and losses on the foreign currency denominated leg

Australian dollar denominated leg

In respect of the first payment under the Australian dollar denominated leg:

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At 30 June 2012, the accrued loss is AUD 295,630.

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The accrued loss for the 2013 income year up to the date of payment (1 January 2013) of the AUD 400,000 is AUD 304,370.

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No translation under Subdivision 960-C is necessary given that payments are denominated in Australian dollars and Gelato Co's functional currency is Australian dollars.

There is no gain or loss in relation to the notional principal exchange on the Australian dollar denominated leg, as there was a receipt of AUD 10 million and repayment of AUD 10 million.

Accordingly, application of the compounding accruals rules to the swap contract is as follows:

Table 14.20 : Compounding accruals gains and losses on the Australian dollar denominated leg

Working out the compounding accruals gains and losses from the swap contract produces the following results:

Table 14.21 : Compounding accruals gains and losses for the swap financial arrangement

Straight line accruals

For a swap contract of this nature, would straight line accruals approximate compounding accruals for the purposes of paragraph 230-135(2)(b)? The answer to this should generally disregard differences in the results of the two methods attributable to unexpected foreign currency movements.

If, however, there was a significant interest rate differential between the two currencies or there was, as in Case study 6 above, a significant non-periodic payment under the swap arrangement, it would be difficult to say that the results of straight line accruals would approximate compounding accruals. However, neither of these elements are present here, there are periodic payments and receipts under the swap contract, and the notional principal does not change during the term of the arrangement. Straight line accruals would, in terms of paragraph 230-135(2)(b), provide a result that approximates compounding accruals, as illustrated by a comparison between the compounding accruals and straight line accruals for this swap. Table 14.25 demonstrates that there is, in the circumstances, only a relatively small difference between the two types of accrual on a year-by-year basis.

Table 14.22 : Straight line accruals gains and losses on foreign currency denominated leg

Table 14.23 : Straight line accruals gains and losses on the Australian dollar denominated leg

Working out the straight line accruals gains and losses from the swap contract produces the following results:

Table 14.24 : Straight line accruals gains and losses for the swap financial arrangement

Table 14.25 : Comparison between compounding and straight line accruals

Case study 8: A total return swap

Party A enters into a three-year swap arrangement with Party B. Assume that it is a notional principal arrangement to which section 230-120 applies. Under the terms of the swap arrangement, Party A and Party B are required to make periodic payments to each other. Party A's periodic payments are calculated by reference to the amount of interest payable if the leg under which the payments are to be made were a bond that it issued. Party B's periodic payments are calculated by reference to the dividends paid on a reference share whose value at the time of entering into the swap arrangement is the same as the value of Party's A bond leg at that time.

As well, Party B is either required to make, or entitled to receive, a single payment at the end of the swap arrangement. The amount or value of Party B's end payment or receipt is calculated by reference to the movement of the price of the reference share over the three-year life of the swap. Such swaps are sometimes referred to as a 'total return swap'.

Any gains or losses on Party B's share-based leg would have to take into account financial benefits, the value of which are dependent on dividends on the reference share, and the movement in the share price. Under the terms of the swap arrangement, these amounts will not be known until the time the relevant payments are due.

No sufficiently certain gain or loss can be calculated on Party B's leg of this swap at the start of, or during, the arrangement. This assumes that financial benefits in respect of this leg are not calculated and set in advance of when they are payable. Accordingly, gains or losses in respect of this leg are made on a realisation basis for the whole term of the swap arrangement.

On the other hand, a sufficiently certain gain or loss can be calculated in respect of the bond leg. In terms of working out the gains or losses in respect of this leg for the purposes of subparagraph 230-120(3)(b)(i), accruals treatment would therefore apply.