House of Representatives

Explanatory Memorandum

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

Chapter 15 Regulation impact statement

Background

15.1 In August 1998, the then Government announced the Review of Business Taxation (Ralph Review) as part of the broader New Tax System. The major objective of the Ralph Review was to design a taxation system that would best contribute to economic growth. The backdrop for the review featured issues including the impact of globalisation on the Australian economy, the increasing sophistication of financial dealings, and the ability of the Australian Government to raise revenue in the face of the future impact of an aging population and increasing costs of health care:

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Review chairman John Ralph AO noted: 'Meeting the demands upon it [the tax system] in the decades immediately ahead poses significant challenges for the Australian Government and the Australian community. Increased globalisation will translate into an increasingly competitive environment for Australian business. The impact of the telecommunications revolution and associated technologies, in diminishing the significance of national boundaries, will make more businesses feel the chill wind of stiff competition. We may remain an island geographically but we will not be able to hide from the forces generated by globalisation.'

15.2 Among the recommendations arising from the Ralph Review was a series of reforms to the taxation of financial arrangements. The final stages of these reforms, Taxation of Financial Arrangements (TOFA) Stages 3 and 4 , broadly give effect to the recommendations contained in Chapter 9 of the Review of Business Taxation: A Tax System Redesigned (Ralph Report). The recommendations seek to address the tax issues associated with the increasing sophistication of financial markets and transactions:

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The then Treasurer announced the Government's broad support for the recommendations in the Ralph Report in Press Release No. 074 of 11 November 1999.

15.3 TOFA Stages 3 and 4 will implement the final stages of reforms to the taxation of financial arrangements. Stages 1 and 2 of TOFA have already been implemented:

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Stage 1 of TOFA (debt/equity reforms) was legislated in 2001 as Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997).

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Stage 2 (foreign currency reforms) was legislated in 2003 as Division 775 of the ITAA 1997.

15.4 Stages 3 and 4 of the TOFA reforms will be introduced into Parliament as Division 230 of the ITAA 1997. These stages of the TOFA reforms cover tax-timing treatments of financial arrangements.

Policy objective

15.5 The objectives of the proposed legislation are to increase clarity of the tax treatment of financial arrangements, to reduce uncertainties and anomalies in the current law, to reduce tax-induced distortions to investment and financing, to facilitate efficient risk management, and to reduce compliance and administration costs.

15.6 The context of these objectives is that the current taxation of financial arrangements is largely based on standard income tax concepts that give significant weight to legal form rather than economic substance. Two aspects are particularly important. First, the current law often focuses on particular cash flows, makes a distinction on a legal basis between capital and revenue, and largely taxes financial arrangements on a realisation basis. This often leads to effective tax rates in present value terms differing across economically similar transactions. This is particularly important in the financial sector where the timing of cash flows is a key driver of profitability. It is also important because economically similar financial arrangements can take different forms or have different cash flow profiles. Second, the current law may inhibit appropriate risk management and risk transfer.

15.7 Despite extensive consultation on TOFA Stages 3 and 4 (see paragraphs 15.64 to 15.75), the principles underpinning the Ralph recommendations have been largely unchallenged. The particular point of discussion during the consultation process has been the best way to articulate the policy objectives of TOFA Stages 3 and 4.

Implementation options

15.8 Three options are considered in this regulation impact statement for meeting the policy objectives of TOFA:

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Option 1: Financial accounting concepts. Under this option, the measure will have a common theme of incorporating relevant financial accounting concepts where possible into the relevant income tax law principles relating to financial arrangements and applying economic gain and loss concepts otherwise.

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Option 2: Direct link. This option allows taxpayers to determine their income tax liability in relation to financial assets and liabilities as determined by their financial accounting treatment, subject to specified income tax law adjustments.

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Option 3: Maintain current arrangements.

Option 1: Financial accounting concepts

15.9 Option 1 has a number of elements. Under this option the key concept is the calculation of gains and losses. The default position is that all gains and losses are treated on revenue account, meaning that there is (with some exceptions) no longer a revenue/capital distinction in Division 230. In addition, gains and losses are assessed in terms of all the cash flows associated with one financial arrangement, rather than focussing on each individual cash flow. The identification of a financial arrangement takes account of normal commercial understandings.

15.10 Once gains or losses have been identified, the default methodology is to apply an accruals regime to economic gains and losses. The accruals regime (Subdivision 230-B) will ensure that any gain or loss that is sufficiently certain to occur is allocated on a time value of money basis. This will reduce tax-induced distortions by reducing the ability of taxpayers to gain tax advantage through income deferral. Where sufficiently certain gains and losses vary from previous estimates, a balancing adjustment may be applied to over- or under-taxation of the actual gain or loss (Subdivision 230-G).

15.11 Where the amount of a gain or loss on a financial arrangement is considered to lack sufficient certainty, the gain or loss will be taxed on a realisation basis (Subdivision 230-B) as long as no elective regime applies. The realisation regime will bring a gain or loss to account in the income year in which it occurs. This approach reduces the compliance costs that might occur if the accruals regime were more extensive and there were consequent frequent re-estimation of gains and losses with resulting balancing adjustments.

15.12 In addition to the default arrangements, the new regime allows a number of options. The options fall into two different groups, one that has the effect of expanding accruals treatment, and one that further enhances risk management by better dealing with volatility. The fair value, financial reports and foreign exchange retranslation elections allow taxpayers to adopt a closer link to financial accounting. These options result in non-realisations tax treatment for an even broader class of transactions than would be the case under the core rules of Division 230. The hedging election allows taxpayers to reduce their post-tax volatility. All four elections are on a voluntary basis due to the potentially adverse consequences that may arise for taxpayers with particular affairs.

15.13 The elective fair value regime (Subdivision 230-C) will permit the taxpayers, who make the election to be taxed on the basis of the gains and losses arising from changes in the fair value of financial arrangements. The fair value regime provides improved price neutrality for financial arrangements and compliance cost savings to taxpayers who make the election. The compliance cost savings are due to the fact that some taxpayers already fair value financial transactions for accounting purposes, reducing the necessity of making separate tax calculations. The fair value election is likely to only appeal to taxpayers which are able to avoid liquidity problems associated with taxing unrealised gains under the fair value taxation.

15.14 Subdivision 230-F allows taxpayers to elect to rely on their financial reports for the purposes of calculating their tax liability with respect to financial arrangements. This option will reduce compliance costs for taxpayers, particularly those with complex financial arrangements that already must be recorded and audited for accounting purposes.

15.15 Taxpayers which elect to apply the foreign exchange retranslation regime (Subdivision 230-D) to their financial arrangements may bring to account changes in value attributable to foreign currency movements. The retranslation election will provide compliance cost savings to taxpayers who are not concerned with dealing with potential tax payment volatility associated with foreign exchange movements and who make the election.

15.16 Finally, taxpayers may also elect to make use of the tax-timing hedging regime (Subdivision 230-E). The new rules will allow after-tax-timing matching to occur, removing the tax distortions caused by tax-timing mismatches under the current tax law. Taxpayers who make the hedging election will also be permitted to match the character of their hedges with the revenue/capital designation of the hedged item, removing distortions arising from character mismatches.

Option 2: Direct link

15.17 A significant element of the discussions during the consultation process is the debate regarding the appropriateness of accounting standards as a basis for tax law.

15.18 Option 2 (referred to as the direct link or formal link approach) involves relying comprehensively on Australian accounting standards to determine the scope and benchmark for taxation of financial arrangements. For example, Australian Accounting Standard AASB 132 Financial Instruments: Disclosure and Presentation (AASB 132) and Australian Accounting Standard AASB 139 Financial Instruments: Recognition and Measurement (AASB 139) describe 'financial instruments' which are similar in nature to the arrangements intended to be covered by TOFA Stages 3 and 4. Under option 2, Division 230 would refer to the relevant sections of AASB 132 and AASB 139 in order to define the arrangements to which the TOFA Stages 3 and 4 rules will apply (with additions and subtractions as necessary). This regulation impact statement analyses a mandatory direct link.

Option 3: Maintain current arrangements

15.19 Option 3 is the current tax law with respect to financial arrangements. With a few exceptions this relies on the normal rules of the income tax system, in particular the distinction (under income tax law) between revenue and capital and income and deductions. In general, tax is paid on a realisation rather than an accruals basis and the timing of tax can differ substantially from the timing of commercial gain, resulting in tax planning and arbitrage opportunities and potentially biasing the allocation of resources to financial instruments that are relatively tax-favoured. In other circumstances, the tax disadvantaged treatment may either inhibit the use of a particular financial arrangement or interfere, in a non-neutral way, with its pre-tax pricing.

15.20 As noted above, the current tax law may also inhibit efficient risk management practices in the financial sector and the corporate sector more broadly. For example, a fund manager may invest in an offshore investment and hedge the foreign currency exposure to reduce earnings volatility. Under the current law the earnings of the investment may be exempt from income tax, but the gains or losses of the hedge may be subject to tax. Accordingly, even though the hedge may be effective in pre-tax terms, it may not be effective in post-tax terms.

Assessment of impacts

Impact group identification

Taxpayers

15.21 TOFA Stages 3 and 4 is intended to apply to financial arrangements held by sophisticated taxpayers with systems in place to meet tax and accounting requirements. Unsophisticated taxpayers will not generally be expected to apply the TOFA Stages 3 and 4 rules.

15.22 With this taxpayer coverage in mind, Division 230 will apply to the financial arrangements of all entities with aggregated turnover of $100 million or more, and to the financial arrangements of all authorised deposit-taking institutions (ADIs), securitisation vehicles or entities which are required (or would be required if the entity were a corporation) to register under the Financial Sector (Collection of Data) Act 2001 with aggregated turnover of $20 million or more:

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The Australian Taxation Office (ATO) estimates that there are approximately 1,800 businesses with aggregated turnover of $100 million or more.

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The ATO estimates that there are a further 6,200 businesses with aggregated turnover between $20 million and $100 million, although not all of these businesses will meet the registration requirement.

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Although no estimates are available, it is possible that other taxpayers may opt into the regime to benefit from the compliance cost savings and utilise some of the elective regimes for other reasons (eg, by using the hedging regime to preserve true economic hedges).

15.23 The Division will not apply to the financial arrangements of individuals or to entities which fall below the turnover thresholds unless those taxpayers hold financial arrangements which allow significant deferral of income.

15.24 Public consultation in October 2008 identified some anomalous and unintended outcomes of the aggregated turnover tests described above. The tests look to a taxpayer's ordinary income derived in the ordinary course of business, but some taxpayers do not account for ordinary income separately from statutory income (notably superannuation funds and investment vehicles) and some do not 'carry on a business' for tax purposes. To ensure the TOFA Stages 3 and 4 rules apply to the taxpayers intended, the following additional threshold tests will apply:

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Division 230 will apply to superannuation funds and investment vehicles with assets valued at $100 million or more.

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Division 230 will apply to taxpayers applying the $100 million turnover test with assets valued at $300 million or more, or financial assets of $100 million or more.

Tax advisors

15.25 The tax advisors employed by entities which hold financial arrangements have been heavily involved in the design of the TOFA Stages 3 and 4 rules and will be similarly involved in the implementation and application of the TOFA Stages 3 and 4 rules. As the TOFA Stages 3 and 4 rules affect sophisticated taxpayers, it is expected that larger tax advice and accounting firms will mainly be affected.

15.26 It is also anticipated that tax advisors will initially bear much of the transitional costs associated with the introduction of Division 230. Whether they ultimately bear these costs will depend on their capacity to charge their clients fully for the time and effort associated with learning the new regime. The Division contains a number of irrevocable elections which taxpayers are expected to seek advice on:

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The ATO anticipates that first and second tier advisory firms will be affected by TOFA Stages 3 and 4. There are approximately 400 such firms.

Systems developers

15.27 The TOFA Stages 3 and 4 rules will necessitate some changes to the accounting and taxation reporting systems used by taxpayers which hold financial arrangements. Systems developers employed by these taxpayers will be involved in developing new systems and refining the interactions between existing accounting and tax reporting systems, and operating and maintaining these reporting systems from year to year. It is anticipated that systems developers will also be heavily involved during the transitional phase associated with the introduction of Division 230:

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The ATO estimate that up to 150 commercial software developers may be involved with TOFA Stages 3 and 4.

Australian Taxation Office

15.28 The ATO will be responsible for the administration of the TOFA Stages 3 and 4 rules. Collection of tax revenue under Division 230 will occur through the pay as you go (PAYG) system. As well as revenue collection under Division 230, the ATO may also be required to provide tax rulings, practice statements and interpretive decisions to interested taxpayers.

Analysis of costs/benefits

15.29 This section outlines the costs and benefits of the three options. The analysis indicates that option 1 is the superior option. To ensure that the discussion is as succinct as possible the regulation impact statement compares all three options at the same time. As a guide to the reader it should be noted that the analysis indicates that option 1 is superior to option 2. The relative merits of option 2 compared to option 3 are less clear as the impact on different groups of taxpayers is quite different. For some taxpayers it is anticipated that option 1 and option 2 will lead to very similar practical outcomes. For these parties, the major differences between the two options are largely confined to the impact on compliance costs. Consequently, particular attention is paid to the compliance savings and costs, both transitional and ongoing, of the two options. However, for some taxpayers, option 1 will have quite different effects, mainly due to the treatment of unrealised gains and losses.

15.30 The revenue impact of the TOFA Stages 3 and 4 rules is unquantifiable.

Benefits

General

15.31 The core rules of option 1 are based on accruals where possible, and realisation otherwise. Unless taxpayers opt for one of the relevant elections they will not be exposed to taxation of uncertain unrealised gains.

15.32 This contrasts with option 2 which would have this outcome due to the construction of financial accounting. The reason for this divergence is that tax and accounting rules are designed for different purposes. Financial accounting is designed to provide relevant stakeholders information about the performance of the entity. Whilst this is relevant for tax, it is not the only consideration. For example, the ability to pay concept underlying the equity principle of tax policy has been interpreted in practice to have regard to liquidity considerations.

15.33 In addition, option 1 is designed to incorporate relevant financial accounting concepts into tax law principles while retaining taxation terminology and phraseology. In essence, this option is a translation of appropriate accounting principles into tax principles. Option 1 offers greater tax revenue integrity compared to option 2:

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Tax terminology: importing, defining and comprehension of accounting terminology and phraseology will not be necessary under this option.

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Principle based outcomes: option 1 will be based on a principled tax framework and may also permit single outcomes, rather than multiple outcomes which may be possible under accounting standards.

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Objective: the accounting standards are designed to provide a particular quality of financial reporting, an objective which does not always align with the goals of the tax law. Option 1 can avoid any conflict arising from this difference.

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Control: the international accounting standards are sometimes amended to achieve superior accounting outcomes. The interpretations and applications of these standards may be different to that of a separate tax law. Option 1 may reduce or remove the impact of these decisions on tax revenue.

15.34 A substantial benefit of options 1 and 2 is that they align more closely the tax-timing of transactions with their underlying commercial substance compared to option 3. This has benefits for resource allocation in the economy. First, it improves the likelihood that the appropriate level of resources are allocated to the financial sector (and financial activities within the non-financial sector) than under the current rules compared to the non-financial sector. Second, it improves the likelihood that resources within the financial sector are allocated to the highest value uses.

15.35 Whether option 1 or option 2 improves resource allocation more than the other depends on the particular treatment of individual transactions under the two options. Where a taxpayer elects to use financial reports under option 1, then there would be little difference between the two options. Similarly, the differences under fair value are likely to be small.

15.36 Where the core rules are in operation, option 1 may result in poorer resource allocation than under option 2. For example, transactions treated on a realisation basis may have a tax treatment that diverges from underlying commercial values further than would be the case under the accounting treatment (which is often fair valued or at least accrued).

15.37 The capacity to hedge for tax purposes under option 1 is a significant economic benefit. Hedging allows economic agents to reduce volatility with associated benefits. Under current law (option 3) an economically effective pre-tax hedge may not be an effective post-tax hedge where the tax-timing or tax character of the hedged item and the hedging instrument differ. In addition, option 1 is superior to option 3 for two reasons. First, option 1 allows all hedges for accounting purposes to be hedges for tax purposes. It also allows some other hedges to be recognised. The broader scope of hedges covered increases the economic benefits from hedging. Second, option 1 allows character matching in addition to timing matching. Option 2 does not allow this as accounting does not deal with tax character. Without tax character matching post-tax hedges are not effective.

15.38 A substantial benefit for taxpayers under option 1 is that a number of the elections which have the potential to tax uncertain unrealised gains are optional. This recognises that tax policy has always been mindful of liquidity constraints and has been reluctant to require involuntary disposals of assets.

15.39 Another consideration between option 1 and 2 is the issue of 'reverse pollution'. Accounting bodies have expressed concern that a direct link between financial reports and tax would result in pressure to amend the accounting standards to ensure more favourable tax outcomes. This may reduce the quality of information available to investors which may in turn result in capital not being directed to the most productive sectors of the economy. Adoption of option 1 limits the extent of reverse pollution. Option 3 would not involve any reverse pollution.

Taxpayers

15.40 In terms of transitional compliance benefits, there are not expected to be any specific benefits for taxpayers under option 1. This would also be true of the direct link approach (option 2). While there are no compliance benefits from option 3, the cost would be zero.

15.41 In terms of ongoing compliance benefits, there is not expected to be any noticeable difference between option 1 and option 2. If anything, there may be a marginal compliance cost benefit in favour of option 2 as option 1 contains elections that will require taxpayers to consider whether one approach is better than the other for their particular circumstances (noting of course that the lack of choice under the direct link may have non-compliance costs for taxpayers). The extent of these additional compliance costs is limited by the fact that most elections in option 1 are irrevocable.

15.42 However, the TOFA Stages 3 and 4 rules themselves should allow significant compliance cost savings for taxpayers in terms of policy coherency, legislative complexity, record-keeping, and enquiries and rulings compared with the current rules (option 3). Division 230 will effectively replace Division 16E of the Income Tax Assessment Act 1936 (ITAA 1936) and require accruals taxation on a less frequent basis, and will partially replace the tax treatment under Division 775 of the ITAA 1997. Tax compliance costs should be reduced through the relatively close alignment with accounting for the fair value, retranslation and hedging regimes:

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The ATO estimate that taxpayers affected by TOFA Stages 3 and 4 will experience a medium decrease in compliance costs during the ongoing stage.

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The reduction in compliance costs is expected to be particularly important for large financial institutions which, if they elect to, will be able to rely on their financial accounting systems without the need to build and maintain duplicate tax systems.

Tax advisors

15.43 In terms of transitional compliance benefits, there are not expected to be any specific benefits for tax advisors under option 1.

15.44 In terms of ongoing compliance benefits for tax advisors, there is not expected to be any noticeable difference between option 1 and option 2. As for taxpayers, there may be a marginal compliance cost benefit in favour of option 2 as option 1 contains elections that will require taxpayers to consider whether one approach is better than the other for their particular circumstances (noting of course that the lack of choice under the direct link may have non-compliance costs for taxpayers).

15.45 However, as for taxpayers, the TOFA Stages 3 and 4 rules may provide some compliance cost relief for tax advisors relative to option 3 on an ongoing basis through the effective replacement of Division 16E of the ITAA 1936 and partial replacement of Division 775 of the ITAA 1997:

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The ATO estimate that tax advisors affected by TOFA Stages 3 and 4 will have nil or minimal change in compliance costs during the ongoing stage compared with option 2.

Systems developers

15.46 In terms of transitional compliance benefits, there are not expected to be any specific benefits for systems developers under option 1.

15.47 In terms of ongoing compliance benefits for systems developers, there is not expected to be any noticeable difference between option 1 and option 2. There is expected to be a significant compliance cost benefit compared with option 3 as the need to build and maintain tax specific systems will be reduced for those taxpayers who make the fair value or financial reports election:

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The ATO estimate that systems developers affected by TOFA Stages 3 and 4 will have nil or minimal compliance costs during the ongoing stage.

Australian Taxation Office

15.48 In terms of transitional administrative benefits, there are not expected to be any specific benefits for the ATO under option 1.

15.49 In terms of ongoing administrative benefits for the ATO, there is not expected to be any noticeable difference between option 1 and option 2. There will be ongoing compliance benefits for the ATO compared with option 3 due to the fact that the ATO may in part be able to rely on taxpayers' financial accounting systems and controls.

Costs

General

15.50 Option 1 is expected to be more difficult, initially, to relate to accounting outcomes, and higher compliance costs compared to option 2 are expected for stakeholders for the transitional period. Both options 1 and 2 will provide greater ongoing certainty than option 3.

Taxpayers

15.51 The TOFA Stages 3 and 4 rules will create significant transitional compliance costs for sophisticated taxpayers subject to the rules. The new rules will expand accruals taxation and introduce sophisticated taxation treatments to many financial arrangements which were previously taxed simplistically. Particular areas where transitional compliance costs are expected to be realised are formal training of staff, comprehension of new obligations, enquiries and rulings, and review of tax planning strategies. It should be noted that the compliance impact will differ for specialists involved in the process. Tax specialists will face costs in understanding the new concepts. This will be less of an issue for finance and accounting specialists as the new approach uses concepts familiar to them:

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The ATO estimate that taxpayers affected by TOFA Stages 3 and 4 will incur a medium increase in compliance costs during the transitional stage.

15.52 The transitional costs for taxpayers are expected to be relatively higher under option 1 compared to option 2. The concepts and principles articulated under option 1 are expected to take more time for taxpayers to unravel compared to the direct reference to accounting under option 2:

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The ATO anticipates that option 1 will result in more rulings and disputes than option 2, and consequentially has a higher transitional compliance cost for taxpayers.

15.53 Although the TOFA Stages 3 and 4 rules are expected to provide overall ongoing compliance cost savings for taxpayers, some taxpayers are likely to bear increased ongoing compliance costs. Under the current tax law, a limited number of taxpayers may be required to tax financial arrangements on an accruals basis under Division 16E. The introduction of Division 230 is expected to significantly expand the number of taxpayers who are required to apply accruals taxation. While taxpayers who were previously subject to accruals taxation under Division 16E will enjoy compliance cost savings due to the simplification of the accruals calculations under TOFA Stages 3 and 4, taxpayers forced to shift from realisation to accruals taxation can expect increased compliance costs, due to the relative complexity of accruals tax calculations.

15.54 In terms of ongoing compliance costs for taxpayers, there is not expected to be any noticeable difference between option 1 and option 2.

15.55 Option 2 would have significantly higher costs in terms of potential tax liabilities and tax volatility than either option 1 or option 2 due to the mandatory use of financial accounts. Some taxpayers would be required to bring to account unrealised gains under the direct link approach. Option 2 also provides less flexibility than option 1, reducing the capacity of taxpayers to match their tax and accounting needs.

Tax advisors

15.56 The TOFA Stages 3 and 4 rules will create significant transitional compliance costs for tax advisors. As with taxpayers, the general areas where transitional compliance costs are expected to be realised for tax advisors are formal training of staff and comprehension of new obligations. A particular cost on tax advisors will be to advise individual clients on the various elections available under Division 230:

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The ATO estimate that tax advisors affected by TOFA Stages 3 and 4 will incur a medium increase in compliance costs during the transitional stage.

15.57 The transitional costs for tax advisors are expected to be higher under option 1 compared to option 2. Transitional costs are higher under both option 1 and option 2 than option 3. While the concepts and principles articulated under option 1 are expected to provide similar outcomes, tax advisors may have greater difficulty in confirming this compared to option 2:

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The ATO anticipates that option 1 will result in more rulings and disputes than option 2, and consequentially has a higher transitional compliance cost for tax advisors.

15.58 In terms of ongoing compliance costs for tax advisors, there is not expected to be any noticeable difference between option 1 and option 2.

Systems developers

15.59 Systems developers employed by taxpayers affected by TOFA Stages 3 and 4 are expected to bear the costs of reviewing tax reporting systems and processes during the transitional period. However, these transitional costs are expected to be lower than those associated with the design/implementation of brand new reporting systems as the process should require refinement and alignment between existing accounting and tax reporting systems:

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The ATO estimate that systems developers affected by TOFA Stages 3 and 4 will incur a medium increase in compliance costs during the transitional stage.

15.60 The transitional costs for systems developers are expected to be higher under option 1 compared to option 2. The principled and conceptual nature of the TOFA Stages 3 and 4 rules when articulated under option 1 may not, initially, be easily translated into linkages between accounting and tax reporting systems:

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The ATO anticipates that option 1 will result in more rulings and disputes than option 2, but has not suggested that this will necessarily result in higher transitional compliance costs for systems developers.

15.61 In terms of ongoing compliance costs for systems developers, there is not expected to be any noticeable difference between option 1 and option 2.

Australian Taxation Office

15.62 The transitional administrative costs for the ATO are expected to be relatively higher under option 1 compared to option 2. These higher costs are expected to be in the form of increased rulings, disputes and litigation between the tax office and taxpayers.

15.63 In terms of ongoing administrative costs for the ATO, there is not expected to be any noticeable difference between option 1 and option 2. The ongoing administrative costs of option 1 are expected to be higher as there is a greater degree of uncertainty regarding the treatment of financial arrangements due to the mismatch between underlying commercial concepts and tax concepts.

Consultation

15.64 The Ralph Review, comprising Mr John Ralph AO, Mr Bob Joss and Mr Rick Allert AM who were assisted by a secretariat consisting of officers from the Treasury, the ATO and the then Department of Industry, Science and Resources, and external advisers, was undertaken between August 1998 and September 1999. Chapter 9 of the Ralph Report, released on 21 September 1999, recommended new rules and regimes for the taxation of financial arrangements. These recommendations included the introduction of an accruals and realisation regime, elective regimes for fair value and retranslation taxation, and recognition of hedging arrangements for tax purposes:

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The then Treasurer announced the then Government's broad support for the recommendations in the Ralph Report in Press Release No. 074 of 11 November 1999.

15.65 Following requests by interested taxpayers for a formal update on progress in TOFA Stages 3 and 4, Treasury released the TOFA Stages 3 and 4 Information Paper on a confidential basis in December 2004. The information paper detailed the broad policy proposals for TOFA Stages 3 and 4. In response to the information paper, 13 submissions were received from industry, taxpayers, peak bodies and tax advisors.

15.66 On 16 December 2005, the then Minister for Revenue and Assistant Treasurer announced the public release of exposure draft legislation for TOFA Stages 3 and 4 (Press Release No. 107 of 2005). In response to the exposure draft, a total of 32 submissions were received, including public submissions from the following industry, taxpayers, peak bodies and tax advisors:

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Association of Superannuation Funds of Australia;

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Australian Bankers' Association;

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Australian Equipment Lessors Association;

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Australian Financial Markets Association;

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Australian Petroleum Production and Exploration Association;

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Australian Securitisation Forum;

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Blake Dawson Waldron;

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Corporate Tax Association and Certified Practicing Accountants Australia (joint submission);

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Ernst & Young;

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Fini Villages;

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Insurance Council of Australia;

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Institute of Chartered Accountants in Australia;

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Investment and Financial Services Association;

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Law Council of Australia;

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Minerals Council of Australia;

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Minter Ellison;

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Namoi Cotton;

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OneSteel;

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PEET & Co;

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Pitcher Partners;

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Property Council of Australia;

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Pricewaterhouse Coopers;

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Retirement Village Association;

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Sydney Futures Exchange;

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Shaddick & Spence;

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Tax Institute of Australia; and

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Walker Group Holding.

15.67 The main issues raised in submissions were:

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The scope of arrangement: Submissions considered that the scope of the TOFA Stages 3 and 4 rules in the 2005 exposure draft was too wide. This judgment was accepted and the scope was narrowed by removing the main contentious element; namely, rights to receive non-monetary assets.

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The accruals/realisation borderline: Submissions argued that the test for distinguishing accruals/realisation treatments set the borderline too low. A different test was incorporated in the 2007 public exposure draft to achieve the appropriate and intended threshold.

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A direct link election: Some submissions continued to call for a 'direct link' with relevant accounting standards. One suggestion was that the proposed discretion in the 2005 exposure draft (to accept the accounting treatment in particular circumstances) could be replaced with an election. This option was considered in the 2007 public exposure draft.

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Hedging rules: While welcoming the 'tax-timing' hedging rules, submissions requested an extension to allow for 'character' matching. A character matching regime was included in the 2007 public exposure draft.

15.68 Following the consideration of responses to the December 2005 exposure draft, Treasury released policy papers covering seven areas of concern raised by the respondents. These papers were released on a confidential basis in May and June 2006. In response to the policy papers, a total of 19 submissions were received from industry, taxpayers, peak bodies and tax advisors.

15.69 On 3 January 2007, the then Minister for Revenue and Assistant Treasurer announced the public release of a second exposure draft in Press Release No. 001 of 2007. In response to the exposure draft, a total of 22 submissions were received, including public submissions from the following industry, taxpayers, peak bodies and tax advisors:

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Australian Bankers' Association;

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Australian Chamber of Commerce and Industry;

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Australian Financial Markets Association;

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Blake Dawson Waldron;

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Certified Practicing Accountants Australia;

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Corporate Tax Association;

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Deloitte Touche Tohmatsu;

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Ernst & Young;

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General Electric;

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Insurance Council of Australia;

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Institute of Chartered Accountants in Australia;

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Investment and Financial Services Association;

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Minerals Council of Australia;

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Pitcher Partners;

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Property Council of Australia;

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Pricewaterhouse Coopers; and

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Tax Institute of Australia.

15.70 In general, submissions were positive about the 2007 public exposure draft, and much of the feedback was of a technical nature. The main policy issues raised in submissions were:

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The tax treatment of finance leases: A number of taxpayer expressed a preference that finance leases not be treated under the TOFA Stages 3 and 4 rules. The Government has since determined that the tax treatment of finance leases will remain unchanged.

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The threshold for mandatory application of the TOFA Stages 3 and 4 rules to businesses: A number of tax advisory firms which service medium sized enterprises have contended that the taxpayer thresholds should be raised as smaller taxpayers subject to the TOFA Stages 3 and 4 rules will be the least well equipped to adapt to the new rules, and would be particularly burdened by the application of accruals taxation. This proposition has been accepted in part, with the aggregated turnover test being raised to $100 million from $20 million for general taxpayers, but the $20 million threshold has been retained for financial entities.

15.71 On 6 August 2007, an exposure draft was released on a confidential basis to parties involved in previous consultation process. In response to the confidential exposure draft, a total of 19 submissions were received from industry, taxpayers, peak bodies and tax advisors.

15.72 In general, submissions were positive about the 2007 confidential exposure draft, and much of the feedback was of a technical nature. The main policy issues raised in submissions were:

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The application date of the legislation: A number of submissions requested that the start date be delayed until 1 July 2008 (optional) and 1 July 2009 (compulsory). This proposition was accepted for the 2007 TOFA Bill.

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The inclusion of TOFA-specific integrity measures: A number of submissions felt that these integrity rules created unnecessary compliance costs. This proposition was accepted for the 2007 TOFA Bill.

15.73 Following the calling of the 2007 Federal election, Parliament was prorogued and the 2007 TOFA Bill consequently lapsed. As part of the 2008 Budget, the Treasurer announced on 13 May 2008 that the TOFA Stages 3 and 4 measures would be re-introduced into Parliament with a start date of 1 July 2009 and that consultation would occur on the technical aspects of the measures (Media Release No. 054 of 2008). Subsequently, the Assistant Treasurer and Minister for Competition Policy and Consumer Affairs announced a 1 July 2009 optional start date and 1 July 2010 compulsory start date.

15.74 On 1 October 2008, the Assistant Treasurer and Minister for Competition Policy and Consumer Affairs announced the release of exposure draft material for TOFA Stages 3 and 4 (Media Release No. 082 of 1 October 2008). In response to the public exposure draft, a total of 10 submissions were received from the following industry, taxpayers, peak bodies and tax advisors:

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Australian Accounting Standards Board;

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Australian Bankers' Association;

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Blake Dawson;

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Institute of Chartered Accountants Australia;

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Investment and Financial Services Association;

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Namoi Cotton;

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Property Council of Australia;

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Pitcher Partners;

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Pricewaterhouse Coopers; and

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Tax Institute of Australia.

15.75 Submissions were generally positive about the 2008 public exposure draft, and much of the feedback was of a technical nature, relating in particular to consolidations interactions. The main policy issues raised in submissions were:

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A limit in the scope of the aggregated turnover test. This may have prevented application of the TOFA rules to superannuation funds and entities which do not 'carry on a business'. This was corrected in the 2008 TOFA Bill.

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The level of the general aggregated turnover test: it was proposed that the turnover test for general taxpayers be raised to $250 million. This proposal was not accepted in the 2008 TOFA Bill because of the potential for increased tax arbitrage between taxpayers subject to the TOFA rules and those outside the TOFA rules.

•

Making the TOFA rules elective: it was proposed that the TOFA rules only be applied by taxpayers who elect for the rules to apply to them. This proposal was not accepted in the 2008 TOFA Bill because the potential for tax arbitrage is even greater than for the $250 million aggregated turnover proposal.

Conclusion and recommended option

15.76 The Government has decided to implement option 1 in order to achieve the TOFA Stages 3 and 4 objectives. Option 1 was preferred over option 2 and the current tax law (option 3) because:

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the current law includes a mismatch between the underlying commercial substance of transactions and the tax treatment which leads to the misallocation of resources;

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the current law inhibits the efficient management of risk by limiting the capacity to achieve post-tax effective hedging;

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the direct link approach achieves some of these objectives (although not all due to the lack of tax-character hedging), but would impose costs and raise liquidity issues for taxpayers due to the taxation of unrealised gains and losses;

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compliance costs for taxpayers will be reduced under option 1 compared to the current law due to the greater certainty and the capacity for some taxpayers to rely on their financial reports;

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under option 1, the tax treatment of financial arrangements will not automatically change without Government consideration as it would under the direct link approach;

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the legislation could apply to a broad range of taxpayers, not just the relative few (but large taxpayers) who apply all the relevant accounting standards; and

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option 1 reduces the potential for financial accounting principles to be influenced by tax considerations (so called 'reverse pollution').

15.77 The Government has also decided to provide an election (the financial accounts election (Subdivision 230-F)) to allow certain taxpayers to rely on the outcomes of their financial reports. This effectively permits some elements of an elective direct link for taxpayers who make the election. The financial accounts election was included in Division 230 because:

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the election will provide transitional compliance cost savings for the taxpayers who make the election;

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eligible taxpayers will be free to weigh the costs and benefits of the financial accounts election and determine whether making the election is in their interests, rather than having the option imposed on certain taxpayers or taxpayer groups; and

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the application of a direct link to accounting via an election will not force smaller taxpayers to apply accounting standards that they have not previously been required to apply.

15.78 The Treasury and the ATO will monitor these taxation measures, as part of the whole system, on an ongoing basis.