House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP)

Chapter 4 - Amendments to foreign currency gains and losses provisions

Outline of chapter

4.1 Part 3 of Schedule 3 to this Bill amends Division 775 (foreign currency gains and losses provisions) of the Income Tax Assessment Act 1997 (ITAA 1997) to extend the scope of a number of compliance cost saving measures in the law, and to make technical amendments to ensure that the provisions operate as intended.

4.2 All references to legislative provisions in this chapter are references to the ITAA 1997 unless otherwise stated.

Context of amendments

4.3 The foreign currency gains and losses provisions contained in Division 775, Subdivision 960-C and Subdivision 960-D of the ITAA 1997 bring to account, for income tax purposes, gains and losses made by taxpayers due to exchange rate movements. They also provide for the translation of amounts of foreign currency into Australian currency or into the taxpayer's applicable functional currency.

Summary of new law

4.4 This Schedule amends Division 775 to ensure that:

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'forex realisation gains' (of a private or domestic nature) from ceasing to have a right to receive foreign currency are assessable where, apart from Division 775, the gain would be taken into account under Part 3-1 or 3-3 of the ITAA 1997;

•

forex realisation gains are exempt income or non-assessable non-exempt income to the extent that, if the gain had been a loss, the loss would have been made in gaining or producing exempt income or non-assessable non-exempt income and would have been disregarded under the loss provisions in Division 775;

•

there is consistent treatment of 'forex realisation losses' made in the course of producing exempt income and non-assessable non-exempt income;

•

forex realisation event 3 occurs when an obligation to receive foreign currency ceases if the obligation is under an option to sell foreign currency;

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forex realisation event 4 occurs when an obligation to pay foreign currency ceases if the obligation is under an option to buy foreign currency;

•

forex realisation event 5 occurs when a right to pay foreign currency ceases if the right is under an option to sell foreign currency; and

•

forex realisation gains or losses from forex realisation event 2 are disregarded on the conversion or exchange of a 'traditional security' into ordinary shares.

Detailed explanation of new law

Certain foreign exchange gains from forex realisation event 2 should not be excluded from assessable income

4.5 Part 3 of Schedule 3 amends the table under paragraph 775-15(2)(b), to ensure that forex realisation gains (of a private or domestic nature) arising from ceasing to have a right to receive foreign currency are assessable where, apart from Division 775, the gain would be taken into account under Part 3-1 or 3-3 of the ITAA 1997. [Schedule 3, item 138, paragraph 775-15(2)(b) (item 1 in the table, column 2)]

4.6 The basic rule in Division 775 is that a forex realisation gain that is of a private or domestic nature is not included in an entity's assessable income.

4.7 However, if the forex realisation gain would have been taken into account under the capital gains tax (CGT) provisions (disregarding Division 775), then, generally speaking, the forex realisation gain should be included in the entity's assessable income, regardless of whether the gain is of a private or domestic nature.

4.8 Note, in this regard, that private gains that do not qualify for the personal use asset exclusions in the CGT provisions are taxable. Examples include collectables that are artwork, jewellery, rare folios and postage stamps, if the asset's acquisition value is more than $500. ^[1]

4.9 The amendments are intended to ensure that certain forex realisation gains of a private or domestic nature that would have been taken into account under the CGT provisions (disregarding Division 775), are included in an entity's assessable income under Division 775. These gains are those in respect of:

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an entity ceasing to have a right to receive foreign currency (but not disposing of that right); and

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the right having been created or acquired in return for the entity paying, or agreeing to pay, an amount of Australian currency or foreign currency (forex realisation event 2).

An example of this scenario would be the withdrawal of an amount from a foreign currency denominated bank account.

Ensuring forex realisation gains are assessable where they are made in relation to deductible obligations that were incurred in gaining or producing exempt income or non-assessable non-exempt income

4.10 Part 3 of Schedule 3 inserts a new section 775-27 to ensure that forex realisation gains are only exempt income or non-assessable non-exempt income, if the gain had been a forex realisation loss, the loss would have been disregarded under section 775-35. [Schedule 3, item 141, section 775-27]

4.11 Forex realisation gains and losses can be made in gaining or producing exempt income or non-assessable non-exempt income. Usually, losses made in gaining or producing exempt income or non-assessable non-exempt income are not deductible. As such, any forex realisation gain or loss in respect of those losses should not be included in assessable income, or allowable as a deduction.

4.12 In this regard, a forex realisation gain made by an entity is exempt income where, if the gain had been a loss, the loss would have been made in gaining or producing exempt income (see section 775-20).

4.13 Similarly, under section 775-25 a forex realisation gain an entity makes is non-assessable non-exempt income where, if the gain had been a loss, the loss would have been made in gaining or producing non-assessable non-exempt income.

4.14 However, some losses that are made in gaining or producing exempt income or non-assessable non-exempt income are deductible (under, for example, section 25-90). Reflecting this, forex realisation losses in respect of losses made in gaining or producing exempt income or non-assessable non-exempt income that are nonetheless deductible, are deductible under Division 775. In this situation, forex realisation gains made in respect of those losses should be included in assessable income.

4.15 Under subsection 775-35(2), a forex realisation loss an entity makes from forex realisation event 3, 4 or 6 is disregarded if it is made in gaining or producing exempt income or non-assessable non-exempt income, unless the obligation that ceases or is discharged gives rise to a deduction.

4.16 The amendments ensure that a forex realisation gain made in this situation is included in assessable income so that such forex realisation gains and losses receive consistent treatment.

Example 4.1 (a)

An entity borrows US$1,000,000 for 20 years. The borrowing requires the entity to make interest payments of 10 per cent per annum, with complete repayment of the principal due in 20 years.

The entity uses the US$1,000,000 to finance the purchase of shares. That investment produces dividends which are non-assessable non-exempt income by virtue of section 23AJ of the Income Tax Assessment Act 1936 (ITAA 1936).

Assume that the interest payments of 10 per cent are deductible by virtue of section 25-90.

When the entity borrows the US$1,000,000, it incurs an obligation to pay foreign currency (being the US$100,000 interest payments). When the entity actually makes an interest payment, forex realisation event 4 occurs. If the amount the entity deducted under section 25-90 in relation to the interest payment is less than the amount the entity actually pays (say due to an increase in the value of the USD relative to the AUD), the entity will have made a forex realisation loss which it can then deduct. The amount of the deduction is equal to the extent that the difference between the amount initially deducted and the amount paid relates to a currency exchange rate effect (subsection 775-55(5)).

So, while the forex realisation loss is made in gaining or producing non-assessable non-exempt income, the loss is not prevented from being deductible because the obligation that gave rise to the loss (being the obligation to make interest payments) is deductible by virtue of section 25-90 (the loss is also not disregarded under paragraph 775-35(2)(b)).

Example 1.1(b)

Assume the same scenario as above except that the amount the entity deducted under section 25-90 is more than the amount it actually paid (say the value of the USD decreased). In this case, the entity will make a forex realisation gain to the extent that the difference between the amount initially deducted and the amount actually paid relates to a currency exchange rate effect (subsection 775-55(3)).

However, this is arguably a gain to which section 775-25 applies. This is because, if the forex realisation gain mentioned above had been a loss, the loss would have been made in gaining or producing non-assessable non-exempt income.

Therefore, without the amendment, the forex realisation gain is not included in the entity's assessable income by virtue of section 775-25. This is despite the fact that a forex realisation loss made in exactly the same situation is deductible by virtue of paragraph 775-35(2)(b).

Ensuring losses are disregarded where they are made from forex realisation event 1, 2 or 5 if the loss is made in gaining or producing non-assessable non-exempt income

4.17 Part 3 of this Schedule amends subsection 775-35(1) to ensure that a forex realisation loss is disregarded for the purposes of Division 775 if the loss is made:

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as a result of forex realisation event 1, 2 or 5 happening; and

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in gaining or producing non-assessable non-exempt income.

[Schedule 3, item 142, subsection 775-35(1)]

4.18 Subsection 775-35(1) disregards forex realisation losses where they are made:

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as a result of forex realisation event 1, 2 or 5 happening; and

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in gaining or producing exempt income.

4.19 Subsection 775-35(2) disregards forex realisation losses where they are made:

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as a result of forex realisation event 3, 4 or 6 happening;

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in gaining or producing exempt income or non-assessable non-exempt income; and

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in respect of an obligation that does not give rise to a deduction.

4.20 Without the amendment, there is no provision in Division 775 that has the effect of disregarding a forex realisation loss that is made:

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as a result of forex realisation event 1, 2 or 5 happening; and

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in gaining or producing non-assessable non-exempt income.

Recognising forex realisation gains on the expiration of foreign currency put options

4.21 Part 3 of this Schedule amends section 775-50 to ensure that forex realisation event 3 occurs when:

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an entity ceases to have an obligation to receive foreign currency; and

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the obligation is under an option to sell foreign currency.

[Schedule 3, item 144, subparagraph 775-50(1)(b)(iii)]

4.22 While Division 775 is primarily concerned with gains and losses that are attributable to currency exchange rate effects, the Division also brings to account gains and losses that are made when an option to buy or sell foreign currency expires without being exercised.

4.23 If:

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an entity ceases to have an obligation, or a part of an obligation, to receive foreign currency;

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the event happens because an option to sell foreign currency (a foreign currency put option) expires without having been exercised, or is cancelled, released or abandoned; and

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had the option been exercised immediately before the event, the entity would have been obliged to buy the foreign currency,

then the entity should have a forex realisation gain equal to the premium or amount received in return for granting the option.

Recognising forex realisation gains on the expiration of foreign currency call options

4.24 Part 3 of this Schedule amends section 775-55 to ensure that:

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forex realisation event 4 occurs when an entity ceases to have an obligation to pay foreign currency, and that obligation is under an option the entity issued to buy foreign currency [Schedule 3, item 145, subparagraph 775-55(1)(b)(xi)] ; and

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a forex realisation gain is made in respect of any premium received on such an option upon that option expiring without being exercised, or is cancelled, released or abandoned [Schedule 3, item 146, paragraph 775-55(4)(a)] .

4.25 A foreign currency call option gives the option holder the right but not the obligation to buy foreign currency.

4.26 From the issuer's perspective, the foreign currency call option gives it:

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a right to receive consideration for entering into the option;

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an obligation to pay the foreign currency to the holder of the foreign currency call option, which is contingent on the holder exercising its option; and

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in exchange for paying the foreign currency to the holder if the option is exercised, the receipt of either another foreign currency, or Australian currency.

4.27 Where an entity receives a premium to grant a foreign currency call option, and that option expires without being exercised, a forex realisation gain should happen to the entity. Section 775-55 is amended to ensure that this is the outcome. The amount of the gain should be the premium the entity received on the expired option.

Recognising forex realisation losses on the expiration of foreign currency put options

4.28 Part 3 of this Schedule amends section 755-60 to ensure that forex realisation event 5 happens when a put option expires, provided that the option was acquired in exchange for a right to receive foreign currency or Australian currency. [Schedule 3, item 147, subparagraph 775-60(1)(b)(iii)]

4.29 A foreign currency put option gives the option holder:

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an obligation to pay a premium to the issuer; and

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the right but not the obligation to sell foreign currency to the issuer, and receive either foreign currency or Australian currency in exchange.

4.30 Where an entity pays a premium in order to be granted a foreign currency put option, and that option expires without it being exercised (or is cancelled, released or abandoned), a forex realisation loss should happen to the entity. The amount of the loss should be the premium the entity paid in order to acquire the now expired option.

Disposal or redemption of traditional securities

4.31 Part 3 of this Schedule inserts a new section 775-168 to ensure that a forex realisation gain or loss an entity makes as a result of forex realisation event 2 occurring, is disregarded if the event happened because of a disposal or redemption that occurred under the circumstances described in subsections 26BB(4) and (5) and 70B(2B) and (2C) of the ITAA 1936. [Schedule 3, item 148, section 775-168]

4.32 Sections 26BB and 70B of the ITAA 1936 generally provide that certain gains or losses made upon the disposal or redemption of a 'traditional security' are included in an entity's assessable income.

4.33 Subsections 26BB(4) and (5) and 70B(2B) and (2C) of the ITAA 1936 provide that this rule does not apply under certain circumstances.

4.34 However, without the amendment, there is nothing in Division 775 that prevents a forex realisation gain or loss occurring in these circumstances from being brought to account in respect of a gain or loss made from the disposal or redemption of a traditional security.

4.35 This is inconsistent with the broad aim of subsections 26BB(4) and (5) and 70B(2B) and (2C), which is to ensure that subsections 26BB(2) and 70B(2) do not apply in respect of gains and losses made in the circumstances described in subsections 26BB(4) and (5) and 70B(2B) and (2C).

Typographical and miscellaneous amendments

4.36 A number of amendments to include the provisions in Division 775 that cause income to be exempt or non-assessable non-exempt income are made to the relevant provisions of the ITAA 1997 that list the provisions about these types of income. [Schedule 3, items 136 and 137, sections 11-10 and 11-55]

4.37 Another set of amendments add asterisks to defined terms. [Schedule 3, items 139, 140 and 143, sections 775-20, 775-25 and paragraph 775-35(2)(a)]

4.38 A further amendment has been included to ensure that the Commissioner of Taxation (Commissioner) is able to amend an assessment in relation to the foreign currency amendments contained in Part 3 of this Schedule. The amendment provides a period of four years from the date this Bill receives Royal Assent for the Commissioner to amend an assessment that is issued before the date of Royal Assent to give effect to the provisions contained in Part 3 of this Schedule. [Clause 4]

Date of application

4.39 These amendments (apart from clause 4) commence on Royal Assent and apply from 17 December 2003. [Clause 2, item 8 in the table ; Schedule 3, item 149]

4.40 Clause 4 commences on Royal Assent. [Clause 2, item 1 in the table]