Taxation of Financial Arrangement (stages 3 and 4)

The Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 implements stages 3 and 4 of the reforms to the taxation of ‘financial arrangements’. Division 230 of the Income Tax Assessment Act 1997 (TOFA Rules) reforms the method for calculating gains and losses on financial arrangements.

The TOFA Rules set out the tax-timing treatment of financial arrangements, including two default methods (accruals and realisation) and four elective methods (fair value, realisation, hedging and financial reports).  The elective methods require the taxpayer to have financial reports prepared and audited in accordance with relevant financial accounting and auditing standards. Most debt, hybrid, equity, derivative and foreign currency transactions will be within its scope.

In this way the accounting standards have been embedded in tax law and play a central role in determining tax-timing outcomes for financial arrangements.

Background

The objective of the TOFA Rules is to minimise the extent to which the tax treatment of financial arrangements impacts a taxpayer’s commercial decisions by:

  • aligning the tax outcome more closely with the commercial recognition of the gains and losses from financial arrangements;

  • allocating gains and losses over the term of the financial arrangement;

  • removing the distinction between capital and revenue.  That is, most gains and losses are treated as being on revenue account – gains are assessable and losses are deductible; and

  • reducing compliance costs.

Who does it apply to?

The reforms will have a major impact on financial institutions, given that the majority of assets, liabilities and business operations of those entities involve financial arrangements within the scope of Division 230.  However, the measures are not limited to financial institutions; they apply to all taxpayer classes subject to certain thresholds and exceptions in an income year commencing on or after 1 July 2010.  These include:

  • authorised deposit taking institutions, securitisation vehicles and financial sector entities with an aggregated annual turnover of at least $20 million;

  • superannuation entities, approved deposit funds, pooled superannuation funds, managed investment schemes if the value of their assets is at least $100 million; and

  • other entities with an aggregated annual turnover of at least $100 million, financial assets of at least $100 million, or assets of at least $300 million.

The rules also apply to ‘qualifying securities’ that a taxpayer holds that mature more than 12 months after a taxpayer starts to hold those securities.

In addition, any taxpayer can elect to have the rules apply to their financial arrangements for income years commencing on or after 1 July 2009. 

What is a financial arrangement?

A financial arrangement is an arrangement where there is a right(s) to receive, or an obligation(s) to provide a financial benefit(s) that is:

  • monetary in value;

  • non-monetary in nature and may be settled by money or a monetary equivalent; or

  • in substance and effect monetary in nature.

This type of right or obligation is termed a ‘cash settlable’ right or obligation.

Specific inclusions to the definition are:

  • equity interests (in limited circumstances);

  • foreign currency;

  • non-equity shares in companies; and

  • commodities and offsetting commodities contracts.

Specific exclusions are:

  • short-term financial arrangements where a non-monetary amount (property, goods or services) is involved; and

  • arrangements held by entities that satisfy the threshold tests where there is no significant deferral of tax.

Division 230 may also not apply to financial arrangements where your rights and/or obligations are the subject of:

  • leasing or licensing arrangements over real and intellectual property;

  • interests in partnerships or trusts;

  • life and general insurance policies;

  • workers’ compensation arrangements;

  • guarantees and indemnities;

  • personal arrangements and personal injury;

  • superannuation and pension income;

  • interests in a foreign investment fund, foreign life policy or a controlled foreign company;

  • proceeds from certain business sales;

  • infrastructure borrowings;

  • farm management deposits;

  • deemed interest payments to owners of offshore banking units;

  • forestry managed investment schemes;

  • ceasing to hold financial arrangements;

  • forgiveness of commercial debts;

  • franked distributions; and

  • retirement village residence and service contracts.

What should you be doing to prepare?

Determine if you will be above the threshold test for mandatory application of the rules on or after 1 July 2010.

Consider if you want to elect into Division 230 early for income years commencing on or after 1 July 2009 and establish the date of your election.

Consider if you want to elect into the Division 230 for existing financial arrangements and establish the date of your election.

Consider whether the accruals or realisation methods are appropriate and whether you meet the eligibility criteria to adopt one of the elective methods.

Determine the administrative, accounting and system changes required to comply.

If you have any queries about the TOFA Rules and if/how they apply to your business, please contact Kevin Shields, Partner, on (08) 9288 6909 or kevin.shields@lavanlegal.com.au.