New Provisions on Tax Timing of Financial Arrangements - International Law Office

Introduction
Tax Timing Provisions
Comment

Introduction

On December 16 2005 the government released exposure draft legislation setting out proposed rules for the tax timing treatment of a broad range of financial arrangements. The provisions will be inserted as a new Division 230 in the Income Tax Assessment Act 1997. Although the draft legislation provides no effective date, it is understood that the government intends the tax timing provisions to apply generally for financial arrangements entered into on or after July 1 2006 (subject to transitional elections). The draft legislation does not clarify the interaction of the tax timing provisions with the current law, nor does it contain any transitional provisions. Under the existing law there is no comprehensive set of rules dealing with the tax treatment of financial arrangements; instead there are only ad hoc rules covering certain types of financial transaction.

This update considers the rules contained in the proposed Division 230 and their potential impact on corporate taxpayers. Corporate taxpayers should monitor developments in the draft legislation, and potential adverse tax and compliance consequences arising from financial transactions should be considered more closely before the effective date of the tax timing provisions.

Tax Timing Provisions

The tax timing provisions apply to 'financial arrangements', a term which is defined broadly in the draft legislation as any legal or equitable right or obligation to receive or provide something of economic value in the future. Accordingly, the provisions would apply not only to traditional financial arrangements (eg, secured and unsecured loans at interest, discounted securities and risk-shifting derivatives), but also to a wide range of other arrangements (eg, accrued/deferred income arrangements, deferred settlement contracts, prepaid income arrangements, prepayments of goods and services, construction contracts, certain lease arrangements and embedded and 'add-on' warranties with a term longer than 12 months).

However, various arrangements are excluded by the provisions, including:

• equity (share) interests (unless the fair value method applies);
  
  
• certain short-term arrangements with a non-cash component;
  
  
• arrangements held by individuals and small businesses (with a turnover of less than A$20 million) where there is no significant deferral of tax;
  
  
• ordinary interests in partnerships and trusts; and
  
  
• arrangements relating to life insurance policies, personal services, restrictive covenants, personal injuries and certain leases and similar arrangements subject to specific loan-compounding accruals provisions (eg, Division 240 hire-purchase arrangements and luxury car leases).

In general, the rules treat all gains and losses relating to financial arrangements to be on revenue account for tax purposes. The rules apply to Australian residents and non-residents with Australian source income equally. There are five tax timing methods for the recognition of gains and losses under proposed Division 230.

Fair value method (elective)
The fair value method makes assessable or deductible any movement to the fair value of financial arrangements as reported on the taxpayer's financial statements. This method is available only to taxpayers that are required to prepare audited financial statements in accordance with Chapter 2M of the Corporations Act 2001 or comparable provisions of a foreign law, and that make an election to use this method. Once an election is made, the method must be applied to all current and future financial arrangements which are fair valued in the taxpayer's accounts.

Only some taxpayers may want to elect to use this method, as it could result in excessive volatility in reported profits, losses and tax liabilities, creating adverse cash flow and liquidity complications. It is likely to be used by traders holding instruments for relatively short times and those buying and selling financial instruments primarily for market-making purposes (eg, financial institutions).

Foreign exchange retranslation method (elective)
Under Australian Accounting Standard AASB 121, certain gains and losses attributable to changes in foreign exchange rates are recognized in the profit and loss statement (foreign currency gains and losses). This method is intended to apply only to these foreign currency gains and losses.

Broadly, under this method any increase in the value of the financial arrangement due to a change in the foreign exchange rate which the taxpayer ought to recognize in the profit and loss statement under AASB 121 is a gain, and any decrease is a loss. As with the fair value method, this method is available only to taxpayers that are required to prepare audited financial statements under the Corporations Act or comparable provisions of a foreign law, and that make a retranslation election. Once an election is made, this method must be applied to all current and future financial arrangements that are subject to financial accounting retranslation treatment in financial accounts.

This method will be beneficial where foreign currency exposures are likely to be such that AASB 121 does not impose significant volatility in earnings. In addition, alignment between the financial accounting and tax outcomes would not have these consequences and would reduce compliance costs.

Hedging method (elective)
This method matches the tax recognition of a gain or loss on a hedging financial arrangement with timing of the gain or loss on the underlying hedged asset, liability or transaction. Generally, a taxpayer may elect this tax timing method for each derivative that is recognized under the Australian Accounting Standards (or comparable standards of a foreign law) as a hedging instrument and whose financial accounts are audited under the Corporations Act or comparable provisions of a foreign law.

Typical derivatives used as hedging financial instruments are swaps, options and forward contracts.

Compounding accruals method
This method allocates gains or losses from financial arrangements to income years according to an implicit rate of return. It will apply where:

• an election to apply another method is not or cannot be made;
  
  
• the performance period of the financial arrangement is greater than 12 months; and
  
  
• it is reasonably likely that a gain or loss will be made.

In determining whether this method applies, the taxpayer is required to consider whether, taking into account all expected future cash flows and any contingencies attached to the financial arrangement, it is relatively certain that an actual net gain or loss will arise.

The explanatory memorandum to the proposed Division 230 states that it is reasonably likely that a gain or loss will arise for the following types of financial arrangement:

• standard fixed-rate bonds;
  
  
• financial arrangements that are classified as 'debt' under Division 974 of the Income Tax Assessment Act; and
  
  
• standard interest rate swaps.

It states that this method would not be available for vanilla options and forwards.

Realization method
This method provides that a gain or loss is assessable or deductible in the income year in which the gain or loss is realized. This method applies where none of the elective tax timing methods apply and the compounding accruals method is not appropriate because the future gain or loss from a financial arrangement is not sufficiently certain. It also applies when a financial arrangement or part of a financial arrangement ceases to be held, except where the fair value method has been chosen. The amount of any realized gain or loss is reduced by the total amount assessed or deducted under the compounding accruals method up to that point, and is attributable to the realized gain or loss.

The explanatory memorandum states that this method is likely to apply to vanilla options and forward contracts.

This diagram shows the application of these rules.

Comment

Effect of the changes
If the draft legislation is enacted in its current form, the proposed Division 230 is likely to have the following effects on corporate taxpayers:

• Given the wide definition of 'financial arrangement' and the application of the accruals method to all financial arrangements (exceeding 12 months) where the gain or loss is reasonably likely, the new rules could apply to a wide range of transactions entered into by companies, including foreign currency denominated transactions, hedging arrangements, loans, supply contracts and warranty arrangements.
  
  
• Corporate taxpayers which are required to prepare audited financial statements under the Corporations Act may be entitled to elect to use the fair value, foreign exchange retranslation and hedging tax timing methods in relation to some of these financial arrangements, instead of applying the compounding accruals and realization methods.
  
  
• Consideration should be given to the potential impact on any carry-forward capital losses. More specifically, if a corporate taxpayer has significant carry-forward capital losses, the shift of items to revenue account may make it more difficult for the taxpayer to utilize such losses in future periods. Conversely, consideration should be given to whether the company traditionally generates substantial capital losses from financial transactions, and thereby whether the proposed measures may be beneficial, as these losses may now be recognized on revenue account.

Next steps for corporate taxpayers
Changes to the draft legislation should be monitored and potential adverse tax and compliance consequences arising from financial transactions should be considered more closely before the effective date of the proposed legislation. Particular points to be considered include:

• identification of all transactions that would be financial arrangements for the purposes of the tax timing provisions, and their likely tax timing treatment under the new rules;
  
  
• to the extent that one or more of the tax timing elections is available for a financial arrangement, a cost-benefit analysis (including tax and compliance costs/benefits) of the tax timing options; and
  
  
• the impact of the new rules on any carry-forward tax losses and future losses, and on deferred tax balances.

For further information on this topic please contact Braedon Clark or Marina Raulings at Minter Ellison by telephone (+61 3 8608 2000) or by fax (+61 3 8608 1000) or by email (braedon.clark@minterellison.com or marina.raulings@minterellison.com).