ATO ID 2010/156: GST and treatment of a currency hedge agreement embedded within a contract for services
Date of decision: 1 September 2010
Business line: Indirect Tax

Issue
Does the agreement, described in the facts, involve each entity making a financial supply of an interest in a derivative under item 11 in the table in subregulation 40-5.09(3) of the A New Tax System (Goods and Services Tax) Regulations 1999 (GST Regulations)?

Decision
Yes, under the agreement described in the facts, each entity makes a financial supply by providing the other entity with an interest in a derivative under item 11 in the table in subregulation 40-5.09(3) of the GST Regulations.

Facts
Entities A and B both carry on an enterprise and are registered for GST. Their relevant dealings with each other are conducted in Australia. Entity A makes a taxable supply of services to Entity B. Under the supply contract, the supply is made over a period of time with the consideration being payable in set periodical amounts expressed in United States dollars (USD). The entities subsequently insert a separate agreement (the agreement) into the supply contract to partially hedge against the risk of loss through exchange rate fluctuations. The agreement protects Entity A against an appreciating Australian dollar and Entity B against a depreciating Australian dollar (AUD). The agreement results in each entity making a foreign exchange gain or loss each time a payment is made. It involves a four-step calculation by which the amounts payable in USD are altered to reflect changes in the exchange rate. To explain the steps, example figures are included in brackets where the AUD has appreciated against the USD over the relevant period. Step 1: Each payment to be made in USD (for example USD 200) is divided into two equal parts ('1' and '2') (USD 100 each). Step 2: Part 2 is converted into Australian dollars (AUD) at the exchange rate that prevailed at a specified time on the contract date (converting USD 100 at the contract date exchange rate of AUD 1 = USD 0.80, Part 2 becomes AUD 125). Step 3: The AUD amount, calculated in step 2, is then converted back to USD at the exchange rate prevailing at a specified time on the day of the payment. (Converting AUD 125 at the payment date exchange rate of AUD 1 = USD 0.90, Part 2 becomes USD 112.50). Step 4: Parts 1 and 2 are then added back to give the total amount payable in USD. (USD 100 + USD 112.50 = total amount payable USD 212.50) If movements in the exchange rate from the contract date to the day of payment cause the AUD to appreciate against the USD (as in the example figures above), Entity A will make a gain under the hedge agreement and Entity B will make a corresponding loss. Alternatively, if exchange rate fluctuations cause the AUD to depreciate against the USD, the reverse will apply.

Reasons for decision
Summary: Subsection 40-5(1) of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) provides that a financial supply is input taxed. Subsection 40-5(2) of the GST Act provides that 'financial supply' has the meaning given by the GST Regulations. Subregulation 40-5.09(1) of the GST Regulations provides that the provision, acquisition, or disposal of an interest mentioned under subregulation 40-5.09(3) or 40-5.09(4) of the GST Regulations (a financial interest) is a financial supply if: However, the provision of a financial interest will not be a financial supply where the provision is a feature of a transaction which is objectively assessed as being integral, ancillary or incidental to the essential character of the transaction. A supply in which the provision of a financial interest forms merely an integral, ancillary or incidental part is a composite supply. A composite supply is treated as the supply of a single thing and for GST purposes assumes the character of the dominant part. If the dominant part of such a supply is services, the composite supply is treated as a taxable supply if it satisfies the requirements of section 9-5 of the GST Act. This is explained in GSTR 2001 / 8 : apportioning the consideration for a supply that includes taxable and non-taxable parts (GSTR 2001/8). The particular feature under consideration in the facts of this case is the insertion of the agreement by which the entities could hedge against exchange rate gains and losses. The value for the supply of services under the supply contract has been negotiated by the entities and fixed in United States dollars (USD). Despite this, the entities have embedded a foreign currency hedge into the supply contract by inserting the agreement. The Dictionary to the GST Regulations defines derivative as 'an agreement or instrument the value of which depends on, or is derived from, the value of assets or liabilities, an index or a rate'. Item 11 in the table in subregulation 40-5.09(3) of the GST Regulations (Item 11) mentions an interest in or under a derivative. Part 9 of Schedule 7 of the GST Regulations provides examples for Item 11. Included in the examples listed in Part 9 are 'forward contracts, futures contracts, swap contracts and options contracts the value of which depends on, or is derived from:...foreign exchange or currency values or currency index values'. Schedule 1 to Goods and Services Tax Ruling GSTR 2002/2 : GST treatment of financial supplies and related supplies and acquisitions , observes that entities usually use derivatives to hedge against changes in interest rates and foreign exchange risks or to minimise business risks. In the facts of this case, the effect of the agreement is to provide a currency hedge in a form similar to the financial instruments mentioned in Part 9 of Schedule 7 of the GST Regulations above. Because the value of the currency hedge under the agreement depends on, or is derived from, changes in the AUD/USD exchange rate, the currency hedge is a 'derivative' as defined in the Dictionary to the GST Regulations. By inserting the agreement into the supply contract, the entities have provided each other with an interest in a derivative, within the meaning of Item 11. In providing each other with the interest in a derivative, the entities are providing each other with non-monetary consideration. This is consistent with the view explained in GST Determination GSTD 2005 / 3 : are contracts for difference and financial spread betting contracts financial supplies ? (GSTD 2005/3). On an objective assessment, the supply of the interest in the derivative by Entity A to Entity B is separately identifiable and retains its own identity within the supply contract. It is not merely integral, ancillary or incidental to the essential character of the transaction, and as such the supply of which it is part is not a composite supply. With each payment, the difference between amounts calculated under steps 1 and 4 in the facts is the effect of the currency hedge. It may be owing by either entity, depending on movements in the exchange rate. Consistent with the explanation in GSTD 2005/3, it is additional consideration for the supply of the interests. In accordance with regulation 40-5.06 of the GST Regulations, each entity is the financial supply provider in relation to the provision of an interest in a derivative. The provision of each interest is for consideration. Each entity is registered for GST and it provides the interest in the course or furtherance of its enterprise. The supply of each interest is connected with Australia. All the requirements in subregulation 40-5.09(1) of the GST Regulations are satisfied, and regulation 40-5.12 of the GST Regulations does not apply. It follows that the provision of the interest by each entity is a financial supply of a derivative under Item 11.

Legislative references: A New Tax System (Goods and Services Tax) Act 1999 section 9-5 section 9-85 subsection 40-5(1) subsection 40-5(2)
Related public rulings and determinations: Good and Services Tax Ruling GSTR 2001/2 | Good and Services Tax Ruling GSTR 2001/8 | Good and Services Tax Ruling GSTR 2002/2 | Goods and Services Tax Determination GSTD 2005/3
Subject references: Goods and services tax Taxable supply GST consideration GST derivatives GST financial supplies