ATO ID 2011/27: Offshore banking units: trading activity
Date of decision: 23 February 2011
Year of income: Year ended 30 June 2010
Business line: Public Groups and International

Issue
Does the execution of 'Non-Deliverable Forward' contracts (NDFs), which constitute executory contracts satisfied by financial settlement, constitute trading in currency or rights in respect of currency under paragraphs 121D(4)(e) or 121D(4)(ea) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Decision
No. NDFs do not constitute trading in currency or rights in respect of currency under paragraphs 121D(4)(e) or 121D(4)(ea) of the ITAA 1936.

Facts
An offshore banking unit (OBU), as part of its foreign exchange business, enters into NDFs with Australian resident and non-resident counterparties. The NDFs are executory contracts performed by financial or cash settlement of amounts payable by the parties to the contract. The amounts payable by the parties to the contract are determined in accordance with an agreed 'fixing rate' which includes or reflects an agreed exchange rate for particular currencies. Accordingly, the parties to the NDF do not perform their contractual obligations by delivery of the currency. The OBU agrees to pay any amount payable by the OBU upon settlement under the NDFs in a particular currency. The execution and settlement of the NDFs satisfies section 121EA of the ITAA 1936.

Reasons for decision
Summary: Section 121D of the ITAA 1936 lists the type of activities that qualify as an offshore banking activity (OB activity) for the purpose of determining offshore banking income of an OBU [1] under Division 9A. Paragraph 121D(1)(c) of the ITAA 1936 states that a 'trading activity' is an OB activity if it meets the requirements of subsection 121D(4). Paragraphs 121D(4)(e) and (ea) of the ITAA 1936 refer to 'trading in currency' or 'trading in rights in respect of currency' as being a trading activity in certain circumstances. 'Trading' is not defined in the ITAA 1936 but section 121ED provides that a person (the trader) is said to trade with another person in a thing if: 'Trading' as a verb has its root word in 'trade' which according to the Macquarie Dictionary [Multimedia], version 5.0.0, 01/10/01 means 'a purchase, sale or exchange' of a thing. Section 121ED of the ITAA 1936 refers to an acquisition or purchase of a thing for the purpose of trading in the thing, or a sale in the course of trading a thing. In the context of paragraphs 121D(4)(e) and (ea) of the ITAA 1936, the thing is currency or rights in respect of currency. NDFs may be transacted in the course of, or in connection with, the OBU's foreign exchange business. Profits made by the OBU under the NDF contracts are assessable as ordinary business income ( Californian Copper Syndicate v. Harris (Surveyor of Taxes ) (1904) 5 TC 159) or as income from isolated business transactions entered with the intent to make profit ( Myer Emporium v. Federal Commissioner of Taxation (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693). However, this does not make NDF transactions trading activities. Trade is not synonymous with business because not all business involves a trade: per Menzies J Hornsby Shire Council v. Salmar Holdings Pty Ltd [1972] 46 ALJR 291 at 292. NDFs are called 'forward' contracts but are not agreements under which different types of currencies are agreed to be delivered or exchanged. The observations of Lord Templeman about interest rate swap in Hazell v. Hammersmith and Fulham London Borough Council and Ors [1991] All ER 545 are relevant to NDFs. His Lordship observed: The transactions were undertaken in the hope that the burden of interest payable in respect of the borrowings...would be mitigated by profits from swap contracts whereby the council successfully forecast movements in interest rates (at 550). The fact remains a swap transaction depends for its success on interest rates rising or falling in conformity with the expectation of the [swap party] at the date of the swap (at 552). ...a parallel contract does not in fact replace the interest under the original borrowing and the swap (at 553). The NDFs are aleatory contracts satisfied by a financial receivable or payable. They fit the description of wagering contracts in Carlill v. The Carbolic Smoke Ball Company [1892] QBD 484: ... according to my view, a wagering contract is one by which two persons, professing to hold opposite views touching the issue of a future uncertain event, mutually agree that, dependent upon the determination of that event, one shall win from the other, and that other shall pay or hand over to him, a sum of money or other stake; neither of the contracting parties having any other interest in that contract than the sum or stake he will so win or lose, there being no other real consideration for the making of such contract by either of the parties. It is essential to a wagering contract that each party may under it either win or lose, whether he will win or lose being dependent on the issue of the event, and, therefore, remaining uncertain until that issue is known. If either of the parties may win but cannot lose, or may lose but cannot win, it is not a wagering contract (per Hawkins J at 490-491). NDFs do not satisfy paragraphs 121D(4)(e) or (ea) of the ITAA 1936 because there is no trade in currency or trade in rights in respect of currency. Further, although the calculation of the amounts payable under the NDFs reflects a currency exchange rate agreed between the parties to the contract, the contract does not confer 'rights in respect of' the designated currency. The phrase 'in respect of' is capable of having a wide meaning depending on its context: per Deane, Dawson, Toohey JJ at Workers' Compensation Board (Qld) v. Technical Products Pty Ltd (1988) 165 CLR 642 at 653. But the connection with the underlying subject must not be 'too remote': Harris v. Federal Commissioner of Taxation (2002) 125 FCR 46; (2001) 50 ATR 410; 2002 ATC 4659 at 4674. NDFs do not create rights 'in respect' of the designated currency in the requisite sense. Rather, the NDF is executed by a payment or a receivable determined by reference, inter alia, to an agreed currency exchange rate. As NDFs do not give rise to rights in respect of the designated currency, they cannot constitute 'trading in rights in respect of' the designated currency for the purpose of paragraphs 121D(4)(e) and 121D(4)(ea) of the ITAA 1936.

Legislative references: Income Tax Assessment Act 1936 subsection 121D(1) subsection 121D(4) paragraph 121D(4)(e) paragraph 121D(4)(ea) section 121EA section 121ED
Case references: Californian Copper Syndicate v Harris (Surveyor of Taxes) (1904) 5 TC 159
Other references: Macquarie Dictionary [Multimedia], version 5.0.0, 01/10/01
Subject references: Forward contracts Offshore banking units Foreign currency Foreign currency rights International transactions