ATO ID 2010/186: Foreign exchange (forex): forex realisation gain on discharge of foreign currency denominated loan
Date of decision: 10 September 2010
Year of income: Year ended 30 June 2007
Business line: Private Groups and High Wealth Individuals

Issue
Can a forex realisation gain made on the discharge of a foreign currency denominated loan to a foreign subsidiary be non-assessable non-exempt income of the taxpayer under section 775-25 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
Yes. A forex realisation gain arising from the discharge of a foreign currency denominated loan advanced in the course of gaining or producing non-assessable non-exempt income is non-assessable non-exempt income under section 775-25 of the ITAA 1997.

Facts
Aust Co is an Australian resident company and the head company of a tax consolidated group. Foreign Co is a wholly owned foreign subsidiary of Aust Co. Aust Co made a foreign currency denominated inter-company loan to its wholly owned subsidiary Foreign Co to enable it to finance the acquisition of all the shares in a foreign resident operating company (foreign shares). The loan was interest free and repayable on demand. Foreign Co discharged the inter-company loan by issuing shares to Aust Co. Aust Co made a forex realisation gain under section 775-45 of the ITAA 1997 when the inter-company loan was discharged.

Reasons for decision
Summary: Section 775-25 of the ITAA 1997 provides that a forex realisation gain made is non-assessable non-exempt income to the extent that, if it had instead been a forex realisation loss, it would have been made in gaining or producing non-assessable non-exempt income. The section therefore directs an enquiry to be made into the nexus between a hypothetical forex realisation loss and the gaining or producing of non-assessable non-exempt income. To determine the link or nexus between a forex realisation loss that could arise on a complete or partial repayment of the borrowings, and what it is 'made in gaining or producing', the purpose for, or use to which, the taxpayer put those borrowings must be considered. A loss or outgoing that is incidental and relevant to the gaining or production of assessable income will satisfy the nexus test (see, for example, W Nevill & Co v. Federal Commissioner of Taxation (1937) 56 CLR 290; (1937) 4 ATD 187; (1937) 1 AITR 67, Ronpibon Tin NL and Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; (1949) 4 AITR 236 ( Ronpibon Tin )). In Federal Commissioner of Taxation v. Smith (1981) 147 CLR 578; (1981) 11 ATR 538; (1981) 81 ATC 4114, the High Court observed at CLR 585-586: What is incidental and relevant in the sense mentioned falls to be determined not by reference to the certainty or likelihood of the outgoing resulting in the generation of income but to its nature and character and generally to its connection with the operations which more directly gain or produce the assessable income. It is not necessary that the relevant income be produced in the year in which a loss or outgoing is incurred. In Ronpibon Tin , at CLR 57, the Court said that the required nexus is also established if the occasion of the loss or outgoing can be found in whatever would be expected to produce assessable income. In Federal Commissioner of Taxation v. Total Holdings (Australia) Pty Ltd [1979] FCA 30; 79 ATC 4279; (1979) 9 ATR 885, the taxpayer borrowed funds at interest to on-lend interest free to a subsidiary. It was held that the taxpayer was entitled to deduct the interest expenditure as its activities were designed to render the subsidiary profitable and promote the generation of assessable income by it and subsequently the derivation of assessable dividends by the taxpayer. Whether the hypothetical forex realisation loss made by Aust Co on the discharge of the inter-company loan is made in gaining or producing non-assessable non-exempt income will depend on the nature of the connection between that loss and the expected production of that income. It requires a consideration of all the facts and circumstances, including the nature of the connection between the making of the inter-company loan and the relevant income earning activities of Aust Co. The inter-company loan was on interest free terms. It was incapable of producing assessable income by way of interest for Aust Co. While discharge of the loan itself was capable of giving rise to a forex realisation gain, or loss, the purpose of advancing the loan was to enable Foreign Co to fund the acquisition of the foreign shares, thereby promoting the profitability of Foreign Co and the potential derivation of dividend income by Aust Co. Any dividends payable by Foreign Co would be non-assessable non-exempt income in the hands of Aust Co under section 768-5 of the ITAA 1997. In these circumstances it is considered there is sufficient nexus between a hypothetical forex realisation loss arising on the discharge of the inter-company loan and the generation of divided income that would be non-assessable non-exempt. Accordingly, a forex realisation gain, had it been a loss, would have been made in the course of gaining or producing non-assessable non-exempt income and will therefore be non-assessable non-exempt income under section 775-25 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 section 768-5 section 775-25 section 775-45
Case references: Ronpibon Tin NL and Tongkah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47 (1949) 8 ATD 431 (1949) 4 AITR 236
Subject references: Borrowings & loans Foreign currency Forex realisation gain Forex realisation loss Hedging Non-assessable non-exempt income