ATO ID 2003/796: Assessability of lump sum receipt on novation of hedging contracts
Date of decision: 1 August 2003
Year of income: Year ending 30 June 2004
Business line: Private Groups and High Wealth Individuals

Issue
Does a taxpayer's right to receive a lump sum upon novation of commodity hedging contracts give rise to assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
Yes. A taxpayer's right to receive a lump sum upon novation of commodity hedging contracts gives rise to assessable income under section 6-5 of the ITAA 1997.

Facts
The taxpayer entered into various commodity hedge contracts to minimise the risk of price fluctuations arising from the sale of a commodity produced by the taxpayer's group members. This was the sole business activity of the taxpayer. In accordance with the taxpayer's business practices, the taxpayer may either buy the underlying commodity at the market price from its group members, or cash settle the commodity hedging contracts. The taxpayer exited the entirety of their commodity hedge contracts by novating their rights and obligations under each of those commodity hedge contracts to the 'New Party'. At the time of novation, the contract price at which the taxpayer was entitled to sell the underlying commodity, was more than the market price of the underlying commodity. In order to obtain the rights and obligations arising under the commodity hedge contracts, the New Party made a lump sum payment to the taxpayer equal to the difference between the market price of the commodity and the hedge contract price.

Reasons for decision
Summary: Whether the right to receive a lump sum upon novation of the hedging contracts gives rise to assessable income under section 6-5 of the ITAA 1997 depends upon whether the receipt is of a revenue character, and if it is, whether it can be said that a receipt has been derived at that time. In the present case, the taxpayer entered into the commodity hedging contracts in relation to its ordinary business activities. If those individual hedge contracts were held to maturity or closed out early, the taxpayer would derive assessable income from the delivery into the contracts of the commodity or via the cash settlement of those contracts. Notwithstanding that the taxpayer has terminated all of its commodity hedge contracts by novation, any amount received would constitute assessable income of the taxpayer, since the lump sum receipt on novation is a receipt which would otherwise be a series of revenue receipts that would be derived from the commodity hedge contracts. The character of such a receipt does not change because it is received in a lump sum. Accordingly, such a receipt would constitute a revenue receipt in the hands of the taxpayer (Federal Commissioner of Taxation v. Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693). At the time of novation, a gain has 'come home' to the taxpayer. The taxpayer has a right without contingency to a quantifiable amount that is recoverable by action at that time and is not obligated to take any further steps to be entitled to payment ( Federal Commissioner of Taxation v. Australian Gas Light Co; 83 ATC 4800; (1983) 15 ATR 105; Arthur Murray (NSW) Pty Ltd v. Federal Commissioner of Taxation 114 CLR 314; 14 ATD 98; (1965) 9 AITR 673; Gasparin v. Federal Commissioner of Taxation (1994) 50 FCR 73; 94 ATC 4280; (1994) 28 ATR 130; Barratt v. Federal Commissioner of Taxation (1992) 36 FCR 222; 92 ATC 4275; (1992) 23 ATR 339). Therefore, a taxpayer's right to receive a lump sum upon novation of commodity hedging contracts gives rise to assessable income under section 6-5 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 section 6-5
Case references: Arthur Murray (NSW) Pty Ltd v. Federal Commissioner of Taxation 114 CLR 314 14 ATD 98 (1965) 9 AITR 673
Subject references: Commodity transactions Derived Financial derivatives Financial instruments Forward sales Forward transactions Hedging Novation Producing assessable income