ATO ID 2003/797: Deductibility of outgoing on novation of hedge contracts
Date of decision: 4 August 2003
Year of income: Year ending 30 June 2004
Business line: Private Groups and High Wealth Individuals

Issue
Does a payment made by a taxpayer in respect of novation of hedge contracts which were entered into to set the future sale price of a commodity produced by the taxpayer's group members give rise to an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
Yes. The payment made by the taxpayer on novation of the hedge contracts is deductible under section 8-1 of the ITAA 1997.

Facts
The taxpayer entered into a number of contracts in order to hedge against price fluctuations of a commodity produced by the taxpayer's group members. The taxpayer was in the business of providing treasury activities for its group members. The taxpayer had a history of hedging its group members' production through the use of hedge contracts. In accordance with the taxpayer's business practices, the taxpayer can either buy the underlying commodity at the market price from its group members and deliver the commodity into the hedge contracts, or cash settle the commodity hedging contracts. The taxpayer novated the hedge contracts to another entity (the 'New Party'). Consequently, the New Party took on equivalent rights and obligations in relation to those hedge contracts. The hedge contracts were 'out of the money', as the price at which the taxpayer was to deliver the underlying commodity (the 'Contract Price') was less than the market price of the underlying commodity as at the date of novation. The taxpayer made a payment to the New Party being the difference between the Contract Price and the market price of the underlying commodity as at the date of novation. After the novation transactions there were no contractual obligations in force that precluded the taxpayer from entering into hedge contracts in the future. Further, after the novation, the taxpayer continued to provide other treasury functions to group members.

Reasons for decision
Summary: For a payment to be an allowable deduction under section 8-1 of the ITAA 1997, the payment must be made in gaining or producing assessable income, or necessarily incurred in carrying on a business for the purposes of gaining or producing assessable income, and notwithstanding this, the payment must not be an outgoing of capital, or of a capital nature. | Detailed Reasoning - Was the payment necessarily incurred in carrying on a business for the purpose of producing assessable income?: Entering into the hedge contracts was a part of the taxpayer's normal business operations. The elimination of the hedging contracts through novation meant that the taxpayer was no longer required to settle the contracts for less than the market price of the commodity, or alternatively buy the commodity from its group members at the market price which was higher than the Contract Price receivable under the hedge contracts. That is, the payment was designed to eliminate or minimise a threatened and recurrent drain on the taxpayer's assessable income. ( W Nevill & Co Ltd v. Federal Commissioner of Taxation (1937) 56 CLR 29; 4 ATD 187 (1937) 1 AITR 67; Metals Exploration Ltd v. Federal Commission of Taxation 86 ATC 4505; (1986) 17 ATR 786) Having regard to the above, it is considered that the payment made was necessarily incurred by the taxpayer in carrying on its business. | Detailed Reasoning - Was the outgoing of capital or of a capital nature?: Notwithstanding the above, if the payment on novation of the hedge contracts was of capital or of a capital nature it would not be deductible in accordance with paragraph 8-1(2)(a) of the ITAA 1997. The factors to consider when determining whether an outgoing is of capital or of a capital nature have been established by case law, (in particular Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; 5 ATD 23; (1938) 1 AITR 403; Foley Bros Pty Limited v. Federal Commissioner of Taxation (1965) 13 ATD 562; (1965) 9 AITR 635 and Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; 8 ATD 190; (1946) 3 AITR 436) and include: In the present case, while the expenditure was incurred once-and-for-all (which might point to the outgoing being of capital or of a capital nature), it was directed at dealing with the taxpayer's ordinary business activities of providing the treasury function to its group members, which of itself is a revenue item. The advantage sought by the taxpayer was to rid itself of the obligations under the hedge contracts, which may have resulted in a reduction of its assessable income. Therefore, the character of this advantage is considered to be of a revenue nature. The advantage gained by novation of the hedge contracts did not result in a benefit of an enduring nature, since each hedge contract related to part only of the group's commodity production. In addition, the payment on novation did not alter the profit-yielding structure of the taxpayer's business or the framework in which the taxpayer produced its assessable income, as subsequent to the novation of the hedge contracts, the taxpayer continued to provide a treasury function for group members. Further, the taxpayer was not precluded from entering into commodity hedge contracts in the future. Given the above, the outgoing is not considered to be of capital or of a capital nature. Therefore, a payment made by a taxpayer in respect of novation of hedge contracts which were entered into to set the future sale price of a commodity produced by the taxpayer's group members gives rise to an allowable deduction under section 8-1 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 section 8-1
Case references: Foley Brothers Pty Ltd v. FC of T 13 ATD 562 (1965) 9 AITR 635
Subject references: Call options Commodity transactions Dealings & transactions Deductions & expenses Financial derivatives Forward rate agreements Forward sales Forward transactions Hedging Incurred Novation Put options