ATO ID 2004/477: GST and agreement to pay or recoup foreign exchange loss or gain when a forward currency contract is closed out
Date of decision: 23 June 2003
Business line: Indirect Tax

Issue
Is the entity, a supplier of goods, making an input taxed supply under subsection 40-5(1) of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act), when it enters into a binding verbal agreement with a client, whereby the client either pays or recoups any respective foreign exchange loss or gain when a forward currency contract is closed out?

Decision
Yes, the entity is making an input taxed supply under subsection 40-5(1) of the GST Act when it enters into a binding verbal agreement with a client, whereby the client either pays or recoups any respective foreign exchange loss or gain when a forward currency contract is closed out.

Facts
The entity is a supplier of goods. The entity's client forecasts an amount of goods that the client will purchase from the entity in the future. The entity then enters into a forward currency contract with a bank to cover any materials used in producing the goods that the entity may import, based on the client's forecast. If the client does not meet their forecast the forward currency contract will be closed out. This may result in a loss or gain. There is also a binding verbal agreement between the entity and the client, whereby the client is bound to pay, or is entitled to receive, the difference arising from the forward currency contract between the entity and the bank. That is, if the forward currency contract between the entity and the bank results in a foreign exchange loss for the entity, the client pays that amount to the entity. If a foreign exchange gain arises, the client is entitled to receive that amount from the entity. The entity does not charge a fee to the client. The forward currency contract between the entity and bank is covered by item 11 in the table in subregulation 40-5.09(3) of the A New Tax System (Goods and Services) Regulations 1999 (GST Regulations) and is an input taxed supply under subsection 40-5(1) of the GST Act. The entity is registered for goods and services tax (GST). The supply is made in the course of the entity's enterprise and is connected with Australia.

Reasons for decision
Summary: Under subsection 40-5(1) of the GST Act, 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 is a financial supply if: Item 11 in the table in subregulation 40-5.09(3) of the GST Regulations lists an interest in or under a derivative. Regulation 3 of 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'. Schedule 1 to Goods and Services Tax Ruling GSTR 2002/2, further provides that a derivative includes financial instruments such as options, forwards, futures, swaps and whose value is tied to or derived from an underlying security, commodity, currency, liability or index. Entities usually use derivatives to hedge against changes in interest rates and foreign exchange risks or to minimise business risks. The entity's client forecasts an amount of goods that the client will purchase from the entity in the future. There is a binding verbal agreement between the entity and the client. Under this agreement, the entity's client is bound to pay or is entitled to receive the difference arising from the forward currency contract between the entity and the bank. If the forward currency contract results in a foreign exchange loss for the entity, the client pays that amount to the entity. If a foreign exchange gain arises, the entity's client is entitled to receive that amount. The binding verbal agreement between the entity and its client is separate to their agreement for the sale of the goods. The value of this verbal binding agreement depends on, or is derived from, the underlying foreign currency values, as reflected in the forward currency contract between the entity and the bank. The entity creates its own interest in a separate derivative and provides the interest in that derivative to its client. As noted, a derivative is an interest mentioned in item 11 in the table in subregulation 40-5.09(3) of the GST Regulations and the supply of an interest in a derivative is a financial supply where all of the conditions of subregulation 40-5.09(1) of the GST Regulations are satisfied. The entity makes this supply in the course of its enterprise and the supply is connected with Australia. The entity is registered for GST. As the entity creates its own interest in a separate derivative, the entity is a financial supply provider in relation to the supply of that interest (regulation 40-5.06 of the GST Regulations). The remaining requirement under subregulation 40-5.09(1) of the GST Regulations is that the entity supplies the interest in the derivative for consideration. The entity does not charge a fee to its client, however, the entity and the client enter into a binding verbal agreement and exchange their reciprocal rights and obligations to pay or receive an amount when the foreign exchange results in either a loss or a gain. The exchanging of their rights and obligations, although not priced, does constitute consideration for the derivative agreement and the payment of the difference by one party to the other is a consequence of the agreement. Accordingly, the supply satisfies the requirements of subregulation 40-5.09(1) of the GST Regulations and the entity is making an input taxed supply under subsection 40-5(1) of the GST Act when it enters into a binding verbal agreement with a client whereby the client either pays or recoups any respective foreign exchange loss or gain when a forward currency contract entered into is closed out.

Legislative references: A New Tax System (Goods and Services Tax) Act 1999 subsection 40-5(1) subsection 40-5(2)
Related public rulings and determinations: Goods and Services Tax Ruling GSTR 2002/2
Subject references: Goods and services tax Input taxed supplies GST financial supplies GST derivatives GST foreign exchange transactions