ATO ID 2005/320: Foreign exchange (forex) gains and losses: tax consequences of certain short-term forex realisation gains or losses
Date of decision: 11 November 2005
Year of income: Year ended 30 June 2005
Business line: Private Groups and High Wealth Individuals

Issue
Do sections 775-70 or 775-75 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to forex realisation gains or losses made under derivative contracts used to hedge the cost of a depreciating asset acquired under a purchase agreement?

Decision
No. Sections 775-70 or 775-75 of the ITAA 1997 do not apply to forex realisation gains or losses made under derivative contracts used to hedge the cost of a depreciating asset acquired under a purchase agreement.

Facts
The taxpayer entered into a purchase agreement to acquire a depreciating asset that has a price denominated in a foreign currency. In order to protect against the risk of adverse exchange rate fluctuations, and provide the foreign currency required to acquire the asset, the taxpayer entered into derivative contracts to hedge the Australian dollar (AUD) cost of the depreciating asset. The cost of the depreciating asset was hedged from the time of entering into the purchase agreement, up to the time of final payment. The taxpayer made forex realisation gains and forex realisation losses from hedging the acquisition cost of the depreciating asset.

Reasons for decision
Summary: Subsections 775-70(1) and 775-75(1) of the ITAA 1997 provide exceptions to the general principle in sections 775-15 and 775-30 of the ITAA 1997 that forex realisation gains or losses are treated on revenue account. One exception applies to certain forex realisation gains or losses that occur where an obligation to pay foreign currency was incurred in return for a taxpayer starting to hold a depreciating asset. The holder of a depreciating asset for these purposes is worked out under Division 40 of the ITAA 1997. Any forex realisation gains or losses made in these circumstances are applied against the asset's cost or opening adjustable value. This recognises that the forex realisation gain or loss is closely related to the character of the gain or loss made on the depreciating asset. The derivative contracts entered into are used to hedge the acquisition cost of the depreciating asset. The right to receive the foreign currency at settlement under the contracts was acquired in return for the taxpayer agreeing to pay an amount of Australian currency. This is not a right which is relevant for the purposes of the short term rules in subsections 775-70(1) and 775-75(1) of the ITAA 1997. The forex realisation gains and losses under the derivative contracts will not be applied against the depreciating asset's cost or opening adjustable value. They will be brought to account as assessable income and allowable deductions under sections 775-15 and 775-30 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 section 775-15 section 775-30 section 775-70 subsection 775-70(1) section 775-75 subsection 775-75(1)
Subject references: Assignment of rights & entitlements Financial derivatives Foreign exchange gains and losses Forex realisation gain Forex realisation loss Hedging Hold a depreciating asset