ATO ID 2010/212: Foreign exchange (forex): forex realisation gain on cessation of a foreign currency swap
Date of decision: 7 April 2010
Year of income: Year ended 30 June 2007
Business line: Private Groups and High Wealth Individuals

Issue
Will a forex realisation gain made on the cessation of a foreign currency swap (FX swap) entered into in the course of a non-assessable non-exempt income producing activity, 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 cessation of a FX swap will be non-assessable non-exempt income under section 775-25 of the ITAA 1997 where that FX swap is integral to the making of a loan advanced in gaining or producing non-assessable non-exempt income.

Facts
Aust Co is an Australian resident company. Foreign Co is a wholly owned foreign subsidiary of Aust Co. Aust Co made an interest-free US dollar (USD) denominated inter-company loan to Foreign Co to enable it to finance the acquisition of all the shares in another foreign resident company. To fund the loan to Foreign Co, Aust Co took out a short-term Australian dollar (AUD) denominated borrowing with a third party lender and exchanged the borrowed funds for USD under the first leg of a FX swap. Aust Co subsequently refinanced the AUD borrowing by taking out a separate USD denominated borrowing, exchanging the borrowed funds for AUD under the second leg of the FX swap and applying the AUD funds it acquired under the FX swap to discharge the original AUD borrowing. The delivery of USD under the FX swap gave rise to a forex realisation gain under section 775-55 of the ITAA 1997.

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 arising on cessation of a FX swap, and whether it is 'made in gaining or producing' a particular type of income, it is necessary to consider the purpose of entering into the FX swap. 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; 4 ATD 187; 1 AITR 67, Ronpibon Tin NL and Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; 8 ATD 431; 4 AITR 236 ( Ronpibon Tin )). In Federal Commissioner of Taxation v. Smith (1980-1981) 147 CLR 578; 11 ATR 538; 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 cessation of the FX swap 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 USD acquired by Aust Co under the first leg of the FX swap were advanced to Foreign Co through an interest free inter-company loan. The inter-company loan was incapable of producing assessable income by way of interest for Aust Co. While the FX swap itself was capable of producing a forex realisation gain or loss, the FX swap was not entered into for speculative purposes. Aust Co entered into the FX swap to convert the AUD proceeds from the original borrowing into USD to enable it to make the loan to Foreign Co in the currency required to fund the acquisition of the shares. Furthermore, the FX swap kept Aust Co safe from the risk that, in refinancing, it would need to borrow a greater amount in USD to discharge the original AUD borrowing. Accordingly, the FX swap was an integral part of the funding arrangements designed to promote 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 a sufficient nexus between a hypothetical forex realisation loss on the cessation of the FX swap and the generation of dividend income that would be non-assessable non-exempt. Accordingly, the forex realisation gain made on cessation of the FX swap is non-assessable non-exempt income under section 775-25 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 section 8-1 section 768-5 section 775-25 section 775-55
Case references: W Nevill & Co v Federal Commissioner of Taxation (1937) 56 CLR 290 4 ATD 187 1 AITR 67
Related ATO interpretative decisions: ATO ID 2010/186
Subject references: Currency swaps Forex realisation gain Forex realisation loss Hedging Non-assessable non-exempt income