ATO ID 2003/835: Deductibility and Assessability on consolidation of forward sales contracts
Date of decision: 5 September 2003
Year of income: Year ended 30 June 2003
Business line: Public Groups and International

Issue
Will the consolidation of a number of forward sales contracts into a fewer number of forward sales contracts with the same counterparties, give rise to assessable income or deductible losses pursuant to section 6-5 or section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) respectively, where the counterparties and the financial position of those counterparties remain the same and the total quantities to be delivered remain the same, but the maturity dates are altered?

Decision
No. The consolidation of the forward sales contracts will not give rise to an assessable gain or a deductible loss under section 6-5 or section 8-1 of the ITAA 1997 respectively, solely as a result of a change in the maturity dates and a consolidation of the quantities.

Facts
Company A held a large number of forward sales contracts with various counterparties. Those forward sales contracts provided for the delivery of a quantity of a commodity on specified dates at a price agreed to by the parties at the time the forward sales contracts were entered into. In respect of each of those forward sales contracts, a common forward price was established. For the purposes of administrative convenience, Company A and the counterparties agreed to terminate the existing forward sales contracts on the understanding that a fewer number of forward sales contracts would be established with the same counterparties. It was agreed by Company A and the counterparties that no consideration would be paid to terminate the original forward sales contracts on the basis that a fewer number of forward sales contracts would be entered into on essentially the same terms. Under the terms of the original forward sales contracts, at maturity, close-out or termination, Company A would be required to either: deliver the commodity which was the subject of the forward sales contract and entitled to receive payment; or in the event of cash settlement, receive payment if a receipt became owing or make a payment if an amount became due. The quantum of the receipt or payment would be determined by reference to the difference between the price specified in the forward sales contract and the market price of the commodity at the maturity date of the forward sales contract. The new forward sales contracts amalgamated the quantities to be delivered under the terminated forward sales contracts and established new maturity dates, by reference to the mid date in the range of maturity dates in respect of each group of terminated forward sales contracts originally entered into with each counterparty. The maturity dates were altered to ensure that the financial position of the parties before and after the newly entered forward sales contracts remained the same.

Reasons for decision
Summary: Whether the cessation of the original forward sales contracts gives rise to assessable income under section 6-5 of the ITAA 1997 or a deductible loss under section 8-1 of the ITAA 1997 depends upon whether it can be said that a receipt is derived or a loss is incurred, respectively at that time. Derivation of income or the incurrence of a loss, in general terms, depends on whether a gain or loss has 'come home' to the taxpayer. Case law dealing with the derivation of income provides that a gain has 'come home' to the taxpayer if a debt is presently recoverable by action or the taxpayer is not obligated to take any further steps to be entitled to payment (be it actual or constructive payment) ( FC of T v. Australian Gas Light Co & Anor (1983) 83 ATC 4800; (1983) 15 ATR 105; Henderson v. Federal Commissioner of Taxation. (1970) 119 CLR 612; 70 ATC 4016; (1970) 1 ATR 596; Arthur Murray (N.S.W.) Pty. Ltd. v. Federal Commissioner of Taxation. (1965) 114 CLR 314; 14 ATD 98; (1965) 9 AITR 673; Rowe J. & Son Pty. Ltd. v. Federal Commissioner of Taxation. (1971) 124 CLR 421; 71 ATC 4157; (1971) 2 ATR 497). In addition, where a debt is presently recoverable by action, generally, there will be a present right to receive an amount in question, that amount will be quantifiable and not subject to any contingency or defeasibility ( Gasparin v. Federal Commissioner of Taxation (1994) 50 FCR 73; 94 ATC 4280; (1994) 28 ATR 130; Barratt & Ors v. Federal Commissioner of Taxation (1992) 36 FCR 222; 92 ATC 4275; (1992) 23 ATR 339; Farnsworth v. Federal Commissioner of Taxation (1949) 78 CLR 504; 9 ATD 33; (1949) 4 AITR 258). The meaning of the term 'incurred' has been consistently held to mean a loss or outgoing is incurred when it has been 'encountered, run into, or fallen upon.' The term incurred also covers losses or outgoings to which a taxpayer is 'definitively committed' or has 'completely subjected' itself and liabilities which have 'come home' (presently existing liability has arisen), but does not cover a loss or outgoing that is impending, threatened or expected ( Federal Commissioner of Taxation v. James Flood Pty Ltd (1953) 88 CLR 492; 10 ATD 240; (1953) 5 AITR 579; Nilsen Development Laboratories Pty Ltd & Ors v. Federal Commissioner of Taxation (1981) 144 CLR 616; 81 ATC 4031; (1981) 11 ATR 505; New Zealand Flax Investments Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 179; 5 ATD 36; (1938) 1 AITR 366). Generally, income is derived or a loss is incurred when a forward sales contract matures, is closed out or is terminated. At those relevant times, a forward sales contract generally gives rise to an entitlement to payment as it coincides with the doing of all things that are required under the terms of the contract (for example, delivery of goods or cash settlement). That is, generally, on the earlier of maturity, close-out or termination, the parties have performed their obligations and a presently recoverable debt is created (the debt at that time is quantifiable and not subject to any contingency or defeasibility). Similarly, those relevant times will generally coincide with when a loss or outgoing is incurred, as at those relevant times a presently existing obligation will arise (for example, a forward sales contract that is cash settled). The terms of the forward sales contracts in this case, provided that at maturity, close-out or termination Company A would be required to: deliver the commodity which was the subject of the forward sales contract and entitled to receive payment; or in the event of cash settlement, receive payment if a receipt became owing or make a payment if an amount became due. In the present circumstances, the parties agreed to terminate the original forward sales contracts on the understanding that a lesser number of forward sales contracts would be entered into that would deal with the same rights and obligations that existed under the original forward sales contracts. This was achieved by using the commodity price relevant to the mid date in the range of maturity dates, and consolidating the quantities of commodity to be delivered. No payment changed hands between the parties and there was no change in the financial position of the parties before or after the termination of the original forward sales contracts. The termination resulted in each party being discharged of their obligations to satisfy performance on the specified dates under the original forward sales contracts on the understanding that the obligations would be performed under the new forward sales contracts entered into. Having regard to the above, particularly the composite nature of the transaction, it cannot be said that a presently existing debt or obligation was created or that the parties had taken the necessary steps to be entitled to payment or had definitely been subjected to the liability, if a liability arose. Accordingly, no gain or loss 'came home' at the time the original forward sales contracts were terminated and the new forward sales contracts were established.

Legislative references: Income Tax Assessment Act 1997 section 6-5 section 8-1
Case references: Taxation, Federal Commissioner of v. Australian Gas Light Co Newcastle Gas Co Ltd 83 ATC 4800 (1983) 15 ATR 105
Subject references: Commodity transactions Deductions & expenses Derived Financial derivatives Forward contracts Forward rate agreements Forward transactions Hedging Incurred