ATO ID 2013/47: Consolidation: tax cost setting - deductibility under section 8-1 of the ITAA 1997 of the tax cost setting amount of a commodity swap contract at the maturity of the swap contract
Date of decision: 12 August 2013
Year of income: Year ending 30 June 2007 Year ending 30 June 2008 Year ending 30 June 2009 Year ending 30 June 2010 Year ending 30 June 2011
Business line: Interpretative Assistance, Public Groups and International

Issue
Can the head company of a consolidated group claim a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the tax cost setting amount of a commodity swap contract held by a joining entity when the contract matures in the circumstances described below?

Decision
No, the head company of a consolidated group cannot claim a deduction under section 8-1 of the ITAA 1997 for the tax cost setting amount of a commodity swap contract held by a joining entity when the contract matures. No loss arises upon maturity of the swap contract.

Facts
An entity enters into a commodity swap contract for the purpose of hedging the financial risks of movements in the spot price of a commodity associated with its business. The swap contract is entered into in the ordinary course of the entity's business. However it is not held for the purpose of gaining a profit from its disposal. The entity does not outlay any amount to enter into this swap contract or to acquire it. The swap contract is created by the exchange of promises. The amounts that the entity is entitled to receive from the counterparty, and the amounts the entity owes the counterparty, under the swap contract are netted off in regular settlement periods. As a result only one payment is either made or received by the entity for each settlement period. However, the swap contract imposes gross but offsetting liabilities on each counterparty. Therefore, the gross receipts and gross outgoings paid under the swap contract are respectively assessable income under section 6-5 of the ITAA 1997 and allowable deductions under section 8-1 of the ITAA 1997. The swap contract matures when all periods provided for in the contract have expired. Subsequently, the entity joined a consolidated group as a subsidiary member. At the joining time, the swap contract is considered to be an asset for the purposes of Part 3-90 of the ITAA 1997. The tax costs of all of the assets of the entity are set in accordance with section 701-10 of the ITAA 1997. The head company does not outlay any additional amounts in relation to the swap contract.

Reasons for decision
Summary: (All references are to the ITAA 1997 unless otherwise stated). When the entity joins the consolidated group, Part 3-90 operates to deem certain facts in relation to the swap contract. For the purpose of working out the head company's income tax liability: In addition, the tax cost of the swap contract is set at its tax cost setting amount under section 701-10. Under the entry history rule, the swap contract is taken to have been entered into and held by the head company under the same circumstances as it was entered into and held by the entity before the joining time. Consequently, the head company is taken to have entered into the swap contract in the ordinary course of its business, for the purpose of hedging the financial risks of movements in the spot price of a commodity associated with its business. Similarly after the joining time, under the single entity rule and the entry history rule, the head company is taken to hold and deal with the swap contract as the entity did. This means that it is taken to hold the swap contract for the same purpose for which it was held before the joining time, until the swap contract comes to an end. A loss may be deductible under section 8-1 where the initial outlay in relation to an asset did not itself constitute a loss or outgoing incurred, and that asset is subsequently lost. This is in accordance with Guinea Airways Ltd v. Federal Commissioner of Taxation (1950) 83 CLR 584, where the taxpayer paid for aircraft spare parts which were not deductible on purchase. The parts were stockpiled by the taxpayer and were later destroyed by bombing during the Second World War. The taxpayer sought a deduction for the destroyed parts upon their destruction. Latham CJ noted (at 589): The claim of the company is not a claim for deduction of the amount expended in purchasing the spare parts and stores or of the value of those actually used. It is a claim in respect of their loss. An asset is lost and a loss incurred where the benefit or value of the asset is forgone and cannot be recovered or realised, for instance, where an asset was destroyed, or where a debt is not recovered to its full value (Parsons, RW 1985, Income Taxation in Australia: Principles of Income, Deductibility and Tax Accounting , The Law Book Company Limited, Sydney, at paragraph [6.52]). In contrast, when the swap contract reaches maturity, the benefits under the contract will have been fully realised by the entity. It has had the benefit of hedging the financial risks associated with its business for the entire time that the swap contract has been in place. Therefore, none of the value of the asset (the swap contract) can be said to have been lost. Rather, when the swap contract comes to an end the asset can be said to have run its course. In this way, there cannot be said to be a loss to the head company upon the maturity of the swap contract. Notwithstanding this, a loss may be deductible upon the ending of an asset where the asset is part of an entity's circulating capital. In Commercial and General Acceptance Ltd v. Federal Commissioner of Taxation (1977) 137 CLR 373; 77 ATC 4375; (1977) 7 ATR 716, Gibbs J observed (at CLR 377) that 'the line of distinction between fixed and circulating capital is not precisely drawn'. Mason J, however, went further (at CLR 383): The distinction between fixed and circulating capital was described by Jenkins L.J. in Reynolds and Gibson v. Crompton (1950) 33 T.C. 288 at p. 303, as 'debatable'. His Lordship went on to say that 'circulating capital' is 'simply an expression used to denote capital expended in the course of the trade with a view to disposal at a profit of the assets produced or acquired by means of such expenditure, and represented at different stages of its career by cash, assets into which the cash has been converted, and debts owing from customers to whom those assets have been sold'. See the same case on appeal Crompton v. Reynolds and Gibson (1952) 1 All E.R. 888 at pp. 893-895. However, it cannot be said that the swap contract here fits this description, as it is not an asset produced or acquired with a view to disposal at a profit. Rather, it was entered into for the purpose of managing the financial risk to the entity's business by hedging against movements in the spot price of a commodity. By this definition, the swap contract is not part of the entity's circulating capital, meaning that no deductible loss will arise upon its maturity (or ending). Furthermore, if an amount were to be received on the maturity of the swap contract, the amount received is properly characterised as ordinary income in its own right ( Commercial and General Acceptance Ltd v. Federal Commissioner of Taxation (1977) 137 CLR 373 at 382-383 per Mason J; Federal Commissioner of Taxation v. Montgomery (1999) 198 CLR 639 at 675-6 [110] - [111] per Gaudron, Gummow, Kirby and Hayne JJ). Therefore, amounts incurred on entry into the swap contract, or for acquiring the swap contract, are not deferred and taken into account in calculating the profit or loss on maturity of the swap contract. Such outgoings are deductible in the year in which they are incurred ( Federal Commissioner of Taxation v. Visy Industries USA Pty Ltd [2012] FCAFC 106; 2012 ATC 20-340 at [84]). Therefore, section 8-1 does not allow the head company to claim that a loss has been made from, or deduct any amount in relation to, the entity's swap contract upon its maturity. The condition in section 8-1 requiring there to be a loss or an outgoing has not been satisfied. It follows that the tax cost setting amount of the swap contract cannot be deducted under section 8-1 upon the maturity of the contract.

Legislative references: Income Tax Assessment Act 1997 section 8-1 section 701-1 section 701-5 section 701-10
Case references: Commercial and General Acceptance Ltd v. Federal Commissioner of Taxation (1977) 137 CLR 373 77 ATC 4375 7 ATR 716
Related public rulings and determinations: Taxation Ruling IT 2050 | Taxation Ruling IT 2682
Related ATO interpretative decisions: ATO ID 2013/46
Other references: Parsons, RW 1985, Income Taxation in Australia: Principles of Income, Deductibility and Tax Accounting, The Law Book Company Limited, Sydney.
Subject references: assets loss consolidation-joining financial derivatives swaps tax cost set amount