Private ruling: Forex realisation gain under section 775-25
Date of advice: 4 September 2017
Published: January 2018
Ruling period: 1/7/20XX - 30/6/20XX
Date scheme commenced: 1 November 20XX

Ruling: Q1: Will Section 775-25 apply to treat any potential foreign exchange gain realised on the proposed capitalisation of an advance a non-assessable non-exempt income? | A1: Yes.

Relevant facts and circumstances: 1. You are an Australian registered company. You are the head company of an Australian tax consolidated group (the ‘ABC tax consolidated group’) for the purposes of Part 3-90 of the Income Tax Assessment Act 1997 (‘ITAA 1997’). 2. You have an AUD functional currency for tax purposes and a foreign functional currency for accounting purposes. 3. You are ultimately held by ABC HeadCorp, a foreign resident company. 4. ABC Sub is an Australian registered company and is a member of the ABC tax consolidated group. ABC Sub holds 100% of the issued capital of ABC ForeignCorp, a foreign resident company. 5. In 2014, ABC Sub advanced an amount of foreign currency to ABC ForeignCorp for the purpose of ABC ForeignCorp acquiring 100% of the issued equity in XYZCorp, a foreign company. 6. The majority of this advanced foreign currency amount was for the purchase of XYZCorp, as shown in the Merger Agreement between ABC ForeignCorp and XYZCorp. 7. This amount was financed by ABC Sub under an extension of ABC Sub’s existing loan facility. The Loan Facility Agreement provides that the amount was advanced to the Borrower to finance the purchase price of XYZCorp. 8. The remainder of the foreign currency advance to ABC ForeignCorp was cash that was advanced by ABC Sub to finance ABC Sub’s investment in XYZCorp. 9. The whole amount of was advanced on an interest free basis to ABC ForeignCorp at a perpetual term, for the sole purpose of funding ABC ForeignCorp’s acquisition of the shares in XYZCorp. The terms of advance of the funds from ABC Sub to ABC ForeignCorp are undocumented. 10. The full balance of the advance could be called upon at the discretion of ABC Sub at any time, or may be settled at the discretion of ABC ForeignCorp if so required. 11. Neither a fair value election, a hedging financial arrangement election nor an election to rely on financial reports applies to the arrangement. 12. ABC Sub intends to capitalise the foreign currency by ABC ForeignCorp issuing equity to ABC Sub in the foreseeable future. As the advance is denominated in foreign currency and you have an Australian dollar functional currency for tax purposes, you will prima facie realise a foreign exchange gain or loss on the capitalisation of the advance. 13. It is estimated that the capitalisation will result in a prima facie AUD foreign exchange gain. 14. You currently have an aggregated turnover in excess of AUD 100 million and assets in excess of AUD 300 million.

Relevant legislative provisions: Income Tax Assessment Act 1936 Section 6 | Income Tax Assessment Act 1936 Section 350 | Income Tax Assessment Act 1997 Section 230-5 | Income Tax Assessment Act 1997 Section 230-50 | Income Tax Assessment Act 1997 Section 701-1 | Income Tax Assessment Act 1997 Section 768-5 | Income Tax Assessment Act 1997 Section 768-10 | Income Tax Assessment Act 1997 Section 768-15 | Income Tax Assessment Act 1997 Section 775-15 | Income Tax Assessment Act 1997 Section 775-25 | Income Tax Assessment Act 1997 Section 960-115 | Income Tax Assessment Act 1997 Section 960-190 | Income Tax Assessment Act 1997 Section 974-20 | Income Tax Assessment Act 1997 Section 974-30 | Income Tax Assessment Act 1997 Section 974-70 | Income Tax Assessment Act 1997 Section 974-75 | Income Tax Assessment Act 1997 Section 995-1

Reasons for decision: Summary: Section 775-25 will apply to treat any potential forex gain made on the proposed capitalisation of the foreign currency advance as non-assessable non-exempt income. | Detailed Reasoning - Detailed reasoning: Legislative Background Division 230 Division 230 ‘Taxation of financial arrangements’ of ITAA 1997 (‘TOFA’) applies to determine the tax treatment of gains and losses from financial arrangements that are within the scope of the division, including foreign exchange (‘forex’) gains and losses. Forex gains and losses that are not within TOFA are taxed under Division 775 ‘Foreign currency gains and losses’ of ITAA 1997. Section 230-5 defines the scope of Division 230. Subsection 230-5(1) states: (1) You have a financial arrangement if you have one or more cash settlable legal or equitable rights and/or obligations to receive or provide a financial benefit. (2) This Division does not apply to all financial arrangements. The main exceptions are if: … (b) the arrangement is a financial arrangement under section 230-50 (equity interests etc.) and neither a fair value election, a hedging financial arrangement election nor an election to rely on financial reports applies to the arrangement. Subsection 230-50 states that you also have a financial arrangement if you have an equity interest. The equity interest constitutes the financial arrangement. Subsection 974-70(1) states that a scheme gives rise to an equity interest in a company if, when the scheme comes into existence: (a) the scheme satisfies the equity test in subsection 974-75(1) in relation to the company because of the existence of an interest; and (b) the interest is not characterised as, and does not form part of a larger interest that is characterised as, a * debt interest in the company, or a * connected entity of the company, under Subdivision 974-B. Item 3 of the table in Subsection 974-75(1) provides that a scheme satisfies the equity test in this subsection in relation to a company if it gives rise to an interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is at the discretion of: (a) the company; or (b) a connected entity of the company. The return may be a return of an amount invested in the interest. Paragraph 974-20(1)(b) states that one of the necessary elements of a scheme satisfying the debt test in relation to an entity is that the entity, or a connected entity of the entity, receives, or will receive, a financial benefit or benefits under the scheme. Subsection 974-30(1) states: The following do not constitute the provision of a * financial benefit by an entity or a * connected entity of the entity: (a) the issue of an * equity interest in the entity or a connected entity of the entity; or (b) an amount that is to be applied in respect of the issue of an equity interest in the entity or a connected entity of the entity. Division 775 Where the tax treatment of a forex gain is determined under Division 775, subsection 775-15(1) provides the basic rule that your assessable income for an income year includes a forex realisation gain you make as a result of a forex realisation event that happens during that year. Section 775-25 modifies this basic rule by stating: | Detailed Reasoning - Certain forex realisation gains are non-assessable non-exempt income: A * forex realisation gain you make is * non-assessable non-exempt income to the extent that, if it had been a * forex realisation loss, it would have been made in gaining or producing non-assessable non-exempt income. ATO Interpretative Decision ATO 2010/212 Foreign exchange (forex): forex realisation gain on cessation of a foreign currency swap gives the following guidance for determining whether a forex gain falls within section 775-25: 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. … 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. … 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…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 23AJ of the Income Tax Assessment Act 1936 . 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. Subdivision 768-A Under Subdivision 768-A of the Income Tax Assessment Act 1997 (ITAA 1997), where an Australian corporate tax entity receives a foreign equity distribution from a foreign company, either directly or indirectly through one or more interposed trusts or partnerships, and the Australian corporate tax entity holds a participation interest of at least 10% in the foreign company, the distribution is non-assessable non-exempt income for the Australian corporate tax entity. Subsection 768-5(1) states: A * foreign equity distribution is not assessable income, and is not * exempt income, of the entity to which it is made if: (a) the entity is an Australian resident and a * corporate tax entity; and (b) at the time the distribution is made, the entity satisfies the participation test in section 768-15 in relation to the company that made the distribution; and (c) the entity: (i) does not receive the distribution in the capacity of a trustee; or (ii) receives the distribution in the capacity of a trustee of a * public trading trust. Subsection 995-1(1) states that “Australian resident” means a person who is a resident of Australia for the purposes of the Income Tax Assessment Act 1936 (ITAA 1936). Subsection 6(1) of ITAA 1936 states that a resident of Australia includes a company which is incorporated in Australia. Section 960-115 states that an entity that is a company is a “corporate tax entity”. Section 768-10 defines a “foreign equity distribution” as: A * distribution or * non-share dividend made by a company that is a foreign resident in respect of an * equity interest in the company. Item 1 of the table in subsection 960-120(1) states that a “distribution” by a company is constituted by “a dividend, or something that is taken to be a dividend, under this Act.” Subsection 995-1(1) states that a “foreign resident” means a person who is not a resident of Australia for the purposes of ITAA 1936. Item 1 of subsection 974-75(1) states that “an interest in the company as a member or stockholder of the company” is an “equity interest”. Section 768-15 provides that an entity satisfies the participation test in relation to another entity where the sum of the following is at least 10%: (a) the * direct participation interest the entity would have in the other entity if rights on winding-up were disregarded; (b) the * indirect participation interest the entity would have in the other entity if: (i) rights on winding-up were disregarded; and (ii) section 960-185 only applied to intermediate entities that are not * corporate tax entities. The definition of “direct participation interest” in a company in item 1 of subsection 960-190(1) directs to the definition of “direct control interest”, which per paragraph 350(1)(a) of ITAA 1936 includes the percentage of the total paid-up share capital of a company that an entity holds. Taxation Ruling TR 2017/3 Income tax: distributions from foreign companies - meaning of 'at the time the distribution is made' when applying the participation test states at paragraph 10: For the purposes of section 768-5 the Commissioner considers that an entity will satisfy the participation test 'at the time the distribution is made' by the foreign company if the entity is the registered holder of at least a 10% participation interest in that company at the commencement of the day that the distribution is made. Part 3-90 Under Part 3-90 of the ITAA 1997, certain groups of entities are treated as single entities for income tax purposes. The single entity rule at section 701-1 has the effect that following a choice to consolidate, for the purpose of working out the amounts of any income tax liability or loss of the head company or subsidiaries, subsidiary members are treated as part of the head company of the group, rather than as separate income tax identities. As a result of the single entity rule, any foreign dividend income or forex gain derived by subsidiary members of a corporate group will be treated as derived by the head company of the group. Further, the head company of a consolidated group will be liable for any income tax calculated in respect of any forex gain made by a subsidiary member of a consolidated group. Analysis Application of TOFA You are the head company of the ABC tax consolidated group. You have an AUD functional currency for tax purposes and a foreign functional currency for accounting purposes. A subsidiary member of your group, ABC Sub, made a foreign currency interest-free advance at a perpetual term to a foreign resident subsidiary, ABC ForeignCorp, for the purpose of ABC ForeignCorp acquiring the shares in XYZCorp, in order for the consolidated group to derive foreign dividend income. ABC Sub intends to capitalise the foreign currency by ABC ForeignCorp issuing equity to ABC Sub in the foreseeable future. It is estimated that the capitalisation will result in a prima facie AUD foreign exchange gain. As per Subsection 230-5(1), the advance that ABC Sub provided to ABC ForeignCorp is a financial arrangement under Division 230 of ITAA 1997 as it is a cash settlable right for you to receive a financial benefit from ABC Sub. As an interest-free advance granted at a perpetual term, which can be settled at the discretion of either ABC Sub or ABC ForeignCorp, this financial arrangement is a scheme that satisfies the equity test in subsection 974-75(1), as it falls under Item 3 of the table in that subsection, as a scheme giving rise to an interest of ABC Sub that carries the right to a return from ABC ForeignCorp to ABC Sub, that is at the discretion of ABC ForeignCorp. As such, paragraph (a) of subsection 974-70(1) is satisfied. The advance from ABC Sub to ABC ForeignCorp can be satisfied by the capitalisation of the advance and ABC ForeignCorp issuing equity to ABC Sub. The issue of such equity interests is not, per subsection 974-30(1), the provision of a financial benefit by an entity. This means that it is not an element of the scheme constituted by the financial arrangement that ABC Sub will receive a financial benefit, as defined in part by subsection 974-30(1). As such, the scheme will not satisfy the debt test under paragraph 974-20(1)(b), and will therefore satisfy paragraph (b) of subsection 974-70(1). As both limbs of subsection 974-70(1) are satisfied, the scheme constituted by the advance that ABC Sub provided to ABC ForeignCorp is an equity interest of ABC Sub in ABC ForeignCorp. Neither a fair value election, a hedging financial arrangement election nor an election to rely on financial reports applies to the arrangement. Therefore, as per Subsection 230-5(2)(b) , the financial arrangement of the advance falls outside the scope of TOFA, and the tax treatment of any forex gain derived from the financial arrangement is instead determined under Division 775. Application of Division 775 Under subsection 775-15(1), any forex realisation gain made by ABC Sub as a result of a forex realisation event that happens during that year would ordinarily be included in the assessable income of ABC Sub, with the single entity rule under section 701-1 then applying to treat that gain as derived by yourself as the head company of the ABC consolidated group, with the gain included in your assessable income. Where section 775-25 applies, this gain would instead be treated as your non-assessable non-exempt income, to the extent that, if it had been a forex realisation loss, it would have been made in gaining or producing non-assessable non-exempt income. As per ATO ID 2010/212, in deciding whether section 775-25 applies, an enquiry must be made into the nexus between a hypothetical forex realisation loss and the gaining or producing of non-assessable non-exempt income. This nexus will be satisfied where a loss or outgoing is incidental and relevant to the gaining or production of assessable income. In the hypothetical example provided, 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. As such, the nexus between a hypothetical forex realisation loss incurred by yourself, and the gaining or producing of non-assessable non-exempt income by yourself, as a result of the capitalisation of the advance by ABC Sub, will be satisfied where that hypothetical loss is incidental and relevant to the gaining or production of assessable income by yourself. The advance was made by ABC Sub for the sole purpose of ABC ForeignCorp acquiring 100% of the shares in XYZCorp so that the ABC tax consolidated group can derive foreign dividend income, as per the Merger Agreement and the Loan Facility Agreement. This is comparable to the example in ATO ID 2010/212 where the forex swap was entered into so that shares in Foreign Co could be acquired in order for Aust Co to derive foreign dividend income. As stated in Ronpibon Tin , at CLR 57, as cited in ATO ID 2010/212, 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. It is not necessary, in order for the nexus to be satisfied, for the assessable income to have been derived if it is expected to be derived. The foreign currency advance that was made to ABC ForeignCorp, and any forex gain or loss made on the capitalisation of the advance, are therefore is incidental and relevant to the gaining or production of that dividend income. In these circumstances it is considered there is a sufficient nexus between a hypothetical forex realisation loss on the capitalisation of the foreign currency advance and the expected generation of dividend income from ABC ForeignCorp. Where this dividend income would be non-assessable-non-exempt income, section 775-25 would be satisfied such that the actual future forex gain would be non-assessable non-exempt income. Application of Subdivision 768-A As a result of the acquisition of the XYZCorp shares by ABC ForeignCorp, profits made by XYZCorp would be paid to ABC ForeignCorp as dividends. These profits would then be paid by ABC ForeignCorp, a foreign resident company, to ABC Sub, a company registered in Australia. As ABC Sub is a subsidiary member of the ABC tax consolidated group of which you are the head company, any dividends paid by ABC ForeignCorp to ABC Sub would be derived by you. Any dividends paid to ABC Sub by ABC ForeignCorp are a distribution, per subsection 960-120(1), made by a company that is a foreign resident, per subsection 995-1(1), in respect of ABC Sub’s equity interest in the company, per subsection 974-75(1). As such, the dividends are a foreign equity distribution. As an Australian registered company, ABC Sub is an Australian resident, per subsection 995-1(1) of ITAA 1997 and subsection 6(1) of ITAA 1936. ABC Sub is also a corporate tax entity per section 960-115 of ITAA 1997. ABC Sub’s direct control interest in ABC ForeignCorp, per paragraph 350(1)(a) of ITAA 1936, would at the time of the distributions be 100% of the share capital of ABC ForeignCorp, such that ABC Sub’s total direct participation interest in ABC ForeignCorp (if rights on winding-up were disregarded) at the time of the distributions would be greater than 10%. As such, ABC Sub’s combined shareholding satisfies the participation test in section 768-15, as per TR 2017/3. ABC Sub would not receive the distribution in the capacity of a trustee or in the capacity of a trustee of a public trading trust. As these conditions have been satisfied, any dividends paid to ABC Sub by ABC ForeignCorp would be non-assessable non-exempt income under section 768-5(1) of Subdivision 768-A. This includes any dividends paid to distribute profits earnt by XYZCorp to the ABC tax consolidated group. Tax Treatment of Forex Gain Under Subdivision 775 As such, there is a sufficient nexus between a hypothetical forex realisation loss incurred by ABC Sub on the capitalisation of the foreign currency advance and the expected generation of non-assessable non-exempt dividend income from ABC ForeignCorp to satisfy section 775-20. The advance was made for the purpose of deriving non-assessable non-exempt dividend income, and that advance and any forex gain or loss made on the capitalisation of that advance is incidental and relevant to the gaining or production of that non-assessable non-exempt dividend income. Conclusion Section 775-25 will therefore apply to treat any potential forex gain made on the proposed capitalisation of the foreign currency advance as non-assessable non-exempt income.