Private ruling: Taxation of Financial Arrangements (TOFA)
Published: October 2013
Ruling period: Year ended 31 December 2012 | Year ending 31 December 2013
Date scheme commenced: 1 January 2012

Ruling: Q1: Is a realised foreign exchange loss arising from the repayment of borrowings used to recapitalise a foreign subsidiary not allowable as a deduction under subsection 230-30(3) of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes. | Q2: Are realised and unrealised foreign exchange losses in respect of borrowings used to acquire a foreign subsidiary not allowable as a deduction under subsection 230-30(3) of the ITAA 1997, to the extent that the borrowings were used to acquire the foreign subsidiary? | A2: Yes.

Relevant facts and circumstances: The taxpayer obtained two loans ( 'the first loan' and 'the second loan' ). The first loan was wholly used to recapitalise a foreign subsidiary. The second loan was partly used to acquire a foreign subsidiary, and partly used for general corporate purposes which solely produce assessable income for the taxpayer. It is reasonably expected that the foreign subsidiaries will pay dividends that will satisfy either section 23AI or section 23AJ of the Income Tax Assessment Act 1936 (ITAA 1936). That is, the dividends will be non-assessable non-exempt (NANE) income. No interest was derived by the taxpayer in respect of the proceeds received from the first loan before the proceeds were used to recapitalise the foreign subsidiary. No interest was derived by the taxpayer in respect of the portion of the proceeds received from the second loan before those proceeds were used to acquire the foreign subsidiary. Division 230 of the Income Tax Assessment Act 1997 (ITAA 1997) applies to the taxpayer in respect of gains and losses in respect of the first loan and the second loan. The taxpayer has made a general foreign exchange retranslation election under subsection 230-255(1) of the ITAA 1997. Foreign exchange gains and losses in respect of the first loan and the second loan are recognised under Subdivision 230-D of the ITAA 1997.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subsection 230-15(2) | Income Tax Assessment Act 1997 Subsection 230-15(2) | Income Tax Assessment Act 1997 Subsection 230-15(3) | Income Tax Assessment Act 1997 Subsection 230-30(3) | Income Tax Assessment Act 1997 Subsection 775-35(2) | Income Tax Assessment Act 1997 Paragraph 820-40(1)(a) | Income Tax Assessment Act 1997 Subparagraph 820-40(3)(b)(ii) | Income Tax Assessment Act 1936 Section 23AI | Income Tax Assessment Act 1936 Section 23AJ

Reasons for decision: Summary: Generally, under Division 230 of the ITAA 1997, a loss you make from a financial arrangement is deductible to the extent that you make the loss in gaining or producing your assessable income, or you necessarily make it in carrying on a business for the purpose of gaining or producing assessable income (subsection 230-15(2) of the ITAA 1997). However, subsection 230-30(3) of the ITAA 1997 provides that a loss made from a financial arrangement is not an allowable deduction to the extent it is made in gaining or producing exempt income or NANE income, unless the loss satisfies the description in subsection 230-15(3) of the ITAA 1997. Foreign exchange losses in respect of the first loan and the second loan are losses made from a financial arrangement. Subsection 230-15(3) of the ITAA 1997 is not applicable, as foreign exchange losses are not a cost in relation to a debt interest that is covered by paragraph 820-40(1)(a) of the ITAA 1997 (subparagraph 820-40(3)(b)(ii) of the ITAA 1997). Taxation Ruling TR 2012/3 Income tax: taxation of financial arrangements - application of subsections 230-30(2) and 230-30(3) of the Income Tax Assessment Act 1997 to gains and losses relating to exempt income or non-assessable non-exempt income explains the principles that apply in deciding whether or not a loss you make from a financial arrangement is made in gaining or producing exempt income or NANE income for the purpose of subsection 230-30(3) of the ITAA 1997. The principles are: · The words 'in gaining or producing' require an examination of whether or not there is a sufficient connection between the identified loss and an income producing activity. Whether a sufficient connection exists will depend on the nature of the loss and the degree of its connection with the activities by which the taxpayer is gaining or producing the relevant income. · The words 'in gaining or producing' have a wide application. · A loss is made in gaining or producing exempt income or NANE income if the loss is incidental and relevant to the exempt income or NANE income producing activity of the taxpayer. · Incidence and relevance requires an examination of the connection that the making of the loss has with the operations which more directly gain or produce the exempt income or NANE income. · Whether a loss has a sufficient connection to the gaining or producing of exempt income or NANE income is a question of fact and circumstances. TR 2012/3 deals with the connection that a foreign exchange loss (made in relation to a loan used to acquire a NANE income producing asset) has with the production of NANE income. TR 2012/3 explains that the nature of a foreign exchange loss made in respect of loan principal is akin to interest paid on the loan. Paragraph 133 of TR 2012/3 summarises the position in respect of the nature of such a loss and its connection to the production of NANE income: A foreign exchange loss is akin to a cost of borrowing, or of obtaining and securing borrowed funds for use in the business. This characterisation of the loss being a cost of borrowing and having regard to the wide nature of the nexus test (assuming there is no issue of the expenditure being too soon or post-derivation) leads to the conclusion that such a loss is made in gaining or producing NANE income. Paragraph 9 of Taxation Ruling IT 2606 Income tax: deduction for interest on borrowings to fund share acquisitions similarly states: As a general rule, interest on money borrowed to acquire shares will be deductible under the first limb of subsection 51(1) where it is expected that dividends or other assessable income will be derived from the investment. Such an expectation will usually exist as shares by their very nature are inherently capable of generating dividends, whether in the short or long term. However, such an expectation must be reasonable and not a mere theoretical possibility; there must be a prospect of dividends or other assessable income being received. Paragraph 20 of IT 2606 refers to the evidence before the Full Federal Court in FC of T v Total Holdings (Australia) Pty Ltd 79 ATC 4279 ( Total Holdings ). Paragraph 20 states: The parent had a policy of requiring dividends to be remitted and it had sufficient control over the subsidiary to ensure that this policy was followed. This was sufficient evidence to show an expectation of income by the parent at some time in the future. Whether foreign exchange losses in respect of the first loan and the second loan have a sufficient connection to the gaining or producing of NANE income is a question of fact and circumstances. Based on the facts and circumstance in respect of the first loan and the second loan and the principles identified above, foreign exchange losses in respect of the first loan and the second loan are made 'in gaining or producing' NANE income. As a result, foreign exchange losses in respect of the first loan and the second loan are not allowable as a deduction under any provision of the ITAA 1997 or the ITAA 1936 to the extent that they are made in gaining or producing NANE income (subsection 230-30(3) of the ITAA 1997). The facts and circumstances for the first loan and the second loan are similar to Example 3 beginning at paragraph 32 of TR 2012/3. In Example 3, a resident company borrowed to acquire shares in a foreign subsidiary, and on repayment of the loan made a foreign exchange gain. There was a reasonable expectation that the shares in the foreign subsidiary would pay dividends that would satisfy section 23AJ of the ITAA 1936. Example 3 concludes that: If an actual loss arose in these circumstances instead of the gain, such a loss would not be allowable as a deduction by virtue of subsection 230-30(3). Paragraph 85 of TR 2012/3 also explains that the principles discussed in TR 2012/3 provide some guidance in the context of Division 775 of the ITAA 1997, which has analogous provisions to section 230-30 of the ITAA 1997. Division 775 of the ITAA 1997 sets out the treatment for particular foreign currency losses where the losses are not subject to Division 230 of the ITAA 1997. In ATO Interpretative Decision ATO ID 2004/752 Income tax - Foreign exchange (Forex): Forex realisation loss on repayment of borrowings to acquire non-portfolio dividend a taxpayer made a foreign exchange loss in respect of the repayment of borrowings used to acquire foreign subsidiaries. The issue was whether the foreign exchange loss was disregarded under subsection 775-35(2) of Division 775 of the ITAA 1997. It is a requirement of the first limb of subsection 775-35(2) of the ITAA 1997 that the foreign exchange loss must be made 'in gaining or producing' NANE income. After referring to Total Holdings and recognising that the shares in the foreign subsidiaries 'are inherently capable of generating income', ATO ID 2004/752 concluded that the foreign exchange loss on repayment of the borrowing was made in gaining or producing NANE income (being dividends that will satisfy either section 23AI or section 23AJ of the ITAA 1936). The expression 'to the extent that' in subsection 230-30(3) of the ITAA 1997 makes it clear that apportionment is required where a loss: · has a connection with an activity that produces both assessable income, and exempt income or NANE income; or · has a connection with more than one activity, one of which produces assessable income and at least one other which produces exempt income or NANE income. There is no need to apportion the foreign exchange loss in respect of the first loan. The foreign exchange loss only has a connection with one activity: the acquisition and holding of the additional shares in the foreign subsidiary. The acquisition and holding of the additional shares in the foreign subsidiary will only produce NANE income, being dividends that will satisfy either section 23AI or 23AJ of the ITAA 1936. In addition, no interest was earned by the taxpayer in respect of the proceeds received from the first loan before the proceeds were used to recapitalise the foreign subsidiary. All of the foreign exchange loss arising from the repayment of the first loan is not allowable as a deduction to the taxpayer under any provision of the ITAA 1997 or the ITAA 1936 (subsection 230-30(3) of the ITAA 1997). Foreign exchange losses in respect of the second loan have a connection with the acquisition and holding of the shares in the foreign subsidiary, which are reasonably expected to produce NANE dividends, and they have a connection with general corporate activities which solely produce assessable income. As a result, apportionment of the foreign exchange losses in respect of the second loan is required. An appropriate method of apportionment is a question of fact in each case. The method to be adopted must be 'fair and reasonable' in all the circumstances (Ronpibon Tin NL and Tongkah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47 at 59). Based on the facts for the second loan, it is fair and reasonable to apportion foreign exchange losses in respect of the second loan based on the extent to which the proceeds received from the second loan were used to acquire the foreign subsidiary.