Private ruling: Treatment of gains and losses arising from transitional net investment in a foreign operation (NIFO) hedges pursuant to section 230-30 of the Income Tax Assessment Act 1997 (ITAA 1997)
Published: May 2014
Ruling period: A number of income years
Date scheme commenced: Before the 2011 income year

Ruling: Q1: Will a gain derived in respect of the taxpayer's NIFO hedges (specifically relating to the taxpayer's net investments in a foreign subsidiary (the Subsidiary)) that were transitioned into TOFA be included in the not assessable income and not exempt income of the taxpayer pursuant to subsections 230-30(1) and 230-30(2) of the ITAA 1997? | A1: Yes. | Q2: Will a loss incurred in respect of the taxpayer's NIFO hedges (specifically relating to the taxpayer's net investments in the Subsidiary) that were transitioned into TOFA be not allowable as a deduction to the taxpayer pursuant to subsection 230-30(3) of the ITAA 1997? | A2: Yes.

Relevant facts and circumstances: Background The taxpayer holds 100% of the share capital in the Subsidiary. The share capital of the foreign subsidiary is denominated in a foreign currency (the Foreign currency) and it has a functional currency in the Foreign Currency. As the shares are denominated in the Foreign Currency, the taxpayer specifically sourced external borrowings in the Foreign Currency to finance the share subscriptions. The taxpayer has confirmed that the dividends paid by the Subsidiary to the taxpayer are non-portfolio dividends as defined in section 317 of the Income Tax Assessment Act 1936 (ITAA 1936) and thus are not assessable and not exempt income to the taxpayer pursuant to section 23AJ of the ITAA 1936. To hedge the taxpayer's exposure to foreign exchange (FX) risk on translation, the taxpayer has designated the borrowings as NIFO hedges for accounting purposes in relation to the taxpayer's investments in offshore assets held through the Subsidiary. The taxpayer entered into the NIFO hedges in the Subsidiary prior to the time the TOFA rules began to apply to the taxpayer. The taxpayer made an existing arrangement election under sub-item 104(2) of the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 (TOFA Act) to bring all financial arrangements which the taxpayer held on the first day of the 2011 income year into the TOFA regime. The taxpayer also made the hedging financial arrangement election under section 230-315 of the ITAA 1997, which applies to both existing financial arrangements, and financial arrangements entered into after the TOFA rules started to apply to the taxpayer. As a result of the taxpayer's elections, the TOFA rules apply to the NIFO hedges on a transitional basis.

Relevant legislative provisions: Income Tax Assessment Act 1936 Section 23AJ | Income Tax Assessment Act 1936 Section 317 | Income Tax Assessment Act 1997 Section 230-15 | Income Tax Assessment Act 1997 Section 230-30 | Income Tax Assessment Act 1997 Section 230-45 | Income Tax Assessment Act 1997 Section 230-50 | Income Tax Assessment Act 1997 Section 230-55 | Income Tax Assessment Act 1997 Section 230-310 | Income Tax Assessment Act 1997 Section 230-315 | Income Tax Assessment Act 1997 Section 230-325 | Income Tax Assessment Act 1997 Section 820-40 | Income Tax Assessment Act 1997 Subsection 995-1(1) | Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 Sub-item 103(1) | Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 Sub-item 103(2) | Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 Sub-item 104(2)

Reasons for decision: Summary: Summary A gain derived in respect of the taxpayer's NIFO hedges (specifically relating to the taxpayer's net investments in the Subsidiary) that were transitioned into TOFA will be included in the not assessable income and not exempt income of the taxpayer pursuant to subsections 230-30(1) and 230-30(2) of the ITAA 1997. Detailed reasoning | Detailed Reasoning - Legislative Background: Sub-item 103(1) of Schedule 1 to the TOFA Act provides that the TOFA rules in Division 230 of the ITAA 1997 will apply for income years commencing on or after 1 July 2010, or for income years commencing on or after 1 July 2009 where an election is made under sub-item 103(2) of the TOFA Act. As the taxpayer did not make an election under sub-item 103(2) of the TOFA Act, the TOFA rules apply to the taxpayer for income years commencing on or after 1 July 2010. Sub-item 104 of the TOFA Act provides that the TOFA rules will apply only to financial arrangements which a taxpayer starts to have in their first applicable income year, or a later income year, unless a taxpayer makes an election under sub-item 104(2) of the TOFA Act to apply the TOFA rules to their existing financial arrangements. As the taxpayer has made an election under sub-item 104(2) of the TOFA Act, the TOFA rules apply to all Division 230 financial arrangements the taxpayer held on the first day of the 2011 income year, and all Division 230 financial arrangements the taxpayer started to have in their first applicable income year or a later income year. The taxpayer entered into the NIFO hedges prior to the time the TOFA rules began to apply to the taxpayer. As a result of the election under sub-item 104(2) of the TOFA Act, the TOFA rules apply to the NIFO hedges on a transitional basis. | Detailed Reasoning - Arrangement: The definition of 'financial arrangement' determines the unit of taxation in respect of which gains and losses are recognised under Division 230. In order to determine whether gains and losses arise under a financial arrangement, it is firstly necessary to establish whether the rights and obligations present in the current case give rise to an 'arrangement' which in turn meets the definition of a 'financial arrangement'. The term 'arrangement' is defined in subsection 995-1(1) of the ITAA 1997, which states: [arrangement] means any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings. As noted in paragraph 2.47 of the Explanatory Memorandum (EM) to the TOFA Act, generally a contract will constitute the relevant arrangement for Division 230 purposes. However, section 230-55 of the ITAA 1997 contains grouping and disaggregation rules which may operate to group rights and obligations under a number of arrangements into one arrangement, or alternatively to disaggregate rights and obligations into a number of arrangements. Relevantly, subsection 230-55(4) of the ITAA 1997 provides: For the purposes of this Division, whether a number of rights and/or obligations are themselves an arrangement or are 2 or more separate arrangements is a question of fact and degree that you determine having regard to the following: (a) The nature of the rights and/or obligations; (b) their terms and conditions (including those relating to any payment or other consideration for them); (c) the circumstances surrounding their creation and their proposed exercise or performance (including what can reasonably be seen as the purposes of one or more of the entities involved); (d) whether they can be dealt with separately or must be dealt with together; (e) normal commercial understandings and practices in relation to them (including whether they are regarded commercially as separate things or as a group or series that forms a whole); (f) the objects of this Division. Accordingly, the six factors in subsection 230-55(4) of the ITAA 1997 must be considered to determine the relevant arrangement for Division 230 purposes. The ATO view in relation to these factors is set out in Taxation Ruling TR 2012/4 Income tax: the operation of subsection 230-55(4) of the Income Tax Assessment Act 1997 (ITAA 1997) in determining what is an 'arrangement' for the purposes of the taxation of financial arrangements under Division 230 of the ITAA 1997 . It is accepted that the taxpayer's transitional NIFO hedges in the Subsidiary meet the definition of an 'arrangement' under subsection 995-1(1) of the ITAA 1997. Where, in accordance with the factors provided in subsection 230-55(4) of the ITAA 1997, there is more than one arrangement in the present case, this ruling applies only to those arrangements which the taxpayer started to have prior to their entry into TOFA. | Detailed Reasoning - Financial arrangement: Subdivision 230-A of the ITAA 1997 provides the tests for determining whether an arrangement is a financial arrangement. Broadly, an arrangement will be a financial arrangement if it satisfies the definition of a financial arrangement under section 230-45 of the ITAA 1997, or the definition of a financial arrangement under section 230-50 of the ITAA 1997 (relating to equity interests). Subsection 230-45(1) of the ITAA 1997 provides: You have a financial arrangement if you have, under an arrangement: (a) a cash settlable legal or equitable right to receive a financial benefit; or (b) a cash settlable legal or equitable obligation to provide a financial benefit; or (c) a combination of one or more such rights and/or one or more such obligations; unless: (d) you also have under the arrangement one or more legal and equitable rights to receive something and/or one or more legal or equitable obligations to provide something; and (e) for one or more of the rights and/or obligations covered by paragraph (d): (i) the thing that you have the right to receive, or the obligation to provide, is not a financial benefit; or (ii) the right or obligation is not cash settlable; and (f) the one or more rights and/or obligations covered by paragraph (e) are not insignificant in comparison with the right, obligation or combination covered by paragraph (a), (b) or (c). The right, obligation or combination covered by paragraph (a), (b) or (c) constitutes the financial arrangement. It is noted that the definition of a financial arrangement in subsection 230-50 of the ITAA 1997 does not apply in the present circumstances. The taxpayer's rights and obligations under the NIFO hedges are cash settlable in accordance with paragraph 230-45(2)(a) of the ITAA 1997 (the benefit is money or a money equivalent). As the rights and obligations under the NIFO hedges are cash settlable, the arrangements will be Division 230 financial arrangements pursuant to the definition in section 230-45 of the ITAA 1997. | Detailed Reasoning - Sections 230-15, 230-30 and 230-310 of the ITAA 1997: The taxpayer has made a hedging financial arrangement election pursuant to section 230-315 of the ITAA 1997 which applies both to their hedging financial arrangements entered into prior to TOFA, and those entered into after the start of TOFA. As a result of this election, the hedging method in Subdivision 230-E of the ITAA 1997 applies to all of the taxpayer's financial arrangements to which the election can apply pursuant to section 230-325 of the ITAA 1997. Generally, the character of gains and losses on hedging financial arrangements is determined pursuant to the table in subsection 230-310(4) of the ITAA 1997. However, in relation to transitional hedging financial arrangements, sub-item 104(10) of the TOFA Act provides: To avoid doubt, subsection 230-310(4) does not apply to a financial arrangement that you started to have before the start of the first applicable income year and that you have at the start of that income year. Accordingly, the table in subsection 230-310(4) of the ITAA 1997 will not apply to determine the character of the gains and losses on the transitional hedging financial arrangements. As a result, subsection 230-310(3) of the ITAA 1997 will provide for the character of the relevant gains and losses. Subsection 230-310(3) provides: Subject to subsection (4): (a) if you make a gain from the financial arrangement - your assessable income includes the gain in accordance with subsection 230-15(1); and (b) if you make a loss from the arrangement - you may deduct the loss in accordance with subsection 230-15(2) and (3). Accordingly, pursuant to paragraph 230-310(3)(a) of the ITAA 1997, a gain made from the transitional hedging financial arrangement will be included in assessable income in accordance with subsection 230-15(1) of the ITAA 1997. It is unclear from the provision whether the effect of this provision is to directly include amounts in assessable income, or whether the gain must be considered in light of subsection 230-15(1) of the ITAA 1997 and associated provisions in Subdivision 230-A of the ITAA 1997. Subsection 230-15(1) of the ITAA 1997 provides: Your assessable income includes a gain you make from a financial arrangement. However, section 230-30 of the ITAA 1997 provides: [Subsection 230-30(1)] Despite section 230-15, a gain that you make from a financial arrangement: (a) to the extent that it reflects an amount that would be treated, or would reasonably expected to be treated, as exempt income under a provision of this Act if this Division were disregarded - is exempt income; and (b) to the extent that it reflects an amount that would be treated or would reasonably expected to be treated, as non-assessable non-exempt income under a provision of this Act if this Division were disregarded - is not assessable income and is not exempt income. [Subsection 230-30(2)] Despite section 230-15, a gain that you make from a financial arrangement: (a) to the extent that, if it had been a loss, you would have made it in gaining or producing exempt income - is exempt income; and (b) to the extent to which, if it had been a loss, you would have made it in gaining or producing non-assessable non-exempt income - is not assessable income and is not exempt income. [Subsection 230-30(3)] A loss you make from a financial arrangement is not allowable as a deduction to you under any provision of this Act (other than subsection 230-15(3)) to the extent that you make it in gaining or producing your: (a) exempt income; or (b) non-assessable non-exempt income. Having regard to the context of these provisions, the Commissioner is of the view that the operation of subsection 230-310(3) of the ITAA 1997 requires gains to be considered for inclusion in the assessable income in accordance with section 230-15 of the ITAA 1997. However, noting the wording in section 230-30 of the ITAA 1997 which provides that it operates 'despite section 230-15', a taxpayer is required to consider whether the gain is to be included in assessable income having regard to section 230-15 of the ITAA 1997 and other provisions in Subdivision 230-A of the ITAA 1997 which support section 230-15 (such as section 230-30). Contextual support for this position is found in relation to losses in subsection 230-30(3) of the ITAA 1997. This provision provides that, where a loss has a nexus to exempt or non-assessable non-exempt (NANE) income, it is not deductible under any provision of this Act (as defined) other than subsection 230-15(3) of the ITAA 1997. Accordingly then, a loss cannot be allowed as a deduction pursuant to subsection 230-310(3) of the ITAA 1997, where this amount has a nexus to NANE income. It is considered appropriate that this principle applies symmetrically to both losses and gains with a nexus to NANE income. The EM to the TOFA Act provides further support for this position. In relation to an amount which would ordinarily, outside of TOFA, be NANE, the EM states at paragraph 3.27: Losses from financial arrangements made in gaining or producing exempt income or non-assessable non-exempt income are not deductible. Gains made from financial arrangements will be exempt income or non-assessable non-exempt income to the extent that they reflect amounts that would be treated or would reasonably be expected to be treated as exempt or non-assessable non-exempt income under a provision outside Division 230 if Division 230 were not enacted. Accordingly, when determining whether a gain from a transitional hedging financial arrangement is included in assessable income, consideration of section 230-15 of the ITAA 1997 is required. However, further regard to the associated provisions such as section 230-30 of the ITAA 1997 is also necessary. As a result, it must be considered whether the gains from the transitional hedging financial arrangements have the requisite nexus to gaining or producing NANE income. | Detailed Reasoning - Nexus: The borrowings were used to purchase shares in the Subsidiary. The taxpayer has confirmed that any dividend income paid by the Subsidiary to the taxpayer in respect of these shares is to be treated as NANE income pursuant to section 23AJ of the ITAA 1936. The taxpayer's transitional NIFO hedges in the Subsidiary are borrowings denominated in the Foreign Currency. Any gain or loss made on the borrowings is therefore considered to be part of the cost of borrowings and has a nexus to the purpose of the borrowings. In the current case, the purpose of the borrowings is to invest in a foreign subsidiary and to derive NANE income through this investment. Accordingly, the borrowings, and gains and losses on the borrowings, have a nexus to gaining or producing NANE income. Hence the FX gains and losses on the borrowings also have the nexus to gaining or producing NANE income. This is consistent with the Commissioner's view relating to the application of subsections 230-30(2) and 230-30(3) of the ITAA 1997 to gains and losses relating to exempt income or NANE income (Refer to 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). | Detailed Reasoning - Conclusion: Foreign exchange gains on the taxpayer's transitional hedges in the Subsidiary have a nexus to gaining or producing NANE income. These gains are characterised as NANE income pursuant to subsections 230-30(1) and 230-30(2) of the ITAA 1997, and as a result, will not be included in the taxpayer's assessable income. | Detailed Reasoning - Question 2: Summary A loss incurred in respect of the taxpayer's NIFO hedges (specifically relating to the taxpayer's net investments in the Subsidiary) that were transitioned into TOFA will not be allowable as a deduction to the taxpayer pursuant to subsection 230-30(3) of the ITAA 1997. Detailed reasoning As noted in the response to question 1, gains in relation to the taxpayer's transitional hedges in the Subsidiary will be included in the NANE income of the taxpayer due to the operation of subsections 230-30(1) and (2) of the ITAA 1997. Likewise, for the reasons outlined in the response to question 1, losses made on the transitional hedges will also, through the application of subsection 230-310(3) of the ITAA 1997, be subject to the requirements of section 230-30 of the ITAA 1997. Relevantly, subsection 230-30(3) of the ITAA 1997 provides: A loss you make from a financial arrangement is not allowable as a deduction to you under any provision of this Act (other than subsection 230-15(3)) to the extent that you make it in gaining or producing your: (a) exempt income; or (b) non-assessable non-exempt income As explained in relation to question 1, gains and losses on the taxpayer's transitional hedges in the Subsidiary are made in gaining or producing NANE income. As a result, a loss is not deductible under any provision of the ITAA 1997 other than subsection 230-15(3) of the ITAA 1997. Relevantly, subsection 230-15(3) of the ITAA 1997 provides: You can also deduct a loss you make from a financial arrangement if: (a) you are an Australian entity; and (b) you make the loss in deriving income from a foreign source; and (c) the income is non-assessable non-exempt income under section 23AI, 23AJ or 23AK of the Income Tax Assessment Act 1936 ; and (d) the loss is, in whole or in part, a cost in relation to a debt interest you issue that is covered by paragraph 820-40(1)(a). Subsection 820-40(3) of the ITAA 1997 provides examples of amounts which are not covered by paragraph 820-40(1)(a) of the ITAA 1997. This includes both losses and outgoing directly associated with hedging or managing the financial risk in respect of the debt interest (paragraph 820-40(3)(a) of the ITAA 1997), and for losses which arise from changes to foreign currency rates (subparagraph 820-40(3)(b)(ii) of the ITAA 1997). Accordingly, the losses on the taxpayer's transitional hedges in the Subsidiary are not considered to be a cost in relation to a debt interest covered by paragraph 820-40(1)(a) of the ITAA 1997. As a result, the amount is not deductible under subsection 230-15(3) of the ITAA 1997. | Detailed Reasoning - Conclusion: As the losses on the taxpayer's transitional hedges in the Subsidiary have a nexus to gaining or producing NANE income and they are not deductible under subsection 230-15(3) of the ITAA 1997, the losses will not be allowed as a deduction under any provision of this Act (as defined) pursuant to subsection 230-30(3) of the ITAA 1997.