Private ruling: Taxation of Financial Arrangements (TOFA) - Hedging Financial Arrangement
Date of advice: 27 November 2015
Published: February 2016
Ruling period: 1 July 20XX to 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Will the proposed hedging process satisfy the recording requirements in subsections 230-355(1) and (4) of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes. | Q2: For the purpose of section 230-360 of the ITAA 1997, will the basis proposed to be adopted by Fund X for the allocation of hedging gains and losses from forward foreign exchange contracts (FFX gains and losses) satisfy the requirements in subsection 230-360(2) of the ITAA 1997? | A2: Yes.

Relevant facts and circumstances: Background Fund X is an Australian resident unit trust, with units quoted on the Australian Securities Exchange (ASX). Fund X invests in units in another unit trust, Fund Y, and holds forward foreign exchange contracts ('FFX'). Fund Y is an Australian resident unit trust with units quoted on the ASX. It invests in a portfolio of international equities. Fund X uses FFX contracts to hedge the foreign currency risk arising from its unit holdings in Fund Y. The FFX contracts are designated from inception as hedges for accounting purposes. Hedging process Fund X hedges the underlying currency exposures by entering into FFX contracts. The hedge is rebalanced regularly so that the exposure to AUD is between a predetermined percentage of the Net Asset Value. Where a FFX gain is realised, the funds are applied towards the purchase of additional units in Fund Y (to the value of the FFX contract gain). Where there is an FFX loss, units in Fund Y are redeemed to fund that loss. Units in Fund Y may be either sold on the ASX, or redeemed in accordance with the constitution of Fund Y. Fund X made a taxation of financial arrangement (TOFA) hedging financial arrangement election under subsection 230-315(1) of the ITAA 1997 in respect of all Fund X's financial arrangements that are treated as hedges for accounting purposes in the relevant income years. Fund X prepares financial statements. The financial statements will be prepared in accordance with the accounting principles, and audited in accordance with the auditing principles. Based on audit procedures performed as per AASB 139: • Fund X has formally adopted hedge accounting; • Hedges effectiveness testing was undertaken; and • The effectiveness testing confirmed the hedges were effective. The audit of the hedge arrangement will continue to be undertaken by Fund X's auditors. Other information Division 230 of the ITAA 1997 applies to Fund X. The hedging financial arrangement election under Subdivision 230-E of the ITAA 1997 is valid. The FFX contracts satisfy the primary definition of 'hedging financial arrangements' pursuant to subsection 230-335(5) of the ITAA 1997 and are recorded as hedging instrument in the financial reports of Fund X. The 'hedged item' for the purpose of subsection 230-335(10) of the ITAA 1997 is the Australian dollar denominated units held in Fund Y. Fund X is an eligible Management Investment Trust and made the election for deemed capital treatment under Division 275 of the ITAA 1997. The hedge accounting approach is in full compliance with AASB 139 Financial Instruments: Recognition and Measurement. Assumptions The FFX contracts designated as hedges for accounting purposes will be highly effective for accounting purposes, and will satisfy the hedge effectiveness requirements in section 230-365 of the ITAA 1997. Fund X will not make an assessable capital gain under CGT Event E4, pursuant to section 104-70 of the ITAA 1997.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 230-E | Income Tax Assessment Act 1997 Section 230-315 | Income Tax Assessment Act 1997 Subparagraph 230-260(2)(c)(i) | Income Tax Assessment Act 1997 Subparagraph 230-260(2)(c)(ii) | Income Tax Assessment Act 1997 Subsection 230-310(4) | Income Tax Assessment Act 1997 Subsection 230-315(1) | Income Tax Assessment Act 1997 Section 230-325 | Income Tax Assessment Act 1997 Section 230-335(10) | Income Tax Assessment Act 1997 Section 230-355 | Income Tax Assessment Act 1997 Subsection 230-355(1) | Income Tax Assessment Act 1997 Subsection 230-355(4) | Income Tax Assessment Act 1997 Subparagraph 230-355(1)(a)(i) | Income Tax Assessment Act 1997 Subparagraph 230-355(1)(a)(ii) | Income Tax Assessment Act 1997 Subparagraph 230-355(1)(a)(iii) | Income Tax Assessment Act 1997 Subparagraph 230-355(1)(a)(iv) | Income Tax Assessment Act 1997 Subparagraph 230-355(1)(a)(v) | Income Tax Assessment Act 1997 Paragraph 230-355(1)(b) | Income Tax Assessment Act 1997 Paragraph 230-355(1)(c) | Income Tax Assessment Act 1997 Subsection 230-355(3) | Income Tax Assessment Act 1997 Subsection 230-355(5) | Income Tax Assessment Act 1997 Section 230-360 | Income Tax Assessment Act 1997 Paragraph 230-360(2)(a) | Income Tax Assessment Act 1997 Paragraph 230-360(2)(b) | Income Tax Assessment Act 1997 Paragraph 230-360(2)(c) | Income Tax Assessment Act 1997 Section 230-365 | Acts Interpretation Act 1901 Section 25

Reasons for decision: Summary: The proposed hedging process will satisfy the recording requirements in subsections 230-355(1) and (4). | Detailed Reasoning - Recording requirements - documentation of the hedging relationship: 1. Section 230-355 sets out the recording requirements that a hedging financial arrangement must satisfy in order for the hedging financial arrangement election to apply to it. 2. Section 25 of the Acts Interpretation Act 1901 provides, inter alia, that 'record' includes information stored or recorded by means of a computer. 3. In the present case, the risk management objective and strategy of Fund X, including the nature of the risk being hedged, is explicitly stated in the documentation. Subparagraph 230-355(1)(a)(v) - risk management objective and strategy 4. The documentation states the 'the objective of the hedge program is to negate the impact of currency fluctuation, whether positive or negative, arising from unit holdings in Fund Y.' Subparagraph 230-355(1)(a)(i) - the hedging financial arrangement, subparagraph 230-355(1)(a)(ii) - nature of risk or risks being hedged and subparagraph 230-355(1)(a)(iii) - hedged item 5. The FFX contracts are entered into to hedge Fund X's exposure to the currency fluctuations as reflected in the unit price of the units held by Fund X in Fund Y. Subparagraph 230-355(1)(a)(iv) - how hedge effectiveness will be tested 6. The documentation provides that Fund X is to prospectively assess the proposed hedging effectiveness by matching the notional value of the FFX to the market value of Fund Y with Foreign Exchange Exposures on a currency by currency basis. 7. Fund X's auditor confirmed that Fund X has formally adopted hedge accounting, retrospective hedge effectiveness testing was conducted, and found the FFX contracts to be effective for AASB 139 purposes. 8. Fund X's auditor advised that the hedge accounting approach as set out in the documentation and through audit procedures conducted for the financial statement audit year was in full compliance with AASB 139 Financial Instruments: Recognition and Measurement. Paragraph 230-355(1)(b) - Any further details that the accounting standards require to be documented in order for an arrangement to be recorded as a hedging instrument in a financial report 9. Effectiveness testing, and compliance with AASB 139 Financial Instruments: Recognition and Measurement and AASB 7 will continue to be conducted by Fund X's auditor for future annual financial statement audits. Paragraph 230-355(1)(c) - methodology for the allocation of FFX gains and losses 10. The methodology for the allocation of FFX gains and losses to income years is outlined in the documentation. 11. Having regard to the relevant documentation, it is considered that Fund X satisfies the recording requirements in subsection 230-355(1). 12. Fund X also satisfies the recording requirements in subsection 230-355(4) as the documentation specifically state that the risk in respect of the hedged item was hedged by the hedging financial arrangement, the extent to which the risk was hedged, and that the rights and obligations comprising the hedging financial arrangement were created, acquired or applied for the purpose of hedging the risk. | Detailed Reasoning - Question 2: Summary The basis proposed to be adopted by Fund X for the allocation of hedging gains and losses from forward foreign exchange contracts ('FFX gains and losses') will satisfy the requirements in subsection 230-360(2). | Detailed Reasoning - Reasoning: 13. Before assessing whether the requirements of section 230-360 have been satisfied, it is necessary to establish that Subdivision 230-E otherwise applies, namely: • That the FFX contract is a hedging financial arrangement for section 230-335 purposes. • That Subdivision 230-E election applies to the FFX contract as required by section 230-325 • Finally, that the requirements of section 230-360 are satisfied. | Detailed Reasoning - Section 230-335: 14. The FFX contract will be a hedging financial arrangement as defined under section 230-335, for the following reasons: • The 'hedged item' for subsection 230-335(10) purposes in this case is an asset, the unit in Fund Y, which is recognised in the standalone financial statement of Fund X. • The FFX contract is a 'derivative financial arrangement' as defined by subsection 230-350(1), which has been acquired for the purpose of hedging a risk in relation to a hedged item (paragraph 230-335(1)(a)). • The FFX contract, as it appears in the standalone financial statement, satisfies the requirements of AASB 139 to be a hedging instrument, and is recognised in the standalone financial statement as a hedging instrument (paragraphs 230-335(1)(b) and 230-335(1)(c)). | Detailed Reasoning - Section 230-325: 15. The FFX contract, which satisfies the definition of hedging financial arrangement, is an hedging financial arrangement to which the Subdivision 230-E election applies pursuant to section 230-325, as: • Fund X starts to have the arrangement in an income year in which it makes the election, or a later income year. • The requirements in sections 230-355 and 230-365 are satisfied. 16. This is subject to the satisfying the requirements of s 230-360, as addressed below. | Detailed Reasoning - Section 230-360: 17. Fund X has made a determination setting out the basis for allocating gains/losses from the FFX contract (subsection 230-360(1)). 18. It is considered the basis of allocation set out in the determination fairly and reasonably corresponds with the basis on which gains, losses or other amounts in relation to the hedged item are recognised under the ITAA 1997 for paragraph 230-360(2)(b) purposes. 19. It is considered the basis of allocation is objective for paragraph 230-360(2)(b) purposes. The basis of allocation is comprehensively set out in the determination. There is little to no discretion to alter or amend gains/losses allocated to recognition events, and the basis of allocation applies to all recognition events relating to the hedged risk with a view to ensuring the matching principle of Subdivision 230-E is satisfied. 20. Finally, the record made under section 230-355 is sufficiently clear for paragraph 230-360(2)(c) purposes. 21. As such, the requirements of section 230-360 and subsection 230-360(2) in particular, are satisfied.

Reasons for decision: Unless otherwise indicated references to legislative provisions are to the Income Tax Assessment Act 1997.