Guide to taxation of financial arrangements (TOFA)
The Taxation of Financial Arrangements (TOFA) reforms were first publicly announced as part of the 1992 federal budget in which the government identified a need for reform of the taxation treatment of financial arrangements. The reforms were later taken up by the Ralph Review of Business Taxation, with the final report – A Tax System Redesigned (the Ralph report) – making various recommendations. Several concepts proposed in the Ralph report have been implemented progressively in stages.
Stage 1 was introduced in 2001 and contained rules to distinguish between debt and equity interests. This was in response to the growing number of hybrid financial arrangements in commercial practice.
Stage 2 was introduced in 2003 and contained new rules to bring to account foreign exchange gains and losses for tax purposes and rules around the translation of foreign denominated amounts.
Stages 3 and 4 were introduced in 2009. Stage 3 introduced hedging rules, under which the tax character and tax timing of gains and losses from a financial arrangement is able to be matched with the tax character and tax timing of gains and losses from a hedged item. Stage 4 provided a comprehensive framework for bringing to account gains and losses on other financial arrangements for tax purposes.
For the purposes of this guide, the term 'TOFA' refers to Stages 3 and 4 of the reforms, being the provisions contained in Division 230 of the Income Tax Assessment Act 1997 (ITAA 1997), and the transitional provisions contained in Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 (the TOFA Act).
TOFA aims to reduce the influence of tax considerations on how financial arrangements are structured. TOFA also aims to closer align the taxation recognition of gains and losses on financial arrangements with commercial recognition of gains and losses.
Although TOFA provides a comprehensive and overarching framework to address the economic substance of arrangements, it is not an exclusive code for the taxation of gains and losses from financial arrangements.
Unless otherwise specified, other provisions of the Income Tax Assessment Act 1936 (ITAA 1936) or the ITAA 1997 still deal with gains or losses from financial arrangements where TOFA does not.
- Legislative references in this guide are to provisions of the ITAA 1997 unless otherwise specified.
- Since the TOFA Act received royal assent, TOFA has been subject to multiple amendments. This guide is current as at December 2013. It is for informational purposes only, and does not represent binding advice.
- If you are seeking binding advice, consider applying for a private ruling.
Addressing the problems of the past
During the 1980s, there were significant economic and legal developments such as the deregulation of the Australian financial sector and floating of the Australian dollar, as well as technological changes. These developments highlighted the deficiencies in existing tax legislation, which did not keep pace with financial innovation.
Before the TOFA reforms, the income tax law emphasised legal form rather than economic substance in the context of financial arrangements. The legislation recognised basic forms of financial arrangements, but did not satisfactorily apply to more complex instruments.
This led to inconsistencies in the tax treatment of transactions with similar economic substance. In addition, income and deductions from financial arrangements were often dealt with on a realisation basis, which was not in line with accounting practice and the economic substance of financial arrangements. The inability of these form-based rules to keep pace with financial innovation created opportunities for tax deferral and tax arbitrage.
Furthermore, the way tax law applied to financial arrangements resulted in tax-timing and tax-classification mismatches. The law did not address the tax-timing treatment of emerging hybrid instruments or new structured products, including those with fixed and contingent returns.
The ad hoc manner in which amendments were made to address new tax products or problems created considerable uncertainty for entities.
Four stages of reforms
The TOFA reforms were implemented in stages, each stage having a particular purpose and addressing particular concerns.
Stage 1: debt and equity interests
Division 974 of the ITAA 1997 was introduced in the New Business Tax System (Debt and Equity) Act 2001 and the New Business Tax System (Thin Capitalisation) Act 2001. It introduced rules for classifying financial instruments as debt interests or equity interests according to the economic substance of the instrument rather than its legal form.
The classification of an instrument is important as it can change its tax outcomes. Broadly, returns on debt interests are not frankable but may be deductible, whereas the returns on equity interests may be frankable but are not deductible.
Significantly, unlike the other stages of the reforms, Division 974 does not include direct taxing provisions. It provides the debt/equity classification of an instrument, with the tax outcomes determined elsewhere under the tax acts.
The economic substance tests of Division 974 also identify debt instruments for the purposes of the thin capitalisation rules in Division 820. The thin capitalisation rules work to limit the use of deductible debt expenses in financing the net Australian assets of a multinational business.
Under this reform, the test for distinguishing debt interests from equity interests focuses on a single organising principle. That is, an instrument is a debt interest where an issuer has an effectively non-contingent obligation to return, to the investor, an amount at least equal to the amount invested.
Stage 2: foreign exchange gains and losses
Division 775 and Subdivisions 960-C and 960-D of the ITAA 1997 were introduced in the New Business Tax System (Taxation of Financial Arrangements) Act (No.1) 2003.
Division 775 took precedence over other provisions that dealt with the tax treatment of foreign currency exchange gains and losses. Under Division 775, forex realisation gains and forex realisation losses, attributable to fluctuations in foreign currency exchange rates, are made when a forex realisation event occurs.
Division 775 no longer applies to financial arrangements subject to TOFA. However, it does apply to all other arrangements and transactions that are affected by fluctuations in foreign currency exchange rates where TOFA does not apply.
Subdivision 960-C and 960-D were also introduced as part of the second stage of the TOFA reforms. Subdivision 960-C provided a general translation rule that broadly provides that all tax relevant amounts should be expressed in Australian currency.
Subdivision 960-D allows certain entities or parts of entities that keep their accounts solely or predominantly in a particular foreign currency to choose that foreign currency as their functional currency. Functional currency is used to work out annual net income, which is then translated into Australian dollars.
Stages 3 and 4: TOFA
Division 230 was introduced by the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 (the TOFA Act). The TOFA Act implements Stages 3 and 4 of the TOFA reforms and are the final set of TOFA reforms recommended by the Ralph report.
Broadly, TOFA introduced a definition of what constitutes a financial arrangement and a framework for calculating gains and losses on financial arrangements through default and elective tax-timing methods.
Stage 3 addresses hedging financial arrangements, allowing for the matching of the tax classification and tax timing of gains or losses from certain hedging financial arrangements with the gains and losses from a hedged item.
Stage 4 deals with the tax treatment of all other financial arrangements by providing a framework for calculating and taxing gains and losses from financial arrangements.
The remainder of this guide relates to Stages 3 and 4 of the TOFA reforms (Division 230 and transitional provisions), referred to as TOFA.
Objects of TOFA
TOFA provides a principles-based framework for the taxation of gains and losses from financial arrangements based on their economic substance rather than legal form. Gains and losses from financial arrangements are generally included in assessable income or allowed as a deduction on revenue account.
TOFA aims to:
- minimise the extent to which the tax treatment of gains and losses from financial arrangements distorts trading, financing and investment decisions, risk taking and management
- more closely align the tax and commercial recognition of gains and losses
- minimise compliance costs.