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Elective methods

Last updated 15 June 2023

If eligible, an entity can use one or more of the elective tax-timing methods.

Although more than one elective tax-timing method can apply to a financial arrangement, the priority rules in section 230-40 determine which tax-timing method takes priority when calculating gains and losses.

The elective tax-timing methods can help reduce compliance costs. This is because the fair value, foreign exchange retranslation and reliance on financial reports methods allow entities to use their financial reports to work out the amount of gain or loss they made from their financial arrangements and how much is attributed to a particular income year for income tax purposes.

The 4 elective tax-timing methods are:

See Section 230-40 – Methods for taking gain or loss into account.

Common requirements

For an entity to be eligible to elect to apply an elective tax-timing method (except for the qualifying forex account election) for an income year, the following common requirements must be met:

  • The entity must prepare financial reports for the income year, according to the accounting principles or comparable standards for accounting made under a foreign law.
  • The financial report must be audited according to the auditing principles or comparable standards for auditing made under a foreign law.

Consolidated groups

Where a consolidated financial report deals with the affairs of all entities in the tax consolidated group, the consolidated financial report can be used to determine whether the group meets eligibility requirements.

Where stand-alone financial reports deal with the affairs of all entities in the tax consolidated group, such reports can be used to determine whether the group meets eligibility requirements. In such cases, all members of the tax consolidated group must prepare stand-alone financial reports to satisfy the requirements.

Where the affairs of the tax consolidated group are reflected in both the consolidated financial report and stand-alone financial reports, the group can use either report type to determine whether it meets eligibility requirements – however it must make this choice consistently.

MEC groups

For a multiple entry consolidated (MEC) group, the provisional head company's consolidated financial report may not reflect the financial arrangements of the entire MEC group. A consolidated report prepared by an eligible tier-1 entity, which is the provisional head company, most likely would not reflect the financial arrangements of other eligible tier-1 entities or of its wholly-owned subsidiaries.

In such a situation, pursuant to section 230-525, the provisional head company may be able to rely on a consolidated financial report prepared by the top company to satisfy the eligibility requirement that you prepare a financial report (for example, under paragraph 230-210(2)(a)). However, whether the provisional head company can rely on the consolidated financial report for these purposes depends on the particular case.

See Section 230-525 – Consolidated financial reports.

Non-consolidated tax entities

Where an entity is not part of a tax consolidated group and does not itself prepare a financial report, it may still be able to satisfy the eligibility requirements. To do this, it can use a consolidated financial report prepared by another entity that properly reflects the first entity's affairs.

Financial arrangements subject to elective tax-timing methods

An elective tax-timing method will only apply to financial arrangements that an entity starts to have in the income year in which the election is made or later income years.

However, an elective tax-timing method can apply to existing arrangements where the entity made both the:

  • transitional election for existing financial arrangements
  • election to apply the tax-timing method on or before the first lodgment date of the entity's tax return that occurs after TOFA first applies.

Gains or losses recognised in financial reports

An elective tax-timing method will only apply to a financial arrangement if the gains or losses from the financial arrangement are recognised or recorded in the relevant audited financial report.

However, an elective tax-timing method may also apply to transactions that are not recognised in the report if they are intra-group transactions of an accounting consolidated group. This requirement will be satisfied where both the following apply:

  • The entity is a member of an accounting consolidated group.
  • The financial arrangement is not recognised in an audited financial report only because it is an intra-group transaction under AASB 127.

Financial arrangements between members of a consolidated group or MEC group are not covered by this requirement because the single entity rule in section 701-1 operates to treat them as not being financial arrangements for all income tax purposes.

When an election ceases to apply

Once made, an elective tax-timing method cannot be revoked.

However, an election to apply an elective tax-timing method will cease to have effect from the start of an income year if the entity ceases to meet the eligibility requirements to make the election.

Where the elective tax-timing method ceases to apply, the entity must make certain balancing adjustments for the relevant financial arrangements.

Entities can make new elections where they again satisfy the relevant requirements.

Example: ceasing to satisfy the eligibility requirements

Staples Co is subject to TOFA. Staples Co elected to apply the fair value method to its financial arrangements in its income year ending 30 June 2011.

For the year ending 30 June 2013, Staples Co did not prepare financial reports according to the relevant accounting principles. As it ceased to meet the eligibility requirements to make the fair value method election in that income year, the fair value method ceased to have effect from 1 July 2012 and certain balancing adjustments must be made in respect of Staples Co's relevant financial arrangements.

End of example

Foreign exchange retranslation method

The foreign exchange retranslation method is relevant to entities with arrangements denominated in, or determined by, reference to a foreign currency. For an entity that has made a functional currency election under Subdivision 960-D, this means a currency that is not its applicable functional currency.

Under AASB 121 The Effects of Changes in Foreign Exchange Rates (AASB 121) or a comparable accounting standard made under a foreign law, certain gains and losses attributable to currency exchange rate movements must be recognised in profit or loss in an entity's financial reports.

The foreign exchange retranslation method only applies to these gains and losses.

An entity that meets the common requirements can elect to apply the foreign exchange retranslation method to all financial arrangements, and those arrangements subject to Subdivision 775-F (general election).

Alternatively, an entity can elect to apply the foreign exchange retranslation method to one or more of its qualifying forex accounts (a qualifying forex account election).

The retranslation method will not apply to a financial arrangement if either the fair value or reliance on financial reports election applies to that particular arrangement, or to the extent that the hedging financial arrangements election applies in relation to that arrangement.

The gain or loss recognised in an income year under the retranslation method will generally be the same as the amount recognised under AASB 121 or its foreign equivalent in the entity's profit or loss. However, an amount will not be recognised if the amount recognised in the entity's profit or loss has been previously recognised in equity.

See Subdivision 775-F – Retranslation under foreign exchange translation election under Subdivision 230-D.

General election

Where an entity makes the general retranslation election, the foreign exchange retranslation method will apply to financial arrangements that satisfy the following:

  • The entity starts to have the financial arrangement in the income year in which it makes the election or in a later income year.
  • An amount attributable to changes in currency exchange rates must be recognised in profit or loss in the financial reports as per AASB 121 or a comparable accounting standard made under a foreign law.

Where the general election ceases to apply, certain balancing adjustments must be made. However, the balancing adjustments are made only to the extent the balancing adjustments are reasonably attributable to currency exchange rate movements.

Qualifying forex account election

Where an entity makes a qualifying forex account election, the foreign exchange retranslation method will apply to the qualifying forex account for which it made the election.

A qualifying forex account is defined in section 995-1 as an account denominated in a foreign currency that has the primary purpose of facilitating transactions or is a credit card account.

A qualifying forex account election will apply:

  • from the time when the entity starts to have the arrangement if the election is made before the entity starts to have the arrangement
  • from the start of the income year in which the election is made if the entity makes an election after it starts to have the arrangement.

See Section 995-1 – Definitions.

Arrangement held prior to making the election

An entity can make this election even if it starts to have the qualifying forex account election before making the election.

However, such an election will not apply to an account that was created before the start of the first year TOFA began applying to the entity, unless that entity has made an election for TOFA to apply to its existing financial arrangements.

For these qualifying forex accounts held prior to making the election to which TOFA applies, the entity must make a balancing adjustment according to Subdivision 230-G calculated as if the taxpayer had ceased the arrangement for its fair value at the time when the election was applied to the arrangement. However, the balancing adjustment will only recognise an amount to the extent it is reasonably attributable to a currency exchange rate effect.

Example: applying the general retranslation election to a US$ loan

Yee Imports Co (Yee) is a large Australian company that is eligible and makes the foreign exchange retranslation method – general election. Yee has a loan of US$1,000 for which gains and losses attributable to changes in foreign exchange rates must be recognised in profit or loss in accordance with AASB 121. Under the loan agreement, Yee does not have to repay any principal until the end of year 4.

When Yee entered into the loan, it had a liability in Australian dollars (A$) of $2,000 (A$1 = US$0.50). By the end of year one, the Australian dollar had appreciated against the US dollar, such that the A$ value of the loan decreased to $1,333. For accounting purposes, a profit of $667 is recognised. This means for tax purposes, a $667 gain is recognised.

In year 2, a gain of $83 is recognised as the Australian dollar value of the loan has decreased from $1,333 to $1,250. In year 3, the Australian dollar value of the loan has increased to $1,428 and a loss of $178 is recognised.

At the end of year 4, when the loan is repaid, Yee performs a balancing adjustment calculation under Subdivision 230-G and works out that it makes a $110 loss.

 

Year 0

Year 1

Year 2

Year 3

Year 4

Amount of debt (US$)

$1,000

$1,000

$1,000

$1,000

0

A$ currency

0.50

0.75

0.80

0.70

0.65

A$ value of debt

$2,000

$1,333

$1,250

$1,428

$1,538

Tax treatment under the foreign exchange retranslation method

0

$667 gain ($2,000 – $1,333)

$83 gain ($1,333 – $1,250)

$178 loss ($1,250 – $1,428)

$110 loss*

* Subdivision 230-G balancing adjustment applies when the financial arrangement ceases.

End of example

The foreign exchange retranslation method only applies to a gain or loss attributable to currency exchange rate movements. The accruals and realisation methods may apply to the gain or loss not attributable to currency exchange rate movements.

Fair value method

The fair value method is a tax-timing method that measures a gain or loss from a financial arrangement as the change in its fair value between 2 points in time. The gain or loss for a particular period is the increase or decrease in its fair value between the beginning and end of the period, adjusted for amounts paid or received during the period.

The term 'fair value' is not a defined term under the tax Acts. However, AASB 139 Financial Instruments: Recognition and Measurement (AASB 139) defines fair value as 'the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm's length transaction'.

The fair value method can give rise to unrealised gains and losses from financial arrangements being brought to tax.

To be eligible to make the fair value method election in an income year, an entity must meet the common requirements.

Financial arrangements subject to this method

If an election to apply the fair value method is made, it will apply to financial arrangements that meet both the following requirements:

  • The entity starts to have the financial arrangement in the income year in which it makes the election, and in later income years.
  • The financial arrangement is either an asset or liability is required (whether or not as a result of a choice made) to be classified or designated or (in whole or in part) otherwise treated in the entity's financial reports as at fair value through profit or loss.

Under AASB 139, the following are generally recognised at fair value through profit or loss:

  • a financial asset or financial liability held for trading
  • a derivative.

AASB 139 states that trading generally reflects active and frequent buying and selling, and that financial instruments held for trading are generally used with the objective of generating a profit from short-term fluctuations in price or dealer's margin.

Equity interests

The fair value can apply to financial arrangements that are equity interests under Division 974, as well as certain rights to receive and obligations to provide equity interests (section 230-50 financial arrangements), subject to the satisfaction of the fair value tax-timing requirements.

However, an entity that has issued its own equity interests cannot fair value those equity interests. This rule is directed at ensuring, for example, that an entity does not obtain a tax deduction for dividends paid.

See Division 974 – Debt and equity interests.

Splitting financial arrangements into two

Under section 230-235, where only part of a financial arrangement is classified or designated at fair value through profit or loss, that part of the arrangement is treated as a financial arrangement subject to the fair value method. The remaining part of the financial arrangement will be treated as a separate financial arrangement and will be subject to another tax-timing method.

See Section 230-235 – Splitting financial arrangements into 2 financial arrangements.

Tax treatment

Where a fair value election applies to a financial arrangement, the gains or losses for an income year will be determined by the accounting principles.

Where the Australian accounting principles, or comparable standards made under a foreign law, require that a fair value measurement through profit or loss be used to determine accounting profits or losses on financial arrangements for an income year, these gains and losses shall be used to determine the taxpayer's gain or loss for an income year from those financial arrangements.

Franked distributions

Franked distributions (received either directly by the taxpayer or indirectly through a partnership or trust) and rights to receive franked distributions (either directly or indirectly) must not be included as a gain or loss that is brought to account according to the fair value method.

Excluding franked distributions from the scope of the fair value election ensures these distributions will remain assessable according to section 44 of the ITAA 1936. Assessing the distribution under section 44 rather than under TOFA will ensure that the imputation system works appropriately for distributions such that franking credits allocated to such distributions are available to the recipient in the income year in which the distribution is taxed to the recipient.

See Section 44 of the ITAA 1936 – Dividends.

Valuation issues

The term fair value is not defined in the tax acts. The term should take its ordinary commercial meaning. In this regard, AASB 139 defines fair value as '… the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date'.

The valuation methods used, and the guidance, definitions and requirements for the elective fair value method generally should be the same as those used for the fair value valuation in relevant accounting principles. As a result, if taxpayers use fair value estimates in their profit or loss accounts that accord with commercially acceptable valuation techniques, they can generally use the same estimates for the elective fair value method.

Example: applying the fair value method to an option

Apple Co meets the eligibility requirements and makes the fair value method election.

Apple Co paid $10 to purchase an option to acquire a share in Banana Co.

The fair value method will apply to Apple Co's option to acquire a share in Banana Co as the option is a derivative recognised at fair value through profit or loss for accounting purposes.

The fair value of the option at the end of each year is set out in the table below. Apple Co sells the option at the end of year 3 for $20.

Apple Co makes a fair value gain of $5 in year one ($15 – $10), a fair value gain of $8 ($23 – $15) in year 2. At the end of year 3, when Apple Co disposes of its option for $20, it performs a balancing adjustment calculation under Subdivision 230-G and works out that it makes a $3 loss.

During the term of the arrangement, Apple Co recognises a net gain of $10, which is brought to account for tax purposes, reflecting the $10 overall economic gain overall; that is, a cost of $10 and proceeds of $20.

Type

Cost

Year 1

Year 2

Year 3

Acquisition cost

$10

Fair value of option price at year end

$15

$23

Disposal of option

$20

Tax treatment under the fair value method

$5 ($15 – $10)

$8 ($23 –$15)

– $3*

* Subdivision 230-G balancing adjustment applies when the financial arrangement ceases.

End of example

Reliance on financial reports method

Broadly, an entity that makes a valid reliance on financial reports election can rely on its financial reports for the purposes of complying with its tax obligations for its financial arrangements.

This election aligns the tax treatment of relevant financial arrangements to the accounting treatment of those arrangements.

This election reduces the administration and compliance costs of the taxation of financial arrangements.

The financial reports election takes precedence over other elective and default tax-timing methods, but only to the extent that the hedging financial arrangements method does not apply to the financial arrangement.

Eligibility requirements

To be eligible to make the reliance on financial reports method election in an income year, an entity must satisfy the following requirements:

  • The entity must prepare a financial report for that income year according to the accounting principles that is audited according to the auditing principles.
  • The entity's auditor has not qualified the auditor's report on the financial report for that income year or any of the last 4 financial years in a way that is relevant to the tax treatment of financial arrangements.
  • The entity's accounting systems and controls and internal governance processes are reliable.
  • No report of an audit or review conducted in the income year or any of the preceding 4 income years included an adverse assessment of accounting systems relevant to the tax treatment of financial arrangements.

Once made, the election to apply the reliance of financial reports method is irrevocable.

However, the election to apply the reliance on financial reports method will cease to apply if any of the eligibility requirements are no longer satisfied. The election will cease to apply from the start of the income year in which this occurs. The entity must then make balancing adjustments under subsection 230-430(2).

Example: qualification in an auditor's report

The auditor's report on the financial reports of Scruffy Ltd has been qualified in relation to the amount of directors' fees recognised in the books.

The qualification will not prevent Scruffy Ltd from making a valid election to apply the reliance on financial reports method, as the directors' fees have no impact on the recognition and measurement of gains and losses on the relevant financial arrangements.

End of example

See Section 230-430 – Balancing adjustment if election ceases to apply.

Financial arrangements subject to this method

The reliance on financial reports method applies to financial arrangements that meet the following requirements:

  • The entity starts to have the financial arrangement in the income year in which it makes the election or later income years.
  • The arrangement is recognised in the financial reports relied on.
  • It is reasonably expected that the amount of the overall gain or loss the entity makes from the arrangement determined in accordance with the financial reports is, or will be, the same as the amount of the overall gain or loss the entity makes as determined according to TOFA, if the reliance on financial reports method election did not apply (same overall gain or loss test).
  • The results of the method used to determine the gain or loss on a financial arrangement for each income year in the financial reports is not substantially different to the results from the methods that would be applied by the rest of TOFA if the reliance on financial reports method election did not apply (results not substantially different test).

However, the election will cease to apply to a particular financial arrangement if any of the above requirements are no longer satisfied for that financial arrangement. The election will cease to apply to that financial arrangement from the start of the income year in which this occurs. When this happens, the entity must make balancing adjustment under subsection 230-430(5).

See Subsection 230-430(5).

Applying the tests

An entity must assume that both a fair value method election and a foreign exchange retranslation general election have been made when determining whether:

  • an entity reasonably expects to make the same overall gain or loss on a financial arrangement
  • the results of the financial reports method are not substantially different from the results from the methods that would apply if the financial reports method did not apply.

This prevents taxpayers from needing to have valid elections in place solely to ensure the financial reports method applies to certain financial arrangements.

However, in applying these tests, do not assume that an election for portfolio treatment of fees, premiums and discounts is made under the accruals method under Subdivision 230-B.

If the election for portfolio treatment of fees, premiums and discounts has not been made, the relevant comparisons in applying these tests are the accruals/realisation methods as if that election was not made.

If the election for portfolio treatment of fees, premiums and discounts has been made, the relevant comparisons in applying these tests are with the accruals/realisation methods on the basis that election has been made.

See Subdivision 230-B – The accruals/realisation methods.

Eliminated accounting intra-group transactions

As stated above, for the financial reports method to apply to a financial arrangement, the arrangement must be recognised in the financial report.

However, where a financial arrangement is not recognised in the consolidated financial report merely because it has been eliminated as an intra-group transaction of the accounting consolidated group, paragraph 230-410(1)(c) is taken to be satisfied in relation to a financial arrangement.

As a consequence, the financial reports method can be applied to the eliminated accounting intra-group transaction.

See Section 230-410 – Financial arrangements to which the election applies.

Tax treatment

If an election to rely on financial reports applies to a financial arrangement, the gain or loss made from the arrangement for the income year is the gain or loss that the accounting principles require the entity to recognise in profit or loss from that arrangement for that income year.

For eliminated accounting intra-group transactions, the gain or loss made from the arrangement for the income year is the gain or loss that the accounting principles would have required the entity to recognise in profit or loss from that arrangement for that income year if the arrangement had not been an intra-group transaction.

Impaired debt arrangements

Where a debt arrangement that is subject to the reliance on financial reports election subsequently becomes impaired, the arrangement ceases to be subject to the reliance on financial reports method, except where the arrangement is fair valued. This is because the arrangement ceases to satisfy the requirement that the differences in the results of the accounting method and the compounding accruals method are reasonably expected to be not substantial.

The reason for this is that the compounding accruals method does not recognise a provision for doubtful debts. Hence, the relevant financial arrangement will become subject to the remainder of TOFA, that is, to a tax-timing method other than the reliance on financial reports method.

Where a debt arrangement that is subject to the reliance on financial reports method becomes impaired, and the financial reports election ceases to apply to it, the arrangement is specifically precluded from being subject to a balancing adjustment. The reason for this is that if a balancing adjustment were applied at the time the financial arrangement becomes impaired, the taxpayer would receive an immediate deduction for the impairment of the debt arrangement. Such a result is contrary to the general policy in relation to doubtful debts for financial arrangements that are not subject to the fair value election.

Hedging financial arrangements method

Entities enter into various hedging arrangements to manage their exposure to risks such as interest rate and currency exchange rate fluctuations. For example, a foreign currency hedge can protect an entity against the foreign currency exchange risk that arises from the purchase of machinery in a foreign currency at a future date.

For income tax purposes, gains and losses on arrangements may be taxed on a different basis (for example, realisation and accruals). Where a financial arrangement is used to hedge the risk in relation to another arrangement, and each are taxed on a different basis, the effectiveness of the hedge, in a post-tax sense, is reduced.

Tax mismatches could also occur where gains or losses made on an underlying hedged item are taxed on capital account, whereas the gains or losses made on the hedging financial arrangement are brought to account on revenue account.

Although the outcomes under the hedging financial arrangements method will not necessarily align with accounting principles, this method broadly reduces post-tax mismatches ensuring that gains and losses from hedging financial arrangements are included in taxable income at the same time as those made from the hedged items are recognised for tax purposes. This method also matches the tax classification or status of a hedging financial arrangement gain or loss with that of the hedged item.

To be eligible to make the hedging financial arrangements method election in an income year, an entity must meet the common requirements. If the hedging method election is not made, an entity cannot use the hedging financial arrangements method for tax purposes, irrespective of whether a financial arrangement is a hedge for accounting purposes.

Once made, the hedging financial arrangements election cannot be revoked.

Financial arrangements subject to this method

The hedging financial arrangements method will apply to a financial arrangement if the following criteria are satisfied:

  • the arrangement is a hedging financial arrangement
  • the entity starts to have the arrangement in the income year in which the election is made or later income years.

The hedging financial arrangements method will not apply to a financial arrangement if the arrangement is:

  • a financial arrangement as defined under section 230-50 unless it is issued by the relevant entity and is a foreign currency hedge
  • subject to an exception contained in subsection 230-330(3), (4) or (5).

Hedging financial arrangement

A financial arrangement is defined in section 230-335 to be a hedging financial arrangement if:

  • it is a derivative financial arrangement or a foreign currency hedge
  • the entity creates, acquires or applies the arrangement for the purpose of hedging a risk or risk in relation to a hedged item
  • at the time the entity creates, acquires or applies the arrangement, it is a hedging instrument for accounting purposes
  • it is recorded as a hedging instrument in the entity's financial reports in the income year in which the rights or obligations are created, acquired or applied.

Derivative financial arrangement

A derivative financial arrangement is defined in section 230-350 as a financial arrangement where:

  • its value changes in response to changes in a specified variable or variables
  • it requires no net investment, or there is such a requirement, but the net investment is smaller than would be required for other types of financial arrangements that would be expected to have a similar response to changes in market factors.

Foreign currency hedge

A foreign currency hedge is defined in section 230-350 as a financial arrangement where:

  • its value changes in response to changes in a specified variable or variables but is not a derivative financial arrangement
  • it hedges a risk in relation to movements in currency exchange rates.

Tax extension hedges

Generally, only those hedging arrangements that satisfy the hedge accounting rules will satisfy the requirements of the hedging financial arrangements method. However, in limited situations, the hedging financial arrangements method will apply to hedging financial arrangements that would not ordinarily meet accounting hedging treatment (subsection 230-335(3)).

Partial hedges

Generally, the whole financial arrangement must be a hedging financial arrangement. However, section 230-340 treats a part of a financial arrangement as a separate financial arrangement where it is used for a partial hedge (such as a forward contract or a proportionate hedge).

For more information, see:

Hedged item

A hedged item is defined in subsection 230-335(10) to be one of the items listed in that subsection (for example, an asset, a liability, a firm commitment), or a part of such an item, in which an entity hedges a risk.

An anticipated dividend is deemed to be a hedged item if it is of the kind referred to in subsection 230-335(4).

Where the hedged item is a net investment in a foreign operation that is carried on through a company in which an entity holds shares, or through a subsidiary company of the entity, the hedged item is deemed for the purposes of tax classification or status matching in the table in subsection 230-310(4) to be either the shares or some other interest (such as long-term intra-group debt) in that company.

See Subsection 230-335 – Hedged financial arrangement and hedged item.

'One-in, all-in' principle

A fundamental principle underlying the hedging election is that the election applies to all accounting hedges and would-be accounting hedges (those where the entity does not satisfy the documentation requirements under this method) on a 'one-in, all-in' basis. This also applies to anticipated hedges in the same manner.

Under this principle, an entity that makes an election to apply the hedging financial arrangements method must apply this method to all of its hedging financial arrangements.

Failure to comply with method

Failure to comply with the record-keeping requirements in sections 230-355 and 230-360, and the requirement in section 230-365 that the effectiveness of the hedge be assessed, can have the following implications (pursuant to section 230-385):

  • The hedging financial arrangements method election will not apply to hedging financial arrangements the entity starts to have after the time those requirements are not met until such time as determined by the ATO.
  • Where section 230-360 has not been satisfied for an existing hedging financial arrangement, we may determine the appropriate basis of allocation for gains and losses from the hedging financial arrangement in a way that satisfies section 230-360.

Where this occurs, pursuant to section 230-380 we may still:

  • treat the requirements of section 230-355, 230-360 or 230-365 as having been met
  • impose additional record-keeping requirements
  • determine the appropriate basis of allocation for gains and losses from the hedging financial arrangement in a way that satisfies section 230-360.

See Section 230-385 – Consequences of failure to meet requirements.

Existing hedging financial arrangements

If an entity made a transitional election for TOFA to apply to its existing financial arrangements, it can also elect to apply the hedging financial arrangements method to those existing hedging financial arrangements if:

  • the election to apply the hedging financial arrangements method is made on or before the first lodgment date that occurs after the start of the income year in which TOFA begins to apply
  • at or soon after making the election, the entity satisfies the record-keeping requirements in section 230-355 and section 230-360
  • the entity satisfies the hedge-effectiveness requirements in section 230-365 at all times from when they created, acquired or applied the arrangement.

However, the tax status matching rules under subsection 230-340(4) cannot apply to existing hedging financial arrangements that have been transitioned into TOFA. Instead, tax classification or status is determined pursuant to subsection 230-310(3).

Documentation requirements

The recording requirements an entity must make under section 230-355 include both:

  • details that are required under the accounting principles
  • terms of the determinations it makes under section 230-360.

The terms of the determinations that an entity makes under section 230-360 must show the basis on which the entity will allocate gains and losses from a hedging financial arrangement for tax purposes.

The determinations must be objective and result in a record of both the:

  • time at which the gain or loss from the hedging financial arrangement is taken into account for TOFA purposes
  • way in which the gain or loss will be dealt with under section 230-310.

To satisfy the requirement of recording the terms of the determinations an entity makes under section 230-360, it can do either of the following:

  • separately record the details required by that section for each of its hedging financial arrangements
  • make a common record, such as a hedge master documentation, for each of several identified classes of hedging financial arrangements that the entity has. This will be sufficient where there is an objective link between the common record and the hedging financial arrangement.

An example of the terms of a determination made under paragraph 230-355(1)(c) is provided in Appendix – Sample tax hedging documentation.

For more information, see:

When the record must be made

The time by which the documentation must be in place differs for existing hedging financial arrangements (under a transitional election) and hedging financial arrangements starting from the time TOFA begins.

Existing hedging financial arrangements – transitional election

If an entity started to have a hedging financial arrangement before entering into TOFA, the entity could have elected to have TOFA apply to that arrangement (sub-item 104(2) of Schedule 1 to the TOFA Act).

Pursuant to sub-item 104(9)(c) of Schedule 1 to the TOFA Act, the hedging record must be in place:

… at, or soon after, the time you make the election, you have in place records in relation to the arrangement that satisfy the requirements of section 230-355 and section 230-360 (other than subparagraph 230-360(2)(c)(ii)).

In general, the necessary hedging documentation for existing hedging financial arrangements must be in place at, or soon after, the time the hedging election is made.

Hedging financial arrangements from 1 July 2010

For hedging financial arrangements the entity started to have from the time TOFA begins to apply to its financial arrangements, subsection 230-355(3) states:

The record must be made or in place, either:

(a) at, or soon after, the time when you create, acquire or apply the hedging financial arrangement

(b) at such other time as is provided for in the regulations for the purposes of this paragraph.

If TOFA begins to apply to the entity from 1 July 2010 and the hedging financial arrangements method is elected, the required records for the hedging financial arrangements must be in place at the same time the hedging financial arrangement is created, acquired or applied. It is not sufficient to put relevant tax documentation in place when the hedging election is made.

For more information, see:

Regulations allowing for an extension of time

The Income Tax Assessment Amendment Regulations 2011 (No. 4) (80 of 2011) extended the time for recording details of the basis for allocating gains and losses for certain hedging financial arrangements for income tax purposes until 30 June 2011.

See Income Tax Assessment Amendment Regulations 2011 (No. 4) (80 of 2011).

Hedge effectiveness requirements

It is a requirement of section 230-365 that the hedge be expected to be highly effective within the meaning of the accounting principles. Hedge effectiveness is addressed in Taxation Determination TD 2011/23.

If the hedge proves to be ineffective, this will result in a balancing adjustment under section 230-375.

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Tax treatment

The gain or loss from a hedging financial arrangement is equal to the overall gain or loss from the arrangement pursuant to subsection 230-300(2). This will be the case whether a gain or loss results from, among other things, the expiration, sale, termination or exercise of a hedging financial arrangement (see Taxation Determination TD 2012/13).

A gain or loss under subsection 230-300(2) will be allocated to income years in accordance with the determination made under section 230-360 (see Tax-timing and tax-status matching).

The exception to this is if a hedging event under section 230-305 applies, in which case the gain or loss is identified in subsection 230-300(5).

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Hedging events under section 230-305

Where an event in the table under subsection 230-305(1) happens (for example, revocation of the hedge or the hedge is ineffective), pursuant to subsection 230-300(5) the gain or loss from the hedging financial arrangement is the gain or loss that would have been made from the hedging financial arrangement if the entity ceased to have the arrangement for its fair value at the time of the event.

This gain or loss will either be allocated according to the determination made under section 230-360, or to the income year in which the event happens, depending on which item of the table in section 230-305 applies to the event.

Paragraph 230-300(5)(b) states that TOFA applies as if the arrangement had been acquired (or reacquired) for its fair value immediately after the event. This requires a reassessment of whether the arrangement will continue to satisfy the definition of hedging financial arrangement in subsection 230-335(1) after the time of the deemed reacquisition.

See Section 230-305 – Table of events and allocation rules.

Tax-timing and tax-status matching

Under the hedging financial arrangements method, the timing of the gains or losses on the hedging financial arrangement is matched with the timing of gains or losses on the hedged item (section 230-360). Similarly, the tax status of the gains or losses on the hedging financial arrangement is generally matched with the tax status of the gains or losses on the hedged item (subsection 230-310(4)).

The tax-timing matching rule ensures that gains and losses made from a hedging financial arrangement are allocated on an objective, fair and reasonable basis. The gains and losses allocated must fairly and reasonably correspond with the basis on which gains, losses and other amounts in relation to the hedged item are recognised or allocated for tax purposes (subsection 230-360). There might be more than one way to fairly and reasonably do this, but the basis of allocation must correspond to the basis of taxation for the hedged item.

Under the tax-status matching rule, the tax classification of gains and losses from hedging financial arrangements are generally matched with the classification of the hedged item (section 230-310). For example, as a result of the tax-status matching rule, a gain or loss made on a hedging financial arrangement might be classified as on capital or revenue account, depending on the classification of the hedged item.

The tax-status matching rules do not apply to gains and losses made from an existing hedging financial arrangement. As a result, gains and losses made from these existing arrangements will be on revenue account and tax status or classification will be determined in the manner set out in subsection 230-310(3).

Example: applying the hedging financial arrangement method

Ben Co is an Australian company with a foreign subsidiary that has an active business in a foreign jurisdiction. Ben Co's interest in the net assets of the foreign subsidiary is a net investment in a foreign operation as defined in AASB 121 being:

  • the net assets of the foreign subsidiary in the consolidated financial report of Ben Co
  • long-term intra-group debt lent by Ben Co to the foreign subsidiary.

The only election Ben Co has made is the hedging financial arrangement method election.

Ben Co takes out a series of rolling foreign exchange forward contracts to hedge the exchange rate risk in relation to its interest in the net assets of the foreign subsidiary.

Ben Co will recognise a relevant portion of the gains and losses from these forward contracts for the purposes of section 230-360. The time of recognition will be when any of the following occur:

  • a dividend is paid by the foreign subsidiary
  • part of the loan principal is repaid
  • there is a capital return from this investment, for example on disposal of shares. 
End of example

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QC27222