The TOFA reforms were implemented in stages, each stage having a particular purpose and addressing particular concerns.
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.
For more information, see:
- Guide to the debt and equity tests
- Division 974 – Debt and equity interests
- Division 820 – Thin capitalisation rules
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.
For more information, see:
- Foreign exchange (forex)
- Division 775 – Foreign currency gains and losses
- Subdivision 960-C – Foreign currency
- Subdivision 960-D – Functional currency
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.