Subsection 230-15(1) states that an entity's assessable income includes a gain made from a financial arrangement.
Subsection 230-15(2) states that an entity can deduct a loss made from a financial arrangement, but only to the extent that it is either:
- made in gaining or producing your assessable income
- necessarily made in carrying on a business for the purpose of gaining or producing assessable income.
As provided for in section 230-15, TOFA only applies to gains and losses made from a financial arrangement. To determine whether an arrangement is a financial arrangement, an entity must first identify the arrangement being tested.
Once the arrangement is identified, the entity can determine whether the arrangement meets the definition of a financial arrangement under section 230-45 or section 230-50.
See Section 230-15 – Gains are assessable and losses deductible.
Arrangement being tested
An arrangement is defined in subsection 995-1(1), as any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings.
In testing the arrangement, an entity is required to identify the relevant rights and obligations that determine the boundary of the arrangement. In doing so, it must determine whether the rights and obligations form a single arrangement or whether these rights and obligations constitute 2 or more separate arrangements.
Typically, the boundary of the arrangement is the terms and conditions of the contract or agreement – however, this may not always be the case. It is possible that rights and obligations under more than one contract could be aggregated to constitute the relevant arrangement if, based on an economic substance approach, those rights and obligations should be considered as one arrangement.
For TOFA purposes, the testing of an arrangement or arrangements is qualified by section 230-55, which contains grouping and disaggregation rules.
Subsection 230-55(4) sets out the following factors that an entity must have regard to when determining if the rights and obligations comprise a single arrangement, or 2 or more separate arrangements:
- the nature of the rights and obligations
- their terms and conditions
- 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
- whether they can be dealt with separately or must be dealt with together
- normal commercial understandings and practices in relation to them
- the objects of Division 230.
For more information, see:
- Section 230-55 – Rights, obligations and arrangements (grouping and disaggregation rules)
- 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.
Variation of an arrangement
Where the terms of a contract or agreement that constitute an arrangement are amended or modified, it is necessary to examine whether this results in:
- existing rights and obligations being modified
- previously existing rights and obligations ceasing to exist
- new rights and obligations coming into existence.
Where new rights and obligations have come into existence as a result of the amendment or modification it is necessary to assess whether these new rights and obligations will be aggregated as a new arrangement pursuant to subsection 230-55(4). Alternatively, these might be aggregated with any previously existing rights and obligations that have not ceased to form part of the previously existing arrangement.
Section 230-45 financial arrangements
A financial arrangement is defined in section 230-45, which provides that an entity has a financial arrangement if it has, under an arrangement, a cash settlable legal or equitable right to receive or obligation to provide a financial benefit, or a combination of one or more such rights and obligations.
However, the arrangement will not be a financial arrangement if under the same arrangement the entity also has a not insignificant right or obligation that is either to provide or receive something that is:
- not a financial benefit
- not cash settlable.
The definition of a financial arrangement draws on, and closely corresponds with, the definitions of financial instruments in the accounting principles as defined in subsection 995-1(1), but does not align completely with those definitions.
For more information, see:
Cash settlable right or obligation
Under subsection 230-45(2), a right to receive or an obligation to provide a financial benefit is cash settlable if one of the following applies:
- The benefit is money or money equivalent.
- In the case of a right, the entity intends to satisfy or settle it by receiving money or a money equivalent, or by starting to have or ceasing to have another financial arrangement, other than an equity interest.
- In the case of an obligation, the entity intends to satisfy or settle it by providing money or a money equivalent, or by starting to have or ceasing to have another financial arrangement, other than an equity interest.
- The entity has a practice of satisfying or settling similar rights or obligations by money or money equivalent.
- The entity deals with the right or obligation to generate a profit from short-term fluctuations in price or from a dealers margin.
- The financial benefit can be converted readily into money or money equivalent, there is a highly liquid market for the financial benefit, and either of the following apply
- for the recipient of the financial benefit, the money or money equivalent is not subject to a substantial risk of substantial decrease in value
- a purpose of the entity for entering into the arrangement is to receive or deliver the financial benefit to raise or provide finance or so that it may be converted or liquidated into money or a money equivalent (other than as part of expected purchase, sale or usage requirements).
- The entity can settle the right or obligation, whether or not it intends to satisfy the right or obligation in that way, and its sole or dominant purpose for entering into the arrangement is not the purpose of receiving or providing delivering the financial benefit as part of its expected purchase, sale or usage requirements.
Example: deferral of payment for the acquisition of goods
On 1 April 2011, Archie Co enters into an arrangement with Luke Co. Under this arrangement, Luke Co will supply Archie Co with a handcrafted wooden desk for $10,000. The desk is due to be completed and delivered on 1 December 2011, with full payment to be made by Archie Co on that day.
By entering into this arrangement, Archie Co has both:
- an obligation to pay $10,000
- a right to receive a non-monetary financial benefit – that is, the desk.
Archie Co's non-monetary financial benefit is not insignificant when compared to its obligation to pay $10,000. As a result, this arrangement is not a financial arrangement under section 230-45.
End of example
Example: deferred purchase agreements
AEHR Co pays $10,000 to enter into an investment product, commonly referred to as a deferred purchase agreement, issued by Big Bank, on 1 July 2011. Under the agreement, AEHR Co is entitled to receive an unspecified number of shares in Edward Finance Co, deliverable on 30 June 2015.
AEHR Co will receive at least 95% of the initial investment (the $10,000) in the form of Edward Finance Co shares. This is the basis of the capital protection. AEHR Co is entitled to a further amount, the value of which is contingent on changes in the level of a nominated market index over the term of the agreement. Thus, AEHR Co receives shares in Edward Finance Co at least equal in value to $9,500.
The requirements in subparagraph 230-45(2)(f) are satisfied for both AEHR Co and Big Bank. The Edward Finance Co shares are readily convertible into money, highly liquid and the financial benefits that the recipient (AEHR Co) is entitled to receive under the arrangement are not subject to a substantial risk of substantial decrease in value. As such, AEHR Co's right to receive, and Big Bank's obligation to provide, the Edward Finance Co shares are cash settlable rights and obligations.
End of exampleWhen does a financial arrangement start?
Generally, whether an arrangement is a financial arrangement is determined at the time that arrangement comes into existence or starts to be held. The legislation does not specify a point in time at which a financial arrangement comes into being; rather, it provides that one exists when the entity holds relevant rights and obligations or assets (section 230-45, section 230-50 and Subdivision 230-J).
As there can be many rights and obligations under an arrangement, including future rights or obligations and contingent rights or obligations, various rights and obligations can start or cease at different times.
For example, an arrangement may not be a financial arrangement at one point in time due to the existence of a right or obligation that is both:
- not cash settlable or relates to something that is not a financial benefit
- not insignificant in comparison to the other cash settlable rights and obligations.
However, the same arrangement may become a financial arrangement at a later point in time – for instance, when there are no longer any not insignificant non-cash settlable rights and obligations under the arrangement.
It can become necessary to reassess whether an arrangement is a financial arrangement. This is the case when an arrangement moves from having some not insignificant non-cash settlable rights or obligations (or rights or obligations to things that are not financial benefits) to an arrangement consisting only of cash settlable rights or obligations. This can also be the case when the arrangement between the parties has not changed and there is no new agreement.
Example: starting to have a financial arrangement
Vin Co enters into an agreement on 1 July 2010 to sell a truck to Just Co for $100,000. At the time of the agreement, Vin Co has:
- a right to receive a monetary financial benefit – that is, $100,000
- an obligation to provide something that is not cash settlable – that is, the truck.
As Vin Co's obligation to provide the truck is not insignificant when compared to its right to receive payment from Just Co, the arrangement is not a financial arrangement on 1 July 2010.
The arrangement may later become a financial arrangement if payment for the truck to Vin Co remains outstanding more than 12 months after it is delivered. Once the truck has been delivered, the only subsisting rights and or obligations under the arrangement will be Vin Co's (cash settlable) right to receive payment from Just Co, so the arrangement will be a financial arrangement at the time Vin Co delivers the truck. The financial arrangement will comprise Vin Co's right to receive $100,000.
End of exampleSection 230-50 financial arrangements
Under subsection 230-50(1), an entity has a financial arrangement where it has an equity interest. The equity interest constitutes the financial arrangement.
For a company, equity interest is defined in Subdivision 974-C (debt and equity rules). For trusts and partnerships, equity interest is defined in section 820-930 (thin capitalisation rules).
Where an arrangement satisfies the definition of a financial arrangement under both section 230-45 and subsection 230-50(1), section 230-50 will take precedence (refer to Taxation Determination TD 2011/12).
Under subsection 230-50(2), an entity also has a financial arrangement if both of the following apply:
- it has under an arrangement a legal or equitable right to receive or obligation to provide an equity interest or a combination of such rights and obligations
- the right, obligation or combination of such rights and obligations does not constitute or form part of a financial arrangement under section 230-45.
TOFA will only apply to a financial arrangement that satisfies the definition in section 230-50 where the entity has made one of the following elections, and the election applies to the financial arrangement:
- a fair value election
- a reliance on financial reports election
- in limited circumstances, a hedging financial arrangements election.
For more information, see:
- Section 230-50 – Financial arrangement (equity interest or right or obligation in relation to equity interest
- Subdivision 974-C – Debt and equity interests
- Section 820-930 – Equity interest in a trust or partnership
- TD 2011/12 Income tax: where an equity interest is a financial arrangement which satisfies both subsections 230-45(1) and 230-50(1) of the Income Tax Assessment Act 1997, which provision applies?
Additional operation
Subdivision 230-J extends the operation of TOFA to arrangements that would not otherwise satisfy the definition of a financial arrangement.
Section 230-530 deems the following to be financial arrangements:
- foreign currency
- legal form shares that are not equity interests in a company (non-equity shares)
- in certain circumstances, commodities and offsetting commodity contracts held by traders.
See Subdivision 230-J – Additional operation of Division.
Exceptions
Subdivision 230-H excludes TOFA from applying to gains and losses for certain financial arrangements.
Short-term arrangements with non-monetary amounts
Under section 230-450, TOFA will not apply to short-term financial arrangements where non-monetary amounts are involved – for example, short term trade credit.
This exception applies where all of the following are met:
- the arrangement is a financial arrangement under section 230-45
- the entity acquired (or provided) goods or other property or services and the financial benefits the entity is to provide (or receive) under the arrangement are consideration for those goods or other property or services
- the period between the payment and the provision of goods other property or services is not more than 12 months
- the arrangement is not a derivative financial arrangement for any income year
- the fair value election does not apply to the arrangement.
See Section 230-450 – Short-term arrangements where non-money amount involved.
Entities falling below the thresholds
Under section 230-455, gains or losses from financial arrangements of individuals and those entities that fall below the relevant threshold tests will generally not be subject to TOFA (see Who the rules apply to).
See Section 230-455 – Certain taxpayers where no significant deferral.
Various rights and obligations
Under section 230-460, the following rights and obligations are excluded, in whole or in part, from the operation of TOFA:
- most leasing or property arrangements
- certain interests in partnerships and trusts
- certain insurance policies
- certain workers compensation arrangements
- certain guarantees and indemnities
- personal arrangements and personal injury payments
- superannuation or pension benefits
- interest in controlled foreign companies
- proceeds from certain business sales
- infrastructure borrowings
- farm management deposits
- rights or obligations to which section 121EK of the ITAA 1936 applies (for owners of an offshore banking unit)
- forestry managed investment scheme interests.
For more information, see:
Forgiveness of commercial debts
Relevant gains made from the release, waiver or extinguishment of a debt under a financial arrangement continue to be subject to the commercial debt forgiveness provisions as set out in Division 245.
Section 230-470 provides that where a taxpayer makes a gain from a financial arrangement from the forgiveness of a debt in accordance with the commercial debt forgiveness provisions, that gain is decreased by certain amounts.
For more information, see:
Franked distributions
TOFA does not apply to gains to the extent they are gains in the form of a franked distribution or a right to receive a franked distribution (section 230-480).
See Section 230-480 – Treatment of gains in form of franked distribution etc.
Retirement villages
Certain gains and losses relating to retirement villages and residential care arrangements are excluded from TOFA (section 230-475).
See Section 230-475 – Clarifying exceptions.
Earnout and deferred consideration arrangements
Earnout and deferred consideration arrangements may be subject to the TOFA provisions in Division 230 of the ITAA 1997.
For an earnout or deferred consideration arrangement be subject to the TOFA rules, the contractual right to receive financial benefits or obligation to provide financial benefits must be a financial arrangement.
TOFA exclusion
There is a specific exclusion from TOFA under subsection 230-460(13) for certain financial arrangements which arise under earnout and deferred consideration arrangements. To be excluded from TOFA, both of the following conditions must be met.
- The financial arrangement arises from:
- the sale of a business
- shares in a company that operates a business
- interests in a trust that operates a business.
- The financial benefits that arise under the financial arrangement are only contingent on aspects of the economic performance of the business (as defined in section 974-85) after the sale.
For the financial benefits to be ‘contingent on aspects of the economic performance of the business’, the financial benefit must be linked to a reasonable measure of this performance in the context of the business or asset.
Financial benefits:
- linked to profits – will be contingent on aspects of economic performance
- based solely on the receipts or turnover of the business – will not be contingent on aspects of economic performance under paragraph 974-85(1)(b).
The relevant business activities need to be closely examined on a case-by-case basis to determine if a contingency is closely related to the profits generated such that it is a proper measure of the economic performance of the business.
Example: TOFA exclusion
A business is sold on the following terms:
- The buyer agrees to pay an initial upfront amount of $500,000.
- The buyer agrees to pay the seller 5% of profits of the business for the next 7 income years.
The following assumptions are made:
- The conditions of a look-through earnout right are not met.
- The seller and buyer are both subject to the TOFA rules and are dealing at arm’s length in relation to the sale of the business.
- The contractual right created under the arrangement is a financial arrangement as defined in section 230-45.
The TOFA exclusion will apply because the financial benefits are contingent on aspects of the economic performance of the business.
The contractual right created under the arrangement will not be subject to the TOFA rules for the seller or buyer.
End of example
Example: TOFA exclusion doesn't apply
A business of mining and selling commodities is sold on the following terms:
- The buyer agrees to pay an initial upfront amount of $500,000.
- The buyer agrees to pay the seller 2% of the gross revenue from the sale of the commodities for the next 10 income years.
The following assumptions are made:
- The conditions of a look-through earnout right are not met.
- The seller and buyer are both subject to the TOFA rules.
- The contractual right created under the arrangement is a financial arrangement.
The TOFA exclusion in subsection 230-460(13) will not apply.
This is because the financial benefits are based solely on the receipts or turnover of the business, and therefore are not contingent on aspects of the economic performance of the business, as defined in subsection 974-85(1).
The contractual right created under the arrangement will be subject to the TOFA rules for the seller and buyer.
End of exampleIf the buyer in the above example agrees to pay the seller 2% of the gross revenue subject to a floor price which is a proxy for expected and predictable costs of sale. The amount payable may be regarded as only being contingent on aspects of the economic performance of the business. In this case, the earnout arrangement cannot be subject to the TOFA rules because the TOFA exclusion in subsection 230-460(13) will apply.
If the floor price is not determined by reference to the expected costs of sale for the business, the amount payable may not be regarded as being contingent on the economic performance of the business (for example, the floor price is based on expectations about the future market price of the commodities). In this case, the earnout arrangement can be subject to the TOFA rules because the TOFA exclusion in subsection 230-460(13) will not apply.
TOFA application
An entity may be required to apply the TOFA rules to a contractual right created under an earnout or deferred consideration arrangement if:
- the entity is subject to the TOFA rules (this may be the entity holding the right or the entity with obligations to provide financial benefits under the right)
- the earnout or deferred consideration arrangement is a financial arrangement
- the TOFA exclusion does not apply.
TOFA gains and losses may arise to the entity from financial benefits provided or received in relation to the contractual right. Where a financial arrangement is created as consideration for the acquisition or provision of an asset, it is necessary to determine the market value of the asset at the time it is acquired or received. That value will be relevant to:
- determining the tax cost of the relevant asset for the buyer, or proceeds for the relevant asset for the seller, for:
- capital gains tax purposes
- under the depreciation (capital allowances) rules
- determining the financial benefits provided or received for creation of the financial arrangement, which is taken into account in calculating any TOFA gain or loss
Where the financial arrangement is a contractual right created under an earnout or deferred consideration arrangement, the market value of the relevant business assets or interests in the entity that operates the business (such as shares in a company or interests in a trust) that are consideration for the right can be determined by working out the market value of the contractual right at the time the assets or interests are provided or received.
When determining the TOFA gains and losses from a financial arrangement, it is necessary to attribute the financial benefits provided against those received under the financial arrangement using appropriate and commercially accepted valuation principles.
The timing of any TOFA gain or loss will depend upon the TOFA method used.
Example: TOFA application
Shares in a company that operates a business are sold on the following terms:
- the buyer agrees to pay an initial upfront amount of $800,000.
- the buyer agrees to pay the seller 50% of the turnover above $500,000 in year 6.
The market value of the business at the time of the contract is $900,000. The market value of the earnout right at the time of the contract is $100,000.
Turnover for the business in year 6 is $800,000. Therefore, the buyer makes an additional payment of $150,000 to the seller.
The following assumptions are made:
- the seller's cost base for the shares is $700,000.
- The TOFA rules apply to the seller and buyer and they are dealing at arm’s length in relation to the sale of the business.
- The earnout right is a financial arrangement as defined in section 230-45.
- The earnout right is not contingent on aspects of the economic performance of the business and therefore the TOFA exclusion does not apply.
- The realisation method is applied.
Year |
Seller |
Buyer |
|---|---|---|
0 |
CGT event A1 occurs. The seller's:
The seller also has a financial arrangement arising from the contractual right to receive contingent financial benefits from the buyer which the seller started to have as consideration for providing the CGT asset. The financial benefits provided by the seller is the market value of the business totalling $900,000. Of the total financial benefits provided, the amount that is consideration for the earnout right is $100,000. |
The buyer's cost base of the purchased shares is $900,000. The buyer also has a financial arrangement arising from the contractual obligation to provide contingent financial benefits to the seller which the buyer started to have as consideration for receiving the CGT asset. The financial benefits received by the buyer is the market value of the business totalling $900,000. Of the total financial benefits received, the amount that is attributable to the buyer having the earnout obligation is $100,000. |
6 |
The seller's financial benefits:
The TOFA gain is $50,000. |
The buyer's financial benefits:
The TOFA loss is $50,000. |
End of example
Example: Earnouts paid/received progressively
A business consisting of CGT and Division 40 depreciating assets is sold on the following terms:
- the buyer agrees to pay an initial upfront amount of $800,000.
- the buyer agrees to pay the seller 50% of the revenue above $500,000 per annum for the next 3 income years.
The market value of the business at the time of the contract is $1,100,000. The market value of the earnout rights at the time of the contract is $300,000 in total.
Revenue for the business in the following 3 income years is:
- Year 1 – $700,000
- Year 2 – $800,000
- Year 3 – $700,000.
Therefore, the buyer makes additional payments to the seller of:
- Year 1 – $100,000
- Year 2 – $150,000
- Year 3 – $100,000
The following assumptions are made:
- The seller's cost base for the business is $700,000.
- The TOFA rules apply to the seller and buyer, and they are dealing at arm’s length in relation to the sale of the shares.
- The earnout right is a financial arrangement as defined in section 230-45.
- The earnout right is not contingent on aspects of the economic performance of the business and therefore the TOFA exclusion does not apply.
- The realisation method is applied and it is assumed for the purposes of this simplified example that, one third of the market value of the earnout rights at the time of the contract is reasonably attributable to each of the 3 income years following the sale of the business.
Year |
Seller |
Buyer |
|---|---|---|
0 |
CGT event A1 occurs. The seller's:
The seller also has a financial arrangement arising from the contractual right to receive contingent financial benefits from the buyer which the seller started to have as consideration for providing the CGT asset. The financial benefits provided by the seller is equal to so much of the market value of the business sold ($1,100,000) that the earnout right is consideration for being $300,000. |
The buyer's cost base of the purchased business is $1,100,000 comprised of the upfront cash amount of $800,000 and the market value of the earnout right of $300,000. The buyer also has a financial arrangement arising from the contractual obligation to provide contingent financial benefits to the seller which the buyer started to have as consideration for receiving the CGT asset. The financial benefits received by the buyer is equal to so much of the market value of the business purchased ($1,100,000) that the earnout right is consideration for being $300,000. |
1 |
The seller's financial benefits:
The TOFA outcome is therefore nil. |
The buyer's financial benefits:
The TOFA outcome is therefore nil. |
2 |
The seller's financial benefits:
The TOFA gain is therefore $50,000. |
The buyer's financial benefits:
The TOFA loss is therefore $50,000. |
3 |
The seller's financial benefits:
The TOFA outcome is therefore nil. |
The buyer's financial benefits:
The TOFA outcome is therefore nil. |
End of example