House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon Wayne Swan MP)

Chapter 11 Interaction and consequential amendments (other than consolidation)

Outline of chapter

11.1 This chapter explains various amendments made to provisions of the:

•

Income Tax Assessment Act 1936 (ITAA 1936);

•

Income Tax Assessment Act 1997 (ITAA 1997);

•

Income Tax (Transitional Provisions) Act 1997 ;

•

New Business Tax System (Taxation of Financial Arrangements) Act 2003 (NBTS (TOFA) 2003); and

•

Taxation Administration Act 1953 (TAA 1953),

which are required as a result of the introduction of Division 230 into the ITAA 1997.

Context of amendments

11.2 Several provisions in the ITAA 1936, the ITAA 1997 and the TAA 1953 currently deal with the taxation of arrangements that may satisfy the definition of 'financial arrangement'. The intended operation of those provisions may be affected by the introduction of Division 230 into the ITAA 1997. Amendments to the other provisions of the tax laws were required to ensure that they operate as intended in the context of the introduction of Division 230. These are the 'consequential amendments' which are required to adjust the operation of the current provisions of the tax laws as a consequence of the introduction of Division 230.

11.3 Further, a number of provisions were included in Division 230 which will affect the operation of other provisions of the Act. Generally, these amendments will affect the amount or value of a financial benefit for the purposes of the other provisions of the tax laws (eg, capital gains tax (CGT) or capital allowance purposes) or the amount or value of a financial benefit for the purposes of calculating a gain or loss for Division 230 purposes. These types of amendments are the 'interaction amendments' as they provide rules which deal with the interaction of the other provisions of the tax laws with Division 230.

Summary of new law

11.4 Generally, the consequential and interaction amendments that are explained in this chapter fall into six categories:

•

ordering rules: a financial arrangement may fall within the scope of provisions of the tax laws other than Division 230. This category of amendment ensures that it is clear which provision will prevail in such circumstances;

•

value setting rules: financial benefits are recognised in Division 230 for a number of purposes. One such purpose is to calculate a gain or loss that will then be brought to account under Division 230. Those financial benefits may also be relevant for other purposes of the tax laws. This category of amendments operates to provide rules which set the values of those financial benefits for the purposes of the tax laws (including Division 230);

•

recognition of gains and losses: this category of amendments provides rules which go to whether an amount is assessable or deductible where a Division 230 financial arrangement is involved;

•

definitional: this category of amendments is required because certain definitions in the tax laws may change as a result of the introduction of Division 230;

•

referencing: this category of amendments comprises technical changes which either introduces signposts to Division 230 in other provisions of the tax laws or updates the relevant finding tables in the ITAA 1997; and

•

record-keeping: this section outlines how the record-keeping requirements have been modified as a result of the introduction of Division 230.

11.5 Further, amendments have been made to ensure that Division 775 of the ITAA 1997 (foreign currency gains and losses) will start to apply to authorised deposit-taking institutions (ADIs), non-ADI financial institutions and securitisation vehicles. The intention to have Division 775 apply to those types of taxpayers when the retranslation module of the taxation of financial arrangements reforms comes into effect was stated in the explanatory memorandum to the NBTS (TOFA) 2003. The retranslation module of the taxation of financial arrangements reforms is contained in Subdivision 230-D of this Bill.

11.6 As a result of the Division 775 amendments, some amendments were required to the NBTS (TOFA) 2003. Those amendments were announced in the then Minister for Revenue and Assistant Treasurer's Press Release No. 073 of 2 September 2005 ( Securitisation vehicles and foreign currency rules ).

Detailed explanation of new law

11.7 As outlined above, the consequential and interaction amendments can be grouped into six categories. Each of the amendments that fit into a particular category is explained below.

Ordering rules

11.8 In situations where a number of different provisions may apply to an arrangement that is also a 'financial arrangement' for Division 230 purposes, these amendments provide rules which determine which provision should take precedence over the other.

12-month prepayment rule

11.9 Subdivision 3 of Division H of Part III of the ITAA 1936 sets out the timing of the deduction that may be allowable when such expenditure is prepaid. These rules alter the normal effect of section 8-1 of the ITAA 1997, which otherwise may have allowed a deduction in full in the year in which the expenditure is incurred.

11.10 Division 230 does not apply to gains or losses made from short-term financial arrangements that arise in respect of the prepayments for goods, property or services [ Schedule 1, item 1, section 230-450 ]. Subdivision 3 of Division H generally applies to certain prepaid expenditure where that expenditure relates to a period which extends beyond the income year in which the expenditure is incurred. That period may be less than 12 months. In such situations, Division 230 will not apply to the gain or loss that arises under the same set of facts. However, the relevant prepayment period may be more than 12 months - where this is the case, there may still be situations where the rules in Subdivision 3 of Division H of the ITAA 1936 and Division 230 overlap.

11.11 Where the rules do overlap, Division 230 will take precedence over Subdivision 3 of Division H of the ITAA 1936. [ Schedule 1, item 33, paragraph 82KZLA(a) of the ITAA 1936 ]

Qualifying securities

Deferred interest and discounted securities

11.12 Division 16E of Part III of the ITAA 1936 taxes gains and losses on certain discounted and deferred interest securities on an accruals basis.

11.13 Provisions throughout the ITAA 1936, the ITAA 1997, the Income Tax (Transitional Provisions) Act 1997 and the TAA 1953 rely on or build on the taxing outcomes and concepts of Division 16E in order to achieve their intent.

11.14 Division 230 of the ITAA 1997 will provide the tax treatment for most of the gains and losses on discounted and deferred interest securities that are acquired or issued on or after 1 July 2010, or 1 July 2009 should the taxpayer so elect, that would otherwise have been taxed under Division 16E.

11.15 To ensure the appropriate operation of provisions that rely or build on the taxing outcomes and concepts in Division 16E where a taxpayer holds a Division 230 financial arrangement, particularly one taxed under the accruals method in Subdivision 230-B, the consequential amendments discussed below are necessary.

Tainted interest income

11.16 The ITAA 1936 deals with the attributable income of controlled foreign companies. The definition of tainted interest income, relies on the taxing outcome under Division 16E of the ITAA 1936. In particular under paragraph 317(1)(b) tainted interest income includes amounts that would have been assessable income under Division 16E had the controlled foreign company been a resident. To ensure that Division 230 does not expand the scope of tainted interest income before it is decided whether Division 230 should be applied in calculating attributable income as part of the Board of Tax's 'review of foreign source income, the definition is amended to include amounts that would have been assessable under Division 16E had Division 230 not been introduced.

Land transport facilities offset

11.17 Division 396 allows a lender a tax offset for certain interest (land transport facilities interest) it derives on approved borrowings for the construction of land transport facilities. 'Land transport facilities interest' is defined by paragraphs 396-30(1)(b) and 396-30(2)(b) of the ITAA 1997 to include amounts that would either be assessable income or allowable deductions under Division 16E. To ensure that Division 230 does not expand the scope of what is land transport facilities interest, the amendments to paragraphs 396-30(1)(b) and 396-30(2)(b) ensure that only those amounts assessable or deductible under Division 230 that would also have been assessable or deductible under Division 16E, had it applied, are land transport facilities interest.

Fixed interest complying approved deposit fund

11.18 Subsection 295-390(5) of the Income Tax (Transitional Provisions) Act 1997 defines what a fixed interest complying approved deposit fund is. A complying approved deposit fund will be a fixed interest complying approved deposit fund if 90 per cent or more of its income is comprised of amounts which, amongst other things, are included in its assessable income under Division 16E of the ITAA 1997. In order to preserve the existing scope of these measures, the amendment ensures that where Division 230 financial arrangements are required to be taken into account in determining whether an approved deposit fund is a complying fixed interest fund, only those amounts that would have been bought to account under Division 16E, had it applied, are taken into account.

Special accrual amount

11.19 Under section 960 of the ITAA 1997, amounts that are denominated in a foreign currency are required to be translated into Australian currency. Generally where these amounts are used in calculating another amount, subsection 960-50(4) of the ITAA 1997 requires each of those amounts to be translated from a foreign currency to Australian currency before the calculation is done. The exception to this is where the amount is a 'special accrual amount' as defined in subsection 995-1(1) of the ITAA 1997.

11.20 Where an amount is a 'special accrual amount' it is calculated without translating the amounts used to calculate it. The special accrual amount is then translated into Australian currency. The definition of 'special accrual amount' includes the accruals taxation of Division 16E securities.

11.21 To ensure that 'special accrual amount' includes amounts calculated under Division 230 that are consistent with its intent, the definition has been amended to ensure that only those gains and losses under Subdivision 230-B that would be accounted for under Division 16E are subject to the 'special accrual amount' rules.

Subsection 57-25(6) of the Income Tax Assessment Act 1936

11.22 Division 57 of Schedule 2D of the ITAA 1936 sets out the income tax treatment of an entity that ceases to be wholly exempt from income tax. In particular, subsection 57-25(2) of the ITAA 1936 treats assets to which section 57-25 applies to have been sold by the taxpayer immediately before the transition time and re-acquired by the taxpayer at the transition time for an amount equal to the asset's adjusted market value for the purposes of determining future tax consequences. However, the deemed re-acquisition rule does not invoke the operation of certain provisions of the ITAA 1936 and the ITAA 1997 if the asset was acquired prior to the commencement of certain provisions listed in subsection 57-25(6).

11.23 To ensure that there is no inadvertent retrospective application of Division 230 to assets acquired prior to the commencement of Division 230 in the circumstances described above, subsection 57-25(6) includes it in its listed provisions Division 230.

Consideration from the transfer of a right to receive income from property

11.24 Section 102CA of the ITAA 1936 includes any consideration received from the transfer of a right to receive income from property in the transferor's assessable income in the income year in which the right is transferred. The consideration is included in the transferor's income in the year in which the right is transferred even if the consideration is, in whole or in part, not actually received until a later income year.

11.25 Such a result is inconsistent with the intended operation of Division 230 in respect of such transactions - that is to bring to account gains (or losses) where there is a delay in time between the disposal of an asset and actual payment of the consideration. This amendment will ensure that section 102CA of the ITAA 1936 will not apply where the right to receive income from property comprises a financial arrangement to which Division 230 also applies. In such situations, the relevant gain or loss that arises from the transfer of such rights is instead brought to account under Division 230. [ Schedule 1, item 35, paragraph 102CA(2)(c) of the ITAA 1936 ]

Complying superannuation funds, complying approved deposit funds and pooled superannuation trusts

11.26 As part of the re-write of the provisions contained in Part IX of the ITAA 1936, Part 3-30 was introduced into the ITAA 1997. In particular, section 295-85 was introduced to ensure that only the CGT provisions (and not the general income provisions) apply if a CGT event happens involving a CGT asset owned by a complying superannuation fund, a complying approved deposit fund or a pooled superannuation trust. Paragraph 295-85(2)(a) of the ITAA 1997 will be amended to add a reference to Division 230 to ensure that where a CGT event happens to a CGT asset that is also a financial arrangement, the relevant gain or loss is brought to account under the CGT provisions and not Division 230. However, the exceptions to the rule in subsection 295-85(2) that are contained in subsection 295-85(3) will still operate to apply Division 230 where there is a gain or loss made in respect of foreign currency fluctuations or there is a disposal of certain types of securities. [ Schedule 1, item 80, paragraph 295-85(2)(a )]

Life insurance companies

11.27 Section 320-45 operates to apply the same treatment for CGT assets that are a virtual pooled superannuation trust asset of a life insurance company, as that described above, for those entities subject to section 295-85. A subsection is proposed to be added to section 320-45 of the ITAA 1997 to ensure that, where relevant, section 320-45 will apply rather than Division 230 to bring to account gains or losses from financial arrangements that are also a virtual pooled superannuation trust asset of a life insurance company. [ Schedule 1, item 82, subsection 320-45(2 )]

Foreign trusts, controlled foreign companies and foreign investment funds

11.28 The Board of Tax's 'review of foreign source income anti-tax deferral rules' is currently considering the operation of the tax law in relation to interests held in controlled foreign companies as well as foreign investment funds and non-resident trusts more widely. Consequently, how Division 230 should apply in relation to interests in controlled foreign companies, foreign investment funds and non-resident trusts will receive further consideration in the light of the outcomes of that review.

11.29 Pending the finalisation of that review, instead of Division 230 applying, the current provisions of the tax laws will apply to bring to account gains or losses made from arrangements that would otherwise be classified as 'financial arrangements' for the purposes of the Division. More specifically, in relation to each of these entities:

•

for non-resident trusts: will be made to ensure Division 230 is disregarded in working out the net income of a non-resident trust estate for certain purposes. This amendment is relevant for the purposes of both Division 6 of Part III of the ITAA 1936 and Division 6AAA of Part III of the ITAA 1936 in calculating the amount to be attributed to a transferor [ Schedule 1, item 34, paragraph 96C(5A)(aa) of the ITAA 1936 ];

•

for controlled foreign companies: an amendment to section 389 of the ITAA 1936 will be made to ensure Division 230 is disregarded in working out the attributable income of an eligible controlled foreign company. This amendment will ensure that attributable income is calculated with reference to the current law (including Division 775 (foreign currency gains and losses), Subdivision 960-C (translation of foreign currency) and Subdivision 960-D (functional currency) of the ITAA 1997) [ Schedule 1, item 49, paragraph 389(ba) of the ITAA 1936 ]; and

•

for foreign investment funds: an amendment to section 557A of the ITAA 1936 will be made to ensure Division 230 is disregarded in working out calculated profit or calculated loss of a foreign investment fund. The amendment will ensure that foreign investment fund income is calculated under the current law [ Schedule 1, item 50, paragraph 557A(c) of the ITAA 1936 ].

Deductions for returns on debt interests

11.30 To avoid doubt, where a debt interest (as per Division 974 of the ITAA 1997) is also a financial arrangement for the purposes of Division 230, the gains or losses on those debt interests are brought to account or allowable as a deduction under Division 230. [ Schedule 1, item 59, subsection 25-85(4A )]

11.31 To avoid doubt, a note has been added to section 25-90 which deals with deductions relating to foreign non-assessable non-exempt income to provide a signpost for the reader that the provisions of Division 230 prevail over section 25-90 when the relevant loss is made in respect of a financial arrangement. [ Schedule 1, item 60, note to section 29-90 ]

Withholding tax

11.32 Where a financial arrangement is held (as an asset) by a foreign resident, any gain or part thereof from the financial arrangement that is income (eg, interest) to which section 128B of the ITAA 1936 applies is not to be assessable under Division 230. Those gains are to be subject to withholding tax as per Division 11A of Part III of the ITAA 1936. Any other gain/loss made from the financial arrangement, including a balancing adjustment gain/loss, is to be dealt with in accordance with Division 230. This policy approach leads to two conclusions in the extreme cases. First, where the only gains that have been or can be made from the financial arrangement are amounts to which section 128B applies or will apply (or would apply but for certain exceptions in that section that are discussed in the next paragraph) and no loss can be made, Division 230 will effectively not apply at all to those gains while the financial arrangement is held by, or when it ceases to be held by, a foreign resident. Second, if no such payments are made/are to be made to a foreign resident in respect of a financial arrangement it holds, Division 230 will apply to determine what gain/loss is made and whether it is assessable or deductible.

11.33 The gains to be disregarded for the purposes of section 230-15 are amounts that are income to which section 128B applies, or would apply but for the exclusions in Division 11A, other than exclusions that deal with situations where the income is intended to be taxed by assessment (if it has an Australian source) rather than by withholding tax. In the current law these latter exclusions are those in paragraphs 128B(3)(d), (e), (gb), and (j), subparagraph 128B(3)(h)(ii) and subsection 128B(3E) or in section 17A of the International Tax Agreements Act 1953 . The disregarded gains, or more correctly the payments by which the gains are realised, are to be subject to withholding tax or in some cases (eg, amounts covered by paragraph 128B(3)(jb) or section 128F) exempt from withholding tax. These gains are hereafter referred to as 'Division 11A payments'.

11.34 Normally, section 128D would result in these Division 11A payments being non-assessable non-exempt income. However, in many cases where the gains from a financial arrangement are dealt with by Division 230 the amount otherwise assessable under that Division will be different from that which is dealt with by Division 11A and so section 128D may not apply. A similar issue arises under the existing law in relation to the eligible return on a qualifying security where some or all of the payments are interest. In that case, an exemption from treatment under Division 16E of Part III of the ITAA 1936 for non-residents is provided by subsection 159GW(1) of the ITAA 1936.

11.35 A payment that is subject to withholding tax is non-assessable non-exempt income and so to that extent a gain from the financial arrangement that would otherwise be assessable will not be [ Schedule 1, item 1, subsection 230-30(1 )]. To the extent that gains reflect payments that are exempt from withholding tax but are nevertheless non-assessable non-exempt income under section 128D (eg, interest that is exempt from withholding tax by section 128F) they also will not be assessable under Division 230. Clearly, these amounts are not intended to be taxed in Australia. However, in relation to amounts that are exempt from withholding tax but are not made non-assessable non-exempt income by section 128D (eg, interest paid to an Australian permanent establishment of a foreign resident), gains will still be determined in accordance with Division 230 and they will be assessable if they have an Australian source.

Example 11.1 : Withholding tax and accruals

In Example 4.2 assume that Hristina Co, the holder of the bond, is a foreign resident and that all the payments are interest to which section 128B applies and on which withholding tax would be payable. In that example, it is determined that the accruals method would apply to the overall gain from the bond. However, because all the gain reflects amounts that will be subject to withholding tax and so are non-assessable non-exempt income (on the assumption that Hristina Co is a foreign resident), each annual gain calculated using the accruals method would be non-assessable non-exempt income. In practice, Hristina Co would probably not even calculate the annual accrual amounts. Nevertheless, Division 230 may still be used by the issuer to calculate its annual losses from the bond and to determine whether they are deductible or not.

11.36 Unlike Division 16E, Division 230 could still apply to other gains or losses from the financial arrangement held by a foreign resident. In particular, any retranslation gain/loss would still be dealt with under Division 230 (if a retranslation election applies to the financial arrangement). If the financial arrangement were subject to a fair value or financial reports election and not all gains are Division 11A payments, the amount recognised in the accounts which would otherwise be used for these methods would be reduced by the amounts of the Division 11A payments. If a loss would otherwise arise for an income year under either method (due to changing interest rates and therefore prices for the financial arrangement), the adjustment for the Division 11A payments would increase that loss.

Example 11.2 : Withholding tax and forex loss

In Example 7.2 assume that A Co, the holder of the note, is a foreign resident and that the gain on maturity is subject to withholding tax. The amount on which withholding tax would be payable is A$1,859 ( = US$1,450/0.78). Because that amount is therefore non-assessable non-exempt income, to that extent the annual gains calculated using the accrual method are non-assessable non-exempt income (or are disregarded). That leaves only the foreign exchange loss caused by the change in A$/US$ exchange rate over the three years. In the absence of a retranslation election, the balancing adjustment calculation on maturity picks up this foreign exchange loss. The balancing adjustment loss would be as calculated in the same manner as in that example except the interest amount captured in step 2 would be A$1,859 rather than the annual assessable gains totalling A$1,295, resulting in a loss of A$5,054. Deductibility would be determined according to section 230-15.

11.37 When it comes to calculating a balancing adjustment under Subdivision 230-G, these Division 11A amounts fall within step 2(c) in the method statement in section 230-395. This is illustrated in the preceding example with the deduction of the interest amount received on maturity of the note. It includes gains that are exempt or non-assessable non-exempt income. This would effectively extend to gains of a foreign resident that are not assessable because they do not have an Australian source or because they are payments that are dealt with by Division 11A. [ Schedule 1, item 1, note to paragraph (c) of step 2 in the method statement in subsection 230-445(1 )]

Trading stock

11.38 Division 70 of the ITAA 1997, which deals with the taxation of trading stock, will not apply to trading stock that is a financial arrangement to which Division 230 applies. Rather, all financial arrangements that are subject to Division 230 should have the gains or losses made on those arrangements recognised under Division 230. In some situations this will allow taxpayers to align the tax treatment of the gains or losses made on their financial arrangement, that otherwise satisfy the definition of 'trading stock', with their financial accounting treatment.

11.39 To avoid doubt, an amendment is made to the definition of 'trading stock' such that financial arrangements that are subject to Division 230 cannot be trading stock for the purposes of Division 70. This means, for example that, while the cost of trading stock which is a financial arrangement will not be an allowable deduction under section 8-1 of the ITAA 1997, that amount will be taken into account in calculating a gain or a loss that may be an allowable deduction under subsection 230-15(2). [ Schedule 1, item 68, section 70-10 of the ITAA 1997 ]

Capital gains tax - anti-overlap rule

11.40 Section 118-27 provides that, where Division 230 applies to a financial arrangement, a capital gain or a capital loss that is made:

•

from a CGT asset;

•

in creating a CGT asset; or

•

from the discharge of a liability,

is disregarded if, at the time of the CGT event from which the gain or loss is made, the asset or liability is, or is part of, a 'Division 230 financial arrangement' [ Schedule 1, item 76, subsection 118-27(1 )]. A Division 230 financial arrangement is one where the gains or losses from the arrangement are brought to account under Division 230 [ Schedule 1, item 11, definition of ' Division 230 financial arrangement' in subsection 995-1(1) of the ITAA 1997 ].

11.41 Where Division 230 applies to gains and losses from a financial arrangement that is a CGT asset (or where a CGT asset forms part of that arrangement), a capital gain or a capital loss that is made from CGT events that happen to that CGT asset is disregarded. However, where a foreign resident makes a gain or loss from a CGT event happening in relation to taxable Australian property but the gain is not assessable or the loss is not deductible under Division 230, the capital gain or loss will still be counted in determining the foreign resident's net capital gain/loss for the year [ Schedule 1, item 76, subsection 118-27(3 )].

11.42 The further references to creating a CGT asset and discharging a liability are intended to reflect the fact that a gain or loss from a financial arrangement:

•

that is or includes a CGT asset, may arise in respect of the creation of that CGT asset, in circumstances that would also give rise to a capital gain or loss; and

•

that is or includes a liability, may arise on the discharging or extinguishment of that liability in circumstances that would also give rise to a capital gain or loss.

This may be relevant for a CGT asset that forms part of a taxpayer's financial arrangement that the taxpayer has created in another entity, giving rise to CGT event D1; or where a discharge of a liability that forms part of a financial arrangement also gives rise to CGT event L7. [ Schedule 1, item 76, subsection 118-27(1 )]

11.43 It is intended that the introduction of section 118-27 will significantly reduce compliance costs by removing the requirement for a CGT calculation to be made for transactions that are wholly covered by Division 230. Such a calculation would still have been required under section 118-20, because that provision requires that any capital gain or capital loss be reduced to the extent to which a gain or loss is brought to account under another provision of the ITAA 1936 or the ITAA 1997, because of the CGT event.

Example 11.3 : Where CGT provisions are not applicable

On 30 June 2011, Scruffy Co acquires a zero coupon bond from Nik Co for its net present value as at that date of $8,944.32.

Nik Co acquired the bond when it was originally issued on 1 July 2009. The terms of the bond are:

•

Issue price: $8,000.

•

Maturity date: 1 July 2012.

•

Amount payable at maturity: $10,000.

•

Internal rate of return: 11.804 per cent.

When it acquired the bond, Nik Co determined that it would make an overall gain on the financial arrangement and was required to return that gain on an accruals basis in accordance with Subdivision 230-B.

A gain of $944.32 has been accrued up until the time of disposal and is required to be included in assessable income in accordance with Division 230.

For CGT purposes, the bond is a CGT asset which has been subject to CGT event A1 upon its disposal. Section 118-27 provides that any capital gain or loss from this CGT event is disregarded. Accordingly, Nik Co is not required to undertake a separate calculation to determine whether there was an amount of any capital gain or capital loss that would otherwise have to have been calculated on the disposal of the financial arrangement. Without section 118-27, the capital gain or capital loss would have been calculated and then reduced under section 118-20 of the ITAA 1997 to the extent to which that gain or loss was brought to account under Division 230.

11.44 Where a taxpayer has elected to align the tax characterisation of a gain or loss from a hedging financial arrangement with the tax characterisation of the hedged item, then the rule in subsection 118-27(1) that disregards relevant capital gains or losses is switched off. This ensures that taxpayers are able to better align their after tax hedging position. [ Schedule 1, item 76, paragraph 118-27(2)(a )]

11.45 Paragraph 118-27(2)(b) also provides an exception to subsection 118-27(1) in circumstances where a capital loss is made from ceasing to have a financial arrangement that is a marketable security (within the meaning of section 70B of the ITAA 1936). The rationale for this is because where subsection 230-415(1) applies, a deduction is not allowable under Division 230 to the extent that the loss is of a capital nature. This loss is a capital loss for the purposes of the CGT provisions.

Foreign currency gains and losses - anti-overlap rule

11.46 A note, following subsections 775-15(4) and 775-30(4), inserted by this Schedule, clarifies that where foreign currency gains and losses are brought to account under either Division 230 or Subdivision 775-F of the ITAA 1997, subsection 230-20(2) has the effect of disregarding gains and losses from such arrangements under Division 775 to the extent they are, or will be, included in assessable income or allowable as a deduction under Division 230.

Value setting rules

11.47 This category of amendments operates to provide rules which set the values of financial benefits in certain situations where a Division 230 financial arrangement is involved.

Section 230-505 and its interaction with Divisions 40, 104, 110 and 112 of the ITAA 1997

11.48 In a general sense, financial arrangements may be acquired or disposed of as a consideration for the acquisition or disposal of an asset or some other thing. Where this occurs, Division 230 changes the ordinary operation of the provisions of the ITAA 1936 and the ITAA 1997, broadly to ensure that this other thing is taken to have been acquired or disposed of for the market value of the financial arrangement that is used as consideration.

11.49 Where a taxpayer provides or acquires a tax relevant thing in consideration for the creation, acquisition, or cessation of a financial arrangement, Division 230 will operate to determine the amount for which that tax relevant thing is taken to have been acquired or disposed of. For example, where the tax relevant thing used as consideration for starting or ceasing to have a financial arrangement is a CGT asset, Division 230 will operate to determine the cost base or capital proceeds of the CGT asset as relevant. Where it is a depreciating asset, Division 230 will operate to work out the termination value and cost of the depreciating asset.

11.50 The object of section 230-505 is to provide appropriate proceeds and cost base interaction rules between the provisions of Division 230 and the rest of the ITAA 1997 and the ITAA 1936 where:

•

Division 230 applies to a taxpayer's gains and losses from a financial arrangement (ie, none of the exceptions discussed in Chapter 2 apply in respect of that arrangement); and

•

that financial arrangement is either received or provided, or the taxpayer otherwise starts or ceases to have it (it is dealt with ) as consideration for something else that is either provided or received ( dealt with ) in return.

11.51 Dealing with a financial arrangement as consideration for dealing with something else may or may not take place as part of a larger transaction. In addition, the taxpayer may deal with only part of the relevant financial arrangement as consideration for dealing with something else, and still be subject to the operation of section 230-505. [ Schedule 1, item 1, section 230-505 ]

11.52 For the purposes of section 230-505, the relevant thing used as consideration for starting or ceasing to have the financial arrangement is not limited to tangible things and may include services, the conferring of a right, incurring an obligation or extinguishing a right or obligation.

Examples of a 'thing' subject to section 230-505

11.53 For the purposes of section 230-505, the relevant thing that a taxpayer may deal with as consideration for starting or ceasing to have all or part of a financial arrangement may include:

•

assuming the obligation of another party to make payments on a loan (acquiring a thing that is an obligation);

•

assuming the right to receive interest payments on a loan (acquiring a thing that is a right);

•

receiving a right to exercise a right to acquire shares, for example, an option (acquiring a thing that is a right);

•

receipt or disposal of property (acquiring or providing a thing that is property including CGT assets, depreciating assets or trading stock);

•

assuming the right of another to deliver equity interests under a forward contract (acquiring a thing that is a right);

•

receiving services (acquiring a thing that is the provision of services); and

•

having a liability waived or otherwise extinguished (acquiring something that is a financial benefit, being the waiver or extinguishment of a liability).

11.54 The relevant thing that the taxpayer deals with as consideration for starting or ceasing to have the financial arrangement may or may not itself be, or form part of, another financial arrangement. However, where the thing dealt with is a tax relevant thing that is not, and does not form part of, a financial arrangement that has its gains and losses subject to Division 230, section 230-505 will have implications for other relevant provisions of the ITAA 1997 outside of Division 230 and of the ITAA 1936. [ Schedule 1, item 1, subsection 230-505(1 )]

Impact of section 230-505 on certain elements of capital proceeds, cost base, cost of a depreciating asset and termination values

11.55 Section 230-505 operates in relation to certain elements of capital proceeds, cost base, cost of a depreciating asset and termination values. However, it does not in general affect the modification rules, special rules and specific rules in the capital gains and capital allowance regimes (eg, the market value substitution rules).

11.56 You might start or cease to have a Division 230 financial arrangement (or part of such an arrangement) as consideration for providing or acquiring a CGT asset. You might also do this as consideration for providing or obtaining a thing relevant to that asset (eg, obtaining services resulting in capital improvements to the asset). In such situations, section 230-505 may apply. The key interactions of section 230-505 with the CGT provisions and the capital allowance provisions are as follows:

•

Section 230-505 generally operates so that the first element of the cost base and reduced cost base for the CGT asset includes the market value of the thing acquired at the time it is acquired. Section 230-505 can also affect the other elements of the cost base to the extent that the financial arrangement represents consideration for something obtained which is relevant to those elements. For example, if a Division 230 financial arrangement is provided as consideration for something acquired that increases an asset's value for the purposes of the fourth element of the cost base (see subsection 110-25(5) of the ITAA 1997), then the market value of the thing acquired at the time it is acquired will be used to calculate that element of the cost base.

•

Section 230-505 generally operates so that the capital proceeds include the market value of the thing provided at the time it is disposed of. The capital proceeds may be from CGT events that involve providing a CGT asset or the creation of rights, for example, CGT event D1 (creating contractual or other rights).

•

Section 230-505 does not change the time at which a CGT event happens under the CGT provisions. The time section 230-505 is satisfied (when you start or cease to have the financial arrangement) may be different from the timing of the CGT event. However, once section 230-505 is satisfied, then the amount determined as the market value for the thing provided (at the time it is provided) will be brought to account in determining the capital proceeds for the CGT event.

•

Section 230-505 generally operates so that the cost of a depreciating asset includes the market value of the depreciating asset that starts to be held. This may come about either because the financial arrangement is started or ceased as consideration to acquire - or to hold - the asset (relevant to the first element of cost), or as consideration for something acquired that goes to the second element of cost (eg, capital improvements).

•

Section 230-505 generally operates so that the termination value or the amount you are taken to have received under a balancing adjustment event includes the market value of the depreciating asset that is disposed of or that is no longer held.

Consideration is taken to be received or provided for the 'thing'

11.57 Where you start to have a financial arrangement that has its gains and losses subject to Division 230 (a Division 230 financial arrangement), or a part of such an arrangement, as consideration for:

•

providing (giving) something to someone else (including by transferring it to someone else, someone else starting to have it, or by its extinguishment); or

•

acquiring (receiving) something from someone else (including by acquiring it from someone else, someone else ceasing to have it, or by creating it),

then the value of the benefit that you give or receive for providing or acquiring that thing is taken to be the market value of the thing at the time you provide or acquire it. [ Schedule 1, item 1, subsection 230-505(2 )]

11.58 Where you cease to have a Division 230 financial arrangement (or part of such an arrangement) in consideration for:

•

acquiring (receiving) something from someone else (including by acquiring it from someone else or by creating it); or

•

providing (giving) something to someone else (including by transferring it to someone else or by its extinguishment),

then the value of the benefit that you give or receive for providing or acquiring that thing is taken to be the market value of the thing at the time you provide or acquire it. [ Schedule 1, item 1, subsection 230-505(2 )]

Interaction with capital gains tax provisions

11.59 To the extent that Division 230 and Parts 3-1 and 3-3 interact, section 230-505 will operate to ensure that there is alignment between the cost base and proceeds rules that are used for the purposes of this Division and those Parts.

Example 11.4 : Disposal of a capital asset with a deferred delivery and settlement - the consideration received/provided for the asset

Buddy Co enters into a contract on 1 July 2010 to sell a CGT asset (which is not a depreciating asset and not a financial arrangement) to Fee Co. The terms of the contract are:

•

delivery of the asset in six months (ie, on 1 January 2011); and

•

the sale price of $120,000 is to be paid 24 months after the contract date on 1 July 2012 (ie, 18 months after delivery of the asset).

Background and assumptions

•

Buddy Co acquired the CGT asset for $80,000.

•

The market value of the CGT asset as at 1 January 2011 is $105,000.

•

Both Buddy Co and Fee Co hold the CGT asset on capital account.

•

Both Buddy Co and Fee Co are subject to Division 230.

Buddy Co - disposal of a CGT asset

On 1 January 2011 when Buddy Co delivers the asset to Fee Co, it will start to have a financial arrangement. This is because at the time of delivery, the only rights and/or obligations Buddy Co has remaining under its arrangement to dispose of its CGT asset to Fee Co, is its right to receive $120,000 in 18 months time from Fee Co. This right is a cash settlable right to receive a financial benefit, as it is a right to receive a financial benefit that is money. Buddy Co's financial arrangement is constituted by this cash settlable right (subsection 230-45(1) and paragraph 230-45(2)(a)).

Under subsection 230-60(1) the market value of the CGT asset (financial benefit provided) is taken to be provided under the financial arrangement started, and is effectively its cost.

Buddy Co therefore starts to have a financial arrangement as consideration for ceasing to have its CGT asset.

Subsection 230-505(2) provides that for the purpose of applying the income tax law to the CGT asset Buddy Co is taken to have obtained the market value of the CGT asset at the time it is provided. This means that for the purpose of Parts 3-1 and 3-3 of the ITAA 1997, Buddy Co is taken to have received capital proceeds on disposal of its CGT asset equal to the market value of the CGT asset at the time it is provided. That is, Buddy Co is taken to have received the market value of its CGT asset from Fee Co, as determined under section 230-505 at 1 January 2011. This value is $105,000 (subsection 230-505(2)).

Pursuant to section 104-10 of the ITAA 1997, CGT event A1 occurs in respect of Buddy Co's CGT asset, on 1 July 2010. From the facts, the cost base of the CGT asset is $80,000. As Buddy Co will be taken to have received capital proceeds of $105,000 (as set out above), it will make a capital gain of $25,000 on disposal of its CGT asset, (being $105,000 less $80,000).

The general financial arrangement cost and proceeds principles apply to the tax treatment of Buddy Co's financial arrangement constituted by its right to receive $120,000 from Fee Co. The cost of the financial arrangement will be the market value of the CGT asset at the time it is provided. The difference between this cost ($105,000) and the proceeds Buddy Co receives from the financial arrangement ($120,000), a $15,000 gain, will be taken into account under Division 230.

Fee Co - acquisition of a CGT asset

On 1 January 2011 when Fee Co receives the CGT asset from Buddy Co, it will start to have a financial arrangement. This is because after the time of delivery, the only rights and/or obligations Fee Co has remaining under its arrangement to acquire the CGT asset from Buddy Co, is its obligation to pay $120,000 in 18 months time to Buddy Co. This obligation is a cash settlable obligation to provide a financial benefit, as it is an obligation to pay a financial benefit that is money. Fee Co's financial arrangement is entirely constituted by this cash settlable obligation (subsection 230-45(1) and paragraph 230-45(2)(a)).

Under subsection 230-60(2) the market value of the CGT asset (financial benefit received) is taken to be received under the financial arrangement started, and effectively constitutes the proceeds from the financial arrangement.

Fee Co therefore starts to have a financial arrangement as consideration for starting to have the CGT asset.

Subsection 230-505(1) provides that for the purposes of applying the income tax law to the CGT asset Fee Co is taken to have provided the market value of the CGT asset at the time it is acquired. This means that for the purpose of Parts 3-1 and 3-3 of the ITAA 1997, Fee Co's cost of the CGT asset is taken to be equal to the market value of the CGT asset, at the time is acquired. That is, Fee Co is taken to have provided the market value of the CGT asset being $105,000.

This $105,000 cost will form part of Fee Co's cost base of the CGT asset (depending on any subsequent facts, it may be the only element in Fee Co's cost base for this asset).

The general financial arrangement cost and proceeds principles apply to the tax treatment of Fee Co's financial arrangement constituted by its obligation to provide $120,000 to Buddy Co. The proceeds of the financial arrangement will be the market value of the CGT asset at the time it is acquired. The difference between these proceeds ($105,000) and the cost Fee Co provides for the financial arrangement ($120,000), a $15,000 loss, will be taken into account under Division 230.

Note - the time of valuation of the thing

Apart from the operation of Division 230, the capital proceeds from a CGT event include the market value of property that is received in respect of the event, calculated as at the time of the event. Where the relevant property is a financial arrangement to which Division 230 applies which is started or ceased as consideration for the CGT asset, the amount that would otherwise be calculated for the purposes of working out the capital gain or loss from the CGT event is replaced by the market value of the asset on the date the taxpayer provides the asset. This date will not always coincide with the date of the CGT event. This may mean that the taxpayer will be required to amend what otherwise may have been taken into account for the purposes of the CGT event.

Division 230 interaction with capital allowance provisions

11.60 To the extent that Divisions 230 and 40 of the ITAA 1997 interact, section 230-505 will operate to ensure that there is alignment between the general financial arrangement cost and proceeds principles that are used for the purposes of Division 230, on the one hand, and the cost and termination value rules that are used in the uniform capital allowances provisions in Division 40 of the ITAA 1997, on the other.

11.61 The interaction of the capital allowance provisions and the Division 230 measures is similar to that for CGT, in that where a financial arrangement is used as consideration for acquiring or providing a depreciating asset, the market value of the depreciating asset must first be determined before the cost and termination value of the depreciating asset (as relevant) can be worked out.

Example 11.5 : Disposal of a depreciating asset with a deferred delivery and settlement - the consideration received/provided for the asset

Smith Co enters into a contract on 1 September 2009 to sell its depreciating asset (which is not a Division 230 financial arrangement) to Jones Co. The terms of the contract are:

•

delivery of the asset in 12 months (ie, on 1 September 2010);

•

the sale price of $250,000 is to be paid 27 months after the contract date, on 1 January 2012 (ie, 15 months after delivery of the depreciating asset); and

•

notwithstanding the application of section 230-505, Division 40 of the ITAA 1997 would operate such that the liability to pay the sale price does not arise until delivery of the depreciating asset.

Background and assumptions

•

Smith Co used the depreciating asset wholly for a taxable purpose and claimed decline in value deductions for it in accordance with Division 40.

•

The adjustable value of the depreciating asset in the hands of Smith Co at the time of delivery was $100,000.

•

The market value of the depreciating asset as at 1 September 2010 is $150,000.

•

Both Smith Co and Jones Co are subject to Division 230.

Smith Co - disposal of the depreciating asset

On 1 September 2010 when Smith Co delivers the depreciating asset to Jones Co, Smith Co will start to have a financial arrangement. This is because, after the time of delivery, the only rights and/or obligations Smith Co has remaining under its arrangement to dispose of its depreciating asset to Jones Co is its right to receive $250,000 in 15 months time from Jones Co. This right is a cash settlable right to receive a financial benefit, as it is a right to receive a financial benefit that is money. Smith Co's financial arrangement is entirely constituted by this cash settlable right (subsection 230-45(1) and paragraph 230-45(2)(a)).

Under subsection 230-60(1) the market value of the depreciating asset (financial benefit provided) is taken to be provided under the financial arrangement started, and effectively constitutes the cost of the financial arrangement.

Smith Co therefore starts to have a financial arrangement as consideration for ceasing to hold its depreciating asset.

Under the terms of the contract, Smith Co will stop holding the depreciating asset on 1 September 2010 when it delivers the asset to Jones Co. A balancing adjustment event will occur for the asset at that time and Smith Co will need to work out a balancing adjustment amount for it.

Subsection 230-505(2) provides that for the purposes of applying the income tax law to the depreciating asset Smith Co is taken to have obtained the market value of the depreciating asset at the time it is provided. This means that for the purpose of working out the balancing adjustment amount for the depreciating asset, Smith Co is taken to have received an amount equal to the market value of the depreciating asset, at the time it is provided. As this value is $150,000, under the provisions of Division 40 of the ITAA 1997 Smith Co is taken to have a termination value of $150,000 for its depreciating asset (subsection 230-505(2)).

Smith Co's adjustable value for its depreciating asset was, as set out in the facts, $100,000 just before the time of the balancing adjustment event (1 September 2010). As Smith Co's termination value of its depreciating asset will be taken to be $150,000 (as set out above), its assessable balancing adjustment amount under Division 40 will be $50,000 (being $150,000 less $100,000).

The general financial arrangement cost and proceeds principles apply to the tax treatment of Smith Co's financial arrangement constituted by its right to receive $250,000 from Jones Co. The difference between the cost of the financial arrangement, being the market value of the depreciating asset ($150,000), and the proceeds Smith Co receives from the financial arrangement ($250,000), a $100,000 gain, will be taken into account under Division 230.

Jones Co - acquisition of the depreciating asset

On 1 September 2010 when Jones Co receives the depreciating asset from Smith Co, Jones Co will start to have a financial arrangement. This is because at the time of delivery, the only rights and/or obligations Jones Co has remaining under its arrangement to acquire the depreciating asset from Smith Co, is its obligation to pay $250,000 in 15 months time to Smith Co. This obligation is a cash settlable obligation to provide a financial benefit, as it is an obligation to pay a financial benefit that is money. Jones Co's financial arrangement is entirely constituted by this cash settlable obligation (subsection 230-45(1) and paragraph 230-45(2)(a)).

Jones Co therefore starts to have a financial arrangement as consideration for starting to hold the depreciating asset.

Subsection 230-505(1) provides that, for the purposes of applying the income tax law to the depreciating asset Jones Co is taken to have provided the market value of the depreciating asset at the time it is acquired. This means that for the purpose of Division 40 of the ITAA 1997, Jones Co's cost of the depreciating asset is taken to be equal to the market value of the depreciating asset, at the time it is acquired. As this value is $150,000, Jones Co is taken to have paid $150,000 to acquire this depreciating asset, for all purposes of the ITAA 1936 and the ITAA 1997 (subsection 230-505(2)).

The normal cost and proceeds rules apply to the tax treatment of Jones Co's financial arrangement constituted by its obligation to pay $250,000 to Smith Co. The difference between the proceeds of the financial arrangement, being the market value of the depreciating asset ($150,000), and the cost Jones Co provides for the financial arrangement ($250,000), a $100,000 loss will be taken into account under Division 230.

Financial arrangements of consolidated groups

11.62 Division 230 applies to consolidated groups and multiple entry consolidated groups (MEC groups) as if the head company of the group is the relevant taxpayer. Chapter 12 contains a detailed discussion of the application of Division 230 to the consolidation regime, and specific consolidation-related amendments.

Financial arrangements denominated in a foreign currency

11.63 For the purposes of the ITAA 1997 and the ITAA 1936, subsection 960-50(1) requires that any amount or value that is denominated in a foreign currency be translated (converted) into Australian currency. In particular, if there are amounts that are elements in the calculation of other amounts those elements are to be translated into Australian currency first and then the other amounts are calculated. An exception to this general rule applies where those other amounts are a 'special accrual amount'. Amounts under Division 16E of the ITAA 1936 were such 'special accrual amounts' (see definition of 'special accrual amount' in subsection 995-1(1) of the ITAA 1997).

11.64 A similar exception to the general translation rule is required for gains or losses that are subject to the accruals method under Subdivision 230-B. An amendment is made to the definition of 'special accrual amount' to include a reference to gains or losses that are subject to the accruals method in Subdivision 230-B where all the financial benefits that are provided and received under the financial arrangement are denominated in a particular foreign currency [ Schedule 1, item 28, definition of ' special accrual amount' in subsection 995-1(1) of the ITAA 1997 ]. If the financial arrangement is comprised of financial benefits that are denominated in more than one currency, the exception for special accrual amounts will not apply to calculating the gains or losses from that arrangement.

11.65 The application of the special accrual amount rule means that the sufficiently certain overall or particular gain or loss that is made from the financial arrangements in the circumstances specified is to be calculated in the foreign currency. Further, the spreading of that overall or particular gain or loss over the relevant accrual period is to be done in the foreign currency. Only the amounts allocated to the relevant accruals intervals are to be translated using the relevant table in subsection 960-50(6) of the ITAA 1997.

Recognition of gains and losses

11.66 The following amendments relate to the manner in which gains or losses are recognised for tax purposes where a Division 230 financial arrangement is involved.

Foreign bank branches and offshore banking units

11.67 Part IIIB of the ITAA 1936 establishes a regime for recognising transactions between foreign banks and their Australian branches. Under section 160ZZW of Part IIIB, the branch is effectively treated as a separate legal entity for certain financial dealings (such as the notional payment of interest by the branch to the bank, notional derivative transactions and notional foreign exchange transactions between the branch and the bank - see sections 160ZZZA, 160ZZZE and 160ZZZF of Part IIIB, respectively). These sections apply where the foreign bank applies Part IIIB in calculating that part of its taxable income that is referable to certain activities of its Australian branch (see section 160ZZVB of the ITAA 1936).

11.68 Section 160ZZZK of Part IIIB extends the application of Part IIIB to foreign financial entities and their Australian permanent establishments. For convenience, the following discussion refers only to foreign banks and their Australian branches, but it should be borne in mind that the amendments will apply more broadly.

11.69 Generally, Division 230 will apply to include gains or losses made on financial arrangements held by the Australian branch of a foreign bank in the calculation of its taxable income, including any gains or losses arising from intra-bank dealings between the Australian branch and the rest of the bank. To avoid doubt, an amendment is made to section 160ZZW of Part IIIB, to provide that gains or losses from financial arrangements entered into between the foreign bank and its Australian branch will be brought to account under Division 230. [ Schedule 1, item 43, subsection 160ZZW(1A )]

11.70 Section 160ZZZA, relating to the notional payment of interest by the branch to the bank, provides that the rate of interest may not exceed the London Inter Bank Offered Rate. The amendment to section 160ZZW is not intended to affect the operation of this requirement.

11.71 Further, an amendment will be made to section 160ZZX of Part IIIB to specify that gains made through the Australian branch of a foreign bank, from financial arrangements to which Division 230 applies, are taken to be sourced in Australia. This will treat these gains in the same way as income from other transactions of the branch. [ Schedule 1, Part 2, items 44 and 45, subsection 160ZZX(2) of the ITAA 1936 ]

11.72 In addition, the permanent establishments in Australia of an offshore banking unit at or through which the offshore banking unit carries on offshore banking activities, are treated as one person for the purpose of the definition of a 'financial arrangement'. The other permanent establishments of the offshore banking unit (either in or outside of Australia) are treated as separate persons. This means that financial arrangements between permanent establishments of an offshore banking unit can be subject to Division 230 [ Schedule 1, item 37, subsection 121EB(3 )]. This reflects the treatment of permanent establishments of an offshore banking unit under Division 9A of Part III of the ITAA 1936. In the absence of making any election made by the foreign financial entity (foreign banks and other financial entities covered by Part IIIB of the ITAA 1936) the default provisions of Division 230 (ie, Subdivision 230-B) will apply to applicable Part IIIB and Division 9A transactions that are financial arrangements.

11.73 The amendments are not intended to change how Division 9A applies to consolidated/MEC groups which contain an offshore banking unit, either as the head company or as a subsidiary member, nor the scope of transactions that are recognised for the purposes of Division 9A. But they will mean that Division 230 will apply to financial arrangements related to the transactions or dealings that are counted as offshore banking activities by Division 9A.

Application of elections to foreign bank branches and offshore banking units

11.74 Foreign financial entities with one or more permanent establishments in Australia (foreign banks and other financial entities covered by Part IIIB of the ITAA 1936) may be eligible to make the various elections. Part IIIB recognises certain intra-entity transactions or arrangements in calculating the taxable income of the foreign financial entity (see sections 160ZZW, 160ZZZ, 160ZZZA, 160ZZZE and 160ZZZF of the ITAA 1936). Where the foreign financial entity makes an election, the election should apply to financial arrangements that are/represent these notional borrowings, notional derivative transactions or notional foreign exchange transactions, in addition to any other financial arrangements that the entity has entered into with other entities. However, the separate-entity rules contained in section 160ZZW does not lead to the result that a separate set of elections can be made by the Australian permanent establishments. Nor should the election apply to any other intra-entity arrangements that are not recognised under Part IIIB (eg, an arrangement between two Australian permanent establishments).

11.75 There is also a separate entity rule in section 121EB of the ITAA 1936 for offshore banking units. Again, this rule is not to be taken to imply that a separate set of elections can be made by the Australian permanent establishments of the entity that carry on offshore banking business or by a subsidiary member of a consolidated/MEC group that is an offshore banking unit. The taxable entity is the entity that makes the election (or does not as the case may be), including the head company of a group where section 717-710 applies. The election applies to all relevant financial arrangements, including those arrangements that arise in the course of carrying on offshore banking business. Because the separate entity rule in section 121EB is only for the purpose of identifying offshore banking activities, the additional financial arrangements to which an election might apply should only be those arising from those offshore banking activities as defined in Division 9A.

11.76 The financial arrangements that are recognised only because of Part IIIB or Division 9A which the accounting standards would have required be classified or designated in financial reports as at fair value through profit or loss if the arrangements had been between separate legal entities are to be the subject of any election made by the taxpayer. [ Schedule 1, item 1, subsections 230-220(3), 230-265(3), 230-335(2) and 230-410(8 )]

11.77 The gain or loss that is made from a financial arrangement arising from dealings that are recognised by Part IIIB or Division 9A and that is covered by an election is the gain or loss that the standards would have required to be recognised in the profit and loss report if they had recognised the arrangement. This will require some departures from the audited financial reports but they should be no different in scope to the departures that were previously required because of the additional 'transactions' that are recognised for tax purposes by Part IIIB and/or Division 9A. Adequate records of these departures should be maintained in accordance with the relevant record-keeping provisions. [ Schedule 1, item 1, paragraphs 230-230(1)(c) and 230-420(1)(c), subparagraph 230-280(1)(b)(iii )]

Deductions for expenditure incurred for capital gain

11.78 Section 51AAA of the ITAA 1936 denies certain deductions where, broadly, the deduction would otherwise only be allowable because of its connection to a capital gain.

11.79 With the introduction of Division 230, subsection 230-15(2) will allow a deduction for a loss from a financial arrangement where the loss is made in gaining or producing assessable income or is necessarily made in carrying on a business for the purpose of gaining or producing assessable income.

11.80 Section 51AAA is amended to deny a deduction that would otherwise be allowable under subsection 230-15(2) only because it was incurred in making a capital gain. [ Schedule 1, item 32, subsection 51AAA(2) of the ITAA 1936 ]

Pay as you go instalments - Taxation Administration Act 1953

11.81 Subsection 45-120(1) of the TAA 1953 states that instalment income for a period includes amounts of ordinary income that are derived during that period, but only to the extent that it is assessable income in the income year. Ordinary income in this sense takes its meaning from section 6-5 of the ITAA 1997.

11.82 Subsection 45-120(2B) operates to include additional amounts within the definition of 'instalment income' by including a new category of statutory income within the definition of 'instalment income'. To the extent that an amount of income is both ordinary income and statutory income, it will only be included as instalment income once. That is, the amount of income will not be double counted.

11.83 Generally, gains made on certain financial arrangements that are subject to Division 230 will be subject to the pay as you go (PAYG) instalments system. The amendment made in this Bill ensures that the PAYG instalment system recognises the gain or loss, or the part of the gain or loss, on a financial arrangement that is attributable to each income year. This is achieved by including gains and losses made from Division 230 financial arrangements within the definition of 'instalment income'.

11.84 The amendment further provides that only the net result of the relevant gains and losses made on financial arrangements, that are subject to Division 230 for a particular income year, will be included as the instalment income amount. That is, the net result of the gains must exceed the losses made in an income year in respect of financial arrangements under Division 230 to be recognised for PAYG purposes. [ Schedule 1, item 100, subsection 45-120(2B) in Schedule 1 to the TAA 1953 ]

11.85 Where the amount of losses exceeds the amount of gains made in an income year in respect of Division 230 financial arrangements, no amount is included in the entity's instalment income under subsection 45-120(2B).

11.86 Taxpayers are to calculate their instalment income having regard to what, if any, of the elective Subdivisions (see Chapter 5) apply to them at the end of the instalment period. Where a taxpayer makes an election to apply any or all of the elective Subdivisions part way through an income year, the taxpayer is expected to calculate their instalment income having regard to elections that have in fact been made by the end of the relevant instalment period.

11.87 The practical consequence of such an approach is that a taxpayer may have to include an amount in their activity statement that would have otherwise been included in an earlier activity statement had an election been made in an earlier instalment period.

The effect of a change of residence of the taxpayer

11.88 If a taxpayer changes from being an Australian resident to a foreign resident (or vice-versa) during an income year, special rules apply to determine the relevant amount of any gain and/or loss for that year from the taxpayer's financial arrangements. The general effect of the rules is to calculate any gain or loss from the financial arrangement for the income year by specifically taking into account the change of residence during the income year, and appropriately apportioning the gain or loss to the periods of different residency [ Schedule 1, item 1, subsection 230-485(1 )]. The specifics of how this is done depend on the method that would otherwise be used to determine the taxpayer's gain or loss for the income year. While theoretically the gain or loss made for the part of the year while a foreign resident has to be calculated, in practice it may not need to be done in many cases because a gain made while a foreign resident would not be assessable or a loss would not be deductible.

11.89 For financial arrangements subject to the realisation method, the rule is more prescriptive as it deems a disposal and immediate reacquisition of the arrangement at the time of the change of residence. This approach has been adopted because this method relies on when the relevant financial benefits are due to be provided, which may not in fact occur in the income year, and therefore not otherwise result in any gain or loss for the income year. Deeming these arrangements to be disposed of at the time of the residence change deals with the tax consequences of the change of residence in the income year in which it occurs (as is the case for all other methods). [ Schedule 1, item 1, subsections 230-485(3) and (4 )]

11.90 Each gain or loss determined in accordance with these rules is taken to be made for the income year in which residence changes, and can therefore be appropriately handled under section 230-15.

11.91 If the change of residence occurs at the end or beginning of an income year the proposed rules for calculating any gain or loss will only have practical relevance for financial arrangements subject to the realisation method. For other methods the rules, although technically applying, will not alter the calculation of the gain or loss.

When the accruals method is used

11.92 Where a change of residence occurs during the income year, a taxpayer that has a financial arrangement subject to the accruals method should apportion any gain or loss on the arrangement for the year across each period the taxpayer is an Australian resident and each period the taxpayer is a foreign resident during the income year. The gain or loss must be apportioned on a reasonable basis as between each of those periods which, under the accruals method, should be determined based on the number of days of each period of different residency. [ Schedule 1, item 1, subsection 230-485(6 )]

11.93 Whether the gain (or loss) for each of these periods is assessable (or deductible) is determined by applying Division 6 (or 8) to these periods as if they were separate income years.

When the fair value, foreign exchange retranslation or financial reports method is used

11.94 A different approach applies for financial arrangements for which the fair value, foreign exchange retranslation or financial reports method has been chosen. The taxpayer must work out a gain (or loss) for both the period of foreign residency and the period of Australian residency. [ Schedule 1, item 1, subsection 230-485(8 )]

11.95 This rule treats these periods as if they were separate income years and therefore will require the taxpayer to have recourse to its financial reports. The taxpayer will have to make appropriate adjustments to the amounts shown in the relevant accounts for the relevant accounting periods (those that overlap the deemed income years). This is consistent with the general rule that applies for these methods where the accounts are not prepared for the income year. In those cases the taxpayer can make appropriate adjustments to the accounts for the overlapping accounting periods.

11.96 Treating the periods of residency as if they were separate income years more accurately determines, in accordance with the specific methods, a gain or loss for each period of different residency.

11.97 Again, whether the gain (or loss) for each of these periods is assessable (or deductible) is determined by applying Division 6 (or 8) to these periods as if they were separate income years.

11.98 The application of this rule may result in a gain for the period of Australian residency and a loss for the period of foreign residency (or vice-versa), or other combinations of gain and loss. Further, the gain may be assessable (eg, a foreign source gain made while an Australian resident) but the loss not deductible (eg, while a foreign resident a loss is not made in deriving assessable Australian source income). To calculate the gain or loss using the same general apportionment rule that applies to the accruals method would provide an incorrect outcome as the starting point would be a gain or loss for the entire income year (rather than allowing for a gain or loss for each period of residency). Therefore, a daily apportionment of the gain or loss for the income year would not be acceptable when these methods are used.

When the realisation method is used

11.99 There is also a separate rule for financial arrangements to which the realisation method applies. If the taxpayer changes residence during the income year, or at the end of an income year, each such financial arrangement is deemed to be disposed of and immediately reacquired at the residence-change time for its fair value at that time. A gain or loss will accumulate (or be realised throughout the period) up until the residence-change time (where there is a deemed disposal and a balancing adjustment gain or loss would be calculated according to Subdivision 230-G). Similarly, a gain or loss will accumulate (or be realised throughout the period) from the residence-change time until the time of actual disposal (whenever that occurs) or other payments may be made. [ Schedule 1, item 1, subsection 230-485(4 )]

11.100 Although the deemed disposal treatment may not seem to be strictly in accordance with the realisation method, its objective is similar to the treatment provided under the other methods (in that it effectively divides an overall gain or loss on realisation into two parts) and is also similar to treatment under the CGT rules where there is a change of residence.

11.101 As there are two times when a gain and/or loss on disposal would be determined, this rule can advance the recognition of a gain or loss in situations where the actual disposal of the financial arrangement is in an income year later than the income year in which the residence change occurs.

11.102 The purpose of dividing the overall gain or loss into component gains and/or losses before and after the change of residence is to enable each component to be treated according to residence immediately before the change of residence and at the time of actual realisation. The assessability and/or deductibility of each component gain and/or loss can be determined separately based on the residency of the taxpayer, the source of any gain and/or the purpose for which any loss is made.

11.103 Further, the rule for deeming a disposal and reacquisition at the residence-change time avoids the risk of not collecting tax upon ultimate disposal (or the risk that the taxpayer will not claim a deductible loss that would otherwise have been allowed).

11.104 An example where this rule may apply is to a gain or loss that arises due to movements in the exchange rate (foreign exchange gains or losses) on a financial arrangement (where no other elective method applies). Any realisation gains or losses that accrue over time will be subject to this rule.

When the hedging financial arrangements method is used

11.105 If the hedging financial arrangements method applies to the financial arrangement, the taxpayer will need to apply the specific change of residence rules that are relevant to the hedged item itself. [ Schedule 1, item 1, subsection 230-485(5 )]

11.106 If the hedged item is itself a financial arrangement, the specific change of residence rules applicable for the method used for that financial arrangement will determine the relevant change of residence rules that are relevant for the hedging financial arrangement (see paragraphs 11.92 to 11.104). If the hedged item is not a financial arrangement (but some other capital asset) then (in cases where a gain or loss is relevant) the specific change of residence rules for the realisation method will apply (see paragraphs 11.99 to 11.104).

When there is a disposal of the financial arrangement in the same income year

11.107 If the financial arrangement is disposed of after the change of residence, but before the end of the income year, these rules will still apply to calculate a gain or loss using the appropriate method up until the change of residence. This is because subsection 230-40(2) is disregarded in determining if the change of residence rules apply [ Schedule 1, item 1, paragraphs 230-485(5)(a) and (7)(a )]. Subsection 230-40(2) gives precedence to taking into account a gain or loss under the balancing adjustment method over all other methods, where one of those other methods might otherwise also apply in an income year. Turning off this rule allows the change of residence rules to continue to apply for that particular income year. However, the gain or loss for the second part of the income year should be calculated using Subdivision 230-G (ie, subsection 230-40(2) is applied at that stage). That calculation would take account of the gain or loss calculated for the first part of the year using the relevant method whether it has been included in taxable income or not. If the realisation method otherwise applied to the arrangement, there would be two applications of the balancing adjustment calculation in Subdivision 230-G in the income year: one for the change of residence and one for the actual disposal of the financial arrangement. Because there is a deemed reacquisition of the arrangement at the residence-change time in this case, the second calculation of a balancing adjustment gain or loss should measure only the gain or loss arising since the residence-change time.

Special rule where a taxpayer ceases to be an Australian resident

11.108 When a taxpayer ceases to be an Australian resident and the financial arrangement has no further connection with Australia there will be, for the purposes of Division 230 (regardless of the method used):

•

a deemed disposal of the interest in the financial arrangement immediately before the taxpayer ceases to be an Australian resident (which may be at the end of an income year or some time during an income year) for its fair value at that time; and

•

a deemed reacquisition of the financial arrangement immediately after the change of residence for its fair value at that time.

[ Schedule 1, item 1, subsection 230-490(2 )]

11.109 The rule only applies if, immediately after the taxpayer ceases to be an Australian resident, gains and losses that could be made in relation to the financial arrangement while the taxpayer remains a foreign resident are neither assessable nor deductible [ Schedule 1, item 1, subsection 230-490(1 )]. The deemed disposal and reacquisition is a special case and is an exception to the general rule in section 230-485. Its aim is twofold - to ensure that:

•

the effective movement of the financial arrangement out of the application of Division 230 is adequately dealt with; and

•

there is a relevant cost of acquisition for the financial arrangement should Division 230 apply to any gains and/or losses on the financial arrangement some time after the taxpayer ceases to be an Australian resident (eg, if the taxpayer again becomes an Australian resident).

11.110 Where this rule applies, effectively Division 230 will no longer apply to the financial arrangement and the specific rules in section 230-485 will have no application to this particular change of residence. This is because those specific rules only apply if the taxpayer would, once a foreign resident, otherwise apply a particular method under Division 230 to determine a gain or loss. While in practical terms Division 230 will no longer apply in relation to this financial arrangement, if the taxpayer once again becomes an Australian resident this section will once more be triggered.

11.111 The deemed disposal rule may result in a balancing adjustment gain or loss under Subdivision 230-G (which is discussed in Chapter 10).

11.112 In other cases where a taxpayer ceases to be an Australian resident, Division 11A of Part III of the ITAA 1936 (interest withholding tax) may apply exclusively while the taxpayer is a foreign resident. The taxpayer would need to know how much gain or loss was made for the part of the year in which it was an Australian resident (in accordance with section 230-485). The assessability and deductibility would be determined according to Division 230. If Division 11A did not deal with all gains while a foreign resident (eg, gains that are not interest), or if there were any losses, the taxpayer would still need to determine the gain or loss made while a foreign resident (by applying section 230-485) and then determine the assessability or deductibility of any gain or loss.

Interaction with withholding tax rules

11.113 There is a possible overlap between taxation under Division 230 and the imposition of withholding tax under Division 11A of Part III of the ITAA 1936 (see paragraphs 11.32 to 11.37) where the holder of a financial arrangement changes from an Australian resident to a foreign resident and an interest payment is subsequently made.

11.114 If no withholding tax is payable (eg, if there is an exemption from withholding tax) then there is no possible overlap and therefore no adjustment is required. However, in cases where withholding tax is otherwise payable, there is an overlap and therefore the amount of withholding tax is reduced by the amount notionally payable on the net amount that was assessable under Division 230. [ Schedule 1, items 38 to 40, section 128NBA of the ITAA 1936 ]

Example 11.6 : Refund of withholding tax when no interest is paid while an Australian resident

Assume the facts in Example 4.5 but also assume that John Doe is an Australian resident when he invests $100 in a zero coupon bond that will pay $120 at maturity in four years time. Also, the bond is issued by an Australian resident. At the beginning of year 4 John Doe becomes a resident of the United States.

The interest (totalling $14.65) that accrues (on a compounding basis) in years 1, 2 and 3 is included each year as a gain calculated under the accruals method. John Doe is paid $120 ($20 of this is interest) at the end of year 4, at which time he is a foreign resident. Withholding tax of $2 is payable on the $20 interest payment. As $14.65 has already been included in assessable income under Division 230 while John Doe was an Australian resident, section 128NBA will credit, on application, an amount of $1.47 (withholding tax of 10 per cent payable on the net Division 230 amount of $14.65). This will mean that withholding tax is effectively only payable on $5.35 which is the gain that would have otherwise accrued in year 4.

The gain that would otherwise have been included in assessable income in year 4 is disregarded because it is part of an amount that is (or is anticipated will be) treated as non-assessable non-exempt income under section 128D of the ITAA 1936.

11.115 Further, this rule in section 128NBA to prevent double taxation also applies to cases where there are periodic interest payments to the taxpayer over the life of the financial arrangement. [ Schedule 1, item 40, subparagraph 128NBA(5)(d)(9)(ii) of the ITAA 1936 ]

Example 11.7 : Refund of withholding tax when interest has been paid while an Australian resident

Assume the facts in Example 4.7 but also assume FLD Finance Co is an Australian resident when purchasing the security for $1,000. Also assume the security is issued by an Australian resident. At the beginning of year 3 FLD Finance Co becomes a foreign resident.

Although FLD Finance Co changes residence, the deemed disposal and reacquisition rules in section 230-490 will not apply because immediately after FLD Finance Co ceases to be an Australian resident the gains (Australian sourced) remain assessable. However, rather than Division 230 applying to assess the gain, any gain that would have otherwise been included in assessable income in years 3 and 4 is disregarded because it is part of an amount or amounts (the interest payments) that will be treated as non-assessable non-exempt income under section 128D of the ITAA 1936.

At the beginning of year 3, $133.36 has previously been included in FLD Finance Co's assessable income (as accrual amounts) under Division 230. Withholding tax is payable on the interest payment in year 3 of $80. However, by the end of year 3 the withholding tax payable is reduced to the amount that would otherwise have been payable on the total interest paid over the three years ($40 + $50 + $80 = $170) less the net amount included in assessable income under Division 230 ($133). The withholding tax payable on $43 (= $133 - $40 - $50) of the $80 interest payment would be credited under subsection 128NBA(1). Therefore, of the $80 interest payment in year 3 withholding tax is effectively only payable on $37 of that payment. In practice, withholding tax is payable on the $80 and once the withholding tax is paid the taxpayer can apply (in the approved form) to the Commissioner of Taxation for a credit of the withholding tax payable on the $43.

When the subsequent $100 interest payment is made in year 4, withholding tax would be payable on that amount. In total, of the overall gain of $270, $133 would be included in assessable income (under Division 230) and $137 would be subject to withholding tax (under Division 11A of the ITAA 1936).

If, in this example, the difference between the total amount included in assessable income under Division 230 in the first two years and the first two interest payments had been greater than the amount of interest paid in year 3, a credit for the full amount of withholding tax paid in year 3 could be claimed and the residual could be claimed after year 4. Alternatively, the claim for the withholding tax credit could be delayed until after year 4. On the other hand, if the first two interest payments had been greater than the total amount included in assessable income under Division 230 in the first two years, there would be no withholding tax credit to be claimed. Instead, the excess would be recognised as a gain (either on disposal or maturity of the security, under Subdivision 230-G).

When a taxpayer becomes an Australian resident

11.116 Where the holder of the financial arrangement changes from being a foreign resident to being an Australian resident, it is not intended that the gains that accrued while that holder was a foreign resident would be assessable as soon as a payment is made when the holder is an Australian resident. This is what is done in relation to qualifying securities covered by Division 16E of Part III of the ITAA 1936 under subsection 159GW(2) of the ITAA 1936. Instead, any such gain would be included in assessable income as a balancing adjustment when the financial arrangement ceases to be held.

Application of change of residence rules to partnerships and trusts

11.117 Where Division 230 applies to a financial arrangement of a partnership or trust, a change of residence is irrelevant in determining the net income of the partnership or trust because of the assumption of residency of the partnership and trust (section 90 and subsection 95(1), respectively, of the ITAA 1936).

11.118 However, if a partner, or a beneficiary that is presently entitled to a share of the trust income, changes residence during the income year, sections 92 and 97, respectively, of the ITAA 1936 require a disaggregation of the net income into its Australian and foreign source components. It is expected that the partner, or beneficiary, would do that by applying the change of residence provisions as if it, and not the partnership or trust, were the entity which held the financial arrangement.

11.119 Similarly, in situations where the trustee may be assessed in respect of some or all of the net income under section 98 of the ITAA 1936 (eg, the beneficiary is under a legal disability or is a foreign resident at the end of the income year) any change in the beneficiary's residence during the year should be taken into account in determining the trustee's liability to tax.

11.120 In situations where the trustee may be assessed in respect of some or all of the net income under section 99 or 99A of the ITAA 1936, and the trustee changes residence during the income year, the change of residence may or may not affect the tax liability of the trustee. If the trustee ceases to be an Australian resident during the income year, there will be no effect because the trust is still held to be a resident trust estate. If the trust becomes a resident trust because a trustee becomes an Australian resident during the income year, it will be treated as a resident trust for the whole income year. In either case, there is no need to determine how much gain or loss was made on the trust's financial arrangements for the part of the year in which the trustee was an Australian resident and how much was made while a foreign resident. Therefore, there is no need to apply the change of residence provisions in this case.

Interaction with value shifting rules

11.121 Section 230-520 applies such that gains and losses on financial arrangements that are attributable to a value shift that would have consequences under the General Value Shifting Regime are disregarded under Division 230. Similarly, gains and losses in respect of financial arrangements are disregarded to the extent that any of the former value shifting rules would have applied in respect of a financial arrangement.

11.122 Broadly, the value shifting rules prevent inappropriate tax consequences from arising (eg, a tax loss or a reduction in assessable income) where, under a scheme, value is shifted from equity or loan interests. Generally, these rules prevent inappropriate tax outcomes from arising by either requiring the tax values of the 'losing' interest to be reduced by the same magnitude of the value shift (note that the tax value of a 'gaining' interest may be revised upwards to the same extent) or, alternatively, losses may be denied when the equity or loan interests are finally realised. Under either approach, correcting the tax outcomes of a value shift generally occurs upon realisation of the interests - that is, the value shifting rules effectively correct the result upon realisation of such interests.

11.123 On the other hand, in many cases Division 230 operates to bring to account gains and losses in respect of a financial arrangement prior to realisation, for example as the gains or losses accrue. Consequently, in the absence of special value shifting rules that apply to Division 230 financial arrangements, where a value shifting arrangement reduces the value of a financial arrangement or the expected future cash flows on a financial arrangement, inappropriate tax consequences from the arrangement could arise in the income year in which the value shift occurs.

11.124 This may occur, for example, where an entity purchases a security that provides for relatively certain fixed cash flows over several years and the entity recognises the gains on the security by applying the accruals method in Subdivision 230-B. During the term of the arrangement a value shift could result in a reduction in the estimated cash flows and consequently a reduction in the overall gain on the arrangement. Without special integrity rules the entity holding the financial arrangement might, for example, re-estimate the gain or loss on the arrangement and the subsequent tax consequences would reflect the re-estimated gain or loss.

11.125 Similarly, where an entity holds an asset that is subject to fair value measurement under Subdivision 230-C, changes in the fair value of such assets recognised in the financial accounts of the entity are brought to account for tax purposes. Absent special integrity rules, if a value shift occurs which causes the fair value of such an asset to decrease, the holder would recognise a loss or reduced gain on that asset in the income year in which the value shift occurs.

11.126 Where a financial arrangement is not subject to Division 230, the value shifting rules would ordinarily prevent the taxpayer from recognising a reduced gain or a tax loss on an arrangement that would trigger the application of specific provisions within the value shifting regime (eg, in the case of indirect value shifting, Division 727-B). As a consequence, a reduction of the adjustable values (eg, cost base) of the financial arrangement would occur in respect of the interests from which value has been shifted. A corresponding adjustment might also be made in respect of the interests to which value has been shifted. Alternatively, losses that would otherwise arise on realisation of the financial arrangement might have been denied to the holder.

11.127 The inclusion of section 230-520 is intended to ensure that inappropriate value shifts that would ordinarily have consequences under Divisions 723, 725, and 727 of the ITAA 1997 are disregarded in determining tax outcomes for financial arrangements that are subject to Division 230. This is accomplished by assuming that a realisation event is taken to have happened in the income year in which the value shift is occurred. Given that this realisation event is assumed to have occurred, consequences are taken to arise under Divisions 723, 725 and 727. It is the gains or losses on shifts in value that are taken to have consequences under Divisions 723, 725 and 727 that are disregarded for the purposes of Division 230. In other words the entity applies Division 230 as if the gains or losses attributable to the value shift never happened.

11.128 Where an entity holds financial arrangements before the commencement of Division 230, Division 230 allows taxpayers to, for example, apply the elective methods such as fair value to those pre-existing financial arrangements subject to certain requirements. Where such an election is made, the taxpayer must make a balancing adjustment which brings about assessable income or an allowable deduction which is to be spread over the first applicable income year and the next three income years. Essentially the balancing adjustment brings to account the difference between what would have been the tax result had Division 230 applied to the pre-commencement financial arrangements from the time the taxpayer started to hold it and the actual tax results in respect of the financial arrangements.

11.129 If a value shift occurred prior to the commencement of Division 230 in respect of a pre-existing financial arrangement causing the value of a financial arrangement to be reduced then, absent special integrity rules, the taxpayer may be able to obtain a tax saving from that value shift through the balancing adjustment. In these circumstances, section 230-520 applies such that where a balancing adjustment is made in respect of existing financial arrangements, any value shifts that would ordinarily have consequences under Divisions 723, 725 and 727 of the ITAA 1997 are disregarded in determining gain or loss determined under the balancing adjustment.

11.130 Value shifts that would have had consequences under repealed value shifting provisions (eg, former Divisions 138, 139 and 140 of the ITAA 1997) are disregarded in determining gains and losses under Division 230 - including for the purposes of any balancing adjustment made in respect of existing financial arrangements.

Definitional and referencing changes

11.131 These amendments are required because the existing definitions contained in the tax laws have been affected by the introduction of Division 230. Further, some amendments have been included to update checklists in the legislation.

Exchangeable interests

11.132 The effect of Subdivision 130-E of the ITAA 1997 is that any capital gain or capital loss from the disposal or redemption of an exchangeable interest to the issuer of the interest or to a connected entity of the issuer, will be disregarded. Subdivision 130-E of the ITAA 1997 also modifies the cost base of the shares acquired as a result of the exchange or redemption.

11.133 Section 130-100 of the ITAA 1997 previously defined an exchangeable interest as a traditional security issued on the basis that it will or may be:

•

disposed to the issuer of the traditional security or a connected entity of the issuer; or

•

redeemed,

in exchange for shares in a company that is neither the issuer of the traditional security or in a connected entity of the issuer.

11.134 Broadly, a traditional security , as defined in subsection 26BB(1) of the ITAA 1936, is a security that is not issued at a deep discount, does not bear significant deferred interest and is not capital indexed. A traditional security may be, for example, a bond, a debenture, a deposit with a financial institution or a secured or unsecured loan.

11.135 Amendments to section 130-100 broaden the application of this provision such that an exchangeable interest will now extend to 'qualifying securities' within the meaning of that term in Division 16E of the ITAA 1936.

11.136 As a result of this amendment, the CGT treatment of exchangeable interests will apply equally to exchangeable interests that are traditional securities and exchangeable interests that are qualifying securities. This is similar to the treatment currently afforded to convertible interests under section 130-60. [ Schedule 1, items 77 and 78, section 130-100 ]

Offshore banking units and foreign bank branches

Hedging activities of offshore banking units

11.137 Financial arrangements of an offshore banking unit are tested in order to determine if they qualify as offshore banking activities. One of those tests determines whether the activity, as represented by a financial arrangement, is a hedging activity. In order to reduce compliance costs, the definition of 'hedging activity' in subsection 121D(8) of the ITAA 1936 will be amended to use the concept of a 'financial arrangement'.

11.138 The phrase 'financial arrangement' will replace the term 'contract' that is currently used in the definition. The Division 230 term 'hedging financial arrangement' has not been adopted because the accounting requirements involved in that concept could have limited the meaning of 'hedging activity'. [ Schedule 1, Part 2, item 37, definition of ' hedging activity' in subsection 121D(8) of the ITAA 1936 ]

Derivative transaction for foreign bank branches

11.139 An amendment will also be made to the definition of 'derivative transaction' in section 160ZZV of Part IIIB, so that it refers to financial arrangements to which Division 230 applies. [ Schedule 1, items 41 and 42, definition of ' derivative transaction' in section 160ZZV of the ITAA 1936 ]

Qualifying forex accounts

11.140 An amendment will be made to the definition of a 'qualifying forex account' in subsection 995-1(1) of the ITAA 1997 to extend its application by repealing the requirement that it must be maintained with an ADI or a financial institution similar to an ADI in Australia or overseas. [ Schedule 1, Part 4, item 111, definition of a ' qualifying forex account' in subsection 995-1(1) of the ITAA 1997 ].

11.141 This change will allow inter-company accounts, that are transactional accounts, to satisfy the definition of qualifying forex account.

Checklists

11.142 The checklists in sections 10-5 and 12-5 of the ITAA 1997 will be amended to include references to 'gains from financial arrangements' and 'losses from financial arrangements'. [ Schedule 1, items 53 and 57, sections 10-5 and 12-5 ]]

Signposts

11.143 The operation of the value setting rules in section 230-505 have been described in paragraphs 11.26 to 11.59. Signposts in the form of notes to provisions have been included in capital allowances [ Schedule 1, items 62 to 68, subsections 40-180(1), 40-185(1), 40-300(1) and 40-305(1 )] and CGT provisions [ Schedule 1, items 70 to 75, subsections 110-25(1) and 116-10(7) and sections 104-5 and 112-5 ] of the ITAA 1997 to highlight the possible application of section 230-505 to the relevant assets that are subject to those provisions. A note has been added to the bad debt provisions to explain that in certain circumstances a loss in relation to a financial arrangement under subsections 230-150(3), (5) and (6) and 230-165(3), (5) and (6) will be treated as a bad debt [ Schedule 1, item 58, subsection 25-35(5 )].

11.144 Signposts have also been added to some CGT provisions to highlight the effect of the hedging provisions in certain situations. [ Schedule 1, items 69 and 70, sections 102-20 and 104-5 ]

11.145 Finally, subsection 6(1) of the ITAA 1936 defines a Division 230 financial arrangement to mean a financial arrangement to which Division 230 applies in relation to your gains and losses from the arrangement, that is, the definition takes on the same meaning as contained in subsection 995-1(1) of the ITAA 1997. [ Schedule 1, item 31, subsection 6(1 )]

Record-keeping

11.146 A number of amendments are being made to section 262A of the ITAA 1936. These amendments will modify the application of section 262A so as to preserve its intended application in a Division 230 context.

11.147 The first amendment modifies subsection 262A(1) so that it applies to all taxpayers that have Division 230 financial arrangements (ie, a financial arrangement to which Division 230 applies). This amendment overcomes the requirement in subsection 262A(1) that a person be carrying on a business before the subsection has application. [ Schedule 1, item 46, subsection 262A(2AAC )]

11.148 The second amendment clarifies the application of subsection 262A(4). The provision ensures that records relevant to the calculation of gains and losses from Division 230 financial arrangements must be kept for at least five years after the taxpayer includes an amount as assessable income or is entitled to a deduction in accordance with Division 230.

11.149 This amendment does not modify the time at which records must first be held (or in place). Accordingly, Division 230 will be relevant when determining the time at which a record must be created or first held. [ Schedule 1, item 46, subsection 262A(2AAD )]

11.150 More specifically, in respect of hedging financial arrangements paragraph 262A(3)(ca) operates to ensure the record must be in place at, or soon after, the time when a taxpayer creates, acquires or applies the hedging financial arrangement. [ Schedule 1, item 47, paragraph 262A(3)(ca )]

Example 11.8 : Documentation requirements for a hedging financial arrangement

Jimmy Co, an Australian resident company, enters into a hedging financial arrangement to hedge against foreign currency movements on the principal amount of loan that is denominated in $US. The loan has a 15-year term and has a nominal value of US$1,000,000.

Jimmy Co enters into a series of six-month forward rate agreements to hedge the foreign currency movements on the principal amount of the loan.

Section 230-310 requires that Jimmy Co has the relevant hedging documentation in place at or soon after the time when the hedging financial arrangement is entered into.

The modifications to section 262A of the ITAA 1936 operate to ensure that all documentation relating to the hedging financial arrangement, including each forward rate agreement, is retained for at least five years after either the:

•

gain on the hedging financial arrangement is included as an amount of assessable income; or

•

loss is claimed as a deduction in accordance with Division 230.

If the loan is structured such that it is an interest only loan throughout its term, then all gains and losses from the hedging financial arrangements will be bought to account at the end of the loan arrangement as this is the time at which the principal amount of the loan is repaid.

In this example Jimmy Co will be required to retain certain records for a period of 20 years, that is, for the 15 years of the loan plus five years to comply with section 262A of the ITAA 1936.

11.151 Finally, for the purposes of subsection 262A(6), a Division 230 financial arrangement is taken to mean a financial arrangement to which Division 230 applies in relation to your gains and losses from the arrangement, that is, the definition takes on the same meaning as contained in subsection 995-1(1) of the ITAA 1997. [ Schedule 1, item 31, subsection 6(1 )]

Foreign currency gains and losses - Division 775 and Subdivisions 960-C and 960-D

11.152 Amendments to ensure that certain types of securitisation vehicles and special purpose vehicles were exempt from Division 775 with effect from 1 July 2003 were announced by the then Minister for Revenue and Assistant Treasurer in Press Release No. 073 of 2 September 2005. That exemption was provided until the commencement of the retranslation and hedging regimes as part of the taxation of financial arrangements legislative framework. Those regimes are to be introduced by this Bill.

11.153 In order to ensure that the law operates as intended in relation to these types of taxpayers the amendments (as described above) are included in this Bill.

11.154 The amendments to Division 775 will apply to 'securitisation vehicles' as defined in section 820-942 of the ITAA 1997 and special purpose vehicles that meet the requirements of subsection 820-39(3) of the ITAA 1997. Generally, those provisions identify certain entities that are eligible for special treatment as securitisation vehicles under the thin capitalisation rules in the income tax law. In particular the following amendments will be made:

•

section 775-170 of the ITAA 1997 will be amended to provide an exemption from Division 775 in respect of foreign exchange realisation gains and foreign exchange realisation losses made by the relevant securitisation vehicles [ Schedule 1, items 106 and 107, subsection 775-170(2 )];

•

section 775-195 of the ITAA 1997 will be amended to exclude the relevant securitisation vehicles from being eligible to make a choice for roll-over relief for facility agreements held by such entities [ Schedule 1, item 108, subsection 775-195(9 )];

•

section 960-55 of the ITAA 1997 will be amended to ensure that the translation rules contained in Subdivision 960-C will not apply to relevant securitisation vehicles for the purposes of working out its assessable income, deductions or tax offsets [ Schedule 1, item 110, subsection 960-55(4 )]; and

•

section 960-60 of the ITAA 1997 will be amended to exclude relevant securitisation vehicles from being eligible to make a choice to apply a functional currency [ Schedule 1, item 110, subsection 960-60(6 )].

11.155 Each of these amendments will take effect from 1 July 2003 - the date of commencement of Division 775 and Subdivisions 960-C and 960-D of the ITAA 1997.

11.156 It has been intended policy that once the retranslation and hedging regimes under the taxation of financial arrangements legislative framework commence, those entities that have been excluded from the operation of Division 775 and Subdivisions 960-C and 960-D of the ITAA 1997 were to become subject to those provisions. The entities affected will be ADIs, non-ADI financial institutions and securitisation vehicles. Amendments are made to ensure that on commencement of Division 230, those entities will also be subject to Division 775 and Subdivisions 960-C and 960-D of the ITAA 1997. [ Schedule 1, items 107, 108, 110, 111 and 113 ]

New Business Tax System (Taxation of Financial Arrangements) Act (No. 1) 2003

11.157 Section 77 of Schedule 4 to the NBTS (TOFA) 2003 is a transitional provision that allowed Division 3B of the ITAA 1936 to continue to apply:

•

to an eligible contract entered into by a taxpayer before the taxpayer's 'applicable commencement date' for Division 775 of the ITAA 1997 (see section 775-155 of the ITAA 1997); and

•

for the purposes of working out the assessable income or allowable deductions of an ADI or a non-ADI financial institution.

11.158 Paragraph 77(1)(b) will be amended to extend the transitional provision as it relates to ADIs and non-ADI financial institutions to those securitisation vehicles referred to in paragraph 11.154. [ Schedule 1, item 113, paragraph 77(1)(b) of the NBTS (TOFA) 2003 ]

11.159 Consistent with the policy outlined in paragraph 11.98, the transitional provisions which allow Division 3B of the ITAA 1936 to have continued operation in relation to ADIs, non-ADI financial institutions and relevant securitisation vehicles will be removed on commencement of Division 230. [ Schedule 1, item 100 ]

Retranslation for qualifying forex accounts

11.160 As a result of the change to the definition of qualifying forex account an amendment has been made to the retranslation election contained in Subdivision 775-E of the ITAA 1997 - see paragraph 11.140 for a discussion of the change. The change provides for the making of a retranslation election in respect of qualifying forex accounts, as modified, with effect:

•

from 17 December 2003; or

•

where you make a choice within 90 days after the commencement of Part 1 of Schedule 1 to the Tax Laws Amendment (Taxation of Financial arrangements) Bill 2008 once enacted, from 1 July 2003.

[ Schedule 1, Part 4, item 109, subparagraph 775-270(2A)(a)(ii )]

11.161 Any existing retranslation election that applies to qualifying forex accounts under Subdivision 775-E of the ITAA 1997 will cease to apply to any account to which a general retranslation election or a qualifying forex account election applies. [ Schedule 1, item 5, subsection 775-270(1A )]

11.162 Other changes to Division 775 relating to the retranslation election have been explained in Chapter 7.