ATO Interpretative Decision
ATO ID 2003/796
Income Tax
Assessability of lump sum receipt on novation of hedging contractsFOI status: may be released
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This ATO ID does not take account of the effect of Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 that implements Stages 3 and 4 of the reforms to the taxation of financial arrangements (TOFA 3 and 4).
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If you reasonably apply this decision in good faith to your own circumstances (which are not materially different from those described in the decision), and the decision is later found to be incorrect you will not be liable to pay any penalty or interest. However, you will be required to pay any underpaid tax (or repay any over-claimed credit, grant or benefit), provided the time limits under the law allow it. If you do intend to apply this decision to your own circumstances, you will need to ensure that the relevant provisions referred to in the decision have not been amended or repealed. You may wish to obtain further advice from the Tax Office or from a professional adviser.
Issue
Does a taxpayer's right to receive a lump sum upon novation of commodity hedging contracts give rise to assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?
Decision
Yes. A taxpayer's right to receive a lump sum upon novation of commodity hedging contracts gives rise to assessable income under section 6-5 of the ITAA 1997.
Facts
The taxpayer entered into various commodity hedge contracts to minimise the risk of price fluctuations arising from the sale of a commodity produced by the taxpayer's group members. This was the sole business activity of the taxpayer. In accordance with the taxpayer's business practices, the taxpayer may either buy the underlying commodity at the market price from its group members, or cash settle the commodity hedging contracts.
The taxpayer exited the entirety of their commodity hedge contracts by novating their rights and obligations under each of those commodity hedge contracts to the 'New Party'.
At the time of novation, the contract price at which the taxpayer was entitled to sell the underlying commodity, was more than the market price of the underlying commodity. In order to obtain the rights and obligations arising under the commodity hedge contracts, the New Party made a lump sum payment to the taxpayer equal to the difference between the market price of the commodity and the hedge contract price.
Reasons for Decision
Whether the right to receive a lump sum upon novation of the hedging contracts gives rise to assessable income under section 6-5 of the ITAA 1997 depends upon whether the receipt is of a revenue character, and if it is, whether it can be said that a receipt has been derived at that time.
In the present case, the taxpayer entered into the commodity hedging contracts in relation to its ordinary business activities. If those individual hedge contracts were held to maturity or closed out early, the taxpayer would derive assessable income from the delivery into the contracts of the commodity or via the cash settlement of those contracts.
Notwithstanding that the taxpayer has terminated all of its commodity hedge contracts by novation, any amount received would constitute assessable income of the taxpayer, since the lump sum receipt on novation is a receipt which would otherwise be a series of revenue receipts that would be derived from the commodity hedge contracts. The character of such a receipt does not change because it is received in a lump sum. Accordingly, such a receipt would constitute a revenue receipt in the hands of the taxpayer (Federal Commissioner of Taxation v. Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693).
At the time of novation, a gain has 'come home' to the taxpayer. The taxpayer has a right without contingency to a quantifiable amount that is recoverable by action at that time and is not obligated to take any further steps to be entitled to payment (Federal Commissioner of Taxation v. Australian Gas Light Co; 83 ATC 4800; (1983) 15 ATR 105; Arthur Murray (NSW) Pty Ltd v. Federal Commissioner of Taxation 114 CLR 314; 14 ATD 98; (1965) 9 AITR 673; Gasparin v. Federal Commissioner of Taxation (1994) 50 FCR 73; 94 ATC 4280; (1994) 28 ATR 130; Barratt v. Federal Commissioner of Taxation (1992) 36 FCR 222; 92 ATC 4275; (1992) 23 ATR 339).
Therefore, a taxpayer's right to receive a lump sum upon novation of commodity hedging contracts gives rise to assessable income under section 6-5 of the ITAA 1997.
Date of decision: 1 August 2003Year of income: Year ending 30 June 2004
Legislative References:
Income Tax Assessment Act 1997
section 6-5
Case References:
Arthur Murray (NSW) Pty Ltd v. Federal Commissioner of Taxation
114 CLR 314
14 ATD 98
(1965) 9 AITR 673
(1994) 50 FCR 73
94 ATC 4280
(1994) 28 ATR 130 Barratt v. Federal Commissioner of Taxation
(1992) 36 FCR 222
92 ATC 4275
(1992) 23 ATR 339 Federal Commissioner of Taxation v. Australian Gas Light Co
83 ATC 4800
(1983) 15 ATR 105 Federal Commissioner of Taxation v. Myer Emporium Ltd
(1987) 163 CLR 199
87 ATC 4363
(1987) 18 ATR 693
Keywords
Commodity transactions
Derived
Financial derivatives
Financial instruments
Forward sales
Forward transactions
Hedging
Novation
Producing assessable income
Date reviewed: 21 May 2018
ISSN: 1445-2782
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