Edited version of private ruling

Authorisation Number: 1011505362197

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Ruling

Subject: Financial arrangements and Division 230

Questions and answers

Issue1

Is the cap contract a 'financial arrangement' under section 230-45 of the Income Tax Assessment Act 1997 ('ITAA 1997')?

Answer:

Yes.

Issue 2

If the answer to issue 1 is yes, does the entire cap contract constitute the relevant financial arrangement under section 230-55 of the ITAA 1997?

Answer:

Yes.

Issue 3

If Company B is entitled to a variable amount at the end of a period and the variable amount exceeds the part of the fixed premium attributable to the variable amount, does Company B make a sufficiently certain gain from a particular event under section 230-110 of the ITAA 1997?

Answer:

Yes.

Issue 4

Will the accruals method apply to the gain in issue 3 above pursuant to section 230-100 of the ITAA 1997?

Answer:

Yes.

Issue 5

Will the gain in issue 3 above occur at the end of the period pursuant to section 230-110 of the ITAA 1997?

Answer:

Yes.

Issue 6

If Company B is not entitled to a variable amount at the end of a period, will Company B make a sufficiently certain loss from a particular event under section 230-110 of the ITAA 1997?

Answer:

No.

Issue 7

Will the realisation method apply to the loss in issue 6 above pursuant to section 230-100 of the ITAA 1997?

Answer:

Yes.

Issue 8

Will the loss in issue 6 above occur when the fixed premium was provided by Company B pursuant to subsection 230-180(2) of the ITAA 1997?

Answer:

Yes.

Issue 9

If Company B is entitled to a variable amount at the end of a period and the variable amount is less than the part of the fixed premium attributable to the variable amount, will Company B make a sufficiently certain loss from a particular event under section 230-110 of the ITAA 1997?

Answer:

No.

Issue 10

Will the realisation method apply to the loss in issue 9 above pursuant to section 230-100 of the ITAA 1997?

Answer:

Yes.

Issue 11

Will the loss in issue 9 above occur when the variable amount is provided to Company B pursuant to subsection 230-180(2) of the ITAA 1997?

Answer:

Yes.

Years of income to which this ruling applies:

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

The scheme that is the subject of the ruling:

Company Q is the head company of a consolidated group.

Company B is a subsidiary member of Company Q's consolidated group at all relevant times.

Company Q has not elected to apply Division 230 of the ITAA 1997 from 1 July 2009.

Company B and Company C (an unrelated party) enter into a cap contract on a day in Income Year 1.

As part of the cap contract Company B pays a fixed premium amount to Company C on a day after the cap contract is entered into in Income Year 1.

The cap contract is effective on a future date in Income Year 2 and terminates on a future date in Income Year 3.

Under the cap contract Company B will become entitled to receive an amount (but never obliged to pay an amount) - the variable amount - at the end of each relevant period for the duration of when the cap contract is effective.

Company B will be entitled to a payment at the end of each relevant period where the spot price exceeds the agreed amount. If the spot price is less than the agreed amount, Company B will not be entitled to any amount and will not be obliged to pay any amount.

The fixed premium is capitalised when it is paid and is not expensed before the cap contract is effective.

Assumptions

Company B will elect to ungrandfather its existing financial arrangements (including the cap contract) under Subitem 2 of Item 104 of the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009.

Company B will not elect for any of the elective methods in Subdivisions 230-C to 230-F of the ITAA 1997 to apply to its financial arrangements.

The individual rights in respect of the cap contract will either result in a numerical gain or loss (that is, it is assumed that a nil amount will not result).

Reasons for Decisions

Issue 1:

Summary

The cap contract is a financial arrangement under section 230-45 of the ITAA 1997.

Detailed reasoning

A 'financial arrangement' is defined in subsection 995-1(1) of the ITAA 1997 by reference to sections 230-45 to 230-55 of the ITAA 1997.

Under subsection 230-45(1) of the ITAA 1997, you have a financial arrangement, if you have, under an arrangement:

· a cash settlable legal or equitable right to receive a *financial benefit; or

· a cash settlable legal or equitable obligation to provide a financial benefit or

· a combination of one or more such rights and/or one or more such obligations;

unless:

· you also have under the arrangement one or more legal or equitable rights to receive something and/or one or more legal or equitable obligations to provide something; and

· for one or more of the rights and/or obligations covered by paragraph (d):

· the thing that you have the right to receive, or the obligation to provide, is not the financial benefit; or

· the right or obligation is not cash settlable; and

· the one or more rights and/or obligations covered by paragraph (e) are not insignificant in comparison with the right, obligation or combination covered by paragraph (a), (b), (c).

The right, obligation or combination covered by paragraph (a), (b), (c) constitutes the financial arrangement.

Subsection 995-1(1) of the ITAA 1997 defines arrangement to mean:

any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings.

The cap contract is an arrangement under this definition.

For the cap contract to be a financial arrangement, Company B must have under the cap contract a 'cash settlable legal or equitable right to receive or obligation to provide a financial benefit'. In relation to this requirement, paragraph 230-45(2)(a) of the ITAA 1997 states that 'a right you have to receive, or an obligation you have to provide, a financial benefit is cash settlable if...the benefit is money or a money equivalent'. Under the cap contract, Company B has an obligation to provide the fixed premium and a right to receive a variable amount. The fixed premium and the variable amount are sums of money. It follows that Company B has a cash settlable right to receive, and an obligation to provide, a financial benefit.

Paragraphs 230-45(2)(d), (e) and (f) of the ITAA 1997 have no application in the present case as Company B has no right to receive, or obligation to provide, a non-cash settlable financial benefit.

Accordingly, the cap contract is a 'financial arrangement' under section 230-45 of the ITAA 1997.

Issue 2:

Summary

The entire cap contract constitutes the relevant financial arrangement under section 230-55 of the ITAA 1997.

Detailed reasoning

Paragraph 2.46 of the Explanatory Memorandum to the Taxation Laws Amendment (Taxation of Financial Arrangements) Bill 2008 ('the EM') states that:

…for Division 230 purposes, a contract will often define the boundaries of a relevant arrangement. This is where the form of the contract is consistent with its substance.

Paragraph 2.47 of the EM states:

The various rights and obligations subsisting under a contract will typically constitute the relevant arrangement for the purposes of Division 230. That is, the contract is typically viewed on a 'stand alone' basis. In this context, the contract is neither aggregated with another contract (or contracts), nor disaggregated into component parts, when determining the relevant arrangement to be considered under Division 230.

The cap contract is entered into under a Single Agreement between Company B and Company C. Prima facie, the rights and obligations under the Agreement constitute one financial arrangement.

However, under subsection 230-55(4) of the ITAA 1997, whether a number of rights and/or obligations are themselves an arrangement or are 2 or more separate arrangements is a question of fact and degree that is to be determined in the light of the factors listed therein. The following observations are relevant to the consideration of these factors.

Paragraph 230-55(4)(a): the nature of the rights and/or obligations

By entering into the cap contract, Company B secures a fixed price when the spot price is above the Cap Price. The cap contract provides for a series of price guarantees.
To secure this benefit for a period, Company B paid a fixed premium amount at the inception of the arrangement. Alternatively, Company B could have entered into a series of European call options or caplets. If Company B had chosen this option, Company B would have been required to pay separate premiums for the European call options. However, Company B made a choice to enter into the cap contract, rather than a series of European options, to achieve the intended price structure.

Paragraph 230-55(4)(b): their terms and conditions (including those relating to any payment or other consideration for them)

Company B paid a fixed premium - in return for a right to receive the variable amount for the period. The pricing of the fixed premium is a relevant factor under this paragraph. As a cap is a series of European style call options (caplets), its price is the sum of these caplets, which Das, in his Swap Financing (1989, the Law Book Company Limited, p. 162) explains as follows:

The cap … is analytically separated into a series of option contracts. … Each separate option is then valued utilising the identified model. … The option premium for each contract is calculated and then summed to give the actual price for the overall contract.

Paragraph 230-55(4)(c): the circumstances surrounding their creation and their proposed exercise or performance (including what can reasonably be seen as the purposes of one or more of the entities involved)

The primary purpose of Company B entering into the cap contract is for the protection against price spikes.

Paragraph 230-55(4)(d): whether they can be dealt with separately or must be dealt with together

Company B, as a contracting party which has performed its obligation - the payment of the fixed premium, has a right to receive the variable amount. Such a right to receive performance of a contract is a chose in action and, therefore, can be assigned in entirety or in part.

The Agreement and any interest or obligation in or under this Agreement may not be transferred by either party without the prior written consent of the other party except for those circumstances as set out in the Agreement. The contract restricts the right to assign the benefit of the contract. However, this section also implies that the individual rights under the cap contract can be dealt with separately as long as Company B obtains the counterparty's consent because there is no condition that prevents Company B from transferring individual rights under the contract.

Paragraph 230-55(4)(e): normal commercial understandings and practices in relation to them (including whether they are regarded commercially as separate things or as a group or series that forms a whole)

In the financial market, various cap arrangements such as an interest rate cap are regarded as a single arrangement. The cap contract has no terms and conditions that distinguish itself from other cap arrangements.

Paragraph 230-55(4)(f): the object of this Division

The objects of Division 230 of the ITAA 1997 are stipulated in section 230-10 of the ITAA 1997. The objects of Division 230 are:

· to minimise the extent to which the tax treatment of gains and losses from your financial arrangements distorts, by providing inappropriate impediments and stimulation, your trading, financing and investment decisions and your risk taking and risk management; and

· to do so by aligning more closely the tax and commercial recognition of gains and losses from your financial arrangements in the following ways:

· by allocating the gains and losses to income years throughout the life of your financial arrangements on a reasonable basis;

· by generally recognising gains and losses on revenue rather than capital account; and

· to appropriately take account of, and minimise, your compliance costs.

The following accounting treatment applies to the cap contract:

· any variable amount that Company B is entitled to is recognised as revenue in the year in which the entitlement arises; and

· the fixed premium is expensed on a straight line basis over a specific period.

Gains and losses under the cap contract are commercially recognised over the life of the arrangement. In light of subsections 230-10(a) and (b) of the ITAA 1997, the tax recognition of the gains and losses under Division 230 of the ITAA 1997 should be closely aligned with this commercial recognition.

The observations above reveal the purpose of entering into the cap contract, which goes to the substance of the arrangement, and the particular form of contract that Company B employed to achieve the purpose. The only form of contract that met the need of Company B was the cap contract. This shows that Company B chose a particular form of contract of which the substance is entirely consistent with its form. We consider that the entire cap contract and not the individual rights thereunder, is the unit of taxation in respect of which gains and losses are recognised under Division 230 of the ITAA 1997.

On the other hand, there are two factors indicating that the cap contract should be decomposed into its constituent elements. The first is that that the upfront fixed premium is priced as a collection of the individual premiums of the constituent options. This factor cannot be regarded as of great weight because it is common to price financial derivatives as a collection of component parts. This fact of itself does not provide a reason to disaggregate a financial arrangement into its component parts. For example, Das in explaining the derivative pricing framework in his Derivative Products and Pricing (2006, 3rd edition revised, John Wiley & Sons (Asia) Pte Ltd, p. 151), states that 'over-the-counter instruments (such as swap) are decomposed into the underlying derivative elements (forward etc) and then priced as the constituent elements'. According to this pricing framework, swaps are priced as a portfolio of forwards and caps as a portfolio of options. The EM at paragraph 4.95 makes it clear that a 'swap financial arrangement (comprising all of the taxpayer's rights and obligations) generally is to be considered as one arrangement' notwithstanding that its pricing is derived from its component parts. As such, this factor alone, is not sufficient to disaggregate the cap contract into individual options.

The second factor that might support disaggregation is that the individual rights under the cap contract can be dealt with separately if Company B obtains Company C's consent. This is the result of the general law that allows an assignment, in entirety or in part, of a contractual right and therefore will not bear any great weight in the context of determining the unit of taxation.

After consideration of the factors listed in paragraphs 230-55(4)(a) to (e) of the ITAA 1997, we concluded that the relevant financial arrangement is the entire contract. The last question, in light of paragraph 230-55(4)(f) of the ITAA 1997, is whether this conclusion would defeat the object of Division 230 of the ITAA 1997.

In the present case, Company B can always make a choice to elect the fair value method or the method of relying on the financial reports, which would achieve the objects of aligning the tax and commercial recognition of gains and losses. As long as these elections are available to a taxpayer, the conclusion would not defeat the object, which is the case in the present case.

Having regard to the factors listed in the subsection 230-55(4) of the ITAA 1997, we conclude that the rights and obligations constituting the cap contract are themselves a single arrangement and the entire cap contract and not each individual right to receive the variable amount constitutes the relevant financial arrangement.

Issue 3

Summary

If Company B is entitled to a variable amount at the end of a period and the variable amount exceeds the part of the fixed premium attributable to the variable amount, Company B makes a sufficiently certain gain from a particular event under section 230-110 of the ITAA 1997.

Detailed reasoning

At the end of a period Company B may be entitled to a Floating Amount. In working out whether Company B will make a gain when it receives the Floating Amount, subsection 230-70(2) of the ITAA 1997 requires Company B to have regard to the extent to which the fixed premium that it provided is reasonably attributable to the Floating Amount. If the Floating Amount that Company B is entitled to at the end of a period exceeds the part of the fixed premium attributable to the Floating Amount, Company B will make a gain for that particular period.

In considering whether this gain is a sufficiently certain gain from a particular event, the conditions in subsection 230-110(1) of the ITAA 1997 must be met. Subsection 230-110(1) states:

You have a sufficiently certain gain or loss from a financial arrangement at a particular time if it is sufficiently certain at that time that you will make a gain or loss from the arrangement of:

· a particular amount; or

· at least a particular amount;

· when one of the followings occurs:

· you receive a particular financial benefit under the arrangement or one of your rights under the arrangement ceases;

· you provide a particular financial benefit under the arrangement or one of your obligations under the arrangement ceases.

The amount of the gain or loss is the amount referred to in paragraph (a) or (b).

Company B will make a sufficiently certain gain from a particular event under section 230-110 of the ITAA 1997 as the above conditions are met.

It is sufficiently certain that Company B will make a gain, at the end of the period, of a particular amount (being the excess of the variable amount over the fixed premium attributable to the variable amount) when it receives a particular financial benefit (being the variable amount).

Issue 4

Summary

The accruals method applies to the gain in issue 3 above pursuant to section 230-100 of the ITAA 1997.

Detailed reasoning

Subsection 230-100(3) of the ITAA 1997 states:

The accruals method provided for in this Subdivision also applies to a gain or loss you make from a financial arrangement if:

· the gain or loss arises from a *financial benefit that you are to receive or are to provide under the arrangement; and

· the gain or loss:

· is sufficiently certain at the time when you start to have the arrangement and before you are to receive or provide the benefit; or

· becomes sufficiently certain after the time when you start to have the arrangement and before you are to receive or provide the benefit; and

· the benefit has not already been taken into account in applying:

· the accruals method provided for in this Subdivision; or

· the realisation method provided for in this Subdivision;

· to another gain or loss from the arrangement.

If Company B makes a gain at the end of a period, the gain will satisfy all the conditions set out in subsection 230-100(3) of the ITAA 1997 for the following reasons:

· the gain arises from a financial benefit (i.e. the variable amount) that Company B is to receive under the cap contract (satisfying paragraph (a));

· the gain becomes sufficiently certain after the time Company B starts to have the cap contract and before Company B is to receive the variable amount (satisfying subparagraph (b)(ii)); and

· the benefit has not already been taken into account in applying the accruals method or the realisation method to another gain or loss from the cap contract (satisfying paragraph (c)).

Accordingly, pursuant to subsection 230-100(3) of the ITAA 1997 the accruals method will apply to the gain.

Issue 5

Summary

The gain in issue 3 above occurs at the end of the period pursuant to section 230-110 of the ITAA 1997.

Detailed reasoning

As explained above in issue 3, Company B will make a sufficiently certain gain from a particular event under section 230-110 of the ITAA 1997 at the end of the Calculation Period when it receives the Floating Amount.

Issue 6

Summary

If Company B is not entitled to a variable amount at the end of a period, Company B does not make a sufficiently certain loss from a particular event under section 230-110 of the ITAA 1997.

Detailed reasoning

At the end of a period, Company B may not entitled to a variable amount at the end of that particular period. In this situation Company B will not receive a financial benefit , rather one of its rights will cease. In working out whether Company B will make a loss in this situation, subsection 230-70(2) of the ITAA 1997 requires Company B to have regard to the extent to which the fixed premium that it provided is reasonably attributable to the right to receive the variable amount. As such, if Company B is not entitled to a variable amount at the end of a period, Company B will make a loss for that particular period. The question that arises is whether this loss is a sufficiently certain loss from a particular event under section 230-110 of the ITAA 1997.

In order to work out whether this loss is sufficiently certain it is particularly important to look at the application of paragraph 230-110(2)(a) of the ITAA 1997. Paragraph 230-110(2)(a) of the ITAA 1997 states:

have regard to the extent of the risk that a *financial benefit that you are not sufficiently certain to provide or receive under the arrangement may reduce the amount of the gain or loss.

Company B, having paid the fixed premium will never be required to provide any further financial benefit at the end of any period but it may receive a variable amount in relation to any subsequent periods. In terms of paragraph 230-110(2)(a) of the ITAA 1997, there is a risk that the loss in a particular period may be reduced by a variable amount that may be received in relation to any subsequent period. In these circumstances, it cannot be said that there is a sufficiently certain loss from a particular event in this situation.

Therefore, if Company B is not entitled to a variable amount at the end of a period, Company B will not make a sufficiently certain loss from a particular event under section 230-110 of the ITAA 1997.

Issue 7

Summary

The realisation method will apply to the loss in issue 6 above pursuant to section 230-100 of the ITAA 1997.

Detailed reasoning

Subsection 230-100(5) of the ITAA 1997 states:

The realisation method provided for in this Subdivision applies to a gain or loss that you make from a financial arrangement if the accruals method provided for in this Subdivision does not apply to the gain or loss.

In considering whether the realisation method applies to the loss in issue 6, it is first necessary to consider whether the accruals method would apply to this loss. In accordance with subsections 230-100(2) and (3) of the ITAA 1997, the accruals method applies to a loss if the loss is: a sufficiently certain overall loss; or a sufficiently certain particular loss. We concluded in issue 6 is that the loss in this issue is not a sufficiently certain loss from a particular event under section 230-110 of the ITAA 1997. Furthermore, the loss cannot be a sufficiently certain overall loss because the loss is related to a particular event under the cap contract.

Accordingly, the accruals method does not apply to the loss in issue 6. It follows that the realisation method will apply to the loss in issue 6 above pursuant to subsection 230-100(5) of the ITAA 1997.

Issue 8

Summary

The loss in issue 6 above occurs when the fixed premium is provided by Company B pursuant to subsection 230-180(2) of the ITAA 1997.

Detailed reasoning

Subsection 230-180(1) of the ITAA 1997 states:

If a gain or loss is to be taken into account using the realisation method, you are taken, for the purposes of section 230-15, to make the gain or loss for the income year in which the gain or loss occurs.

Subsection 230-180(2) of the ITAA 1997 states:

For the purpose of subsection (1), a gain or loss from a financial arrangement is taken to occur at the time at which the last of the financial benefits taken into account in determining the amount of the gain or loss:

· is provided; or

· if the financial benefit is not provided at the time when it is due to be provided under the arrangement and it is reasonable to expect that the financial benefit will be provided - is due to be provided.

Company B makes the loss in issue 6 because it is not entitled to any variable amount at the end of the period. The only financial benefit taken into account in working out the amount of the loss is the part of the fixed premium attributable to the right to receive the financial benefit. In accordance with subsection 230-180(2) of the ITAA 1997, the loss is taken to occur at the time when the fixed premium, being the last financial benefit taken into account in working out the amount of the loss, was provided by Company B. The loss in issue 6 above occurs when the fixed premium is provided by Company B pursuant to subsection 230-180(2) of the ITAA 1997.

Issue 9

Summary

If Company B is entitled to a variable amount at the end of a period and the variable amount is less than the part of the fixed premium attributable to the variable amount, Company B will not make a sufficiently certain loss from a particular event under section 230-110 of the ITAA 1997.

Detailed reasoning

As explained above in issue 6, where Company B makes a loss at the end of a period and not a gain, it is particularly important to look at the application of paragraph 230-110(2)(a) of the ITAA 1997 to work out whether this loss is sufficiently certain.

In terms of paragraph 230-110(2)(a) of the ITAA 1997, there is a risk that the loss may be reduced by a variable amount that may be received in relation to any subsequent period. Therefore, there is not a sufficiently certain loss from a particular event in this situation.

Therefore, if Company B is entitled to a variable amount at the end of a period and the variable amount is less than the part of the fixed premium attributable to the variable amount, Company B will not make a sufficiently certain loss from a particular event under section 230-110 of the ITAA 1997.

Issue 10

Summary

The realisation method will apply to the loss in issue 9 above pursuant to section 230-100 of the ITAA 1997.

Detailed reasoning

In considering whether the realisation method applies to the loss in issue 9, we need to determine whether the accruals method would apply to this loss. As explained above in issue 7, under subsections 230-100(2) and (3) of the ITAA 1997, the accruals method applies to a loss if the loss is: a sufficiently certain overall loss; or a sufficiently certain particular loss. We concluded in issue 9, that the loss is not a sufficiently certain loss from a particular event under section 230-110 of the ITAA 1997. Furthermore, the loss cannot be a sufficiently certain overall loss because the loss is related to a particular event under the cap contract.

Accordingly, the accruals method will not apply to the loss in issue 9. Pursuant to subsection 230-100(5) of the ITAA 1997, the realisation method will apply to the loss in issue 9.

Issue 11

Summary

The loss in issue 9 above occurs when the variable amount is provided to Company B pursuant to subsection 230-180(2) of the ITAA 1997.

Detailed reasoning

According to subsection 230-180(2) of the ITAA 1997, the loss is taken to occur at the time at which the last of the financial benefits taken into account in working out the amount of the loss is provided. In this situation the loss is made because the variable amount that Company B is entitled to is less than the part of the fixed premium attributable to the variable amount. In accordance with subsection 230-180(2) of the ITAA 1997, the loss is taken to occur at the time when the variable amount, being the last financial benefit taken into account in working out the amount of the loss, was provided to Company B. Therefore, the loss in issue 9 above occurs when the variable amount is provided to Company B in accordance with subsection 230-180(2) of the ITAA 1997.

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