Edited version of private ruling

Authorisation Number: 1011544595485

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Ruling

Subject: Taxation of Financial Arrangements

Question 1

Will the rulee have a financial arrangement for the purposes of section 230-45 of the Income Tax Assessment Act 1997 (ITAA 1997) comprising its rights and obligations under the Agreement?

Answer

Yes. The rulee will have a financial arrangement as defined in section 230-45 of the ITAA 1997 comprising its rights and obligations under the Agreement.

Question 2

Does the rulee have a sufficiently certain overall gain or loss from the financial arrangement comprising the Agreement under subsection 230-105(1) of the ITAA 1997?

Answer

No. The rulee does not have an overall gain or loss from the Agreement under subsection 230-105(1) of the ITAA 1997. Instead, the rulee has a series of particular gains and losses from the Agreement under subsection 230-110(1) of the ITAA 1997.

Question 3

Can the rulee make a choice under subsection 230-130(2) of the ITAA 1997 to spread its gain or loss from the financial arrangement comprising the Agreement in accordance with subsection 230-130(3) of the ITAA 1997 instead of in accordance with subsection 230-130(1) of the ITAA 1997?

Answer

No. An overall gain or loss must exist in order to make the choice under subsection 230-130(2) of the ITAA 1997. The rulee does not have an overall gain or loss at the start of the arrangement.

Question 4

If:

· the answer to questions 2 and 3 is yes, and a choice is made under subsection 230-130(2) of the ITAA 1997, or

· The rulee does not have a sufficiently certain overall gain or loss from the financial arrangement comprising the Agreement

will the periods over which the gain or loss from that arrangement is to be spread commence in the income year in which the Promissory Notes under such arrangement commence to be issued?

Answer

No. Under subsection 230-130(3) of the ITAA 1997, the series of particular gains and losses will be spread over the period to which they relate. This period will commence at the start of the income year in which the relevant Payment is made and end at the end of the income year during which the attributable Promissory Note Receipt (under subsection 230-75(3) of the ITAA 1997) is received.

Year(s) of income or period(s) to which this ruling applies:

Years of income ended 30 June 20XX to 30 June 20XY

Commencement date of scheme:

Years of income ended 30 June 20XX

The scheme that is the subject of the ruling:

The rulee has entered into an Agreement in relation to a financial arrangement that will run for a number of years.

Key elements of the financial arrangement involving the rulee

The rulee borrows funds from third parties.

The rulee makes payments relating to the purchase of a series of Promissory Notes from entity A.

The Promissory Note Receipts commence after the completion of each stage of the agreement.

The Promissory Note Receipts that the rulee receives on each of the Promissory Notes is sufficient to pay down both its debt obligations, and fund a return to the rulee's equity investors.

Variations during each stage of the agreement is reflected in an increase or decrease (as the case may be) of the purchase price the rulee pays entity A for the Promissory Notes.

The rulee is not able to assign or otherwise deal with its rights under the agreement without the prior written consent of another party.

Termination of the agreement is provided for under the agreement. If a termination event occurs, the payment amounts made to entity A may be reduced.

Relevant provisions:

Income Tax Assessment Act 1997 Section 230-45

Income Tax Assessment Act 1997 Section 230-75

Income Tax Assessment Act 1997 Section 230-105

Income Tax Assessment Act 1997 Section 230-110

Income Tax Assessment Act 1997 Section 230-130

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Explanation: (This does not form part of the notice of private ruling)

All legislative references are to the ITAA 1997 unless otherwise indicated.

Question 1

Summary

Yes. The rulee will have a financial arrangement as defined in section 230-45 comprising its rights and obligations under the Agreement.

Detailed reasoning

Identification of the arrangement under subsection 230-55(4)

An 'arrangement' is defined broadly in subsection 995-1(1) to include any arrangement, agreement, understanding, promise or undertaking. Section 230-55 modifies this broad notion of an arrangement by providing guidance as to which specific rights and obligations constitute the relevant arrangement for the purposes of Division 230.

Whether a number of rights and/or obligations are themselves an arrangement or are two or more separate arrangements is a question of fact and degree that must be determined having regard to each of the factors listed in subsection 230-55(4). The way various rights and obligations are combined under subsection 230-55(4) is an objective enquiry, the purpose of which is to identify the correct 'unit of taxation' upon which the provisions of Division 230 apply.

Generally, under section 230-55, a contract will define the boundaries of an arrangement, especially where the form of the contract is consistent with its substance; refer to paragraph 2.47 of the Explanatory Memorandum to the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 (EM). That paragraph goes on to state:

…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.

Prima facie, the rights and obligations arising under the Agreement will constitute one arrangement, encompassing a series of Promissory Notes that are issued following completion of each stage. However, section 230-55 is not limited by the form of a single contract in the identification of an arrangement so it could be possible to alternatively determine that each of the Promissory Notes themselves are separate arrangements.

Under the Agreement, the rulee will purchase the Promissory Notes from entity A. Under the Agreement, the rulee has a right to receive the Promissory Notes which acknowledge the rulee's right (as assignee) to receive the Promissory Note Receipts.

Accordingly under the Agreement, the rulee will have:

· rights to receive financial benefits comprising the Promissory Notes and the Promissory Note Receipts; and

· obligations to provide financial benefits, being the Payments.

In this case it is considered that the contract comprising the Agreement is the relevant arrangement under subsection 230-55(4). The rights and obligations of the parties are set out in the Agreement which is intended to, and does, operate as one and reflects the legal form and economic substance of the contract; being the valid equitable assignment of the Promissory Notes as part of a structured finance arrangement which provides the rulee and entity A with the funding the parties require to satisfy their respective obligations.

The rulee's rights and obligations to receive and provide financial benefits are contractually bound together and would not exist independently of each other. The rights to receive the Promissory Notes and the Promissory Note Receipts are commercially and inextricably linked to the obligations to pay the amounts it is required to pay in order to purchase the Promissory Notes by way of Payments. These rights and obligations under the Agreement cannot be dealt with separately. The parties created these rights and obligations with the purpose of effecting an arrangement for the purchase of the Promissory Notes and the normal commercial understanding or practice in relation to a purchase of assets would be to regard the rights and obligations under the agreement as forming a whole.

Importantly, the rulee cannot assign or deal with any rights under the Agreement without the prior written consent of another party. This suggests that the parties to the transaction view the rights and obligations as constituting a single arrangement.

For accounting purposes the Agreement is accounted for as one financial asset. The rulee recognises a financial asset in respect of its right to receive Promissory Note Receipts under the Agreement. Each Promissory Note is not accounted for separately. Interest on this financial asset is recognised in the rulee's profit or loss statement under the effective interest method in accordance with AASB 139.

Having regard to the factors in subsection 230-55(4), it is considered that the rights and obligations under the Agreement comprise one arrangement. That is: the rulee's rights to receive the Promissory Notes and Promissory Note Receipts together with the rulee's obligations to make the Payments in order to purchase the Promissory Notes will be taken to comprise one arrangement for the purposes of section 230-55(4), being the Agreement.

Is the arrangement identified a financial arrangement under section 230-45?

It is necessary to consider whether the identified arrangement comprising the Agreement meets the definition of a 'financial arrangement'. Subdivision 230-A provides the test for determining whether an arrangement is a financial arrangement. Broadly, an arrangement will be a financial arrangement if it satisfies the 'primary definition' under section 230-45 (dealing with cash settlable rights and obligations to financial benefits) or the 'secondary definition' under section 230-50 (dealing with equity interests and rights and obligations to equity interests).

Broadly, you have a financial arrangement under subsection 230-45(1), if you have, under an arrangement, a:

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

(b) cash settlable legal or equitable obligation to provide a financial benefit; or

(c) combination of one or more such rights and/or one or more such obligations.

* denotes a term defined in section 995-1 of the ITAA 1997

Under the Agreement, the rulee has rights to receive the Promissory Notes and the Promissory Note Receipts and obligations to make Payments. These amounts are 'financial benefits' within the meaning of section 974-160 because they are 'anything of economic value'. Therefore, the Agreement does, on its terms, create legal rights to receive and obligations to provide financial benefits.

Under paragraph 230-45(2)(a), a right to receive or an obligation to provide a financial benefit is cash settlable if the benefit is money or money equivalent. As the Promissory Notes, the Promissory Note Receipts and the Payments are money or a right to receive money, they are financial benefits that are money or a money equivalent (as defined in subsection 995-1(1)). Therefore, the rights to receive the Promissory Notes, the Promissory Note Receipts and the obligations to provide Payments will be cash settlable under paragraph 230-45(2)(a).

Accordingly, as the Agreement consists entirely of cash settlable legal rights and obligations to receive and provide financial benefits, it will satisfy the definition of a 'financial arrangement' under subsection 230-45(1).

For completeness, we note that the secondary definition of a financial arrangement under section 230-50 does not apply as, under the arrangement, the rulee does not have an equity interest as defined in subsection 974-75(1).

Question 2

Summary

No. the rulee does not have an overall gain or loss from the Agreement under subsection 230-105(1). Instead, the rulee has a series of particular gains and losses from the Agreement under subsection 230-110(1).

Detailed reasoning

The concept of a gain or loss

A gain from a financial arrangement is included in assessable income under subsection 230-15(1), while a corresponding loss is deductible under subsection 230-15(2) if it is:

(a) made in gaining or producing assessable income, or

(b) necessarily made in carrying on business for the purposes of gaining or producing assessable.

Division 230 does not define 'gain' or 'loss'. The EM provides, at paragraph 3.4, that, as a general rule, the gain or loss from a financial arrangement can be calculated by deducting the cost of the financial arrangement (including the expenses provided at maturity or upon disposal) from the money received from the financial arrangement (including the proceeds received at maturity or upon disposal). Where the result is a positive amount, a gain will arise. Conversely, a loss will arise where the result is a negative amount (paragraph 3.10 of the EM).

Generally the gain or loss from the financial arrangement that is assessable or deductible in a particular income year is determined by the tax timing methods in Subdivisions 230-B to 230-F and the balancing adjustment in Subdivision 230-G.

Rights and/or obligations subject to an exception

However, Division 230 does not apply to your gains and losses from a financial arrangement for any income year to the extent that your rights and/or obligations under the arrangement are the subject of an exception; refer to subsection 230-460(1) and, generally, Subdivision 230-H. Specifically, a right carried by an interest in a trust, or an obligation that corresponds to such a right, is the subject of an exception if one of the requirements in subsection 230-460(3) is met.

It is considered that, upon the issue of a Promissory Note by entity B to entity A and until the Promissory Note is transferred to the rulee, entity A holds that Promissory Note on trust for the benefit of the rulee. The right to the Promissory Note is a right that the rulee has under its financial arrangement. Therefore it is a right carried by an interest in a trust and subject to the exception in subsection 230-460(3) if one of the requirements in that subsection is satisfied. As there is only one class of interest in the trust, the requirement in paragraph 230-460(3)(a) is satisfied.

Accordingly, the rulee's rights to the Promissory Notes under the financial arrangement are the subject of an exception. Similarly, the obligations that correspond to such rights (being entity A's obligations to provide Promissory Notes to the rulee) are also under the exception in subsection 230-460(3).

As the rights to receive Promissory Notes and the obligations to provide Promissory Notes are the subject of an exception, gains or losses under the Agreement financial arrangement, to the extent they arise in respect of these rights and obligations, are not assessable or deductible under Division 230. However, the rulee's right to receive Promissory Note Receipts under a Promissory Note and its obligation to provide Payments are not covered by any exceptions and Division 230 will apply to any gains or losses that arise in respect of those rights and obligations.

It is noted that the rulee will make an election under subitem 104(2) of Schedule 1 to the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 to apply Division 230 to all of its financial arrangements within the period allowed by subitem 104(5) of the same Schedule.

Subdivision 230-B - The accruals/ realisation methods

As a result of the rulee not making an election under sections 230-210 and 230-395, the tax timing method that will apply to the Arrangement will be the accruals or realisation method in Subdivision 230-B and, upon termination, the balancing adjustment method in Subdivision 230-G.

The accruals method in Subdivision 230-B applies broadly to sufficiently certain gains and losses made from a financial arrangement. To the extent that the accruals method applies the realisation method does not (subsection 230-100(5)). The accruals method can apply to either a sufficiently certain overall gain or loss, or a sufficiently certain particular gain or loss, but not both with respect to the same gain or loss.

Sufficiently certain overall gain or loss

The rulee will have a sufficiently certain overall gain or loss under section 230-105 if it is sufficiently certain, at the start of the arrangement, that it will make an overall gain or loss of a particular amount, or at least a particular amount. When considering whether the rulee has a sufficiently certain overall gain or loss, it is assumed that the Agreement will continue for the rest of its life, and regard must be had to the extent of the risk that a financial benefit that is not sufficiently certain to be provided or received under this arrangement may reduce the amount of the gain or loss (subsection 230-105(2)).

Section 230-115 provides that when deciding whether it is sufficiently certain at a particular time that a gain or loss will be made from a financial arrangement, regard must be had only to the financial benefits that are sufficiently certain to be received and provided. A financial benefit is sufficiently certain if it is reasonably expected that it will be received or provided and at least some of the amount or value of the benefit is fixed or determinable with reasonably accuracy (subsection 230-115(2)). When determining this, it must be assumed that the financial arrangement will be held for the rest of its life and regard must be had to certain factors including the terms and conditions of the arrangement, accepted pricing and valuation techniques, the economic substance and effect of the arrangement and the presence of any contingencies (subsection 230-115(3)).

The rights and obligations that the rulee has under the Agreement, that are not covered by the exception in subsection 230-460(3), are the rights to receive Promissory Note Receipts once the Promissory Notes are issued at the end of each relevant stage and the obligations to provide Payments for the purchase of the Promissory Notes.

The Agreement sets out expected amounts and dates on which the Payments and the Promissory Note Receipts will be provided and received respectively. These amounts allow, prima facie, an overall gain of $XX to be calculated at the start of the arrangement. The issue is whether the 'overall gain' at that time is sufficiently certain under section 230-105, having regard to whether the financial benefits to be provided and received under the Arrangement are 'sufficiently certain' in accordance with subsection 230-115(2).

Given the inherent nature of such an arrangement it is highly probable that the Payments and, as a consequence, the Promissory Note Receipts that are outlined in the Agreement will be varied over the life of the arrangement. This is provided for in the Agreement in that the purchase price the rulee will pay entity A for the Promissory Notes can be altered or adjusted by reference to the actual costs incurred during the arrangement.

With regards to paragraph 230-115(2)(a), assuming that the rulee will continue to have the Agreement for the rest of its life, it is reasonably expected that the rulee will provide the Payments and receive the Promissory Note Receipts under the arrangement (even though the quantum may vary under the arrangement).

It is noted that specific clauses allow the arrangement to be terminated. These termination clauses will operate only in limited circumstances. As a result, it is reasonable to expect that the financial benefits will be provided or received under the arrangement. While a termination event is a risk, it is considered that the probability of the event(s) occurring is too remote.

In addition to determining that it is reasonably expected that the financial benefits will be received under the arrangement, consideration must also be given under paragraph 230-115(2)(b) as to whether at least some of the amount or value of the benefit is fixed or determinable with reasonable accuracy. The ability for the Payments and Promissory Note Receipts to vary in response to the actual costs incurred means that the amount of the financial benefits received and provided under the arrangement are not fixed. This fact leads to the conclusion that at least some of the amount or value of the financial benefits received and provided under the arrangement cannot be determined with reasonable accuracy.

Due to the uncertainty of the actual Payments to be paid by the rulee to entity A and the Promissory Note Receipts that the rulee will receive, the amount of any gain or loss is not sufficiently certain under subsection 230-105(1) at the start of the arrangement. As a result, the rulee does not have a sufficiently certain overall gain or loss under section 230-105.

Sufficiently certain particular gain or loss

As the rulee does not have a sufficiently certain overall gain or loss, consideration must be given to whether it has a sufficiently certain particular gain or loss under section 230-110 at a particular time (see subparagraph 230-100(3)(b)(ii)). Subsection 230-110(1) provides that an entity has a sufficiently certain particular gain or loss at a particular time if it is sufficiently certain at that time that it will make a gain or loss of a particular amount or at least a particular amount when the particular financial benefit is received or provided or one of the rights or obligations under the arrangement ceases.

Under the Agreement, the rulee has obligations to provide Payments and rights to receive the Promissory Note Receipts upon the issue of the Promissory Notes at the end of each stage of the arrangement.

The amount payable to the rulee in respect of each Promissory Note will vary in response to variations in the Payments. This means that when a Payment is calculated with reference to the actual costs incurred under the arrangement, and this amount is actually paid, it can be reasonably expected that the rulee will receive the associated Promissory Note Receipts and the amount of the receipts can be calculated with reasonable accuracy at that time.

Once a Payment is provided by the rulee, the obligation to provide that Payment is one that the rulee is sufficiently certain to provide (paragraph 230-115(9)(a)).

However, the mere making of a Payment does not give rise to a loss per se (either under the accruals or realisation method). This is because, as a result of the application of the attribution rules in section 230-75, the Promissory Note Receipts are attributable to the Payments provided.

That being said, an additional consequence of the payment by the rulee of a Payment is that the right to receive financial benefits (the Promissory Note Receipts) becomes one which the rulee is sufficiently certain to receive. The only risk that exists subsequent to the providing of the Payment is the risk of termination. However it is considered that the probability of a termination event occurring is too remote to render these rights to receive financial benefits, as being not sufficiently certain.

Accordingly, the rulee will be able to determine the sufficiently certain particular gain at the time of providing the Payment by attributing appropriate Promissory Note Receipts to the Payment (subsection 230-75(3)).

In summary, given that the amount of the gain from the Agreement cannot be calculated with reasonable accuracy at the start of the arrangement, the rulee does not have a sufficiently certain overall gain as defined under section 230-105. Instead, it has and will have, as further Payments are made by the rulee, a series of sufficiently certain particular gains pursuant to section 230-110 representing the difference between the Payments and the attributable Promissory Note Receipts (as determined by subsection 230-75(3)) at the time that each Payment is made.

Question 3

Summary

No. An overall gain or loss must exist in order to make the choice under subsection 230-130(2). The rulee does not have an overall gain or loss at the start of the arrangement.

Detailed reasoning

Section 230-130 specifies the period over which gains and losses are to be spread under the accruals method. For sufficiently certain overall gains and losses, the period over which the gain or loss is to be spread, begins at the start of the arrangement and ends when the arrangement ceases (subsection 230-130(1)).

Subsection 230-130(3) allows particular gains and losses to be spread over the period to which the gain or loss relates, having regard to the pricing, terms and conditions of the arrangement. Subsections 230-130(4) and 230-130(5) then place certain restrictions on the start and end of the period over which the gains or losses can be spread. 

Subsection 230-130(2) contains an exception to the general rule in subsection 230-130(1) for determining the period over which sufficiently certain overall gains and losses are to be spread. This exception allows a sufficiently certain overall gain or loss to be spread as a particular gain or loss if it can be split into constituent gains or losses that can be spread under subsection 230-130(3).

As stated earlier, the rulee does not have a sufficiently certain overall gain or loss pursuant to section 230-105 at the start of the arrangement. Therefore, as there is no overall gain, the rulee cannot make the choice under subsection 230-130(2) to spread a sufficiently certain overall gain or loss as a series of particular gains or losses.

Question 4

Summary

No. Under subsection 230-130(3), the series of particular gains and losses will be spread over the period to which they relate. This period will commence at the start of the income year in which the relevant Payment is made and end at the end of the income year during which the attributable Promissory Note Receipt (under subsection 230-75(3)) is received.

Detailed reasoning

Period over which the particular gains or losses is to be spread

As the rulee has a series of sufficiently certain particular gains from the Agreement, these gains must be spread over the period to which they relate (subsection 230-130(3). In determining this period, regard must be had to the pricing, terms and conditions of the arrangement. The parameters of the period over which a gain or loss from a financial arrangement is to be spread is limited by subsections 230-130(4) and 230-130(5).

Subsection 230-130(4) specifies that the period over which a particular gain or loss can be spread must not start earlier than the time when you start to have the financial arrangement nor start earlier than the start of the income year during which the gain or loss becomes sufficiently certain.

Subsection 230-130(5) provides that the end of the period over which a particular gain or loss can be spread must not end later than the time you cease to have the arrangement and the income year during which the financial benefit which gives rise to the gain or loss is received, provided, or is to cease.

Subsections 230-130(4) and 230-130(5) define the outer limits of the period over which the particular gains and losses can be spread. The actual period over which the particular gains and losses can be spread may be shorter than the period starting at the start of the arrangement and ending at the cessation of the arrangement which are the boundaries set by subsections 230-130(4) and 230-130(5) respectively.

As stated earlier, each particular gain becomes sufficiently certain when the Payment is made (the gain is determined having regard to subsection 230-75(3) by reference to the amount of the Promissory Note Receipt that is attributable to the relevant Payment). Pursuant to paragraph 230-130(4)(b), this means that the period over which the sufficiently certain particular gain is to be spread must not start earlier than the start of income year in which the relevant Payment is made. In accordance with subsection 230-130(5), it follows that the end of the period over which a sufficiently certain particular gain is to be spread must not end later than the end of the income year in which the financial benefit (the Promissory Note Receipt) is received.

The EM at paragraph 4.134 explains that having regard to the pricing, terms and conditions of the arrangement will give an indication of what the financial benefit was provided or received for, and hence a reference point to which period that financial benefit relates. It further states that "…generally, the period to which the financial benefit relates would also be the period to which particular gain or loss relates, except in cases of deferral of payment where the time value of money may not be fully reflected."

Prima facie, it could be argued that the period to which a sufficiently certain particular gain in the present circumstances relates would be the period in which a connected Promissory Note Receipt is received. However, such a conclusion would ignore the reality that most of the gain that arises out of the Promissory Note Receipt is almost entirely compensation for the rulee forgoing other investments. In other words - it is a gain that arises out of the time value of money. As the above extract from the EM states, the period to which the gain relates must reflect the time value of money (deferred interest).

The period to which a gain that is in the nature of deferred interest relates is the period over which the lender did not have the use of its money. It cannot simply be the period in which the financial benefit giving rise to the gain is received, and nor can it be at a time when every possible contingency is resolved (such as when each of the relevant Promissory Notes are issued). Once it is determined that it is sufficiently certain that the rulee will receive a financial benefit, the fact that contingencies remain has no bearing on the analysis as to the period to which the gain relates.

The pricing, terms and conditions also signify that the Agreement is a highly structured financing arrangement with the Payments and Promissory Note Receipts factoring in deferred interest. Therefore, the period to which the particular gains relate starts when the Payment is provided, and ends when the final Promissory Note Receipt that is attributable to that instalment of the Payment is received. This properly reflects the economic substance of the arrangement.

Additionally, accruing the particular gains from the Agreement over the period of the cash flows is consistent with the accounting treatment the rulee is using under AASB 139, being the application of the effective interest rate method over the term of the Agreement.

The attribution rules in section 230-75 will operate to attribute that part of the Promissory Note Receipt attributable to the instalment of the Payment outflow in order to determine the relevant particular gain.

Accordingly, it is not appropriate to commence accruing particular gains from the Agreement from the date each of the Promissory Notes are issued as this is not the period to which the gains relate.

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