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Ruling

Subject: Debt Financing Arrangement

Question 1

Will subsection 230-55(4) of the ITAA 1997 apply to treat the credit agreement and each draw down made under the credit agreement as separate arrangements for the purposes of Division 230 of the ITAA 1997?

Answer

Yes.

Question 2

Will both the credit agreement and each draw down made under the credit agreement be treated as a financial arrangement for the purposes of Division 230 of the ITAA 1997?

Answer

Yes.

Question 3

Will Company X make a loss that is deductible pursuant to subsection 230-15(2) of the ITAA 1997 from a financial arrangement constituted by a draw down under the credit agreement?

Answer

Yes.

This ruling applies for the following periods:

From the start of the Credit Agreement and ending on the final maturity date.

Relevant facts and circumstances

Company X has entered into a credit agreement with Company Y (a related company) to borrow money for its business (the credit agreement).

Company Y has entered into a credit agreement with Company Z (a related company) to borrow money.

Under the credit agreement, Company X is required to pay the principal, interest and other fees and expenses to Company Y by the final maturity date and in accordance with the agreement.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 Section 230-15

Income Tax Assessment Act 1997 Section 230-20

Income Tax Assessment Act 1997 Section 230-40

Income Tax Assessment Act 1997 Section 230-45

Income Tax Assessment Act 1997 Section 230-50

Income Tax Assessment Act 1997 Section 230-55

Income Tax Assessment Act 1997 Section 230-75

Income Tax Assessment Act 1997 Section 230-85

Income Tax Assessment Act 1997 Section 230-100

Income Tax Assessment Act 1997 Section 230-105

Income Tax Assessment Act 1997 Section 230-110

Income Tax Assessment Act 1997 Section 230-130

Income Tax Assessment Act 1997 Section 230-135

Income Tax Assessment Act 1997 Section 230-170

Income Tax Assessment Act 1997 Section 230-175

Income Tax Assessment Act 1997 Section 230-180

Income Tax Assessment Act 1997 Section 230-210

Income Tax Assessment Act 1997 Section 230-255

Income Tax Assessment Act 1997 Section 230-315

Income Tax Assessment Act 1997 Section 230-395

Income Tax Assessment Act 1997 Section 230-435

Income Tax Assessment Act 1997 Section 230-445

Income Tax Assessment Act 1997 Section 230-450

Income Tax Assessment Act 1997 Section 230-455

Income Tax Assessment Act 1997 Section 974-160

Income Tax Assessment Act 1997 Section 995-1

Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 sub-item 103(2) of Schedule 1

Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 sub-item 104(2) of Schedule 1

Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 sub-item 104(5) of Schedule 1

Reasons for decision

Question 1

The definition of 'financial arrangement' determines the unit of taxation in respect of which gains and losses are recognised under Division 230 of the ITAA 1997. In order to determine whether gains and losses arise under a financial arrangement, it is first necessary to establish whether the rights and obligations under the agreement give rise to an 'arrangement' that in turn meets the definition of a financial arrangement.

An 'arrangement' is defined in subsection 995-1(1) of the ITAA 1997 and includes any arrangement, agreement, understanding, promise or undertaking, whether express or implied. Section 230-55 of the ITAA 1997 modifies this broad notion of arrangement and provides guidance in subsection 230-55(4) of the ITAA 1997 as to which specific rights and obligations will make up the arrangement to be tested for the purposes of the Division.

Whether a number of rights and/or obligations themselves an arrangement or are two or more separate arrangements is a question of fact and degree. A contract will often define the boundaries of a relevant arrangement, especially where the form of the contract is consistent with its substance. Relevantly, paragraph 2.47 of the Explanatory Memorandum to the Taxation Laws Amendment (Taxation of Financial Arrangements) Bill 2008 (the EM) states:

…[T]he 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. 

However, section 230-55 of the ITAA 1997 is not limited by the form of a single contract in the identification of an arrangement. 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) of the ITAA 1997. 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 of the ITAA 1997 apply.

The issue that arises in respect of the credit agreement is how the various rights and obligations are combined under subsection 230-55(4) of the ITAA 1997 to identify an arrangement(s) and whether or not each of the draw downs made under the credit agreement form individual arrangements in their own right or are a part of one arrangement including the credit agreement.

It is considered having regard to subsection 230-55(4) of the ITAA 1997 and the facts provided, that the credit agreement and each draw down under the credit agreement are separate arrangements for the purposes of Division 230 of the ITAA 1997.

Question 2

The arrangements must meet the definition of a 'financial arrangement' before they will be subject to Division 230 of the ITAA 1997. Broadly, an arrangement will be a financial arrangement if it satisfies the 'primary definition' of a financial arrangement under section 230-45 of the ITAA 1997 (cash settlable rights and obligations to financial benefits) or the 'secondary definition' under section 230-50 of the ITAA 1997 (equity interests and rights and obligations to equity interests).

It is noted that the secondary definition of a financial arrangement in subsection 230-50 of the ITAA 1997 does not apply.

It is first necessary to test whether the credit agreement is a financial arrangement as defined in section 230-45 of the ITAA 1997.

The rights and obligations that arise under the credit agreement are in respect of financial benefits (as defined in paragraph 974-160(1)(a) of the ITAA 1997) for the purposes of section 230-45 of the ITAA 1997. Further, the rights and obligations in respect of those financial benefits will be cash settlable within the meaning of paragraph 230-45(2)(a) of the ITAA 1997 as the benefits are monetary amounts.

As the rights and obligations under the credit agreement are cash settlable rights to receive and obligations to provide financial benefits, the exclusions to the definition of a financial arrangement in paragraphs 230-45(1)(d) to (f) of the ITAA 1997 have no application. Likewise, the exclusion rules in sections 230-450 and 230-455 of the ITAA 1997 have no application on the facts presented.

Thus, the credit agreement is an arrangement that constitutes a financial arrangement as defined in section 230-45 of the ITAA 1997.

It is also necessary to test whether each draw down under the credit agreement is a financial arrangement as defined in section 230-45 of the ITAA 1997.

The rights and obligations that arise under each draw down under the credit agreement are rights or obligations to receive or provide financial benefits (as defined in paragraph 974-160(1)(a) of the ITAA 1997) for the purposes of section 230-45 of the ITAA 1997. Further, the rights and obligations will be cash settlable within the meaning of paragraph 230-45(2)(a) of the ITAA 1997 as they are rights and obligations to receive or provide monetary amounts.

As the rights and obligations under each draw down are cash settlable rights to receive and obligations to provide financial benefits, the exclusions to the definition of a financial arrangement in paragraphs 230-45(1)(d) to (f) of the ITAA 1997 have no application. Likewise, the exclusion rules in sections 230-450 and 230-455 of the ITAA 1997 have no application on the facts presented.

Therefore each draw down under the credit agreement will be a financial arrangement for the purposes of section 230-45 of the ITAA 1997.

Question 3

In order for Company X to deduct a loss under subsection 230-15(2) of the ITAA 1997, it must make a loss from a financial arrangement to which Division 230 applies.

As explained at Question 10, each draw down under the credit agreement is a financial arrangement. Thus, each draw down will have its gains and losses worked out under Division 230 of the ITAA 1997.

Division 230 of the ITAA 1997 does not define 'gain' or 'loss'. The EM provides that, as a general rule, the gain or loss from a financial arrangement can be calculated by subtracting the cost of the financial arrangement from the money received from the financial arrangement. Where the result is a positive amount, a gain will arise. Conversely, a loss will arise where the result is a negative amount.

For the purposes of this ruling, it has been assumed that Company X will not make any of the tax timing method elections contained in Subdivisions 230-C to 230-F of the ITAA 1997. Therefore, Subdivision 230-B of the ITAA 1997 will apply for Company X to work out the gains and losses it makes from this arrangement.

If a gain or a loss is allocated to an income year in accordance with the accruals method, Company X is taken to have made that gain or loss in that income year: section 230-170 of the ITAA 1997. Alternatively, if the realisation method applies to take account of the gain or loss, Company X is taken to have made that gain or loss in the income year in which it occurs: subsection 230-180(1) of the ITAA 1997.

Subdivision 230-B of the ITAA 1997 - the accruals and realisation methods

A taxpayer will apply the accruals method where there is:

· a sufficiently certain overall gain or loss at the time the taxpayer starts to have the arrangement; or

· a sufficiently certain particular gain or loss.

Therefore, in determining whether or not Company X applies the accruals method to a draw down, it needs to be worked out whether or not, and the extent to which, particular financial benefits that are provided or that are received under the arrangement, or so deemed to be provided or received under the arrangement, cause Company X to make gain(s) or loss(es).

It is considered that the receipt of the first draw down under the credit agreement creates an obligation in Company X to provide certain financial benefits into the future. These are:

· the obligation to provide interest on the outstanding amount of the draw down to Company Y as specified;

· the obligation to provide an indemnity payment where Company X is required to make any deduction or withholding for or on account of any tax from the payment of principal, interest or other amounts payable under the draw down; and

· the obligation to repay the principal amount of each draw down by the Final Maturity Date.

This then raises the question as to whether or not these obligations listed above give rise to losses. It is considered that the obligation to provide interest is a loss equal to the amount of interest provided: subparagraph 230-75(4)(c)(i) of the ITAA 1997.

In addition, the amount of the indemnity payment is also a loss because there are no financial benefits received or to be received that are reasonably attributable to it: subsection 230-75(2) of the ITAA 1997.

Overall gain or loss - first draw down under the credit agreement

Company X will make a sufficiently certain overall gain or loss from each draw down only 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 (subsection 230-105(1) of the ITAA 1997).

In deciding whether an overall gain or loss is sufficiently certain, Company X may only have regard to the financial benefits it is sufficiently certain to receive or provide (subsection 230-115(1) of the ITAA 1997).

Subsection 230-115(2) of the ITAA 1997 provides that a financial benefit to be received or provided will be sufficiently certain only if it is reasonably expected that Company X will receive or provide the financial benefit and at least some of the amount or value of the financial benefit is, at that time, fixed or determinable with reasonable accuracy. In assessing whether this requirement is satisfied, it is assumed that Company X will continue to have the financial arrangement for the remainder of its life.

In determining whether a financial benefit is fixed or determinable with reasonable accuracy, certain variables which may affect the value of the financial benefit are deemed to remain constant over the life of the arrangement: subsection 230-115(4) of the ITAA 1997. A draw down will be subject to a variable interest rate. For the purposes of determining if these financial benefits are fixed and determinable with reasonable accuracy, Company X must assume that the interest rate will continue to have the same value it had at the reference point: see subsection 230-115(4) of the ITAA 1997.

Further, the obligation to make an indemnity payment where an amount is deducted or withheld from the interest payment must also be assessed to determine if it is a financial benefit that it is sufficiently certain to be provided. This financial benefit is also an amount that depends on a variable that is based on an interest rate, as the indemnity payment is based on the rate of interest used to calculate the interest payment: see paragraph 230-115(4)(a) of the ITAA 1997. Again, for the purposes of determining if these financial benefits are fixed and determinable with reasonable accuracy, Company X must assume that the interest rate will continue to have the same value it had at the reference point in order to determine if the indemnity payment is a financial benefit that it is sufficiently certain to provide: see subsection 230-115(4) of the ITAA 1997.

Accordingly the only financial benefits Company X is to have regard to in determining whether it makes a sufficiently certain overall gain or loss from a draw down is the first draw down under the credit agreement, the obligation to repay that draw down, and the interest payment and indemnity amount in respect of that draw down. Those benefits may give rise to a loss as discussed in the paragraphs above having regard to the attribution rules. This is a loss of at least a particular amount for the purposes of subsection 230-105(1) of the ITAA 1997 which on the face of it means there is a sufficiently certain overall loss.

Sufficiently certain particular gain or loss - further draw downs under the credit agreement

Company X will have a sufficiently certain particular gain or loss from a financial arrangement where it is sufficiently certain, at a particular time, that a gain or loss of a particular amount, or at least a particular amount. This is when:

· the taxpayer receives a particular financial benefit or one of the taxpayer's rights ceases under the arrangement; or

· the taxpayer provides a particular financial benefit or one of the taxpayer's obligations ceases under the arrangement.

Where a second draw down is made and in the case of each subsequent draw down, further obligations to provide financial benefits under the arrangement constituted by the draw down will become sufficiently certain.

The receipt by Company X of a draw down under the credit agreement subsequent to the first draw down may give rise to a particular loss provided that the amount that is paid (consisting of the repayment of the draw down, interest and indemnity payment(s)) exceeds the receipt(s) in respect of which these payments are made. This is the case in the present circumstances.

The amount of that loss is one that Company X is sufficiently certain to make if the requirements in subsection 230-110(1) of the ITAA 1997 are satisfied in relation to that loss. As discussed above, in respect of the first draw down, and for the same reasons, each of the obligations to provide the financial benefits in respect of a draw down subsequent to the first draw down, being:

· the obligation to pay interest;

· the obligation to make an indemnity payment as required; and

· the obligation to repay the draw down on the Final Maturity Date,

are financial benefits that Company X is sufficiently certain to provide following the receipt of the draw down to which those obligations relate (see paragraph 230-115(1)(b) of the ITAA 1997).

Are the losses described above deductible?

The Commissioner considers that a loss that Company X makes that arises from a financial benefit it provides in the form of interest on a draw down, or an indemnity payment in relation to the interest on that draw down, is deductible under subsection 230-15(2) of the ITAA 1997.

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