Edited version of your private ruling

Authorisation Number: 1012629342190

Ruling

Subject: Taxation of Financial Arrangement (TOFA)

Question 1

Will the Royalty Transactions relating to the payments due to ABC that arise from the Documentation satisfy the definition of an "arrangement" separate from any other rights and obligations that arise from the same Documentation for the purposes of section 230-55 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Will the Royalty Transactions satisfy the definition of a "financial arrangement" for the purposes of section 230-45 of the ITAA 1997?

Answer

Yes

Question 3

Will section 230-180 of the ITAA 1997 apply to determine in which income year a gain or loss that ABC makes under the Royalty Transactions is to be included in assessable income or allowed as a deduction for the purposes of section 230-15 of the ITAA 1997?

Answer

Yes

This ruling applies for the following period

Financial year ended 30 June 20XY to 20XZ

The scheme commences on

1 July 20XX

Relevant facts and circumstances

ABC, an Australian body corporation, providing service to a particular industry, entered into various agreements with an overseas corporation XYZ to develop two technology systems to service that industry, known as system 1 and system 2.

In the beginning, ABC entered into an agreement with XYZ to develop system 1 under which ABC was granted copyright to the system. Later, ABC entered into another agreement with XYZ to develop system 2 along with system 1, with various rights and obligations but without any copyright to it. ABC was entitled to a royalty payment (Royalty Series 1) under this agreement (Original Agreement) for each unit of the system 2 sold.

Later it was found that development of system 1 was not viable. In a later year, ABC entered into another agreement with XYZ where the agreement in relation to the development of system 1 would cease but ABC would continue participating with developing system 2. Accordingly a deed of variation (Deed of Variation) was entered into between the parties whereby not only the development of system 1 was abandoned but some changes were made to the rights and obligations of the parties in relation to the development of system 2. This Deed of Variation and the Original Agreement are termed here as the Documentation. Under the new agreement, ABC was entitled, on satisfying various terms and conditions, to a royalty payment (Royalty Series 2) for each unit of the system 2 sold.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 Division 974

Reasons for decision

Unless otherwise stated all legislative references are to the Income Tax Assessment Act 1997.

Question 1:

Summary

The right to receive Royalty Series 1 and Royalty Series 2 payments (the Royalty Transactions) should be separate arrangements from any other rights and obligations that arise from the Documentation.

Detailed reasoning

Broadly, Division 230 brings to account gains and losses from a unit of taxation for the purposes of Division 230 termed a 'financial arrangement'.

Sections 230-45 and 230-50 provide tests to determine whether you have a 'financial arrangement'. The tests in section 230-45 and in subsection 230-50(2) apply on the basis of whether you have an 'arrangement' of a specified kind.

Accordingly, the first step in applying the definition of "financial arrangement" in section 230-45 is to determine the relevant "arrangement".

The term 'arrangement' is a very broad construct which is defined in subsection 995-1(1) except so far as the contrary intention appears, as 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 Documentation should prima facie be an "arrangement" for these purposes on the basis that they represent a series of agreements between two entities which places rights and obligations on these entities.

However, subsection 230-55(4) determines the scope of that to which section 230-45 and subsection 230-50(2) tests apply, providing criteria by which it is determined whether a number of rights and/or obligations are themselves an 'arrangement' or are 2 or more separate 'arrangements' for the purposes of Division 230.

So, the particular 'financial arrangement' identified by section 230-45 or subsection 230-50(2) will depend on the particular 'arrangement' identified by subsection 230-55(4).

It will often be the case that what is determined pursuant to subsection 230-55(4) to be the 'arrangement' is consistent with the legal form of the arrangement: a subsection 230-55(4) arrangement will often be the rights and obligations under a particular contract. But subsection 230-55(4) can operate to identify as an 'arrangement' something other than the rights and/or obligations under a particular contract.

There are specific grouping rules and disaggregation rules in section 230-55 to determine whether a number of rights and/or obligations constitute one arrangement or more than one arrangement. Whether a number of rights and obligations are themselves one or more arrangements is a question of fact to be determined by having regard to a series of factors. In particular, subsection 230-55(4) provides the following:

(4) For the purposes of this Division, 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 you determine having regard to the following:

a. the nature of the rights and/or obligations;

b. their terms and conditions (including those relating to any payment or other consideration for them);

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);

d. whether they can be dealt with separately or must be dealt with together;

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);

f. the objects of this Division.

In applying this subsection, have regard to the matters referred to in paragraphs (a) to (f) both in relation to the rights and/or obligations separately and in relation to the rights and/or obligations in combination with each other.

According to the Explanatory Memorandum to the Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008 (TOFA EM), in determining whether a financial arrangement exists, the testing time is when the arrangement comes into existence or commences to be held, or following certain changes in the rights and obligations of an arrangement.

Does the Documentation constitute one aggregated arrangement or two or more separate arrangements?

An analysis of each of the subsection 230-55(4) factors is provided below in relation to whether the rights and obligations to receive or provide financial benefits arising from the entire Documentation constitute one aggregated arrangement or two or more separate arrangements.

Nature of the rights and obligations

When viewed as a whole, the terms of the Documentation impose certain material rights and obligations on ABC which have a degree of economic value and should therefore be considered financial benefits in accordance with section 974-160.

Paragraph 2.47 of the TOFA EM states that the various rights and obligations subsisting under a contract will typically constitute the relevant arrangement for the purposes of Division 230.

However, paragraph 2.50 of the TOFA EM then proceeds to say that when considering the nature of the rights and obligations, regard should be had also to the substance and character of these rights and obligations. The Commissioner has acknowledged these principles in Taxation Ruling TR 2012/4 (TR 2012/4).

In this respect, it is noted that the rights and obligations listed above stem from the same set of related legal documents.

Importantly, ABC has no ownership rights over the system 2 and associated IP relating to ABC which vests with XYZ upon its creation. Therefore, there are no further rights or obligations apart from those that arise under the Documentation.

ABC's rights to the royalties were fully "earned" by it at that time the obligations to make payments under each of the original agreement and the Deed of Variation was discharged and ABC did not have any further obligations to undertake further actions to have an unconditional right to receive the royalties.

Therefore, following ABC's' payment of the Development Cost to XYZ, the overall effect, in substance, for ABC of the above rights and obligations under the Documentation is that it effectively receives three separate forms of potential income streams.

Although the royalty streams essentially have two components, these rights are not considered to be separate from each other as it is only the amount of the royalty that changes over the course of time depending on the rate of return achieved by ABC and does not constitute a separate arrangement with XYZ with respect to the royalty rights.

This factor is therefore considered to be neutral in the determination of whether there is one or more than one arrangement. Whilst the legal form of the Documentation creating the subject rights and obligations to financial benefits indicates that there is one aggregated arrangement, the overall substance indicates that there are three separate arrangements.

Terms and conditions

While ABC's rights to receive the royalty are perpetual rights, the other rights and obligations arising under the Documentation have a limited period. Also ABC's entitlements to the royalties are linked to the payment of two respective amounts. Therefore the Documentation provides a clear nexus between these financial benefits and, importantly, do not provide such a nexus between these financial benefits and other financial benefits arising from the same Documentation.

This factor is therefore considered to be positive in the determination of whether the Documentation comprises more than one arrangement.

Circumstances surrounding creation

The TOFA EM states at paragraph 2.50 that consideration should be had to the intentions of one or both parties in entering the arrangement.

The intention of both ABC and XYZ in creating the rights and obligations with respect to the further development of system 2 (versus the system 1 development project which was entered into earlier for the development of a new type of technology) contained in the original agreement must objectively have been that they were all to arise at the same time given they were created under the same legal document. The main reason for this was to document in the one place all arrangements between ABC and XYZ relating to the development of the system 1 and system 2 and, therefore, the fact that there is one legal document does not indicate an intention for there to be just one arrangement. Whilst it does indicate that the rights and obligations under the Documentation would not have arisen independently of each other, it is noted that Example 2.1 of the TOFA EM states that "the fact that the swap and the borrowing may not have been entered into without the other, is not sufficient for them to comprise one arrangement."

Once again, the rights to receive the royalties are perpetual rights, whilst the other rights and obligations arising under the Documentation have a limited period. Therefore, the intention of the parties to the Documentation must objectively have been that there was more than one arrangement as the Royalty Transactions would continue to exist despite the existence of the other rights and obligations from the same Documentation.

This factor is therefore considered to be positive in the determination of whether the Documentation comprises more than one arrangement. Whilst the circumstances surrounding creation could arguably point towards the existence of one arrangement, the circumstances surrounding expected performance and termination point more heavily towards disaggregation.

Separate rights and obligations

Consistent with the Commissioner's view outlined in paragraph 19 of Taxation Ruling TR 92/14 (TR 92/14), this factor only looks to the legal, rather than commercial, constraints on whether the rights and obligations can be dealt with together or separately.

Again, under the Documentation, the right to receive the royalties can be disposed of by ABC separately from and without altering its rights and obligations under the Documentation.

Once again, the legal terms also allow the Royalty Transactions to continue to exist once the other rights and obligations arising under the Documentation are extinguished.

Therefore, whilst the rights and obligations to financial benefits under the Documentation may be closely linked, the legal terms are such that they are not dictated by each other.

For completeness, it is noted that the examples of aggregated arrangements given in the TOFA EM, particularly Examples 2.2 and 2.3, generally deal with situations where the rights and obligations arising from the arrangement cannot be separated from the instrument itself. For example, the rights granted to the holder of the convertible note in Example 2.2 are attached to the holding of the convertible note and each of these rights cannot be considered separately from the instrument as it would lose its commercial characteristics. Example 2.3 similarly deals with rights to receive income from a bond. Such characteristics do not exist in the current circumstances.

This factor is therefore considered to be positive in the determination of whether the Documentation comprises more than one arrangement.

Normal commercial understandings and practices

Paragraph 2.50 of the TOFA EM states that:

"a comparison with similar or typical commercial arrangements may help determine the commercial understanding of the relevant rights and/or obligations under consideration".

The other identifiable rights and obligations to financial benefits arising from the Documentation are not a standard feature of royalties and as the decision to grant a right to a royalty represents a separate commercial decision as to whether to allow a purchase discount or provide exclusive rights to sell a product, it is considered that these rights are not one aggregated arrangement.

This factor is therefore considered to be positive in the determination of whether the Documentation comprises more than one arrangement.

Purpose of Division 230

The objects of Division 230 are contained in section 230-10 as follows:

n 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;

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

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

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

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

It is noted here that the Royalty Transactions are separately accounted for as financial assets and the amounts paid to acquire the royalty streams are fair valued in accordance with AASB 139. This has the effect that the amounts paid to acquire the royalty streams are amortised as an expense over the expected life of the arrangements. This aligns with the expected tax treatment under Division 230 should the Royalty Transactions be regarded as separate arrangements.

By more closely aligning the tax and accounting treatments, treating the Royalty Transactions as separate arrangements appropriately takes account of, and minimises, compliance costs for ABC.

This factor is therefore considered to be positive in the determination of whether the Documentation comprises more than one arrangement.

Conclusion

The analysis undertaken above of each of the subsection 230-55(4) factors produces the result that none of the factors clearly point to aggregation of the rights and obligations as being the most appropriate treatment.

Division 230 does not provide guidance on what weight to place on the various factors, which implies that appropriate weight should be given to each of the factors in the context of the relevant circumstances.

As stated above, TR 2012/14 provides quite significant detail in relation to the Commissioner's view on the intended operation of subsection 230-55(4) in determining what is an "arrangement" for the purposes of Division 230. In relation to balancing the factors contained in subsection 230-55(4), the Commissioner states at paragraph 138 of TR 2012/14 that "the criteria are to be read together rather than merely separately, and as providing an overall conclusion, not as an approach of mere mechanical arithmetic". The result of the above analysis that more factors point towards disaggregation than aggregation, whilst very relevant, is not therefore ultimately determinative.

Given the nature of the transaction, the applicant submits that the most significant weight should be placed on the terms and conditions, the ability to deal with rights and obligations separately, as well as commercial understandings and practices. All of these factors point towards disaggregation as the most appropriate treatment.

On this basis the most appropriate application of subsection 230-55(4) is to treat the Royalty Transactions as separate arrangements to the other rights and obligations arising under the Documentation.

Question 2:

Summary

The Royalty Transactions will satisfy the definition of a "financial arrangement" for the purposes of section 230-45.

Detailed reasoning

Subsection 230-50(1)

Subsection 230-50(1) provides that a taxpayer has a financial arrangement if the taxpayer has an equity interest. The equity interest would constitute the financial arrangement.

In Taxation Determination TD 2011/12 (TD 2011/12), the Commissioner outlined his view that where an arrangement constitutes a financial arrangement under both subsection 230-45(1) and subsection 230-50(1), subsection 230-50(1) applies in preference to subsection 230-45(1).

A threshold question is therefore whether either of the Royalty Transactions constitutes an equity interest in XYZ.

Sections 974-70 and 974-75 together provide that a scheme gives rise to an equity interest in a company if, when the scheme comes into existence, it gives rise to one of the following interests (items 1-4):

Items:

1. An interest in the company as a member or stockholder of the company;

2. An interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is in substance or effect contingent on the economic performance of the company or a connected entity of that company, or a part of the company's activities or of a connected entity's activities;

3. An interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is at the discretion of the company or a connected entity of the company; or

4. An interest issued by the company that gives its holder a right to be issued with an equity interest, or an interest that will or may convert into an equity interest.

Scheme is defined broadly in section 995-1 to include "any arrangement" or "any scheme, plan, action, course of action or course of conduct, whether unilateral or otherwise". On this basis, the Royalty Transactions should both constitute a "scheme" as defined.

Neither Royalty Transaction gives rise to an interest in XYZ as a member or stockholder and, as such, Item 1 can have no application to the Royalty Transactions.

In relation to the remaining items, it is noted that subsection 974-75(2) further requires that the scheme be a "financing arrangement" for the company for it to be classified as an equity interest under these items.

Pursuant to subsection 974-130(1)(a), a scheme is a financing arrangement for an entity if it is entered into to raise finance for the entity. As the Royalty Transactions resulted in XYZ receiving cash amounts of certain amount, XYZ has raised finance from the arrangements and this subsection would prima facie be satisfied.

However, subsection 974-130(4) provides a list of schemes that are taken not to be entered into or undertaken to raise finance, one of which is a scheme for the payment of "royalties" (other than in specific listed circumstances that are not relevant to the current transaction).

The definition of "royalty" is contained in section 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936) and includes, inter alia, any amount paid or credited, however described or computed, and whether the payment or credit is periodical or not, to the extent to which it is paid or credited, as the case may be, as consideration for:

• the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trademark, or other like property or right;

• the use of, or the right to use, any industrial, commercial or scientific equipment; or

• the supply of scientific, technical, industrial or commercial knowledge or information.....

Again it is noted that the Documentation does not provide ABC with any ownership rights over the system 2 and associated intellectual property. As the subject royalties arise under the Documentation as a result of funding provided by ABC, rather than from the use of any ABC copyright, provision of specific knowledge, or any other scenario listed in the definition of "royalty" above, it is unlikely that the Royalty Transactions result in a "royalty" as defined in subsection 6(1) of the ITAA 1936. It is therefore possible that the Royalty Transactions constitute a "financing arrangement" for XYZ.

Assuming this is the case, it is noted that the amount of royalties paid by XYZ under either Royalty Transaction are not at the discretion of XYZ, but rather in accordance with the formula provided by the Documentation. Further, none of the rights granted to ABC under the Royalty Transactions will or may convert into equity interests in XYZ in the future. Therefore, items 3 and 4 above can have no application to the Royalty Transactions.

In relation to item 2 above, as the amount of royalties paid by XYZ to ABC are linked to the sales of system 2 units, the question is whether that arrangement qualifies as an interest that carries a right to a variable return from XYZ that is in substance or effect contingent on the economic performance of part of XYZ's activities.

In this regard, paragraph 2.32 of the Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001 states:

There can be circumstances where a right to a return or an amount of a return is based on the turnover of the entity obliged to make the relevant payments. An example is a lease contract where part of the rentals is based on the lessee's turnover. Generally speaking, turnover-based returns will be excluded from being regarded as contingent on economic performance in the relevant sense

The same analysis should be applied to the current royalty scenario as sales of system 2 units are not a close proxy for the economic performance of XYZ or any part of its activities.

On the basis of the above, neither Royalty Transaction should constitute an equity interest for the purposes of Division 974 of the ITAA 1997. Therefore, neither Royalty Transaction should constitute a financial arrangement for the purposes of subsection 250(1).

Section 230-45 (application to the Royalty Transactions)

As the Royalty Transactions are not financial arrangements under section 230-50, consideration must be given to whether the Royalty Transactions each satisfy the definition of a financial arrangement under section 230-45.

Subsection 230-45(1) specifies that you have a financial arrangement if you have, under an arrangement, a cash settlable legal or equitable right to receive, or obligation to provide, a financial benefit, unless, you also have under the arrangement, rights to receive or obligations to provide something that is not cash settlable and not insignificant in comparison to the cash settlable rights or obligations.

It is noted that under the Documentation, ABC has no ownership rights over the system 2 and associated intellectual property. The funding provided by ABC is consideration for the rights it received to the future income streams tied to the sales of the system 2 units. This funding was used by XYZ to develop the system 2 and was not payments by ABC in return for XYZ's agreement to deliver a product to ABC. This is supported by the fact that the payments of the agreed amount are fixed payments and do not change in accordance with the actual costs incurred by XYZ well in respect of the development of the system 2. Therefore the above material rights and obligations are the only relevant rights and obligations to be considered under the Documentation and are termed the Royalty Transactions with reference to the timing of when these rights and obligations come into existence.

As stated previously, for section 230-45 to be satisfied, the rights and obligations to provide or receive the financial benefits identified above need to be "cash settlable". In accordance with subsection 230-45(2), such rights and obligations are cash settlable if and only if:

(a) the benefit is money or a money equivalent;

(b) in the case of a right - you intend to satisfy or settle it by receiving money or a money equivalent or by starting to have, or ceasing to have, another financial arrangement;

(c) in the case of an obligation - you intend to satisfy or settle it by providing money or a money equivalent or by starting to have, or ceasing to have, another financial arrangement;

(d) you have a practice of satisfying or settling similar rights or obligations as in (b) and above (whether or not you intend to satisfy or settle the right or obligation in that way);

(e) you deal with the right or obligation, or with similar rights or obligations, in order to generate a profit from short-term fluctuations in price, from a dealer's margin, or from both;

(f) none of the above applies but you satisfy subsection 230-45(3); or

(g) you are able to settle the right or obligation as mentioned in (b) or (c) (whether or not you intend to satisfy or settle the right or obligation in that way) and you do not have, as your sole or dominant purpose for entering into the arrangement under which you are to receive or provide the financial benefit, the purpose of receiving or delivering the financial benefit as part of your expected purchase, sale or usage requirements.

On examination of the Documentation, it is established that all rights and obligations arising from the Royalty Transactions are cash settlable. As such, each of the Royalty Transactions should constitute a "financial arrangement" in accordance with section 230-45.

Question 3:

Summary

Section 230-180 will apply to determine in which income year a gain or loss that ABC makes under the Royalty Transactions is to be included in assessable income or allowed as a deduction for the purposes of section 230-15.

Detailed reasoning

Section 230-180 should apply to determine in which income year a gain or loss that ABC makes under the Royalty Transaction is to be included in assessable income or allowed as a deduction for the purposes of section 230-15.

Section 230-180

Given that ABC has not made any other relevant tax timing elections under Division 230, the accruals or realisation method will apply to determine the amount and timing of gains and losses from the Royalty Transactions pursuant to Subdivision 230-B.

The circumstances in which the accruals method is to apply are specified in subsections 230-100(2) and (3). The accruals method will apply to the extent that the financial arrangement will produce a "sufficiently certain" gain or loss at the time when you start to have the financial arrangement or at any particular subsequent time. If a gain or loss from a financial arrangement cannot be determined with sufficient certainty at a particular time then the realisation method applies pursuant to subsection 230-100(5).

"Sufficiently certain" in relation to financial benefits is defined in section 230-115. Subsection 230-115(2) provides that a financial benefit that you are to receive or to provide is treated as sufficiently certain only where there is a reasonable expectation that the financial benefit will be received or provided and that at least some of the amount or value of the benefit is, at that time, fixed or determinable with reasonable accuracy.

ABC has legal rights to receive royalties in accordance with a fixed formula in the Documentation, as well as legal obligations to provide funding at certain agreed milestones. However, because the amount of royalties that may potentially be received ultimately depends on the amount of sales of system 2, the value of the financial benefits to be received is not "fixed or determinable with reasonable accuracy" until the date a system 2 is sold. Therefore, there should not be an "overall gain or loss" to which the accruals rules under Division 230 should apply.

Similarly, there should not be a "particular gain or loss" to accrue under the financial arrangement on the basis that it is not possible to determine or reasonably estimate when a royalty is to be received until a sale of system 2 is made.

Accordingly, pursuant to subsection 230-100(5), the "realisation" method should apply to determine gains and losses arising from the Royalty Transactions. Section 230-180 then provides that, if a gain or loss is to be taken into account using the realisation method, the gain or loss is taken to be made in the year in which the gain or loss occurs.

We note that the TOFA EM states at paragraph 3.9:

3.9 Division 230 will not contain a definition of a 'gain' or a 'loss'. However, as a general rule a 'gain' or a 'loss' from a financial arrangement may be calculated as follows:

n Step 1 - calculate the money received from a financial arrangement including that received at maturity or upon disposal.

n Step 2 - calculate the cost of the financial arrangement including those expenses at maturity or upon disposal.

n Step 3 - deduct the amount at step 2 from the amount at step 1.

3.10 There will be a gain from a financial arrangement if the amount at step 3 is positive. On the other hand, there will be a loss from a financial arrangement if the amount at step 3 is negative.

3.11 Division 230 will contain rules for determining the amount at step 2 and allocating it to the amount in step 1 so as to ensure that the appropriate amount of gain or loss is subject to Division 230.

In determining when a gain or loss occurs under either of the Royalty Transactions (under which there are a number of financial benefits provided and received), section 230-180 provides that a gain or loss from a financial arrangement is taken to occur at the time at which the last of the financial benefits which is taken into account in determining the gain or loss is provided or is due to be provided. In this regard, paragraph 4.218 of the TOFA EM states:

Further, the rules in relation to the apportionment of financial benefits in sections 230-70 and 230-75 are relevant to determining whether a gain or loss occurs for realisation purposes. In this sense, there could be several gains or losses that are made from a single financial arrangement - which could arise from a number of different payments or receipts made under the arrangement. Such gains or losses might each separately represent a gain or loss which is subject to the realisation method.

Sections 230-70 and 230-75 would therefore be relevant to determining gains or losses from the Royalty Transactions given that there are a series of receipts that may arise under either arrangement.

Subsection 230-70(1) states that subsection 230-70(2) is applied in working out whether you make, or will make, a gain or loss (and the amount of the gain or loss) at a time when you receive a particular financial benefit under the financial arrangement. The gain or loss is to be calculated in nominal (and not present value terms).

Subsection 230-70(2) then states that you must have regard to the extent to which the financial benefits you have provided, or are to provide, under the financial arrangement are reasonably attributable, at the time mentioned in subsection (1), to the benefit or obligation. Any attribution must reflect appropriate and commercially accepted valuation principles that properly take into account:

n the nature of the rights and obligations under the financial arrangement;

n the risks associated with each financial benefit, right and obligation under the arrangement; and

n the time value of money.

Each right to receive a royalty is satisfied or is due to be satisfied on each date of sale of a system 2 unit. Accordingly, a calculation using the principles set out in section 230-70 will be required to determine whether ABC has made a gain or loss at each sales date.

Assessability of gains and deductibility of losses under TOFA

Subsection 230-15(1) provides that gains from financial arrangements are included in assessable income. Accordingly, any gain made by ABC from the Royalty Transactions will be included in the assessable income of ABC under section 230-15.

Subsection 230-15(2) provides that a loss from a financial arrangement is deductible only to the extent:

n It is made in gaining or producing your assessable income; or

n It is necessarily made in carrying on a business for the purpose of gaining or producing your assessable income.

Any loss made by ABC from the financing transaction will therefore be an allowable deduction for ABC under section 230-15 as it will be necessarily incurred by ABC in carrying on a business for the purpose of gaining or producing assessable income.

Specific exclusions from assessability under Division 230

Any gains or losses arising from the Royalty Transactions will not be made in gaining or producing exempt income or non-assessable non-exempt income. We further note that any gains or losses would not constitute a loss of a private or domestic nature.

The exceptions contained in Subdivision 230-H would apply to deem Division 230 not to apply to the Royalty Transactions.

Accordingly, gains or losses made by ABC from the Royalty Transactions should be included in assessable income or be allowable deductions, pursuant to section 230-15, in the income year in which the gain or loss occurs, pursuant to section 230-180.

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