Edited version of private advice

Authorisation Number: 1051897119475

Date of advice: 9 September 2021

Ruling

Subject: Taxation of financial arrangements

Question 1

Does the Equity Swap satisfy the definition of 'financial arrangement' pursuant to section 230-45 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Will a gain made by AusCo, as head company of the AusCo tax consolidated group, from the Equity Swap be included in the assessable income of AusCo pursuant to subsection 230-15(1) of the ITAA 1997?

Answer

Yes

Question 3

Will a loss made by AusCo, as head company of the AusCo tax consolidated group, from the Equity Swap be an allowable deduction of AusCo pursuant to subsection 230-15(2) of the ITAA 1997?

Answer

Yes

This ruling applies for the following period periods:

Income year ended 30 June 20XX

Income year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Group structure and overview

AusCo group is an Australian diversified operating and investment group.

AusCo is the head entity of the AusCo income tax consolidated group (the AusCo TCG).

The AusCo group's revenue is primarily assessable and derived in Australia from its 100% owned operating businesses. The AusCo group also holds a broad portfolio of strategic and liquid investments from which it derives both assessable and non-assessable non-exempt (NANE) income.

SubCo, a subsidiary member of the AusCo TCG, is a limited partner in a foreign limited partnership (the LP).

SubCo intends to enter into an equity swap transaction to hedge a certain indirect economic risk exposure related to its investment in the LP.

The AusCo TCG is subject to the taxation of financial arrangements (TOFA) rules contained in Division 230 of the ITAA 1997. AusCo has not made any timing based elections pursuant to Division 230.

Background

The LP is a private equity fund which holds long-term investments.

The interest in the LP has been held by SubCo as a long term capital investment and is not held as trading stock or as a revenue asset. At all times since the LP was formed, SubCo's interest in the LP as a limited partner has always been greater than 10%.

No member of the AusCo group holds any interest in the General Partner of the LP.

One investment held by the LP is shares in ForeignCo, listed on a foreign stock exchange.

AusCo group is unable to participate or exert any influence over the LP's investment decisions.

There is no certainty as to the quantum of distributions which may be paid by the LP to SubCo from time to time. It is not possible for AusCo to direct the LP to sell its indirect interest in ForeignCo shares and return the proceeds to the AusCo group.

SubCo's interests in the LP satisfies the requirements of Subdivision 768-A of the ITAA 1997. Any distributions received by SubCo from the LP are treated as non-assessable non-exempt (NANE) income.

The Equity Swap

SubCo intends to enter into a cash settled equity swap transaction (the Equity Swap) with Entity A to hedge SubCo's indirect economic exposure to ForeignCo shares which it has by virtue of its interest in the LP.

The Equity Swap will result in SubCo having no net economic exposure to ForeignCo shares when its indirect interest in ForeignCo through the LP and the Equity Swap are considered in combination.

The Equity Swap does not reference the LP, other than as an input to calculate AusCo's exposure to ForeignCo shares (i.e. the Equity Swap does not reference the value of the LP, it only references the value of the ForeignCo shares).

SubCo proposes to enter into the Equity Swap because of the high volatility in the share price of ForeignCo shares.

The Equity Swap will be governed by the terms and conditions of an agreement between Entity A and SubCo (the Swap Agreement).

Under the specific terms of the Equity Swap:

•         If the value (the share price) in the underlying interest in ForeignCo increases, SubCo will be required to make a cash payment to Entity A upon termination of the Equity Swap. If the value (the share price) of the underlying interest in ForeignCo decreases, Entity A will be required to make a cash payment to SubCo.

•         SubCo must also pay Entity A a commission on entry and exit (Entry and exit commission) that is calculated as X basis points of the notional value of the Equity Swap.

•         Entity A must pay SubCo a "Floating Amount" which is based on the Australian Bank Bill swap rate and applied to the notional value of the Equity Swap.

•         All obligations under the Equity Swap must be cash settled. The Equity Swap will not be settled through the delivery of shares in ForeignCo.

SubCo may partially terminate the Equity Swap during its term in order to change its economic exposure to ForeignCo. SubCo may take such action where its indirect exposure to ForeignCo through the LP changes.

The payments which will or could be made by SubCo to Entity A under the Equity Swap can be summarised as follows:

•         Entry and exit commissions;

•         Floating Amount (where the result is negative); and

•         A cash settlement amount (where the price of ForeignCo shares increase during the term of the Equity Swap).

The payments which will be made by Entity A to SubCo under the Equity Swap can be summarised as follows:

•         Floating Amount (if the result is positive); and

•         A cash settlement amount (where the price of ForeignCo shares decrease during the term of the Equity Swap).

AusCo group's investment activities

The AusCo group holds strategic and liquid investments in a broad portfolio comprising publicly listed equities, unlisted equities, other ventures as well as property investments.

AusCo derives franked and unfranked assessable dividends and NANE dividends from these investments.

The amount of income derived from the investments is subject to market forces and the extent to which the AusCo group derives assessable income versus NANE income is different for each income year and depends upon which investments are paying dividends. Each investment is selected for its exposure to a particular end market rather than the investment structure.

The AusCo group has an investment strategy and actively manages its investment portfolio and economic risk exposure. AusCo group's Portfolio Manager prepares reports for the Investment Committee on a monthly basis. The Investment Committee reviews investments and opportunities put to them and a monthly investment report is submitted to the AusCo board.

The Audit and Risk Committee of the Board of Directors (the AusCo Board) is responsible for assisting the Board with oversight of the group's risk management framework.

The Investment Committee has actively considered entering into various financial instruments and meets monthly to review existing investments and consider opportunities. The Investment Committee undertakes a detailed selection process for investments and has specific requirements for value and/or a strategic rationale for each investment.

The AusCo group make investments that realise value by enhancing shareholder returns through capital growth and/or dividend income and by providing other strategic benefits.

The AusCo group has used a number of different financial instruments in the past as yield enhancement strategies and to eliminate trading volatility and risk, such as taking derivative positions, entering into both equity settled and cash settled equity swaps, and caps and collars.

As part of the AusCo group's regular investment management, a number of different strategies were considered by the Investment Committee to manage the groups indirect economic exposure to ForeignCo shares. As the group does not have the ability to realise any gains through direct sale of the shares, the Investment Committee looked at methods of realising any gains indirectly. The Investment Committee discussed various proposals before determining that the Equity Swap proposal should be put to the AusCo Board for approval.

Assumption(s)

The LP is not a foreign hybrid limited partnership for Australian tax purposes (as defined in section 830-10 of the ITAA 1997).

The LP is a corporate limited partnership (as defined in section 94D of the Income Tax Assessment Act 1936 (ITAA 1936)). Distributions made by the LP to SubCo are treated as dividends for Australian tax purposes.

The LP is not a Controlled Foreign Company and the AusCo TCG is not subject to the provisions contained in Part X of ITAA 1936 in respect of its investment in LP.

The ForeignCo shares are not expected to pay any dividends during the period of the Equity Swap.

SubCo will continue to hold its interest in the LP during the term of the Equity Swap.

The LP is expected to hold its interest in ForeignCo shares during the term of the Equity Swap. SubCo will close out the Equity Swap if the investment in ForeignCo shares is realised by the LP during the term of the Equity Swap.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 230-15(1)

Income Tax Assessment Act 1997 subsection 230-15(2)

Income Tax Assessment Act 1997 subsection 230-30(2)

Income Tax Assessment Act 1997 subsection 230-30(3)

Income Tax Assessment Act 1997 section 230-40

Income Tax Assessment Act 1997 section 230-45

Income Tax Assessment Act 1997 subsection 230-55(4)

Income Tax Assessment Act 1997 section 230-120

Income Tax Assessment Act 1997 subsection 974-160(1)

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Question 1

Does the Equity Swap satisfy the definition of 'financial arrangement' pursuant to section 230-45 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

Yes, the Equity Swap satisfies the definition of a financial arrangement pursuant to section 230-45.

Detailed reasoning

Division 230 deals with the tax treatment of gains and losses from financial arrangements.

For Division 230 to apply to the Equity Swap, the Equity Swap must be an arrangement that satisfies the definition of a financial arrangement.

Will the Equity Swap constitute an arrangement for the purposes of Division 230?

To determine whether the Equity Swap is a financial arrangement, it is first necessary to identify the arrangement being tested.

An arrangement is defined in subsection 995-1(1), 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.

There are a number of rights and obligations under the Equity Swap.

In testing the arrangement, it is necessary to determine whether these rights and obligations form a single arrangement or whether these rights and obligations constitute two or more separate arrangements.

Subsection 230-55(4) sets out factors that need to be considered when determining whether rights and/or obligations form a single arrangement or two or more separate arrangements for the purposes of Division 230. Whether a number of rights and/or obligations constitute one or more arrangements is a question of fact and degree.

Subsection 230-55(4) provides:

(4)  For the purposes of Division 230, 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 determined 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), and

(f)    the objects of this Division.

In applying subsection 230-55(4), regard must be had to all of the matters referred to in paragraphs (a) to (f).

Taxation Ruling TR 2012/4 Income tax: the operation of subsection 230-55(4) of the Income Tax Assessment Act 1997 in determining what is an 'arrangement' for the purposes of the taxation of financial arrangements under Division 230 (TR 2012/4) provides the Commissioner's view on the application of subsection 230-55(4) in determining whether a number of rights and/or obligations are themselves an arrangement or are two or more separate arrangements for the purposes of Division 230.

TR 2012/4 provides (at paragraph 6) that it will often be the case that the arrangement is consistent with the legal form of the arrangement. That is, a subsection 230-55(4) arrangement will often be the rights and obligations under a particular contract.

In applying the factors at subsection 230-55(4) to SubCo's rights and obligations in respect of the Equity Swap, relevant matters considered include:

•         SubCo has a right to receive certain payments from Entity A and the obligation to provide certain payments to Entity A. These rights and obligations arise under a single contract, being the Swap Agreement between Entity A and SubCo.

•         All of the obligations to make cash payments in respect of the Equity Swap only exist during the term of the Equity Swap; and

•         The rights and obligations in respect of the Equity Swap cannot be dealt with separately

•         The normal commercial understanding and normal commercial practice is for swaps of this nature to be dealt with as a single instrument.

•         Treating the Equity Swap as a single arrangement would not defeat the objects of Division 230.

Having regard to the factors in subsection 230-55(4), on balance, SubCo's rights and obligations under the Equity Swap can be grouped into a single arrangement for the purposes of Division 230.

Accordingly, the Equity Swap will constitute an arrangement as defined under section 995-1.

Will the Equity Swap constitute a financial arrangement under section 230-45?

Section 230-45 is the general test for a Division 230 financial arrangement.

Subsection 230-45(1) of the ITAA 1997 provides:

You have a financial arrangement if you have, under an *arrangement:

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

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

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

unless:

(d)  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

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

                                                     (i)        the thing that you have the right to receive, or the obligation to provide, is not a financial benefit; or

                                                    (ii)        the right or obligation is not cash settlable; and

(f)    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) or (c).

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

Are there cash-settlable legal or equitable rights to receive or obligations to provide financial benefits under the Equity Swap?

Subsection 230-45(2) specifies the circumstances in which a right to receive or obligation to provide a financial benefit that you have is cash settlable.

In regards to the Equity Swap, the relevant rights and obligations that SubCo will or could have are:

•         An obligation to make payments to Entity A, being:

-        Entry and exit commissions

-        Floating Amount (where the result is negative)

-        A cash settlement amount (where the price of ForeignCo shares increases)

•         A right to receive payments from Entity A, being:

-        Floating Amount (where the result is positive)

-        A cash settlement amount (where the price of ForeignCo shares decreases)

Paragraph 974-160(1)(a) defines financial benefit to mean anything of economic value.

Subsection 230-45(2) provides that:

A right you have to receive, or an obligation you have to provide, a *financial benefit is cash settlable if, and only if:

(a)  The benefit is money or a *money equivalent; ...

As each of the relevant rights and obligations that arise from the Equity Swap are in respect of money, SubCo's rights and obligations under the Equity Swap constitute cash-settlable rights to receive or obligations to provide financial benefits.

Are there any relevant non-insignificant rights or obligations under the Equity Swap?

Paragraphs 230-45(1)(d) - (f) are not satisfied in respect of the Equity Swap as there are no non-insignificant rights or obligations that are either not cash settlable or in respect of something that is not a financial benefit.

Conclusion

As SubCo has cash settlable rights and obligations under the Equity Swap, and paragraphs 230-45(1)(d) - (f) are not satisfied, the Equity Swap is a financial arrangement under section 230-45.

Question 2

Will a gain made by AusCo, as head company of the AusCo tax consolidated group, from the Equity Swap be included in the assessable income of AusCo pursuant to subsection 230-15(1) of the ITAA 1997?

Summary

Yes, a gain made by AusCo from the Equity Swap will be included in the assessable income of AusCo pursuant to subsection 230-15(1) of the ITAA 1997.

Detailed reasoning

AusCo has not made any TOFA tax timing elections under Division 230. Pursuant to section 230-40, the accruals and the realisation methods under Subdivision 230-B are the default methods which apply to financial arrangements that are not subject to any of the elective tax timing methods of Division 230.

In applying subdivision 230-B to the Equity Swap, section 230-120 needs to be taken into account when considering financial arrangements with a notional principal. Section 230-120 provides special rules for determining the timing and recognition of gains and losses from financial arrangements which involve a notional principal. Where section 230-120 applies, the gains and losses from the arrangement are to be worked out under subsection 230-120(3).

The note under subsection 230-120(1) confirms that a swap contract is an example of a financial arrangement to which section 230-120 applies.

Gain and losses in respect to the Equity Swap are gains and losses made from a financial arrangement which involves a notional principal and are to be worked out under section 230-120.

As AusCo may make a gain from the Equity Swap, where the share price of ForeignCo decreases, the question arises as to whether such a gain will be included in the assessable income of AusCo.

Is a gain made by AusCo from the Equity Swap determined under subdivision 230-B assessable?

Generally, under Division 230 a gain you make from a financial arrangement is included in your assessable income in accordance with subsection 230-15(1).

However, subsection 230-30(2) provides that, despite section 230-15, a gain made from a financial arrangement will be exempt income or NANE income to the extent that, if the gain had been a loss instead (a 'hypothetical loss'), the hypothetical loss would have been made in gaining or producing exempt income or NANE income.

Taxation Ruling TR 2012/3 Income tax: taxation of financial arrangements - application of subsections 230-30(2) and 230-30(3) of the Income Tax Assessment Act 1997 to gains and losses relating to exempt income or non-assessable non-exempt income (TR 2012/3) explains the principles that apply in deciding whether or not a loss you make, or hypothetical loss you would have made, from a financial arrangement is made in gaining or producing exempt income or NANE income for the purposes of subsections 230-30(2) and 230-30(3).

The principles are set out in paragraphs 9 to 14 of TR 2012/3 and include:

•         The words 'in gaining or producing' require an examination of whether or not there is a sufficient nexus or connection between the identified loss and an income producing activity. Whether a sufficient nexus exists will depend on the nature of the loss and the degree of its connection with the activities by which the taxpayer is gaining producing the relevant income.

•         The words 'in gaining or producing' have a wide application (Amalgamated Zinc (De Bavay's) Ltd v. Federal Commissioner of Taxation (1935) 54 CLR 295 at 309; [1935] HCA 81).

•         A loss is made in gaining or producing exempt income or NANE income if the loss is incidental and relevant to the exempt income or NANE income producing activity of the taxpayer (Ronpibon Tin NL and Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; [1949] HCA 15 (Ronpibon)).

•         Incidence and relevance requires an examination of the connection that the making of the loss has with the operations which more directly gain or produce the exempt income or NANE income (Charles Moore & Co (WA) Pty Ltd v. Federal commissioner of Taxation (1956) 95 CLR 344 at 351; [1956] HCA 77 at paragraph 7).

•         Whether a loss has a sufficient connection to the gaining or producing of exempt income or NANE income is a question of fact and circumstances.

TR 2012/3 sets out a number of examples to illustrate the application of these principles. Examples 5 and 6 of TR 2012/3 are of relevance to the particular facts in the present case.

SubCo is entering into the Equity Swap to hedge the price movement in one specific underlying investment of the LP, being the shares in ForeignCo. AusCo does not hold the shares in ForeignCo directly. AusCo has an indirect economic exposure to the shares in ForeignCo via its investment in the LP, an investment which derives NANE income dividends for AusCo. The Equity Swap entitles SubCo to receive a payment where the price of ForeignCo shares decrease during the term of the Equity Swap and obliges SubCo to make a payment where the price of ForeignCo shares increase during the term of the Equity Swap. The Equity Swap does not reference the LP, other than as an input to calculate AusCo's exposure to ForeignCo.

The facts and circumstances of the Equity Swap are similar to Example 5 in TR 2012/3. In Example 5, a resident company enters into a foreign currency forward contract to hedge the foreign currency risk that arises from translating into Australian dollars the forecast earnings of a foreign subsidiary. There was a reasonable expectation that the shares in the foreign subsidiary would pay dividends that were NANE income. Example 5 concludes that:

44. The loss is not made in gaining or producing NANE income. The forecasted earnings of the subsidiary are not sufficiently proximate to the NANE income because they do not bear a sufficiently proximate relationship to the quantum and timing of any dividends which might be ultimately received. Therefore the loss on the forward contract is not sufficiently proximate with the activities and processes that more directly produce NANE dividends.

The explanation in paragraphs 121 and 122 of TR 2012/3 is also relevant. Paragraphs 121 and 122 state:

121. Although the entry into the contract took place in the context of a subsidiary carrying on activities that produce earnings that might eventually be received as NANE income, the contract was not entered into in respect of known, declared or reasonably expected dividends (see Example 4). Therefore the loss is not sufficiently proximate to the production of NANE income...

122. If a gain was made instead of an actual loss such a gain would not be NANE income under subsection 230-30(2). Such a gain would be assessable under subsection 230-15(1).

In the present case, although any distributions received from the LP are treated as NANE income for AusCo, the Equity Swap is not entered into in respect of known, declared or reasonably expected distributions from the LP. There is no certainty as to the quantum of distributions which may be paid by the LP to SubCo from time to time. The Equity Swap is simply intended to lock in the current value of AusCo's indirect interest in ForeignCo shares. Consistent with the reasoning in Example 5, a hypothetical loss on the Equity Swap will not be sufficiently proximate to the production of NANE income dividends from the LP.

Example 5 can be contrasted with Example 4 in TR 2012/3, where a resident company enters into a foreign currency forward contract to hedge the foreign currency risk in relation to a NANE dividend which had been declared but not yet paid. In that example, there is a sufficient connection between the entry into the forward contract with activities and processes that more directly produce the NANE dividend income. Paragraph 41 notes that:

41. The conclusion in paragraph 39 above would not follow where the hypothetical loss made on the forward contract was made in the course of pursuing the making of a speculative gain on the forward contract, as distinct from a purpose of mitigating the specific foreign currency risk in relation to the dividend. This might be indicated where the exposure in respect of the forward contract is not matched with the exposure in relation to the NANE dividend, or is for a different period

Example 6 in TR 2012/3 also provides some relevance when considering the facts of the present case. In Example 6, a resident company borrows Australian dollars to buy foreign currency and acquire further ordinary shares in its foreign subsidiary, which is expected to pay dividends that are NANE income. The resident company enters into a three year foreign currency forward contract to hedge against the currency exchange rate movements relating to the initial cost of its investment (the shares) in the foreign subsidiary. That is, the hedge is entered into in relation to the risk that the capital committed to the foreign investment will diminish in value over the life of the hedge. In that example, the investment in the foreign subsidiary was held as an ongoing investment rather than for trading or speculative purposes and the shares continued to be held after the forward contract expired.

Example 6 concludes that:

49. If the gain had been a loss instead, this hypothetical loss would not have been made in gaining or producing NANE income. The change in fair value of an investment held on an ongoing basis does not affect the NANE income producing potential from that activity. The loss would not be sufficiently proximate with the activities and processes that more directly produce NANE dividends.

The explanation at paragraph 126 relating to Example 6 is also relevant. Paragraph 126 states:

126. In these circumstances, the hypothetical loss made on the forward contract is not made in gaining or producing NANE income as the change in value of an investment held as an ongoing investment does not affect the income-earning potential from that activity. The forward contract does not secure or maintain the use of the capital in the income earning activity, nor does it protect against risks that may imperil that activity. The process by which the NANE income is gained or produced does not include merely minimising the risk of a fall in the Australian dollar value of the capital committed for the period of the hedge or the disposal of the investment at some unknown future time. Therefore the hypothetical loss is too remote from the process of producing NANE income, or any gains from an ultimate disposal of the investment.

Similar to Example 6, AusCo holds the interests in the LP as an ongoing investment. The change in value of AusCo's investment in the LP (as a result of a change in value of the ForeignCo shares or another investment of the LP) does not affect the NANE income earning potential from the investment. The process by which the NANE income is gained or produced from the LP does not include merely minimising the risk of a fall in the value of one specific underlying investment. Further, the Equity Swap does not reference the value of the LP, it only references the value of AusCo's exposure to ForeignCo shares. Following the reasoning in Example 6, a hypothetical loss on the Equity Swap appears too remote from the process of producing NANE income dividends from the LP.

Consistent with the reasoning outlined in TR 2012/3, a hypothetical loss on the Equity Swap will not be sufficiently proximate to the production of NANE income dividends from the LP for the purposes of subsection 230-30(2). Accordingly, if a gain was made on the Equity Swap, such a gain would not be NANE income under subsection 230-30(2). Such a gain would be assessable to AusCo under subsection 230-15(1).

Question 3

Will a loss made by AusCo, as head company of the AusCo tax consolidated group, from the Equity Swap be an allowable deduction of AusCo pursuant to subsection 230-15(2) of the ITAA 1997?

Summary

Yes, a loss made by AusCo from the Equity Swap will be an allowable deduction of AusCo pursuant to subsection 230-15(2) of the ITAA 1997.

Detailed reasoning

As set out above, any gains and losses in respect to the Equity Swap are made from a financial arrangement which involves a notional principal and are to be worked out under section 230-120.

As AusCo may make a loss from the Equity Swap, where the share price of ForeignCo increases, the question arises as to whether such a loss will be an allowable deduction of AusCo.

Generally, under Division 230 a loss you make from a financial arrangement is deductible to the extent that you make the loss in gaining or producing your assessable income, or you necessarily make it in carrying on a business for the purpose of gaining or producing assessable income in accordance with subsection 230-15(2).

The tax treatment of losses related to NANE income is an exception to this general approach of losses being deductible.

Subsection 230-30(3) provides that a loss made from a financial arrangement is not an allowable deduction to the extent it is made in gaining or producing exempt income or NANE income, unless the loss satisfies the description in subsection 230-15(3) of the ITAA 1997.

Consistent with the reasoning set out in Question 2, that a hypothetical loss on the Equity Swap will not be sufficiently proximate to the production of NANE income dividends from the LP for subsection 230-30(2) purposes, an actual loss on the Equity Swap would not be considered to be made by AusCo in gaining or producing NANE income under subsection 1230-30(3).

Accordingly, a loss made from the Equity Swap will be deductible to AusCo where it satisfies either of the paragraphs under subsection 230-15(2).

Subsection 230-15(2) provides:

230-15(2)

You can deduct a loss you make from a *financial arrangement, but only to the extent that:

(a) you make it in gaining or producing your assessable income; or

(b) you necessarily make it in carrying on a *business for the purpose of gaining or producing your assessable income.

Nexus Requirements

The Explanatory Memorandum to the Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008 (TOFA EM) provides (at paragraph 3.72) that the rule in subsection 230-15(2) reflects the general deduction rule in section 8-1, in particular the nexus aspects. This means that case law in respect of the nexus aspects of section 8-1 is also relevant when determining whether losses made from a financial arrangement satisfy subsection 230-15(2).

As such, in order for a loss arising from the Equity Swap to be deductible under subsection 230-15(2), a nexus must be established between the loss and the gaining or production of AusCo's assessable income, or with the carrying on of a business for the purpose of gaining or producing AusCo's assessable income.

In determining whether a loss or outgoing has been made in the course of gaining or producing assessable income or in the carrying on of a business for that purpose, the courts have considered whether:

•         The loss or outgoing is incidental and relevant to the operations or activities regularly carried on by the taxpayer for the production of income (Ronpibon).

•         The loss or outgoing has the essential character of an outgoing incurred in gaining assessable income or necessarily incurred in carrying on a business for that purpose - in other words, an essential character of an income-producing or business expense (Lunney v. FC of T; Hayley v FC of T [1958] HCA 5; (1958) 100 CLR 478 (Lunney)).

In respect of determining whether a loss or outgoing is incidental and relevant, the court in Ronpibon stated (at CLR 57) that:

For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income...

Notwithstanding the differences in other respects in the present provision, the expression "incurred in gaining or producing the assessable income" has been left unchanged and bears the same meaning. In brief substance, to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income.

In relation to the second positive limb in paragraph 8-1(1)(b) of the ITAA 1997, it was held in Ronpibon that a loss or outgoing will be 'necessarily incurred in carrying on' a business if it is 'clearly appropriate' or 'adapted' for the carrying on of the business. Restating the test another way, the court in Magna Alloys and Research Pty Ltd v. FC of T 80 ATC 4542 at 4559 held that a loss or outgoing will be 'necessarily incurred' if it is 'reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business being carried on for the purpose of earning assessable income'.

The court in Charles Moore & Co (WA) Pty Ltd v FCT [1956] HCA 77; (1956) 95 CLR 344 (Charles Moore) at 351 stated that:

...Phrases like the foregoing or the phrase 'incidental and relevant' when used in relation to the allowability of losses as deductions do not refer to the frequency, expectedness or likelihood of their occurrence or the antecedent risk of their being incurred, but to their nature or character. What matters is their connection with the operations which more directly gain or produce the assessable income.

In respect of essential character, in Lunney, Williams, Kitto and Taylor JJ explained (at CLR 501):

Examination of [ earlier] cases,... shows that the expression 'incidental and relevant' was not used in an attempt to formulate an exclusive and exhaustive test for ascertaining the extent of the operation of the section; the words were merely used in stating an attribute without which an item of expenditure cannot be regarded as deductible under the section...

In the context in which they have been used the expressions relied upon... have been intended as a reference, not necessarily to the purpose for which an item of expenditure has been incurred, but, rather, to the essential character of the expenditure itself...

Hill J summarised both principles in FC of T v Firth [2002] FCA 413 (Firth) at [6] as follows:

The positive tests require that there be a connection between the loss or outgoing on the one hand and the assessable income or business on the other. The nature of that connection has been expressed in different ways in the cases. It is sometimes said that there must be a 'perceived connection' between the loss or outgoing and the assessable income or business: FC of T v Hatchett 71 ATC 4184 at 4187... In other cases it has been said that the expenditure must be 'incidental and relevant ' to the operations or activities regularly carried on by the taxpayer for the production of income: Ronpibon Tin NL & Tongkah Compound NL v FC of T (1949) 8 ATD 431 at 435; (1949) 78 CLR 47 at 56, FC of T v Smith 81 ATC 4114 at 4117. These ways of describing the connection that is a necessary prerequisite to deductibility are but part of the process of identifying the essential character of the expenditure in order to determine whether a particular loss or outgoing is in fact incurred in gaining or producing the assessable income or in carrying on a business which more directly contributes to the gaining or production of the assessable income: Lunney v FC of T (1958) 11 ATD 404; (1957-1958) 100 CLR 478 at 413 and 499 respectively.

The Equity Swap relates to an investment which derives NANE dividend income for AusCo. The nexus requirement would not be satisfied in respect of paragraph 230-15(2)(a).

A loss under the Equity Swap would however be deductible to the extent that it satisfies paragraph 230-15(2)(b).

The AusCo group carries on an operating and investment business. The AusCo group has a broad portfolio of investments ranging from listed and unlisted equities, other ventures and property investments. Investments are undertaking for the purposes of gaining returns through both capital growth and dividend income, as well as for other strategic purposes. Whilst the investment operations derive both assessable and NANE income, the investments are selected in accordance with the AusCo group's investment strategy and are selected for their exposure to a particular end market rather than the investment structure. The amount of income derived from the investments is subject to market forces and the extent to which the AusCo group derives assessable income versus NANE income is different for each income year, depending upon which investment declares dividends and to what extent. Overall, AusCo group's investment business is considered to be one that is carried on for the purpose of gaining or producing assessable income.

Necessarily incurred

Based on the case law outlined above, a loss on the Equity Swap will be necessarily made in carrying on AusCo's investment business if it is 'incidental and relevant' to the operations of AusCo's investment business (Ronpibon). The essential character of the loss and its connection with the operations which more directly gain or produce the assessable income also needs to be considered (Lunney and Charles Moore).

In carrying on its investment business, the AusCo group actively manages its investment portfolio and economic risk exposure via the group's Investment Committee and Portfolio Manager. The AusCo group has a clear investment strategy. In line with its risk management framework, the AusCo group has used a number of different financial instruments in the past as yield enhancement strategies, to manage trading volatility and eliminate risk. This has included the purchasing of both equity settled and cash settled equity swaps.

The ForeignCo share has demonstrated high price volatility. The Investment Committee considered a number of different strategies to manage the AusCo group's indirect economic exposure to the ForeignCo investment and to best position the group to realise any gain in the underlying investment. As the group did not have the ability to realise any gains through direct sale of the shares, the Investment Committee looked at methods of realising any gains indirectly and sought approval for the Equity Swap proposal by the AusCo board.

The Equity Swap proposed to be entered into by SubCo is therefore considered to be incidental and relevant to the operations of AusCo's investment business, whereby the economic risks associated with the group's investment portfolio are actively managed via the group's Investment Committee and Portfolio Manager. Any loss on the Equity Swap is considered to be necessarily made by AusCo in carrying on its investment business for the purpose of gaining or producing assessable income.

Therefore, a loss made on the Equity Swap will be an allowable deduction of AusCo under subsection 230-15(2).

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