Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
Chapter 4 - Regulation impact statement - Tax treatment of foreign exchange gains and losses
4.1 The policy objective of the proposed reforms to the taxation of foreign currency gains and losses is to:
- restore the broad policy intention of the current taxation law (i.e. Division 3B of the ITAA 1936) which has been undermined by judicial decisions (
FC of T v Energy Resources of Australia Ltd
185 CLR 66 and Victoria Co Ltd v DFC of T
2000 ATC 4755 );
- remove anomalies relating to tax treatment of foreign currency gains and losses; and
- provide certainty as to how foreign currency gains and losses are brought to account for tax purposes.
4.2 The measure to reform taxation of foreign currency gains and losses includes the following elements.
- A general translation rule is introduced into the income tax law that translates foreign currency denominated amounts into A$ so that Australian income tax liability is calculated by reference to a common unit of account.
- A 'functional currency' rule is introduced. Under this rule, the net income or loss of an entity (or specified part of an entity) that functions predominantly in foreign currency can be determined in that currency, with the net amount being converted into A$. The functional currency rule is directed at lowering compliance costs associated with the general translation rule.
- A core realisation principle is introduced into the income tax law which, together with the translation rule, ensures that foreign currency gains and losses are generally brought to account when realised, regardless of whether there is an actual conversion of foreign currency amounts into A$. This addresses a number of uncertainties and anomalies which arise under the current law's treatment of foreign currency gains and losses.
- The amendments ensure that foreign currency gains and losses have a revenue character, subject to limited exceptions. This is done by including foreign currency gains in assessable income, and treating foreign currency losses as allowable deductions, when they are realised.
- Exceptions to the timing and characterisation aspects of the realisation approach where the foreign currency gain or loss is closely linked to a capital asset, are introduced. This addresses anomalies between the proposed provisions dealing with the taxation treatment of foreign currency gains and losses and the capital gains and capital allowances provisions.
- Roll-over relief is provided for foreign currency gains and losses of an issuer of short term discounted securities issued under certain finance facility agreements.
4.3 While not explicitly addressed in the recommendations made by A Tax System Redesigned, the proposed reforms are consistent with the recommendations made in this report to reform taxation of financial arrangements.
4.4 The potential compliance, administrative and economic impacts of the measures in this bill have been carefully considered by the Government and through extensive consultation with the business sector. The final bill addresses a number of concerns raised in relation to compliance issues (see paragraph 4.12).
4.5 The proposed reforms to the taxation of foreign currency gains and losses affects all taxable entities dealing in foreign currency, other than ADIs and non-ADI financial institutions. These entities have been excluded from the proposed foreign currency measures for the time being in view of the Government's proposal to introduce more extensive retranslation rules as part of further reform of taxation of financial arrangements. Deferring the application of the foreign currency measures of the bill will significantly reduce the compliance costs that these entities would have otherwise faced.
4.6 The proposed foreign currency reforms address a number of uncertainties and anomalies under the current law's treatment of foreign currency gains and losses. Through roll-over relief, for example, the proposals better reflect commercial financing arrangements. Consequently, the reforms will improve neutrality, clarity and certainty in relation to the taxation of foreign currency gains and losses. In addition, the proposed reforms introduce a 'functional currency' approach that allows aggregation of foreign currency transactions to determine a net amount. These factors are expected to lower compliance costs relative to current law over the medium to long term.
4.7 Taxpayers are currently required to determine the income tax consequences of many foreign-currency-denominated transactions. To some degree, the principles contained in the proposed reforms are already present in the current law implying that, for many taxpayers, there is no or minimal change in compliance costs relative to the current position. However, there could be a small compliance impact for taxpayers in the short-term as they familiarise themselves with the new law.
4.8 In general, the impact of the proposed foreign currency reforms on individuals and small business is expected to be small to negligible, as these taxpayers rarely engage in complex foreign-currency-denominated transactions.
4.9 In terms of the impact on the ATO's administrative processes, no additional on-going costs are expected relative to the cost of administering the current law. However, there are likely to be some relatively small transitional costs associated with internal training, informing taxpayers of the new law and answering taxpayer questions on interpretation of the new law.
4.10 The impact on the Commonwealth's revenue collections is unquantifiable. However, the proposed reforms to the taxation of foreign currency gains and losses is expected to protect the Commonwealth's revenue base which is potentially at risk of being eroded due to the uncertainties of the current tax law.
4.11 The proposed reforms have been subject to extensive consultation. Consultation occurred as part of the Review of Business Taxation over the period August 1998 to July 1999. Following the Government's plans to reform taxation of foreign currency gains and losses in the 2002-2003 Federal Budget, consultations were undertaken with industry representatives on the policy framework to implement this reform. Further consultations were undertaken based on exposure draft legislation that was released by the Government in December 2002.
4.12 Consultations on exposure draft legislation reveal some concerns about compliance costs associated with the transitional rules, the scope of the functional currency rules and how foreign currency denominated bank accounts are treated. The final bill addresses these concerns by:
- providing taxpayers the option to elect existing transactions into the new rules and setting the commencement date at the beginning of the entity's income tax year commencing on or after 1 July 2003;
- extending the functional currency election to cover Australian resident entities which are required to prepare financial accounts under the Corporations Act 2001 , and which conduct their business and keep their accounts in a foreign currency, and to foreign investment funds; and
- introducing a number of measures (namely, a FIFO rule, a retranslation rule and a de minimis rule) to lower compliance costs associated with calculating foreign currency gains and losses in respect of foreign currency denominated bank accounts.
4.13 The proposed measure addresses a number of uncertainties and anomalies relating to the current taxation of foreign currency gains and losses. For these reasons, the proposed measure is expected to provide net benefits to the Australian economy.
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