Edited version of private ruling

Authorisation Number: 1011611366289

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Ruling

Subject: Foreign exchange gains and losses

Issue 1

Question 1

Will Division 775 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to an exchange gain or loss arising to the MEC group on Payments to settle the loan?

Answer

No.

Issue 2

Question 1

Will an exchange gain or loss that is made by the MEC Group on Payments to settle the loan be on capital account for the purpose of the former Division 3B of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes.

Issue 3

Question 1

Will any exchange gain or loss that is made by the MEC group on Payments to settle the loan be considered a currency exchange gain or loss for the purposes of the former Division 3B of the ITAA 1936?

Answer

No.

Issue 4

Question 1

Will the making of the Payments in respect of the loan give rise to Capital Gains Tax (CGT) event C2 under section 104-25 of the ITAA 1997 or CGT event D1 under section 104-35 of the ITAA 1997 for the MEC group?

Answer

No.

Issue 5

Question 1

Will the exchange gain which arises on the Prepayment of the loan be subject to tax under Division 775 of the ITAA 1997, section 6-5 of the ITAA 1997 or the former Division 3B of the ITAA 1936, or give rise to a capital gain under section 104-25 or section 104-35 of the ITAA 1997?

Answer

No.

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The taxpayer is the provisional head company of a MEC group which entered a loan agreement with a related foreign resident company.

The loan was entered into prior to the applicable commencement date as defined in section 775-155 of the ITAA 1997.

The taxpayer has not made an election under section 775-150 of the ITAA 1997.

Assumptions

This ruling is given on the basis of the facts stated in the description of the scheme as set out above. Any material variation from these facts (including any matters not stated in the description above and any departure from these facts) will mean that the ruling will have no effect. No entity will then be able to rely on this ruling as the Commissioner will consider that the scheme has been implemented in a way that is materially different from the scheme described.

Relevant legislative provisions

Division 3B of the Income Tax Assessment Act 1936 (ITAA 1936)

Section 775-150 of the Income Tax Assessment Act 1997 (ITAA 1997)

Section 775-165 of the ITAA 1997

Section 775-155 of the ITAA 1997

Section 104-25 of the ITAA 1997

Section 104-35 of the ITAA 1997

Reasons for decision

These reasons for decision accompany the Notice of private ruling

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Issue 1 Question 1

Summary

Will Division 775 of the ITAA 1997 apply to an exchange gain or loss arising to the MEC group on Payments to settle the loan?

Detailed reasoning

As the taxpayer entered into the loan before the applicable commencement date and has not made an election under section 775-150 of the ITAA 1997, any forex gain or loss made under FRE 4 is disregarded under section 775-165 of the ITAA 1997.

Issue 2 Question 1

Summary

Will an exchange gain or loss that is made by the MEC group on Payments to settle the loan be on capital account for the purpose of the former Division 3B of the ITAA 1936?

Detailed reasoning

In determining whether a foreign exchange gain or loss is on revenue or capital account, it is necessary to consider the primary purpose of the borrowing to which it relates.

Under the current arrangement, the head company has affirmed that the taxpayer used the loan to acquire shares in Company C from a foreign company to strengthen the capital structure of the Group. The head company has also affirmed that the taxpayer company is not a financing entity, it does not pursue profit by borrowing and on-lending funds, it does not make forex gains as an ordinary incident of business, and the funds were not raised and used as working capital to finance its day to day operations.

The tax characterisation of any foreign exchange gain or loss made on repayment of the outstanding principal will follow the characterisation of the borrowing.

This principle was discussed in Avco Financial Services Ltd v. FCT (1982) 150 CLR 510; (1982) 82 ATC 4246; 13 ATR 63 (Avco) where currency exchange gains and losses arising from the repayment of loans used in the ordinary business of a finance company were held to be revenue in nature. Gibbs J stated:

Where a taxpayer carries on the business of borrowing and lending money, the moneys used for that purpose are analogous to trading stock - the taxpayer in effect deals in the money. Exchange gains and losses, regularly and frequently made and incurred, in the course of making repayments of borrowed money which is used by a taxpayer in making loans in the course of its finance business are outgoings made in the day to day conduct of the business and for the purpose of carrying on the business as a going concern … The exchange losses were in my opinion losses on revenue account, and of course the gains have the same character.

Mason, Aickin and Wilson JJ in Avco stated:

… the borrowing of money and the repayment of loans by a finance company in the ordinary course of its business stand in a different situation from borrowings by a company not undertaken in the ordinary course of its income-earning business. The essence of the business of a finance company as carried on by the taxpayer is the borrowing and lending of money, the rates of interest payable on money lent being significantly higher than the rates payable on the money borrowed, for it is from the difference in the rates that the company generates its profit, after making provision for bad debts. There is therefore an important and material difference between borrowing by a finance company in the ordinary course of its business and borrowing by a manufacturing or trading company. In general the finance company's borrowings provide money which it turns over at a profit. Borrowing otherwise than for on-lending or for the repayment of funds borrowed for on-lending, that is, borrowing undertaken for capital rather than revenue purposes, as is CAGA, is an exception to the general rule. On the other hand, borrowing by a manufacturing or trading company is often undertaken to strengthen the capital or profit-earning structure of the company. A finance company usually borrows in order to increase its working capital which is then turned over at a profit; the manufacturing or trading company frequently borrows to strengthen its permanent capital.

The above principles were reiterated in FCT v. Hunter Douglas Ltd (1983) 14 ATR 629; 83 ATC 4562 (Hunter Douglas), which involved currency exchange losses on the repayment of loans denominated in a foreign currency. In Hunter Douglas, the Federal Court made clear the difference in taxation treatment of foreign exchange gains and losses made by a finance company and a trading or manufacturing company. For the former, the exchange gains and losses could be on revenue account because the company's business is making and taking loans; that is how it pursues profit. On the other hand, a manufacturing or trading company pursues its profits by making or selling goods or services. Fisher J stated:

The position is different where the company is not a finance company but a trading or manufacturing company which incurs exchange losses or gains otherwise than through the purchase of trading stock. Here the losses or gains will in the ordinary course be on capital account. For them to be on revenue account it is necessary for the taxpayer to establish that the additional expenditure to meet exchange losses was expenditure incurred in the process of producing its income, and in the words of Mason, Aickin and Wilson JJ in Avco set out above, as an integral part of that process.

Conclusion

The Loan was not made as an integral part of the borrower's trading activities. It was obtained for a capital purpose. Accordingly, any foreign exchange gain made on repayment of the loan would also be on capital account.

Issue 3 Question 1

Will any exchange gain or loss that is made by the MEC group on Payments to settle the loan be considered a currency exchange gain or loss for the purposes of the former Division 3B of the ITAA 1936?

Detailed reasoning

Despite its repeal, Division 3B of the ITAA 1936 continues to have effect in relation to eligible contracts entered into between 19 February 1986 and a taxpayer's applicable commencement date as defined in section 775-155 of the ITAA 1997.

The loan, entered into in 2004, constitutes an eligible contract as defined in section 82V of the ITAA 1936. The MEC Group's applicable commencement date under section 775-155 of the ITAA 1997 is 1 April 2004. As the loan was issued after 19 February 1986 and MEC group did not make a transitional election under section 775-150 of the ITAA 1936, Division 3B of the ITAA 1936 will continue to apply in relation to the Loan.

Division 3B of the ITAA 1936 operates to include certain foreign exchange gains of a capital nature in a taxpayer's assessable income. Currency exchange gains made under an eligible contract are included in assessable income under section 82Y of the ITAA 1936. Currency exchange losses made under an eligible contract are an allowable deduction under section 82Z.

Paragraph 82V(2)(b) of the ITAA 1936 states that for the purposes of Division 3B, a gain shall be taken to have been made, or a loss to have been incurred, at the time when it is realised. In relation to a loan, this will be when the loan is repaid. This is supported by the Explanatory Memorandum to the Taxation Laws Amendment Bill (No 5) 1986:

An exchange gain will not be assessable, nor an exchange loss deductible, until the gain or loss is realised. In broad terms, in the case of a borrowing or loan, this will be when the borrowing or loan (or an instalment) is repaid …

Federal Commissioner of Taxation v. Energy Resources of Australia (1996) 185 CLR 66; 96 ATC 4536; (1996) 33 ATR 52 (ERA)

In ERA, the High Court discussed what constitutes a currency exchange gain or loss for the purposes of Division 3B of the ITAA 1936. ERA involved the discharge of a US dollar denominated liability using US dollar funds held by the taxpayer where the liability was on capital account. The issue in ERA was whether a currency exchange gain or loss would arise on the discharge of the US dollar liability held by the taxpayer. The High Court made the following comments:

… since the taxpayer dealt only in US dollars, any loss or gain could only be in US dollars, and it was that loss or gain that the Act required to be converted into Australian dollars, not some hypothetical loss or gain arising from fluctuations in the US/Australian exchange rate. The taxpayer received US dollars, paid in US dollars, and did not convert the US dollars into Australian dollars. Where a taxpayer borrows money on capital account in US dollars and repays the loan in US dollars, it makes no revenue profit or loss from the borrowing even though the exchange rate may be different at each date. Indeed, arguably it makes no profit or loss. If it converts the US dollars that it receives into Australian dollars and then converts Australian dollars into US dollars to repay the loan, it may make a profit or loss on the transaction. But the profit or loss results from the exchange transaction and not from the borrowing. Where there is no exchange transaction and the loan is on capital account, the taxpayer makes no loss or gain … .

And further:

… for the reasons that we have already given, the taxpayer made no currency exchange gain or loss. The unit of account and the unit of payment under the contract or contracts involved in this case were US dollars. The taxpayer made no gain or loss under those contracts that was 'attributable to currency exchange rate fluctuations'.

No conversion upon the receipt of loan proceeds

At the time the loan was issued, there was no actual conversion from foreign currency into Australian dollars. Rather, the foreign currency proceeds from the borrowing were used immediately to fund the foreign currency acquisition of Company C shares from a foreign company.

Therefore, there was no conversion from foreign currency to Australian dollars at the time that the loan was issued.

Accordingly no foreign currency exchange gain or loss will arise under Division 3B of the ITAA 1936 in respect of any repayments made under the Loan.

No currency exchange gain made under an eligible contract

ERA also made it clear that for a currency exchange gain or loss to come within Division 3B of the ITAA 1936, any such gain or loss must be made under the eligible contract.

In Victoria Co Ltd v. Deputy Commissioner of Taxation [2000] FCA 1622; 2000 ATC 4755; 46 ATR 119 (Victoria), Lee J, discussed when a currency gain or loss was made under the eligible contract for Division 3B purposes:

In FC of T v. Energy Resources of Australia Ltd 94 ATC 4923 at 4941-4945; (1994) 54 FCR 25 at 50-54, Gummow J explained the meaning of a currency exchange gain or loss in Div 3B and the meaning of the words 'under an eligible contract'. The appeal from that decision was determined in Energy Resources. The reasons of Gummow J were consistent with the reasons expressed by the High Court on the appeal.

As Gummow J stated (ATC pp 4943-4945; FCR pp 53-56), when Div 3B speaks of a gain or loss being made or incurred 'under' an eligible contract it suggests that the gain or loss was made or incurred in exercise of a right, or discharge of an obligation, conferred or imposed by the terms of the eligible contract and not a gain or loss that has, in a broad sense, a contract as the source of that gain or loss.

Although more than one contract may make up the 'eligible contract' for the purpose of Div 3B, the relevant rights and obligations in respect of which currency was purchased and from which a currency exchange rate fluctuation could be identified were to be found in that 'eligible contract'. As expressed by Gummow J (ATC p 4944; FCR p 54):

In my view, a currency exchange gain, for the purposes of the Division, shall be taken to have been made or incurred under an eligible contract when realised in respect of currency purchased in the exercise of rights or the performance of obligations arising under the terms of the eligible contract.

Under the current arrangement, the eligible contract was the Loan. However, there were no terms, rights or obligations under the Loan for conversions of currency to be made. Accordingly, based on the principles enunciated in ERA and Victoria, any currency gain or loss on the Loan would not be made or incurred under the eligible contract.

Conclusion

Given the above, no foreign currency exchange gain or loss will be made or incurred under Division 3B of the ITAA 1936 in respect of repayments made under the Loan.

Issue 4 Question 1

Summary

Will the making of the Payments in respect of the loan give rise to Capital Gains Tax (CGT) event C2 under section 104-25 of the ITAA 1997 or CGT event D1 under section 104-35 of the ITAA 1997 for the MEC group?

Detailed reasoning

CGT event C2

Section 104-25 of the ITAA 1997 states;

CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset:


(a) being redeemed or cancelled; or


(b) being released, discharged or satisfied; or


(c) expiring; or


(d) being abandoned, surrendered or forfeited; or


(e) if the asset is an option - being exercised; or

(f) if the asset is a convertible interest - being converted.

Under the current arrangement the loan is a liability of the head company as the borrower. Under paragraph 52 of Taxation Ruling TR 96/23, the borrower is not considered to own nor dispose of an asset as a result of the creation of an interest in a debt.

The head company as the borrower will not trigger CGT event C2 in respect of the payment to settle the loan as it is not considered to have a CGT asset.

CGT event D1

Section 104-35(1) of the ITAA 1997 describes CGT event D1 as:

CGT event D1 happens if you create a contractual right or other legal or equitable right in another entity.

The head company has not created a contractual right or other legal or equitable right in the creditor or any other entity as a result of the payments to settle the Loan. CGT event D1 will not be applicable to the head company. As a result, no capital gain or loss will arise to the MEC group under section 104-35 of the ITAA 1997.

Conclusion

The payment by the head company to settle the loan will not give rise to CGT event C2 under section 104-25 of the ITAA 1997 nor CGT event D1 under section 104-35 of the ITAA 1997.

Issue 5 Question 1

Will the exchange gain which arises on the Prepayment of the loan be subject to tax under Division 775 of the ITAA 1997, section 6-5 of the ITAA 1997 or the former Division 3B of the ITAA 1936, or give rise to a capital gain under section 104-25 or section 104-35 of the ITAA 1997?

Detailed reasoning

For the reasons submitted in questions 1 to 4 above the prepayment of the loan will not be subject to tax under Division 775 of the ITAA 1997, section 6-5 of the ITAA 1997 or the former Division 3B of the ITAA 1936 nor give rise to a capital gain under section 104-25 or section 104-35 of the ITAA 1997.