Edited version of private ruling

Authorisation Number: 1011671577593

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Ruling

Subject: Interest Rate Swaps

Question 1

Are 'in the money' interest rate swaps held by Company A assets for tax cost setting purposes?

Answer

Yes.

Question 2

Are 'in the money' interest rate swaps held by Company A reset cost base assets for tax cost setting purposes?

Answer

Yes.

Question 3

Does subsection 701-55(6) of the Income Tax Assessment Act 1997 (ITAA 1997) operate to enable Company A to deduct the tax cost setting amount of 'in the money' interest rate swaps under section 8-1 of the ITAA 1997?

Answer

Yes.

Question 4

Is the tax cost setting amount of 'in the money' interest rate swaps immediately deductible at the joining time?

Answer
No.

Question 5

If the tax cost setting amount is not deductible at the joining time, is it deductible over the life of the interest rate swaps on a 'properly referable' basis?

Answer

No.

Question 6

Is the tax cost setting amount of 'in the money' interest rate swaps deductible upon realisation of the swaps?

Answer

Yes.

This ruling applies for the following periods:

Year ending 30 June 2008

Year ending 30 June 2009

Year ending 30 June 2010

Year ending 30 June 2011

Year ending 30 June 2012

The scheme commences on:

1 July 2007

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.

Background

Schemes of arrangement were implemented between Company A and Company B, resulting in a merger between the two entities via a 100% share acquisition of Company B's equity interests. Company B and all of its subsidiaries joined Company A's tax consolidated group.

As a result of the merger, the tax values of Company B's assets brought into Company A's tax consolidated group were determined according to the tax cost setting rules contained in Division 705-C of the ITAA 1997.

Company A provides financial services. Through its newly acquired subsidiaries in the Company B group, Company A operates a financial service business.

Interest Rate Swap (IRS)

At the joining time, Company B held significant IRS assets and liabilities in its accounts. These assets and liabilities related to the fair value (that is, market value) of IRS instruments that had been entered into over a number of years prior to the merger.

At the joining time, IRS contracts with an expected net future cash flow (after being discounted to present value) that were positive were recorded as net receivable assets in the balance sheet. IRSs which had an expected positive net cash flow (in present value terms), are herein referred to as 'in the money swaps'. These 'in the money swaps' had a measurable market value, and were allocated part of the allocable cost amount (ACA) at joining time.

These IRSs were an important part of Company B's active hedging strategy to manage its exposure to interest rate risk and maintain its net interest income. This hedging strategy continues under the Company A group.

Company B's interest rate risk was mainly as a result of the mismatch between variable rate borrowing (liabilities) and fixed rate lending (assets) it undertook in the ordinary course of its operations. Whilst the majority of Company B's funding or borrowing was at a floating rate (with reference to market rates), a portion of its lending was at a fixed rate.

Company B's interest rate risk was managed by an internal management committee, with the primary objective being to maintain and enhance the performance of Company B's net interest income over time.

The primary method Company B used to manage interest rate risk was to enter into 'pay fixed-receive floating' IRSs which 'swap' the fixed rate payable to another party, in return for a floating rate receivable from the other party. Without hedging, to the extent that market rates increased, Company B's margin on monies lent, its net interest income, would erode and Company B's profitability would be adversely impacted. These 'pay fixed-receive floating' IRSs hedged this downside risk through locking in the cost of funding for Company B and therefore, also Company B's net interest income. Conversely, where Company B's cost of funding was obtained at a fixed rate of interest and lending was made at variable market rates, Company B would enter into 'pay floating-receive fixed' IRSs.

The terms of Company B's IRSs with external third parties are governed by the International Swaps Dealers Association Master Agreement (ISDA Master Agreement). This agreement outlines the terms and conditions associated with swaps entered into, but not of itself outline the payment terms of a specific swap arrangement. Instead, confirmations are entered into as appropriate between Company B and the third party confirming the payment terms only.

Confirmations referred to the ISDA Master Agreement for all other terms. It is provided in the ISDA Master Agreement that the ISDA Master Agreement, together with each confirmation, forms a single IRS between the parties.

Payment and receipts under the IRSs were generally made on a monthly basis and because the counterparties to the payment 'leg' and receipt 'leg' were the same, a net swap payment or receipt was made each month depending on the movement in the market interest rates. This was in accordance with the netting-off requirements in the IRS.

Company B regularly entered into swap contracts with third parties. As an ordinary part of its business, Company B also provided a swap facility to associated entities on a regular basis. Company A has also traditionally used IRSs as a regular and ordinary part of its business in order to manage interest rate risk, liquidity and capital adequacy.

The IRSs the subject of this ruling were all entered into by Company B with parties that were, at all times, not members of the Company B tax consolidated group. None of those parties to the IRSs became members of the Company A tax consolidated group on or after the merger.

The number of IRS agreements entered into by Company B each month varied, with the figure largely dependent on changes in activity in the financial markets and any economic or global events which altered the perception of future movements in interest rates. Although Company B had IRSs with terms extending to 10 and 20 year terms, the large majority of their IRSs were made on 6 month to 5 years terms.

There was no internal restructuring of the IRSs after the merger. All of the IRSs have since matured or continue to unwind based on the original maturity profile of the IRSs.

Prior to the merger, Company B had a minimal (if any) tax cost for these IRSs, when compared to the fair value of the IRSs at the joining time. This is due to the fact that the IRSs were generally entered into without any consideration or 'premium' being paid in relation to them. All inflows and outflows in relation to the IRSs have been consistently treated as ordinary income and deductions as appropriate in the hands of Company B.

The ACA Process

As a result of the merger, Company A undertook a tax cost setting process pursuant to Sub-Division 705-C of the ITAA 1997. This process involved allocating the cost of holding or acquiring membership interests (plus liabilities and some other adjustments) to the assets of the relevant subsidiary members. The tax cost setting process that Company A undertook in relation to the merger with Company B involved the following steps:

(a) The calculation of Company B's total ACA,

(b) Deducting from the ACA the tax value of retained cost base assets, and

(c) Apportioning the remaining balance of the ACA to Company B's reset cost base assets in proportion to their market values (subject to further adjustments for assets held on revenue account and over-depreciated assets).

Company A considered the 'in the money' IRS to be reset cost base assets, and therefore had their tax cost reset to their market value at the joining time. The tax cost setting amount (TCSA) of the IRSs was calculated on the basis that the swaps are revenue assets under ordinary principles. The limitations under section 705-40 (which limit the amount of ACA which can be allocated to revenue assets), were considered irrelevant in this case as the final TCSA was lower than each IRS's market value.

Assumption

Company A does not make an election under Division 230 of the ITAA 1997 to apply the division to pre-existing financial arrangements.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 70B

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Subsection 701-55(6)

Income Tax Assessment Act 1997 Subsection 705-25(5)

Income Tax Assessment Act 1997 Subsection 705-359(2)

Income Tax Assessment Act 1997 Subsection 713-515(1)

Income Tax Assessment Act 1997 Subsection 713-705(2)

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA of the ITAA 1936 applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA of the ITAA 1936, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

Question 1

The term 'asset' is not defined in Part 3-90 of the ITAA 1997. Given the omission of a definition of asset, it lends to giving it its ordinary meaning in commerce or business.

Taxation Ruling TR 2004/13 addresses the question of what is an asset for the purposes of the tax cost setting rules in Part 3-90 of the ITAA 1997. An asset for the purpose of the tax cost setting rules is anything recognised in commerce and business as having economic value to the joining entity at the joining time for which a purchaser of its membership interests would be willing to pay. In the context of business and commerce, assets would include things that would be expected to be indentified by a prudent vendor and purchaser as having value in the making of a sale agreement. These things would also fall within the scope of a due diligence examination undertaken on behalf of a prudent purchaser.

The Explanatory Memorandum to the New Business Tax System (Consolidation) Bill (No. 1) 2002 states at paragraph 5.19 that: 'An asset, for the purposes of the cost setting rules, is anything of economic value which is brought into a consolidated group by an entity that becomes a subsidiary member of the group'.

An IRS contract is an agreement between two parties to exchange two different cash flows over time in respect of a notional principal amount. At the joining time, an IRS with an expected positive net future cash flow (that is, an 'in the money' IRS), has economic value. The above definition is broad enough to encompass an 'in the money' IRS. It is accepted that an IRS contract which is 'in the money' at the joining time will have value in business and commerce to the joining entity and to the consolidated group.

Question 2

Section 995-1 of the ITAA 1997 states that the term 'retained cost base asset' is to be given the meaning provided by subsections 705-25(5), 713-515(1) and 713-705(2) of the ITAA 1997.

Subsection 705-25(5) of the ITAA 1997 outlines the definition of a 'retained cost base asset' as being:

a) Australian currency, other than trading stock or collectables of the joining entity; or

b) a right to receive a specified amount of such Australian currency, other than a right that is marketable security within the meaning of section 70B of the Income Tax Assessment Act 1936 (ITAA 1936), or

Example: A debt or a bank deposit

c) a right to have something done under an arrangement under which:

§ expenditure has been incurred in return for the doing of the thing; and

§ the thing is required or permitted to be done, or cease being done, after the expenditure is incurred.

Paragraph 705-25(5)(a) is not applicable as an IRS is not Australian currency.

Paragraph 705-25(5)(c) deals with pre-payments and is not applicable. There is no future service to be provided (or thing to be done) in relation to the acquisition of an IRS.

In order for the IRSs to fall within paragraph 705-25(5)(b), it must be established that that swaps constitute 'a right to receive a specified amount of………Australian currency'.

Taxation Ruling TR 2005/10 considers the interpretation of paragraph 705-25(5)(b) and at paragraph 9 provides that, subject to the specific exception for marketable securities within the meaning of section 70B of the ITAA 1936, a retained cost base asset 'is an indefeasible, present right to the actual or constructive receipt of a fixed, nominal amount of Australian currency'.

Payments made under an IRS contract are contingent rights. Any right to receive Australian currency is contingent upon the party having a net receivable amount under the swap agreement, which in turn is dependant on the movements in the interest rates. Therefore, one can not conclude that at the date of the merger there is an indefeasible right to receive payment of a fixed, nominal amount.

At paragraph 30 of TR 2005/10, it is stated that a 'fixed, nominal amount would include a dollar amount that can be definitively arrived at by the use of a formula, rather than an expressly stipulated dollar amount, provided that it is not a self adjusting formula that could result in differing amounts to which there is a right to receive after the date of the agreement'.

Any amounts payable/receivable under an IRS contract are netted off for the duration of the agreement. Therefore, the net amount payable/receivable will change up until the calculation date with reference to the movements in the interest rate. Whilst it is calculated with reference to a formula, the amount is not fixed and the fluctuations in the interest rate may result in no amounts ever being paid/received.

Since the IRSs do not satisfy subsection 705-25(5) of the ITAA 1997, and are not excluded assets under subsection 705-35(2) of the ITAA 1997, they are classified as reset costs base assets.

Question 3

Whether subsection 701-55(6) of the ITAA 1997 applies to the 'in the money' interest rate swaps depends on whether a provision of the ITAA 1997 or ITAA 1936 would apply to work out assessable income or allowable deductions in a way that brings into account the cost of the interest rate swaps, outgoings incurred, amounts paid, or expenditure in respect of the interest rate swaps, or amounts of a similar kind in respect of the interest rate swaps. This in turn depends on the nature of the interest rate swaps, and how they are used in the context of the taxpayer's business (GP International Pipecoaters Pty Ltd v. FCT (1990) 90 ATC 4413).

The taxpayer enters into the interest rate swaps for the purpose of hedging or managing financial risks associated with its business or income producing activities. They are entered into as an ordinary incident of carrying on their business of banking and are therefore affixed with a profit-making purpose: FC of T v. Myer Emporium Ltd (1987) 163 CLR 199 per Mason ACJ, Wilson, Brennan, Deane and Dawson JJ at 209-211 and California Copper Syndicate v. Harris (1904) 5 T.C. 159.

The interest rate swaps are characterised as revenue assets or circulating capital; they are items that are turned over or consumed in the running of the business. The interest rate swaps are not trading stock, as they are not produced, manufactured or acquired for the purposes of manufacture, sale or exchange in a business. In BP Australia Ltd v. FCT (1965) 112 CLR 386 at 398 it was said:

Fixed capital is prima facie that on which you look to get a return by your trading operations. Circulating capital is that which comes back in your trading operations….The lump sums were circulating capital which is turned over and in the process of being turned over yields a profit or loss; they were in part the constant demand which must be answered out of the returns of trade.

The character of the advantage sought in entering into the interest rate swaps was to manage its exposure to interest rate risk and maintain the taxpayer's net income. The interest rate risk arose from a mismatch between variable rate borrowings and fixed rate loans that the taxpayer had entered into in the ordinary course of its business. In essence, the purpose of the interest rate swaps was to maintain the profit the taxpayer makes from lending the funds it obtains from borrowings (including from depositors) at a higher rate than it pays. The interest rate swaps form part of the activities that have been described as an ordinary incident of the business of banking (Punjab Co-operative Bank Ltd, Amritsar v. Income Tax Commissioner Lahore [1940] AC 1055 per Viscount Maugham at 1072-1073). They are entered into as part of the process by which the taxpayer operates to obtain regular returns by means of regular outlays (Sun Newspapers Ltd v. FCT (1938) 61 CLR 337 at 359).

Although most of the banking and insurance cases are concerned with the assessability or deductibility of profits or losses made on the realisation of assets or investments, the principle is not limited to profits made on the disposal of investments (Australia and New Zealand Banking Group Ltd v. FC of T (1994) 94 ATC 4026 at 4041 and AVCO Financial Services Ltd v. FCT (1982) 150 CLR 510 at 518).

In AVCO Financial Services Ltd v. FCT (1982) 150 CLR 510 the High Court considered that the money used in the business of borrowing and lending is analogous to trading stock and is on revenue account (518, 527, 530, 531). In Modern Permanent Building and Investment Society v. FCT (1958) 98 CLR 187 Williams J said at 191 'money can in a metaphorical sense be said to be the stock-in-trade of a bank'.

Therefore the interest rate swaps would be acquired on revenue account for the purposes of subsection 701-55(6) of the ITAA 1997 and therefore sections 6-5 and 8-1 of the ITAA 1997 apply. However, there is a question as to what is to be allowed by way of deductions under section 8-1. If only the net proceeds are brought to account as assessable income, it will be the loss incurred on the realisation or expiry of the swap that is deducted under section 8-1.

Questions 4, 5 and 6

The 'cost' of acquiring a swap, and any proceeds received on the realisation or expiry of a swap are of a capital nature. However, the difference between the costs of acquisition and any realisation proceeds, that is the net gain or loss, is on revenue account and hence either assessable income or an allowable deduction. It is the detachable difference between the sums; that is the net amount or net profit that bears the character of income (Coles Myer Finance Ltd v. FC of T (1993) 176 CLR 640 and Commercial and General Acceptance Ltd v. FC of T (1977) 137 CLR 373 at 382-282).

The interest rate swaps do not form part of the fixed capital of the business of the taxpayer; they are entered into on revenue account and are akin to circulating capital. Circulating capital describes the situation where the taxpayer profits from their capital by realising or parting with it, not by retaining it and deriving income from it. The money expended on acquiring interest rate swaps will come back to the taxpayer in the form of profits payable under the swap contract, or in the event that the swap is realised or terminated. The money expended on the swaps is turned over or consumed in the course of the taxpayer's trading operations and in the process of doing so yields a profit or loss.

In Lamont v. Commissioner of Taxation [2005] FCA 513 Hill J said at [45]:

Except for expenditure on trading stock there are few, if any, examples where expenditure on assets has been said to be on revenue account. Rather, in cases where the expenditure is not expenditure on trading stock what is brought to account is the net profit or net loss as the case may be of the business. Professor Parsons in his work Income Taxation in Australia (Law Book Company, 1985) says at [7.17]: "Where assets are turned over in the carrying on of a business but are not trading stock - the investments of a life insurance company or a banking company, or the investments in London Australia Investment Co Ltd (1977) 138 CLR 106 - the cost of an asset it not deductible though it will enter the calculation of loss or profit on realisation.

The interest rate swaps are assets that are not trading stock but are turned over in the ordinary course of business, the proceeds from the swap in part recover its capital and in part realise a profit, or if it fails to recover its capital, it incurs a loss. The assessment of the net gain or loss of the 'in the money' interest rate swaps must be determined using a method which gives a substantially correct reflex of the taxpayer's true income. In this case the assessment of the net gain or loss at the end of the swap gives a substantially correct reflex of the taxpayer's true income from the swap.

Therefore the deemed payment equal to the tax cost setting amount of each 'in the money' interest rate swap will be taken into account in determining whether an amount of assessable income has been derived under section 6-5 of the ITAA 1997 or an amount of allowable deduction has been incurred under section 8-1 of the ITAA 1997 in respect of the maturity or expiry of each 'in the money' interest rate swap.