Edited version of private ruling

Authorisation Number: 1011699150581

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Ruling

Subject: Source of income

Relevant facts and circumstances

The taxpayer, an Australian resident superannuation fund, applied for a private binding ruling.

In its application the taxpayer stated that:

§ an entity based in Australia acts as its custodian

§ the fund has a number of investments for which it receives income in foreign currency

§ it maintains a foreign currency hedging program which is implemented and managed by a hedge fund manager based in Australia

§ all the foreign exchange contracts under the hedge fund program are settled (that is, ultimately paid or received) in Australian Dollars in an Australian bank account

§ the counterparties to the foreign exchange hedging contracts entered into by the hedge fund manager may be Australian traders and/or institutions or based offshore

§ the 'back office' support for all the foreign currency contracts the hedge fund manager enters into on behalf of the taxpayer occurs in Australia

§ the hedge fund's management team overseeing the taxpayer's transactions is located in Australia

§ the initial decisions on trade sizes, timing and counterparties with whom to trade are initiated by the hedge fund manager in Australia, prior to being sent to an overseas regional trading desk, whereas for global banks the domicile of the counterparty will vary from trade to trade.

The taxpayer stated that it makes investments with managers who operate on its behalf outside of Australia and in currencies other than Australian dollars.

The investments being hedged are all subject to Australian income tax (including tax on capital gains) as "low tax components" of taxable income, except to the extent that they are used to meet current pension liabilities. The investments derive exempt income to the extent that they are used to meet current pension liabilities.

The taxpayer obtained an actuary's certificate indicating an exempt proportion in respect of the income from investments under question.

Summary

The taxpayer, its custodian, bank and foreign currency hedge manager are based in Australia, where initial decisions on trades are made, settled and provided with 'back office' support. Accordingly, the taxpayer's foreign exchange gains and losses derived under its foreign currency hedging program are domestic source income or losses for Australian tax purposes.

Detailed reasoning

Subsection 6AB(1) of the Income Tax Assessment Act 1936 (ITAA 1936) defines foreign income to mean income derived from sources in a foreign country. There is however, no statutory definition of 'source'.

In Nathan v. Federal Commissioner of Taxation (1918) 25 CLR 183 (Nathan), Issacs J who read the judgment of the Court stated:

The Legislature in using the word "source" meant, not a legal concept, but something which a practical man would regard as a real source of income. Legal concepts must, of course, enter into the question when we have to consider to whom a given source belongs. But the ascertainment of the actual source of a given income is a practical, hard matter of fact.

As discussion of cases cited below indicates, such an 'ascertainment of the actual source of a given income' will consider the following factors:

§ the place where the services are performed

§ the place where the contract is made; and

§ the place where the remuneration is made.

Furthermore, it would be likely that one factor might sometimes be more important than another and the circumstances of each case need to be taken into account (see Spotless Services Limited v. FC of T 93 ATC 4397 at 4409) in a practical way (see Spotless Services Limited v. FC of T 95 ATC 4775 at 4789). Furthermore, where the persons who enter a contract are located in different countries, the place where the contract is entered into will be determined according to the vagaries of the rules of offer and acceptance and might have little impact on what an ordinary person would describe as the real source of the income.

A contract is made by the acceptance of an offer. Sometimes it is difficult to decide who are the offeror and the offeree. For example, in a shop, a storekeeper invites customers to make an offer (invitation to treat), the customer (offeror) makes the offer to purchase and the storekeeper (offeree) accepts the customer's offer when and if payment is accepted.

Where acceptance is by instantaneous communication, such as, by phone or facsimile, the contract is made at the place where the acceptance of the offer is received. Entores Ltd v. Miles Far East Corporation, [1955] 2 QB 327; [1955] 2 All ER 493, is a case where a contract resulted from messages transmitted instantaneously between the parties by teleprinter. At p. 332, Denning, L J, said: 'When a contract is made by post it is clear law throughout the common law countries that the acceptance is complete as soon as the letter is put into the post box, and that is the place where the contract is made', whereas with instantaneous communications his Lordship said, at p. 334: 'The contract is only complete when the acceptance is received by the offeror: and the contract is made at the place where the acceptance is received'.

In the case of foreign exchange contracts, an offer may be made by a person located in one country and accepted by a person located in another. It is considered that the place of contract has less significance if the actual persons who entered into the contract on behalf of the contracting parties were physically located in different countries at the time of entering into the contract.

In such circumstances, the place where an entity carries out its investment and decision-making activities is more important than the place of contract. In Watson v. CT (WA) (1930) 44 CLR 94; 1 ATD 61 (Watson), an accountant in private practice in Western Australia, closed his office temporarily and travelled to Victoria to agitate for proposed change in Federal tax legislation on his client's behalf, for which he was to receive a success fee. It was held that the source of the income (the success fee) was Western Australia (at a time of state income tax) because that was where the taxpayer carried on his practice. Similarly, in Malayan Shipping Company Ltd v. Commissioner of Taxation (Cth) 71 CLR 156 (Malayan) the taxpayer company was found to be carrying on business in Australia as 'the essence of the business was [the principal's] decision in Melbourne to charter and sub-charter' a tanker 'which in every substantial sense gave rise to the profits which the company made …'.

In Esquire Nominees Ltd (as Trustees of Manolas Trust) v. Federal Commissioner of Taxation (Cth) 73 ATC 4114 (Esquire Nominees) a majority of the High Court found that a dividend was derived from sources within the Territory of Norfolk Island rather than in Australia where its income earning operations occurred. Barwick C.J. in his judgment handed down on 24 September 1973 stated that in regard to an investment company: '… its net income from its investments will be its profits … in my opinion, the place where the company makes its investment income will be the place where it has its central management and control'. In Lord Jauncey's words in HK-TVB International Ltd v. Commissioner of Inland Revenue 3 HKTC 468 (HK-TVB) at page 480 ' a proper approach is to ascertain what were the operations which produced the relevant profits and where those operations took place'.

Taxation Ruling TR 94/14 Income tax: application of Division 13 of Part III (international profit shifting) - some basic concepts underlying the operation of Division 13 and some circumstances in which section 136AD will be applied (TR 94/14) reflects similar concepts as follows at paragraph 123:

In determining the source or sources of income or the extent to which expenditure was incurred in deriving income for the purposes of section 136AE, regard would be had, amongst other things, to:

(a)   the nature and extent of any relevant business activities;

(b) the place or places at which the business is carried on;

(c) the functions performed in each country, the assets and skills employed in each country and the risks and responsibilities borne by the various entities;

(d) the economic value added to the relevant property in each location;

(e) the application of common law rules relating to source;

(f)   the degree of connection between each amount of expenditure and the income derived in each jurisdiction;

(g) other circumstances relevant to a particular company and "agreement"; and

(h) the operation of any source rules in any applicable double tax agreement.

In its application the taxpayer has stated that it has a number of investments from which it receives income in foreign currency and accordingly maintains a foreign currency hedging program. The custodian of its fund is an Australian entity and the hedging program is implemented and managed by a hedge fund manager based in Australia.

As stated in the Facts, the initial decisions on trade sizes, timing and counterparties with whom to trade, are initiated in Australia, by the hedge fund manager, prior to being sent to a regional trading desk overseas, whereas for global banks the domicile of the counterparty will vary from trade to trade. All the foreign exchange contracts entered into under the hedging program are settled in Australian Dollars in an Australian bank account managed by an Australian branch of the taxpayer's bank. The counterparties to each foreign exchange hedging contract entered into by the hedge fund manager may be Australian traders and/or institutions or based offshore, however the 'back office' support for all the contracts entered into on behalf of the taxpayer occur in Australia.

In sum: the taxpayer, its custodian, bank and foreign currency hedge manager are based in Australia, where initial decisions on trades are made, settled and provided with 'back office' support. Therefore, the 'practical, hard matter of fact' (Nathan) is that the essential decisions giving rise to the gains and losses (Watson, Esquire Nominees, Malayan and HK-TVB) relating to the foreign currency hedging takes place in Australia. Accordingly, the taxpayer's foreign exchange gains and losses derived under the foreign currency hedging are domestic source income or losses for Australian tax purposes.