Edited version of private ruling

Authorisation Number: 1011784129945

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Ruling

Subject: TOFA Accounting Methods

Question 1

Will the accruals method under section 230-100 of the Income Tax Assessment Act 1997 (1997) apply to the financial arrangement between SV and a State Government?

Answer

Yes.

Question 2

Will the allocation of gains arising from the financial arrangement between SV and the State Government using the compounding accruals method satisfy the requirements of paragraph 230-135(2)(a) of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

1 July 2011 - 30 June 2030

Relevant facts and circumstances

Construction Stage

Diagrams were submitted representing the proposed transactions that will occur during the various stages of the Major Project.

A consortium represented by Project Company (as head company of a tax consolidated group) has been selected as the successful bidder to construct stage 1 of the Major Project. Project Company has entered into the Project Deed with a State Government.

Project Company is a company incorporated in Australia and resident of Australia for income tax purposes. Equity contributions are currently nominal, however these will increase over time during the construction period. All equity contributions from establishment through the construction period will be pro rata.

Project Company shareholders will acquire their initial holding prior to Project Company holding any interest in land or entering into any contract or agreement to acquire any interest in land.

The State Government has contracted with Project Company to construct the Major Project. Project Company intends to subcontract this project to third parties.

SV is a company incorporated in Australia for the purposes of the Corporations Act 2001 and is a resident of Australia for income tax purposes.

SV will borrow funds from financial institutions which it will on lend at interest to Project Company in order to fund the construction and associated costs of the Major Project.

Project Company has the right to access the land during the construction period for the purpose of constructing the Major Project development.

The Major Project will be jointly funded by the Governments of the Commonwealth and the State, as well as a City Council.

Construction - State Contribution

A diagram was submitted representing the transactions occurring once 100% of the equity is committed, and 50% of the debt is contributed. These requirements trigger the contribution by State Government of an amount on a progressive basis.

The Applicant has stated that SV will draw down additional funds from financial institutions (beyond the previously mentioned 50% contribution) under an 'on-lending facility' established at the commencement of the Major Project.

SV will then loan these funds to Project Company at an interest rate approximating the rate on the funds it has borrowed.

During this stage, Project Company will pay further construction costs to the third party contractors.

Completion Securitisation Stage

A diagram was submitted representing the transactions occurring on completion of construction.

Project Company will have initially paid for the construction of the Major Project development. However, on completion the State Government will reimburse Project Company for these costs in accordance with the Project Deed.

Further, upon completion, the State Government will enter into a lease over the land comprising the Major Project with Project Company for a period of 15 years.

The State Government will then enter into an agreement with SV and Project Company, by virtue of which SV will pay an amount to Project Company at the direction of the State Government. In exchange for SV receiving the State Government's entitlement to the future lease payments which are to be made by Project Company.

The size of the payment made by SV upon completion of construction of the Major Project (to Project Company on behalf of the State Government), will be calculated utilising the interest rate(s) associated with SV's financing costs. Further, the amount of the lease rental payments (which will ultimately be paid from Project Company to SV under the Agreement) will be negotiated between Project Company and the State Government. At no point will Project Company hold the freehold title in the land the subject of the Major Project.

The Applicant has stated that any gain (or loss) made by SV under the arrangement between SV and the State Government will be spread using the compounding accruals methodology (refer paragraph 230-135(2)(a) of the ITAA 1997).

The Applicant has further stated that the taxpayer has not (and will not) make an election under Division 230 of the ITAA 1997 (in relation to the methodology to be applied in determining how to spread the gain or loss).

The State Government will in part use this upfront securitisation payment to meet its obligations under the construction contract with Project Company.

Project Company will repay part of its outstanding loan from SV represented by the construction payment from the State Government.

Operation Stage

A diagram was submitted describing the operations phase of the Major Project.

Once completed, Project Company will derive 'availability payments' from the State Government in return for the operation of the Major Project. These availability payments are subject to certain levels of abatement based on key performance measures. These payments are contemplated under the Agreement. The final calculation of the amount of the payments has formed part of the pricing detailed in the Agreement between the parties.

Project Company does not bear various risks associated with the Major Project.

Project Company will be obliged to make lease payments under the lease with the State Government. As stated above, these will be subject to a payment direction to SV.

At the end of the 15 year project period, the (leasehold) interests of Project Company in the relevant project assets revert to the State Government for no further consideration.

Completion of Construction Phase - Project Company's position

During the construction phase of the Major Project, Project Company will have borrowed an amount from SV. Further, during the construction phase the Applicant expects that an amount of interest will be payable on these outstanding borrowings.

Project Company will use a portion of the amount borrowed under the loan facility to make payments of interest during the construction phase. In other words, Project Company is borrowing both its capital and interest requirements during the construction phase of the Major Project. At the completion of this construction phase, an amount of principal will be outstanding.

As stated previously, upon entering into the securitisation arrangement at the completion of the construction phase, the State Government will direct a payment to Project Company for its construction costs.

Accordingly, once Project Company applies the proceeds of this payment towards its outstanding borrowings, Project Company will still have an amount outstanding. These outstanding funds, and future interest payments will be repaid over time from operating cash flows

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 Subdivision 230-B

Income Tax Assessment Act 1997 section 230-5

Income Tax Assessment Act 1997 section 230-10

Income Tax Assessment Act 1997 subparagraph 230-10(b)(ii)

Income Tax Assessment Act 1997 section 230-20

Income Tax Assessment Act 1997 section 230-40

Income Tax Assessment Act 1997 subsection 230-40(1)

Income Tax Assessment Act 1997 subsection 230-40(4)

Income Tax Assessment Act 1997 section 230-45

Income Tax Assessment Act 1997 subsection 230-45(1)

Income Tax Assessment Act 1997 paragraph 230-45(2)(a)

Income Tax Assessment Act 1997 paragraph 230-45(2)(b)

Income Tax Assessment Act 1997 paragraph 230-45(2)(c)

Income Tax Assessment Act 1997 paragraph 230-45(2)(d)

Income Tax Assessment Act 1997 section 230-55

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

Income Tax Assessment Act 1997 section 230-100

Income Tax Assessment Act 1997 subsection 230-105(1)

Income Tax Assessment Act 1997 section 230-115

Income Tax Assessment Act 1997 subsection 230-115(1)

Income Tax Assessment Act 1997 subsection 230-115(2)

Income Tax Assessment Act 1997 subsection 230-115(3)

Income Tax Assessment Act 1997 section 230-135

Income Tax Assessment Act 1997 subsection 230-135(2)

Income Tax Assessment Act 1997 paragraph 230-135(2)(a)

Income Tax Assessment Act 1997 section 230-455

Income Tax Assessment Act 1997 Division 974

Income Tax Assessment Act 1997 paragraph 974-160(1)(a)

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Unless specified otherwise, all legislative references in the following reasons for decision are to the Income Tax Assessment Act 1997.

Question 1

The definition of 'financial arrangement' determines the unit of taxation in respect of which gains and losses are recognised under Division 230. In order to determine whether gains and losses arise under a financial arrangement, it is first necessary to establish whether the rights and obligations under the agreement give rise to an 'arrangement' that in turn meets the definition of a financial arrangement.

An arrangement is defined in subsection 995-1(1) and includes any arrangement, agreement, understanding, promise or undertaking, whether express or implied. Section 230-55 modifies this broad notion of arrangement and provides guidance in subsection 230-55(4) as to which specific rights and obligations will make up the arrangement to be tested for the purposes of the Division.

The relevant arrangement is the Securitisation Agreement whereby the SV makes an upfront payment and the State Government assigns its rights to future lease payments to be made by Project Co over the term of the Securitisation Agreement to SV.

This arrangement must meet the definition of a 'financial arrangement' before it will be subject to Division 230.

Is the arrangement identified a financial arrangement under section 230-45?

Subdivision 230-A provides the test for determining whether an arrangement is a financial arrangement. Broadly, an arrangement will be a financial arrangement if it satisfies the 'primary definition' of a financial arrangement under section 230-45 (cash settlable rights and obligations to financial benefits) or the 'secondary definition' under section 230-50 (equity interests and rights and obligations to equity interests).

Subsection 230-45(1) 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.

It is noted that the secondary definition of a financial arrangement in subsection 230-50 does not apply in the present circumstances.

SV's relevant rights to receive and obligations to provide financial benefits under the Securitisation Agreement must be tested against section 230-45. The relevant rights and obligations under the Securitisation Agreement are as follows:

· the right to receive financial benefits being the rights to future lease payments to be made by Project Co over the term of the Securitisation Agreement; and

· the obligation to provide an upfront payment to the State Government of $295 million.

These rights and obligations that arise under the Securitisation Agreement are rights or obligations to receive or provide financial benefits (as defined in paragraph 974-160(1)(a)) for the purposes of section 230-45. Further, the rights and obligations will be cash settlable within the meaning of paragraph 230-45(2)(a) as they are rights and obligations to receive or provide monetary amounts.

As the rights and obligations under the Securitisation Agreement are cash settlable rights to receive and obligations to provide financial benefits, the exclusions to the definition of a financial arrangement in paragraphs 230-45(1)(d) to (f) have no application.

Therefore, the Securitisation Agreement will be a financial arrangement for the purposes of section 230-45.

Is the Securitisation Agreement a financial arrangement to which Division 230 applies?

In order for SV to be assessed on a gain under subsection 230-15(1), it must make a gain from a financial arrangement to which Division 230 applies. Based on facts stipulated by the Applicant, section 230-455 will not operate to exclude any gains or losses made from the Securitisation Agreement by the SV from the operation of Division 230. Further, the exclusion rules in sections 230-460 have no application on the facts presented. Accordingly the Securitisation Agreement will be a Division 230 financial arrangement as defined in subsection 995-1(1).

Application of the tax-timing methods

The gain or loss from a financial arrangement is brought to account in the manner prescribed in Subdivisions 230-B and 230-G, unless one of the elective tax timing methods in Subdivisions 230-C, 230-D, 230-E, or 230-F apply.

The applicant has advised that SV will not make any of the tax timing method elections contained in Subdivisions 230-C to 230-F. Therefore, Subdivisions 230-B and 230-G will apply for SV to work out the gains and losses it makes from this arrangement.

Accruals method or realisation method

SV will apply the accruals method under Subdivision 230-B in respect of the Securitisation Agreement where there is:

· a sufficiently certain overall gain or loss at the time SV starts to have the arrangement; or

· a sufficiently certain particular gain or loss.

SV will make a sufficiently certain overall gain or loss from the Securitisation Agreement only if it is sufficiently certain at the start of the arrangement that it will make an overall gain or loss of a particular amount or at least a particular amount (subsection 230-105(1)).

In deciding whether an overall gain or loss is sufficiently certain, SV may only have regard to the financial benefits it is sufficiently certain to receive or provide (subsection 230-115(1)).

Subsection 230-115(2) provides that a financial benefit to be received or provided will be sufficiently certain only if it is reasonably expected that SV will receive or provide the financial benefit and at least some of the amount or value of the financial benefit is, at that time, fixed or determinable with reasonable accuracy. In assessing whether this requirement is satisfied, it is assumed that SV will continue to have the financial arrangement for the remainder of its life.

Under the Securitisation Agreement, an overall gain will be made by the SV as a consequence of the difference between the financial benefits received (lease receivables that SV receives over the period of the arrangement) and the amount that SV initially pays the State Government.

When the SV enters into this financial arrangement with the State Government, both the amount paid (i.e. the amount paid by the SV to the State Government) and the amount to be received (i.e. the amount of lease receivables to be received by the SV from Project Co as directed by the State Government) will be sufficiently certain.

Therefore, the financial arrangement will result in an overall gain which is sufficiently certain at the time when SV enters into the arrangement with the State Government. Accordingly, the accruals method described in Subdivision 230-B will apply.

Question 2

Where a taxpayer has determined that Subdivision 230-B applies, and that the accruals method applies in respect of a sufficiently certain gain or loss, it becomes necessary to determine how that gain or loss is to be spread.

Subsection 230-135(2) provides that the gain or loss is to be spread using:

(a) compounding accruals; or

(b) a method whose results approximate those obtained using the compounding accruals method.

The methodology referred to paragraph 230-135(2)(a) is described at paragraph 4.143 of the 2008 EM, which states:

to apply the compounding accruals method, a taxpayer estimates the rate of return (the discount rate) that equates the net present value of all relevant cash flows (financial benefits) to zero. A taxpayer applies that rate to the initial investment, to provide an estimated year-by-year gain which forms the basis for taxation. Although the discount rate is determined by reference to net present values, Division 230 applies to gains or losses so that the total nominal gains or losses are brought to account…

The Applicant has stated that SV will spread any gain (or loss) which it makes under the arrangement with the State Government utilising the compounding accruals methodology referred to in paragraph 230-135(2)(a).

The Commissioner confirms that the allocation of gains arising from the arrangement between SV and the State Government utilising the compounding accruals methodology will satisfy the requirements of paragraph 230-135(2)(a).