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Ruling

Subject:

Tax implications on foreign currency denominated liabilities

Question 1

Does section 960-85 of the Income Tax Assessment Act 1997 (ITAA 97) have any application to Company A's 'foreign currency' denominated liabilities arising under the Financing Facilities (FFs)?

Answer

Yes.

Question 2

Can section 775-55 of ITAA 1997 apply to bring to account for income tax purposes any embedded gains or losses calculated on translation to USD under section 960-85 of ITAA 1997?

Answer

No.

Question 3

Can sections 6-5 and 8-1 of ITAA 1997 apply to bring to account for income tax purposes any embedded gains or losses calculated under section 960-85 of ITAA 1997 upon the repayment in USD of the FFs?

Answer

No.

Question 4

Can section 102-5 of ITAA 1997 apply to bring to account for income tax purposes any embedded gains or losses calculated under section 960-85 of ITAA 1997, upon the repayment in USD of the FFs?

Answer

No.

Question 5

Can subdivisions 245-B and 245-C of ITAA 1997 apply to bring to account for income tax purposes any embedded gains or losses calculated under section 960-85 of ITAA 1997 upon the ultimate repayment in USD of the FFs?

Answer

No.

This ruling applies for the following periods:

The 2012 income year and future years

The scheme commenced on:

In the 2012 income year

Relevant facts

Background

Entity A is an Australian tax resident company that is required to prepare financial reports under section 292 of the Corporations Act 2001 for the year ending 31 December 2012.

Entity A has a year-end for Australian tax and accounting purposes of 31 December. Entity A is part of a wholly-owned global group. The ultimate parent company of the group is Entity B. Entity B is incorporated in another country and listed on that country's Stock Exchange.

Entity B is an involved in energy production as well as transmission and distribution.

The principal activities of Entity A in Australia relate to the energy and resources sector as a result of its participation in the X project. Entity A is participating in the X project and is planning to supply goods through long-term contracts to overseas entities.

As a participant in the X project, Entity A is required to provide funding in relation to the development of capital infrastructure and plant, and also exploration for reserves.

The provision of finance is not a core business activity of Entity A or the group it belongs to.

The first supply under the long-term contracts has occurred.

Functional Currency Provisions

Entity A conducts a significant part of its activities in USD, with the majority of its future sales revenue and financing facilities denominated in USD.

Entity A made a USD, functional currency choice for tax purposes effective from a date.

An applicable functional currency choice was made by Entity A under item 1 of the table in subsection 960-60(1) of the ITAA 1997, being within 90 days of 1 January 2012 as required under item 1 of the table in section 960-65 of the ITAA 1997, and made in writing as required under subsection 960-60(2) of the ITAA 1997.

In accordance with the 'applicable functional currency' requirements in section 960-70 of the ITAA 1997, the sole or predominant currency in which Entity A kept its accounts as at that date was the USD.

As at that date, a number of Entity A's financing facilities had drawn down components which had not yet been repaid. As these facilities were denominated in USD, unrealised gains/losses existed based on exchange rate movements attributable to the drawn down amounts.

Entity A has not made any transitional election under Division 230 of the ITAA 1997 in relation to financial arrangements entered into prior to the mandatory start date of Division 230 or an election to early adopt Division 230.

Entity A's USD Financing Facilities

The USD funds are drawn down under the two financing facilities from Company B, and are referred as the Financing Facilities (FF).

Details of the amounts that have been drawn down from the FF, the date of the drawn down, and the date of maturity were provided.

The funds drawn down in USD are used to meet USD's cash contributions in relation to Entity A's interest in the X project. If funds drawn down are not required immediately, they are held in USD term deposit accounts until needed. Funds drawn down in USD are not converted into AUD.

Key terms of the FF

All advances and repayments in respect of the facilities are to be made in USD.

The facilities are interest bearing loans and principal and accrued interest payments are due twice annually.

The facilities are to be repaid in full by date of maturity.

The FF will not be released, waived or extinguished other than by way of repayment in whole or prior to expiration.

The facilities may be voluntarily prepaid by Entity A prior to the maturity date if Entity B agrees.

Entity B can modify the maximum borrowing amount or cancel the loan at any time. To the extent the maximum borrowing amount or the facility is cancelled, Entity A is required to immediately repay the excess amount in the event of a reduction (i.e. the amount of the facility that exceeds the reduced maximum borrowing amount) or the full amount of the borrowing in the event of a cancellation.

In the event of default on Entity A's part, the latter is required to repay the loans with a penalty.

The FF constitute debt for the purposes of subdivision 974-B of the ITAA 1997.

Relevant legislative provisions

Section 6-5 of the Income Tax Assessment Act 1997

Section 8-1 of the Income Tax Assessment Act 1997

Section 102-5 of the Income Tax Assessment Act 1997

Subsection 102-5(1) of the Income Tax Assessment Act 1997

Section 102-20 of the Income Tax Assessment Act 1997

Division 104 of the Income Tax Assessment Act 1997

Section 104-25 of the Income Tax Assessment Act 1997

Section 108-5 of the Income Tax Assessment Act 1997

Subdivision 245-B of the Income Tax Assessment Act 1997

Subdivision 245-C of the Income Tax Assessment Act 1997

Section 245-35 of the Income Tax Assessment Act 1997

Section 245-36 of the Income Tax Assessment Act 1997

Section 245-37 of the Income Tax Assessment Act 1997

Subdivision 960-D of the Income Tax Assessment Act 1997

Section 960-59 of the Income Tax Assessment Act 1997

Subsection 960-60(1) of the Income Tax Assessment Act 1997

Subsection 960-60(2) of the Income Tax Assessment Act 1997

Section 960-65 of the Income Tax Assessment Act 1997

Section 960-70 of the Income Tax Assessment Act 1997

Subsection 960-70(1) of the Income Tax Assessment Act 1997

Section 960-80 of the Income Tax Assessment Act 1997

Subsection 960-80(1) of the Income Tax Assessment Act 1997

Subsection 960-85(1) of the Income Tax Assessment Act 1997

Paragraph 960-85(1)(a) of the Income Tax Assessment Act 1997

Paragraph 960-85(1)(b) of the Income Tax Assessment Act 1997

Subsection 960-85(2) of the Income Tax Assessment Act 1997

Subdivision 974-B of the Income Tax Assessment Act 1997

Subsection 995-1(1) of the Income Tax Assessment Act 1997

Division 775 of the Income Tax Assessment Act 1997

Section 775-55 of the Income Tax Assessment Act 1997

Schedule 2C of the Income Tax Assessment Act 1936 (repealed)

Division 245 of the Income Tax Assessment Act 1936 (repealed)

Section 292 of the Corporations Act 2001

Tax Laws Amendment (Transfer of Provisions) Act 2010

Subsection 245-5(1) of the Income Tax (Transitional Provisions) Act 1997

Subsection 245-5(2) of the Income Tax (Transitional Provisions) Act 1997

Reasons for decision

Question 1

Summary

Entity A has foreign denominated liabilities from draw downs made from the FF. Section 960-85 of the ITAA 1997 will apply, and Entity A will be required to apply the two step process to the draw downs made from the FF.

The two step process will bring to account the unrealised exchange gains or losses in relation to the drawn down amounts arising from fluctuations between the Australian currency and the applicable functional currency between the 'event time' (the date that the draw down is made) and the time the choice to use the applicable functional currency takes effect.

Detailed reasoning

The making of an applicable functional currency choice

Section 960-59 of the ITAA 1997 states that the object of Subdivision 960-D of the ITAA 1997, in dealing with functional currency, is for the purposes of reducing compliance costs and reflecting commercial practice. It allows certain entities whose accounts are kept solely or predominantly in a particular foreign currency to calculate their net incomes by reference to the functional currency.

Under item 1 of the table in subsection 960-60(1) of the ITAA 1997, an Australian resident that is required to prepare financial reports under section 292 of the Corporations Act 2001 may choose to use their 'applicable functional currency'.

For an Australian resident making a choice under item 1 of the table in subsection 960-60(1) of the ITAA 1997, the 'applicable functional currency' is defined in subsection 960-70(1) of the ITAA 1997 to be the sole or predominant foreign currency in which they kept their 'accounts' at the time they made the choice.

Entity A is an Australian resident company required to prepare financial reports under section 292 of the Corporations Act 2001 for the 2012 income year.

You have advised that in accordance with section 960-70 of the ITAA 1997 that the sole and predominant currency in which Entity A kept its accounts as at that date was USD.

As Entity A made an applicable functional currency choice in writing as required under subsection 960-60(2) of the ITAA 1997, under item 1 of the table in subsection 960-60(1) of the ITAA 1997 within 90 days of that date as per the 'backdated startup choice' requirement under item 1 of the table in subsection 960-65 of the ITAA 1997, this choice will be effective from that date.

An amount that is not in the applicable functional currency is to be translated into the applicable functional currency if item 1 of the translation rules in section 960-80 of the ITAA 1997 is satisfied. In your case Entity A satisfies the requirements of item 1 of section 960-80 of the ITAA 1997.

Application of subsection 960-85(1) of the ITAA 1997

Item 1 of subsection 960-85(1) of the ITAA 1997 is the special translation rule for translation where the event happened before the current choice took effect.

Subsection 960-85(1) of the ITAA 1997 states:

    If:

(a) as the result of a choice (the current choice) made by you under item 1 of the table in subsection 960-60(1), subsection 960-80(1) requires that an amount be translated to the *applicable functional currency; and

(b) the amount is attributable to an event that happened, or a state of affairs that came into existence, at a time (the event time) before the current choice took effect;

    the table has effect:    

The intended effect of the operation of the special translation rule was to embed any currency exchange fluctuation between the time of the borrowing and the time of making the functional currency choice into the amount of the company's liability for tax purposes (see paragraph 3.84 of the Explanatory Memorandum to the New Business Tax System (Taxation of Financial Arrangements) Bill (No.1) of 2003 (Cth)).

Application of paragraph 960-85(1)(a) of the ITAA 1997

Paragraph 960-85(1)(a) of the ITAA 1997 requires that as a result of the applicable functional currency choice that subsection 960-80(1) of the ITAA 1997 requires an amount to be translated into the applicable functional currency.

From the date Entity A's USD functional currency choice took effect, item 1 of the table in subsection 960-80(1) of the ITAA 1997 requires Entity A to work out its taxable income or tax loss in USD and then translate this net amount to AUD. Pursuant to subsection 960-80(1) of the ITAA 1997, in working out Entity A's taxable income or tax loss an amount that is not in the applicable functional currency of USD is to be translated into the applicable functional currency, being USD.

You have made a USD applicable functional currency choice, and prior to this choice draw downs were made from the FF in USD. In this case subsection 960-80(1) of the ITAA 1997 still requires the draw downs to be translated to the applicable functional currency. This is because for tax purposes, prior to the functional currency choice taking effect, there was no applicable functional currency.

As stated in Taxation Ruling TR 2007/5 Income Tax: functional currency- when is an amount not in the 'applicable functional currency'? (TR 2007/5), at paragraphs 32 to 34:

32. The general rule does not apply to the two step translation under section 960-85. An 'amount' is not in the 'applicable functional currency' for the purposes of section 960-85, where the provisions within Subdivision 960-D have not previously recognised it as such.

33. Section 960-85 is concerned with amounts which are 'attributable to an event that happened or a state of affairs that came into existence' in a prior year, (a 'prior year event'), being a year in which the use of the 'applicable functional currency' did not occur. The concept of 'applicable functional currency' in this respect is purely an income tax law one. In the absence of a valid choice under subsection 960-60(1) to use this currency, there is no 'applicable functional currency' and the appropriate currency required to be used for income tax purposes is Australian currency.

34. It is considered that amounts which are 'attributable to' a 'prior year event' in a year in which the use of the 'applicable functional currency' did not apply, are thereby amounts which are not in the 'applicable functional currency'. This is so even where the amounts (or their elements), are denominated in the relevant source in the non-Australian currency that subsequently becomes the 'applicable functional currency'.

Accordingly, paragraph 960-85(1)(a) of the ITAA 1997 is satisfied.

Application of paragraph 960-85(1)(b) of the ITAA 1997

TR 2007/5 provides guidance as to the meaning of 'attributable to' an event. Paragraph 109 of TR 2007/5 states that according to the case of Central Asbestos Co v Dodd (1972) 2 All ER 1135 at 1141, 'attributable' means capable of being attributed. Further, that ''Attribute' has a number of cognate meanings; you can attribute a quality to a person or thing, you can attribute a product to a source or author, you can attribute an effect to a cause. The essential element is connection of some kind.'

Paragraph 110 of TR 2007/5 states that:

In the case of a transactionally based amount, such as expenditure on acquiring an asset; it is natural to attribute the amount to the transaction that causes the expenditure. This is the 'event or state of affairs' which most clearly causes the amount of that expenditure to come into existence.

In your case we would look to the transaction which caused the liabilities, being the draw down/s from the FF. This is the case because it is this transaction that gives rise to Entity A's loan liabilities.

Paragraph 112 of TR 2007/5 in relation to identifying the event time states:

112. Where an amount to which section 960-85 potentially applies involves mainly a statutory concept, it is necessary to examine the income tax provision(s) giving rise to the existence of this amount, in order to determine whether there is a relevant 'event time', for the purposes of section 960-85.

113. This examination should reveal whether or not there is an 'event or state of affairs' arising in relation to the operation of the provision(s), which can be said most naturally to be the cause of that amount. It is this 'event or state of affairs' that is the attributable one, in the sense in which this term is used in section 960-85.

As the draw downs from the FF were made prior to Entity A's functional currency choice taking effect on the date, they are attributable to an event that happened before the functional currency choice took effect.

Paragraph 960-85(1)(b) of the ITAA 1997 would apply as the amount is attributable to an event that happened, or a state of affairs that came into existence, at a time before Entity A's functional currency choice took effect.

As a result, paragraph 960-85(1)(b) of the ITAA 1997 is satisfied.

Conclusion

As both limbs of subsection 960-85(1) of the ITAA 1997 will be satisfied, the table in subsection 960-85(1) of the ITAA 1997 will have effect for Entity A. Therefore, the two-stage translation process will apply to the draw downs made before Entity A's functional currency choice took effect.

For practical purposes Entity A may or may not have translated the draw downs to Australian currency at the exchange rate applicable at the time of the draw down. This is the first step under the two step translation that will need to be done.

Entity A must then translate to the applicable functional currency, being USD, at the date when the applicable functional currency choice took effect.

Question 2

Detailed reasoning

Subsection 995-1 of the ITAA 1997 defines foreign currency as a currency other than Australian currency. In the provisions, item 1 of subsection 960-80(1) of the ITAA 1997 in column three at paragraph (a)(ii) states that the definition of foreign currency in subsection 995-1(1) of the ITAA 1997 does not apply. Also, item 1 of subsection 960-80(1) also states at paragraph (a)(iii) that once the translation rules apply, the applicable functional currency is not taken to be a foreign currency.

For practical purposes once the applicable functional currency choice is made amounts included in working out your taxable income or tax loss must be in the applicable functional currency. This means you must translate all amounts you receive or pay in another currency, including AUD amounts, into the applicable functional currency.

The functional currency translation rules, including applicable exchange rates, follow the principles in the core foreign currency translation rules for translating foreign currency amounts to AUD. However, AUD is treated as a foreign currency while your applicable functional currency is not a foreign currency, for the purposes of working out your taxable income or tax loss in the applicable functional currency.

In your case the translation rules apply such that the applicable functional currency, being USD, will no longer be a foreign currency once the applicable functional currency choice is made.

Section 775-55 of the ITAA 1997 only applies where an obligation to pay a foreign currency ceases. When the applicable functional currency choice is made the draw downs from the FF are no longer an obligation to pay a foreign currency. The obligation is now an obligation to repay the applicable functional currency.

Conclusion

The USD applicable functional currency choice that Entity A makes, which is effective from the date means that USD will not be a foreign currency on and from that date. Accordingly, section 775-55 of the ITAA 1997 will not apply in respect of Entity A's draw downs on and from the date as Entity A no longer has an obligation to repay a foreign currency. For this reason section 775-55 of the ITAA 1997 will not bring to account any embedded gain or loss at the time of the two-step translation.

Question 3

Summary

The FF draw downs and future repayments are of a capital nature, and therefore any embedded currency exchange fluctuation between the time of the borrowing and the making of the functional currency choice into the amount of Entity A's liability for the FF draw downs would also take the character of capital. This means that when the FF are repaid, any embedded gains in the liability would not be ordinary income under section 6-5 of the ITAA 1997, and any embedded losses in the liability would not be general deductions under section 8-1 of the ITAA 1997.

Detailed reasoning

The question arises as to whether sections 6-5 and 8-1 of the ITAA 1997 may apply when the FF are repaid.

Section 6-5 of the ITAA 1997 states that if you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income with a number of exceptions. One of these exceptions is if the loss is a loss or outgoing of capital, or of a capital nature.

When we refer to an embedded gain or a loss, we are referring to the unrealised exchange gains or losses in relation to the drawn down amounts arising from fluctuations between the Australian currency and the applicable functional currency between the 'event time' (the date that the draw down is made) and the time the choice to use the applicable functional currency takes effect.

Case law has established that an exchange gain or loss, which refers to the discharge of a liability on capital account is not assessable as ordinary income under section 6-5 of the ITAA 1997, nor deductible under section 8-1 of the ITAA 1997 (Federal Commissioner of Taxation v Hunter Douglas Limited 83 ATC 4562 (Hunter's case), Federal Commissioner of Taxation v Energy Resources of Australia Limited (1996) 185 CLR 66 96 ATC 4536 (1996) 33 ATR 52).

Case law has established that generally, loans and repayments of loans are on capital account (Hunter's case). Further, in the case of a loan, any exchange gain or loss resulting from the borrowing (or lending) of money will ordinarily follow the nature of the transaction. So if a borrowing (which is a liability) is for capital purposes and is not of circulating or working capital, then any related exchange gain or loss will not be assessable or deductible; see Hunter's case and also Commercial and General Acceptance Ltd v FCT (1977) 137 CLR 373; 7 ATR 716.

On the other hand, if the borrowing is of working or circulating capital, that is to say it is a borrowing of funds that are to be used in the ordinary and regular processes by which the money-making activities of a business are carried on, then any exchange gain or loss will be assessable or deductible under section 6-5 or 8-1 respectively; Texas Co (Australasia) Ltd v FCT (1940) 63 CLR 382; 2 AITR 4; Avco Financial Services Ltd v FCT (1982) 150 CLR 510; 13 ATR 63. Borrowings made by finance companies in the ordinary course of their business are an example of this.

In this case, the arrangement under consideration is the FF, which are USD loans borrowed by Entity A. As a participant in the X project, Entity A is required to provide funding in relation to the development of capital infrastructure and plant, and also exploration for future reserves (e.g. in addition to the reserves currently identified).The provision of finance is not a core business activity of Entity A or the group.

As the borrowed funds are used for capital expansion and exploration, the use of the borrowed funds falls on capital account. This is because it can be said to strengthen the business entity, structure or organisation set up or established for the earning of profit (Sun Newspapers Ltd v FCT (1938) 61 CLR 337 at 359).

Entity A has also stated that it is not a finance entity and that there are no other characteristics of its business undertakings that would lead to a conclusion that the foreign exchange gains or losses are on revenue account.

Conclusion

The FF draw downs are of a capital nature, and therefore any currency gains or losses relating to the draw downs would also take that character. This means that any embedded currency gains would not be ordinary income under section 6-5 of the ITAA 1997 at the time the borrowing is repaid. Similarly, any embedded currency losses would not be general deductions under section 8-1 of the ITAA 1997 at the time the borrowing is repaid.

Question 4

Detailed reasoning

Section 102-5 of the ITAA 1997 provides the method for working out a taxpayers net capital gain. Subsection 102-5(1) of the ITAA 1997 requires a taxpayers assessable income to include any net capital gain (if any) for the income year.

Broadly, a 'CGT asset' is defined in subsection 995-1(1) of the ITAA 1997 by reference to section 108-5 of the ITAA 1997, as any kind of property or a legal or equitable right that is not property, that is acquired after 19 September 1985.

In order for a net capital gain or loss to arise on the future repayment of Entity A's FF liabilities, a CGT event must occur (section 102-20 of the ITAA 1997). The CGT events in Division 104 of the ITAA 1997 require the transaction to include a CGT asset of the taxpayer, and generally do not extend to events involving liabilities.

Where there is no CGT event in relation to the taxpayer, a capital gain or loss cannot arise in the hands of the taxpayer for the purposes of section 102-20 of the ITAA 1997.

CGT Determination Number 3: Capital Gains: What are the CGT consequences for the borrower (debtor) when a debt is waived (CGT TD 3), relevantly states at paragraph 1 that -  

For CGT purposes, the borrower is not considered to have an asset. Accordingly, when the lender waives the debt, the borrower does not dispose of an asset and therefore makes no capital gain or loss.

Conclusion

As Entity A's liability for the FF is not a CGT asset it follows that repayment of the liability, being the USD denominated borrowings can not result in a capital gain or loss for the purposes of section 102-5 of the ITAA 1997.

Question 5

Detailed reasoning

Application of Schedule 2C of the Income Tax Assessment Act 1936 (ITAA 1936)

The debt forgiveness provisions were contained in Division 245 of the ITAA 1936. These provisions were rewritten under the Tax Laws Amendment (Transfer of Provisions) Act 2010 (No 79 of 2010) which repealed the former Division 245 rules in Schedule 2C of the ITAA 1936.

Even though Schedule 2C of the ITAA 1936 has been repealed, subsection 245-5(2) of the Income Tax (Transitional Provisions) Act 1997 states that Schedule 2C of the ITAA 1936 continues to apply to debts forgiven before the rewrite in the 2009/10 income year and earlier income years.

Entity A has not had the benefit of any debt forgiveness for the FF from Entity B up to and including the 2009/10 income year. As such, Schedule 2C of the ITAA 1936 has no application.

Application of Subdivision 245-B in the ITAA 1997

Subsection 245-5(1) of the Income Tax (Transitional Provisions) Act 1997 states that the rewritten Division 245 of the ITAA 1997 applies to debts forgiven during a taxpayer's 2010/11 income year and subsequent years.

Section 995-1 of the ITAA 1997 states that to 'forgive' a debt has the meaning given by sections 245-35, 245-36 and 245-37 of the ITAA 1997.

Section 245-35 of the ITAA 1997 describes what constitutes forgiveness of a debt. Section 245-36 of the ITAA 1997 describes what constitutes forgiveness of a debt if the debt is assigned. Section 245-37 of the ITAA 1997 describes what constitutes forgiveness of a debt if a subscription for shares enables payment of the debt.

Subsection 245-35(a) of the ITAA 1997 states that a debt is forgiven where a debtor's obligation to repay a debt is released, waived, or is otherwise extinguished other than repaying the debt in full.

Subsection 245-35(a) of the ITAA 1997 will not apply, as the debt Entity A owes Entity B, being the FF, will not be released, waived or extinguished other than by way of repayment on or prior to the maturity date.

Section 245-36 of the ITAA 1997 will not apply as Entity B will not assign the right to receive payment of the FF to another entity. Entity A will repay the FF to Entity B on or prior to maturity date.

Section 245-37 of the ITAA 1997 will not apply as Entity A will not issue shares to another party and use the funds to repay the FF. Entity A will repay the FF on or prior to maturity date through profits generated from project X.

Conclusion

Section 245-35 of the ITAA 1997 will not apply as there has been no forgiveness of debt. As such the provisions in Subdivision 245-B of the ITAA 1997 can not apply. Subdivisions 245-C of the ITAA 1997 for the calculation of the gross forgiven amount of debt will also not apply.

Other comments

Potential application of Part IVA of the ITAA 1997

This ruling is subject to the possible application of Part IVA of the ITAA 1997. The Explanatory Memorandum to the New Business Tax System (Taxation of Financial Arrangements) Bill (No. 1) 2003 gives guidance as to the possible application of Part IVA of the ITAA 1997 when a functional currency choice is made.

Choices made for the sole or dominant purpose of obtaining a tax benefit

3.88 Where the choice to use a functional currency is made with the sole or dominant purpose of obtaining a tax benefit, the choice, or a scheme of which the choice is part, may be subject to the operation of Part IVA of the ITAA 1936, despite subsection 170C(2) (see also paragraph 3.96). For example, the tax benefit arising from a scheme could be increased because a functional currency election has been made.

3.96 Subparagraphs 177C(2)(a)(i), (b)(i) and (c)(i) of the ITAA 1936 are amended in order to add a further exception to the tax benefit exclusion rule relating to functional currency elections. [Schedule 4, items 26 to 28]