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Ruling

Subject: Hedge contracts, TOFA and consolidation

Question 1

Are the hedge contracts entered into before the incorporation date by entities within the X Co group, and taken to be contracts of Y Co as a consequence of the acquisition of the X Co group by the Y Co tax consolidated group and the operation of the single entity rule within section 701-1 of the ITAA 1997 not subject to the operation of Division 230 of the ITAA 1997 in determining the taxable income of the Y Co tax consolidated group for the relevant income year and subsequent years, because of the operation of section 701-5 of the ITAA 1997?

Answer

Yes.

Question 2

Will a gain made by Y Co from realising a commodity hedge contract be included in assessable income under section 6-5 of the ITAA 1997?

Answer

Yes.

Question 3

Will a loss made by Y Co from realising a commodity hedge contract be deductible under section 8-1 of the ITAA 1997?

Answer

Yes.

Question 4

Where Y Co makes a foreign currency gain or loss under a foreign currency hedge contract will that gain or loss be covered by Division 775 of the ITAA 1997?

Answers

Yes.

This ruling applies for the following period

2011 to 2014 income years

The scheme commenced during

The relevant income year

Relevant facts and circumstances

· Y Co and its wholly owned subsidiary, Z Co, were incorporated during 20XX (incorporation date).

· Y Co elected to form a consolidated group under Part 3-90 of the ITAA 1997 effective from the incorporation date with Y Co as the head company.

· Towards the end of 20XX (the joining time), when Y Co acquired all the shares in X Co and its wholly owned subsidiaries (the X Co group) from W Co, the X Co group became members of the Y Co consolidated group and stopped being members of the W tax consolidated group.

· X Co has a hedging policy and in accordance with that policy hedges risks in relation to foreign currency exchange rates and commodity prices.

· As at the joining time, there were a number of hedge contracts entered into by X Co and its subsidiaries. These contracts were commodity forwards, commodity futures and commodity swaps. These contracts were used to manage the price received on the sale of the group's commodity production. In addition, foreign currency exposures were managed through entering into currency forward and swap contracts (collectively 'hedge contracts'). This ruling does not apply to any contracts that started to be had after the incorporation date.

· The ruling applies only to hedge contracts that were recorded as liabilities in X Co accounts at the joining time.

· When the X Co group was part of the W tax consolidated group, the hedge contracts to which this ruling applies were not subject to Division 230 of the ITAA 1997.

· Y Co and Z Co have not made transitional elections in relation to the application of Division 230 of the ITAA 1997.

· The hedge contracts are financial arrangements as defined in section 230-45 of the ITAA 1997.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 section 230-20

Income Tax Assessment Act 1997 section 230-45

Income Tax Assessment Act 1997 section 701-1

Income Tax Assessment Act 1997 section 701-5

Income Tax Assessment Act 1997 subsection 701-55(5A)

Income Tax Assessment Act 1997 Subdivision 715-F

Income Tax Assessment Act 1997 subsection 715-375(2)

Income Tax Assessment Act 1997 paragraph 715-375(1)(c)

Income Tax Assessment Act 1997 Division 775

Income Tax Assessment Act 1997 section 775-10

Income Tax Assessment Act 1997 section 775-15

Income Tax Assessment Act 1997 section 775-30

Reasons for decision

All legislative references are to the Income tax Assessment Act 1997 (ITAA 1997) unless specified otherwise.

Question 1

Summary

The out of the money hedge contracts entered into before the incorporation date by entities within the X Co group, and taken to be contracts of Y Co as a consequence of the acquisition of the X Co group by the Y Co tax consolidated group and the operation of the single entity rule within section 701-1 are not subject to the operation of Division 230 in determining the taxable income of the Y Co tax consolidated group for the relevant income year and subsequent years, because of the operation of section 701-5.

Detailed reasoning

Under section 701-1, subsidiary members of a consolidated group are taken, for head company and entity core purposes (core purposes), to be part of the head company of the group, rather than separate entities for any period the subsidiaries are members of the group. The core purposes to which the single entity rules includes the working out of the amount of the head company and subsidiary member's liability for income tax and the amount of a loss for a relevant period.

Thus, the effect of subsection 701-1(1) (the single entity rule), is that, for core purposes, the hedge contracts held by the X Co subsidiaries are taken to be held by Y Co from when those subsidiaries became subsidiary members of the Y Co consolidated group.

Section 701-5, which is also a core rule, sets out the entry history rule:

For the head company core purposes in relation to the period after the entity becomes a *subsidiary member of the group, everything that happened in relation to it before it became a subsidiary member is taken to have happened in relation to the *head company.

It is considered that the entry history rule would supply the facts which establish the time at which the relevant hedge contracts started to be had.

It therefore follows that all of the hedge contracts are taken to have been had by Y Co at the time when the X group started to have them.

Items 102 to 104 of Schedule 1 to the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 set out the application provisions for Division 230. Item 103 sets out the income year from which Division 230 applies and item 104 sets out which financial arrangements to which Division 230 applies.

Pursuant to item 103, Division 230 applies to Y Co as head company of the Y Co consolidated group from the incorporation date, being the first income year that started on or after 1 July 20XX. Sub-item 104(2) provides that Division 230 applies to financial arrangements that Y Co started to have in that first income year or a later year.

The question then becomes whether the financial arrangements that are the subject of this ruling were started to be had by Y Co before or after 1 July 20XX.

As stated above, the effect of the entry history rule is that Y Co started to have the financial arrangements when the X Co group companies started to have them. All of the arrangements to which this ruling applies were acquired by those companies prior to the incorporation date.

It follows that these financial arrangements will not be financial arrangements to which Division 230 applies. Neither subsection 701-55(5A) (in the case of assets) nor subsection 715-375(2) (in the case of liabilities) will alter this result. In the case of assets, subsection 701-55(5A) will not operate to deem the assets to be started to be had at the joining time, because Division 230 is not to apply in relation to the asset. In the case of liabilities, subsection 715-375(2) will not operate to deem the liabilities to be started to be had at the joining time because, at the joining time, paragraph 715-375(1)(c) is not satisfied.

It is noted that any hedge contracts that were first held by a X Co entity on or after the incorporation date and up until the joining time will be subject to Division 230 at the joining time (when they will be held by Y Co as head company) and are not the subject of this ruling request.

Question 2

Summary

A gain made by Y Co from realising a commodity hedge contract will be included in assessable income under section 6-5.

Detailed reasoning

A gain made upon the realisation of a hedge contract that is not a Division 230 financial arrangement will be ordinary income under section 6-5.

Under subsection 6-5(1), assessable income includes income according to ordinary concepts. The hedge contracts are an ordinary incident of the business of Y Co of producing and dealing in a commodity, and accordingly, the profit made from the realisation of those contracts is ordinary income. The hedge contracts are acts done in what is 'truly the carrying on or a carrying out of a business' (Californian Copper Syndicate (1904) 12 SLT 196).

Question 3

Summary

A loss made by Y Co from realising a commodity hedge contract will be deductible under section 8-1.

Detailed reasoning

8-1(1)

You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a *business for the purpose of gaining or producing your assessable income.

8-1(2)

However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

A loss made on the realisation of a hedge contract will be a loss incurred in gaining or producing assessable income of Y Co, or it will necessarily be incurred in carrying on a business for the purpose of gaining or producing assessable income. The X Co group and therefore Y Co entered into (taking account of the entry history rule) the hedge contracts as a part of its business. Such a loss will have the necessary connection with the operations or activities which more directly gain or produce assessable income (Taxation Ruling TR 95/33 paragraph 9.) Such a loss is 'reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of that business' (Magna Alloys & Research Pty Ltd v FC of T 80 ATC 4542 per Deane and Fisher JJ at p 4561). The hedge contracts are connected with the income producing activities, and are used to manage the prices received on its commodity production and trading (Coles Myer Finance Limited v FCT 93 ATC 4214).

Gains and losses made on the realisation of the hedge contracts are not capital in nature. On the basis that the hedges were designed to manage the prices the company receives on its commodity production, gains and losses from those hedges will also be revenue in nature. The advantage sought from the incurring of the expenditure is not permanent or enduring nor connected with the profit yielding structure of the business (Sun Newspapers v FCT (1938) 61 CLR 337).

Question 4

Summary

Where Y Co makes a foreign currency gain or loss under a foreign currency hedge contract, that gain or loss will be covered by Division 775.

Detailed reasoning

On the basis that the foreign currency hedge contracts are not Division 230 financial arrangements, for the reasons set out in answer to question 1, where Division 775 is capable of applying to a foreign exchange gain or loss, then Division 775 will deal with that foreign exchange gain or loss and not Division 230, nor any other part of the Act.

Sections 775-15(4) and 775-30(40) provide that Division 775 gains and losses taken into account in calculating assessable income are not also taken into account under any other provisions of the Act.

However, where an arrangement is a Division 230 financial arrangement then Division 230 applies to the exclusion of Division 775 and other parts of the Act, per section 230-20(4). The notes to subsections 775-15(4) and 775-30(40), which were enacted with the Division 230 amendments also make clear that where Division 230 applies, Division 775 has no application. And finally, the Explanatory Memorandum to Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2009 at paragraph 7.38 confirms the general application of Division 775, except where Division 230 also applies to the gain.

Section 775-10 sets out the objects of Division 775;

The objects of this Division are as follows:

(a) to recognise *foreign currency gains and losses for income tax purposes;

(b) to quantify those gains and losses by reference to the change in the Australian dollar value of rights and obligations;

(c) to treat certain foreign currency denominated financing facilities that are the economic equivalent of a loan as if the relevant facility were a loan;

(d) to reduce compliance costs by not requiring the recognition of certain low-value foreign currency gains and losses that involve substantial calculations.

The basic assessable income rule in Division 775 is in subsection 775-15(1):

Your assessable income for an income year includes a *forex realisation gain you make as a result of a *forex realisation event that happens during an income year.

Where Y Co makes a foreign currency gain under a foreign currency hedge contract because there was a 'forex realisation event' under Division 775, in relation to that contract, then any 'forex realisation gain', that Y Co makes in relation to that event will be included in Y Co's assessable income for that year.

The basic deduction rule in Division 775 is in subsection 775-30(1):

You can deduct from your assessable income for an income year a *forex realisation loss that you make as a result of a *forex realisation event that happens during a year.

Where Y Co makes a foreign currency loss under a foreign currency hedge contract because there was a 'forex realisation event,' under Division 775, in relation to that contract, then any 'forex realisation loss' that Y Co makes in relation to that event will be deducted from Y Co's assessable income for that year.