Edited version of your private ruling

Authorisation Number: 1012470859953

Ruling

Subject: Foreign exchange gains and losses

Question 1

For the following transaction entered into after 30 June 2010, are the relevant realised foreign exchange gains or losses made by XYZ Limited (XYZ), in gaining or producing non-assessable non exempt (NANE) income as described in the facts of this ruling excluded from being assessable or deductible respectively under section 230-30 of the ITAA 1997:

(a) XYZ's acquisition of XN Limited (XN) during the relevant income year (under an agreement executed during the relevant income year).

Answer 1:

(a) The relevant realised foreign exchange gains or losses made by XYZ in relation to its acquisition of XN during the relevant income year, in gaining or producing NANE income as described in the facts of this ruling are excluded from being assessable or deductible respectively under section 230-30 of the ITAA 1997.

Question 2

For the following transaction entered into prior to 30 June 2010, are the relevant realised foreign exchange gains or losses made by XYZ, in gaining or producing NANE income as described in the facts of this ruling excluded from being assessable or deductible respectively under sections 775-25 and 775-35 of the Income Tax Assessment Act:

(a) XYZ's acquisition of MM Limited (MM) during the relevant income year (under an agreement executed during the relevant income year).

Answer 2:

The relevant realised foreign exchange gains or losses made by XYZ in relation to the acquisition of MM during the relevant income year, in gaining or producing NANE income as described in the facts of this ruling are excluded from being assessable or deductible respectively under sections 775-25 and 775-35 of the ITAA 1997.

This ruling applies for the following periods

The year ended June 30 June 2009

The year ended June 30 June 2010

The year ended June 30 June 2011

The year ended June 30 June 2012

The scheme commences on

01 July 2008

Relevant facts and circumstances

Background

1. XYZ Limited (XYZ) is an Australian resident public company listed on the Australian Securities Exchange (ASX). It is incorporated in and a tax resident of Australia for income tax purposes.

2. XYZ Limited is the head company of the XYZ income tax consolidated group.

3. The XYZ group has traditionally been an Australian-based business, but is experiencing increased growth in its overseas investments.

4. At the time of acquisition, XYZ is reasonably expected to receive dividend income from its investments in these foreign subsidiaries. These dividends may be classified as non-assessable non-exempt (NANE) income under section 23AJ of the ITAA 1936.

5. XYZ is mandatorily required to apply Division 230 of the ITAA 1997 ("the TOFA rules") from 1 July 2010. XYZ did not make a transitional election under sub-item 104(2) of the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 to bring pre-existing financial arrangements into Division 230 nor did it make any tax timing elections for the income year ended 30 June 2011.

6. XYZ did, however, make a hedging election under subdivision 230-E of the ITAA 1997 with effect from June 2012, and this election will apply to any new hedging financial arrangements entered into by XYZ on or after 1 July 2011.

7. The transactions have been entered into both pre and post 30 June 2010, and therefore Division 775 of the ITAA 1997 will apply to the "pre" transactions and Division 230 of the ITAA 1997 will apply to the "post".

8. The Commissioner has been requested not to rule on the application of Subdivision 230-E of the ITAA 1997 to acquisitions that occurred on or after 1 July 2011.

Relevant facts and circumstances

9. XYZ has completed various acquisitions of foreign operating companies, including XN and MM.

10. The following steps have been executed as part of financing each of the share acquisitions:

a. XYZ entered into a contract to acquire the shares (or a percentage of shares) in a foreign operating company.

b. The acquisition was required to be completed and settled at a future date (settlement date) in a foreign currency that was relevant to the country where the shares are being acquired. The amount was due at the settlement date.

c. Separate Syndicated Facility Agreements (the Facility Agreements) were entered into in order to fund the acquisition of the shares.

d. XYZ entered into one or more forward arrangements to hedge the acquisition consideration. The forward arrangements were settled on the same date that the share purchase is settled or very soon prior to settlement.

e. On the settlement date, XYZ used the funds from the Facility Agreements to settle the forward arrangements, receiving sufficient foreign currency required to pay the Vendor and settle the acquisition.

f. Upon closing out of the forward, XYZ realised a foreign exchange gain or a foreign exchange loss.

11. The entering of forward arrangements to hedge the acquisition consideration was a direct requirement of the Financial Institution lenders under the Facility Agreements and had the effect of locking in the acquisition consideration, mitigating XYZ's foreign exchange exposure on the acquisition.

XN Limited

12. This related to the acquisition of an interest in XN Limited (XN) during the relevant income year.

13. XYZ agreed to acquire the shares in XN during the relevant income year.

14. The consideration for the acquisition was in foreign currency.

15. The interest in XN was to be settled during the relevant income year.

16. XYZ's functional currency is AUD. Therefore, in the lead up to settlement and in line with the requirements of its financial institution lender to hedge the purchase consideration, XYZ took out forward contracts with various financial institutions.

17. XYZ took out a number of forward contracts in relation to the XN acquisition during the relevant income year.

18. The Loan Agreement relating to the XN acquisition was executed during the relevant income year.

19. The XN acquisition was settled during the relevant income year. Forward contracts relating to the XN acquisition were closed out. A foreign exchange gain has been realised from these forward contracts.

MM Limited

20. This related to the acquisition of an interest in MM Limited (MM) during the relevant income year.

21. XYZ entered into a share purchase agreement to acquire the shares during the relevant income year.

22. The consideration for the acquisition was in foreign currency.

23. XYZ took out forward contracts in relation to the MM acquisition during the relevant income year.

24. The interest in MM was settled during the relevant income year.

25. A foreign exchange loss has been realised from these forward contracts.

Forward Contracts

26. All forward contracts were taken out and designated as a hedge against the foreign exchange risks to the acquisition price for:

a) XN Acquisition;

b) MM Acquisition

27. The hedged item for the forward contracts made were either in relation to a) a firm commitment (within the meaning of the accounting principles i.e. AASB 139) or b) a highly probable forecasted transaction (within the meaning of the accounting principles i.e. AASB 139).

28. For completeness, for accounting purposes the forward contracts were fair valued at settlement (and included as part of the cost of the investment) with the gain in fair value recorded through reserves (equity) in compliance with AASB 139.

29. Relevant hedging documentation required by AASB 139 for the acquisitions for which the forward contracts were designated as an accounting hedge has been put in place by XYZ.

Reasons for decision

Question 1

For the following transactions entered into after 30 June 2010, are the relevant realised foreign exchange gains or losses made by XYZ Limited (XYZ), in gaining or producing non-assessable non-exempt (NANE) income as described in the facts of this ruling excluded from being assessable or deductible respectively under section 230-30 of the ITAA 1997:

(a) XYZ's acquisition of XN Limited (XN) during the relevant income year (under an agreement executed during the relevant income year).

Summary

(a) The relevant realised foreign exchange gains or losses made by XYZ in relation to its acquisition of XN during the relevant income year, in gaining or producing NANE income as described in the facts of this ruling are excluded from being assessable or deductible respectively under section 230-30 of the ITAA 1997.

Detailed reasoning

29. Division 230 of the ITAA 1997 applies to financial arrangements entered into by XYZ on or after 1 July 2010.

30. Division 230 of the ITAA 1997 brings to account certain gains and losses made on financial arrangements where you have one or more cash settleable legal or equitable rights and/or obligations to receive or provide a financial benefit. (Section 230-5 of the ITAA 1997)

31. Section 230-15 of the ITAA 1997 provides that your assessable incomes includes a gain you make from a financial arrangement and that you can deduct a loss you make from a financial arrangement, but only to the extent that:

- You make it in gaining or producing you assessable income or

- You necessarily make it in carrying on a business for the purpose of gaining or producing your assessable income

32. Section 230-30 of the ITAA 1997 details the tax treatment of gains and losses related to exempt income or NANE income and where a gain or loss on a financial arrangement has a requisite nexus with NANE income should not be assessable and should not be deductible.

33. Subsection 230-30(2) and subsection 230-30(3) of the ITAA 1997 provides that:

(2) Despite section 230-15, a gain that you make from a financial arrangement:

(a) to the extent that, if it had been a loss, you would have made it in gaining or producing exempt income - is exempt income; and

(b) to the extent to which, if it had been a loss, you would have made it in gaining or producing *non-assessable non-exempt income - is not

assessable income and is not exempt income.

(3) A loss you make from a financial arrangement is not allowable as a deduction to you under any provision of this Act (other than subsection 230-15(3)) to the extent that you make it in gaining or producing your:

(a) exempt income; or

(b) non-assessable non-exempt income.

34. TR 2012/3 provides guidance on the operation of subsections 230-30(2) and (3) of the ITAA 1997 and states that the words 'in gaining or producing' adopted by subsection 230-30(2) and 230-30(3) reflect the same nexus enquiry as for the deduction test in paragraph 230-15(2)(a) of the ITAA 1997, and as for the first positive limb and reflected in the third negative limb of section 8-1 of the ITAA 1997, and its predecessor section 51 of the ITAA 1936. These words require an examination of whether or not there is a sufficient nexus or connection between the identified loss and an income producing activity. (Paragraph 9 of TR 2012/3)

35. In this regard, the nexus of realised foreign exchange gains and or losses in relation to the forward agreements entered into as part of XYZ's acquisition of XN need to be tested in relation to the NANE producing investment.

Foreign exchange gains and losses that have a nexus with NANE income

36. The question of nexus, in relation to the deductibility of outgoings 'incurred in gaining or producing assessable income', has been discussed in case law. It provides guidance to the application of subsections 230-30(2) and 230-30(3) of the ITAA 1997.

37. In W Nevill & Co v. Federal Commissioner of Taxation (1937) 56 CLR 290, it was held that a loss or outgoing is deductible if it is incidental and relevant to the activities carried on for the production of income.

38. In Ronpibon Tin NL and Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47, the High Court stated at CLR 56:

For expenditure to form an allowable deduction as an outgoing incurred in gaining

or producing the assessable income it must be incidental and relevant to that end.

The words "incurred in gaining or producing the assessable income" mean in the

course of gaining or producing such income. [Emphasis added]

And further, at CLR 57:

… to come within the initial part of the sub-section it is both sufficient and necessary

that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce

assessable income. [Emphasis added]

39. It follows then that there must be a sufficient connection or nexus between the loss or outgoing and activities regularly carried on for the production of income.

40. As per John v Federal Commissioner of Taxation (1989) 166 CLR 417, an outgoing incurred 'in the course of' gaining or producing assessable income may properly be understood as referring to an outgoing that is 'a cost of a step taken in the process of gaining or producing income'.

41. In Fletcher v Commissioner of Taxation (Cth) (1991) 173 CLR 1, the High Court found that the question of whether an outgoing was incurred 'in gaining or producing assessable income' was a question of characterisation. That is,

…the relationship between the outgoing and the assessable income must be such as to impart to the outgoing the character of an outgoing of the relevant kind.. an outgoing will not properly be characterised as having been incurred in gaining or producing assessable income unless it was " incidental and relevant to that end". [Emphasis added]

42. In accordance with TR 2012/3, incidence and relevance requires an examination of the connection that the making of the loss has with the operations which more directly gain or produce the exempt income or NANE income (Paragraph 13 of TR 2012/13)

43. With respect to a gain derived on a financial arrangement, subsection 230-30(2) of the ITAA 1997 confers exempt income or NANE income status if that gain had been a hypothetical loss instead, and that loss would have been made in gaining or producing exempt income or NANE income.

44. Whether a loss or outgoing is 'incidental and relevant' to gaining or producing assessable income does not depend on the certainty or likelihood of the outgoing resulting in the generation of income, but its nature and character and generally its connection with the activities which more directly gain or produce the assessable income (Federal Commissioner of Taxation v. Smith (1981) 147 CLR 578; (1981) 34 ALR 16; (1981) 55 ALJR 229).

45. The acquisition of XN by XYZ have been financed in accordance with steps a) to f) outlined in paragraph 10 of the relevant facts and circumstances.

46. The acquisition of XN by XYZ was required to be settled in a foreign currency and therefore XYZ's Financial Institution lenders required them to enter into a hedging program to "sufficiently hedge" the acquisition consideration, ensuring that XYZ did not need to borrow additional funds when settling the share acquisitions.

47. Relevant clauses in respect of the Facilities Agreements that require the acquisition consideration to be hedged have been provided by the Applicant.

48. The relevant facts and circumstances highlights that the primary reason for XYZ entering into the forward contracts as hedging arrangements was to convert a set amount of the Australian dollars borrowed under the Facility Agreements into the foreign currency required to fund the acquisitions.

49. The hedging arrangements were capable of producing a gain or loss as result of the fluctuation in the value of the foreign currency relative to XYZ's functional currency. However, the direct and immediate purpose for entering into the hedging arrangements was not for 'hedging or speculative purposes', but rather that appropriate hedging be taken out as a requirement of XYZ's Financial Institution lender in order to mitigate XYZ's foreign exchange exposure on the acquisition cost for XN. This was reflected in XYZ's hedging documentation required under AASB 139 of these transactions.

50. The hedging arrangements required by the Facility Agreements were closed out on or very close to the same day that XYZ required the foreign currency to pay the Vendor and settle the acquisition. The amounts and payment dates of the forward contracts were matched to the settlement amounts and dates for the foreign share acquisitions. In essence, the hedges secured the foreign currency funds needed to acquire the shares.

51. In ATO ID 2004/571, the Commissioner concluded that a nexus can be established between a hypothetical forex realisation loss incurred on repayment of borrowings used to acquire shares in a foreign company, and the derivation of NANE dividends on those shares.

52. ATO ID 2004/572 draws reference to subsection 775-35(2) of the ITAA 1997 which is replicated in section 230-30 of the ITAA 1997. Subsection 775-35 of the ITAA 1997 is the provision which applies where Division 230 of the ITAA 1997 does not because the transaction is not the subject of Division 230 or was prior to Division 230 applying.

53. In relation to the acquisition of MN Limited by XYZ, a relevant nexus exist between the outgoing (i.e. the loss or hypothetical loss on the forward contract) and the derivation of NANE dividends. That is, the occasion of the outgoing is the acquisition of the shares from which NANE income is reasonably expected to be derived. XYZ entered into forward arrangements to hedge the acquisition consideration for XN Limited.  [This is different from hedging against the long term capital value of the initial investment which is not recognised as having the requisite nexus as outlined in example 6 of TR 2012/3.] 

54. As stated above, XYZ was required under the Facility Agreements to ensure that the acquisition consideration is "sufficiently hedged". The hedging arrangements maintained the funds committed in acquiring the foreign shares (including borrowing from the third party Financial Institutions), allowing XYZ to meet its contractual obligations, and in doing so, enhanced XYZ's ability to receive NANE income.

55. The foreign share acquisition of MN was expected to enhance XYZ's income earning capacity by promoting the derivation of dividend income dividends paid by the foreign subsidiaries to XYZ would be NANE income under section 23AJ of the ITAA 1936.

56. On these facts, there is a sufficient nexus between the forex realisation loss arising on the closing out of the hedge and the generation of NANE dividend income on the foreign shares. A loss would be made in the course of gaining or producing exempt income or NANE income and should be disregarded under subsection 230-30(3) of the ITAA 1997.

57. By extension, pursuant to subsection 230-30(2) of the ITAA 1997, a gain from the hedging arrangements, had it been a loss, would have been made in the course of gaining or producing NANE income and will therefore be NANE income under subsection 230-30(2) of the ITAA 1997.

Question 2

For the following transactions entered into prior to 30 June 2010, are the relevant realised foreign exchange gains or losses made by XYZ, in gaining or producing NANE income as described in the facts of this ruling excluded from being assessable or deductible respectively under sections 775-25 and 775-35 of the Income Tax Assessment Act (ITAA 1997):

(a) XYZ's acquisition of MM in the relevant income year (under an agreement executed in the relevant income year).

Summary

The relevant realised foreign exchange gains or losses made by XYZ in relation to the acquisition of MM in the relevant income year, in gaining or producing NANE income as described in the facts of this ruling are excluded from being assessable or deductible respectively under sections 775-25 and 775-35 of the ITAA 1997.

Detailed reasoning

58. Refer to question 1.

59. Paragraph 85 to 87 of TR2012/3 state:

85. The principles discussed in this Ruling will also provide some guidance in the context of Division 775 which has an analogous provision to subsection 230-30(2) at section 775-25. Division 775 sets out the treatment for particular foreign currency gains and losses (called forex realisation gains and forex realisation losses) and will continue to be relevant where the gains and losses from the financial arrangements of a taxpayer are not subject to Division 230.

86. Broadly speaking, a forex realisation gain is exempt income or NANE income to the extent that, had it been a forex realisation loss, it would have been made 'in gaining or producing' exempt income or NANE income.12 The nature of the enquiry is similar to the enquiry in subsection 230-30(2).

87. Subsection 230-30(1) provides that a gain you make from a financial arrangement will be exempt income or NANE income to the extent that it reflects an amount that would be exempt income or NANE income if Division 230 was disregarded. Consequently, a gain from a financial arrangement is exempt income or NANE income under subsection 230-30(1) to the extent that the gain would be a forex realisation gain that is exempt income or NANE income under section 775-25, if Division 230 was disregarded. Such a gain may also be exempt income or NANE income under subsection 230-30(2) as well.

60. Any forex realisation loss made by XYZ arising from the forward contracts in respect of the acquisition loan relating to MM would be made by XYZ in gaining or producing NANE income. Therefore, pursuant to section 775-25 of the ITAA 1997, any forex realisation gain made by XYZ on the forward contracts taken out in relation to the acquisition loan relating to MM will be treated as NANE income.

61. Accordingly, any forex realisation gain made by XYZ on the repayment of the Acquisition Loan relating to MM will be NANE income pursuant to section 775-25 of the ITAA 1997, because if it had of been a loss, it would have been a loss made in the course of gaining or producing of NANE income.