Edited version of your private ruling

Authorisation Number: 1012487170174

Ruling

Subject: Consolidations and derivatives held by joining entity

Question 1

Are 'in the money' derivative contracts held by the entity assets for tax cost setting purposes pursuant to subdivision 705-A of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Are 'in the money' derivative contracts held by the entity reset cost base assets for tax cost setting purposes pursuant to subsection 705-35 of the ITAA 1997?

Answer

Yes

Question 3

Are 'in the money' derivatives a 'right to future income' under section 701-63 of ITAA 1997 'pre-rules'?

Answer

No

Question 4

Can the Head Company, via subsection 701-55(6) of the ITAA 1997, include the tax cost setting amount of its 'in the money' derivative contracts when calculating any net profit assessable under section 6-5 of the ITAA 1997 or net loss deductible under section 8-1 of the ITAA 1997 which arises under the contracts, or any loss or outgoing upon their maturity, or at the joining time?

Answer

No

This advice applies for the following periods

1 January 2007 to 31 December 2007

1 January 2008 to 31 December 2008

1 January 2009 to 31 December 2009

1 January 2010 to 31 December 2010

1 January 2011 to 31 December 2011

The arrangement commenced on

An earlier income year

Relevant facts and circumstances

The Head Company

The Head Company is incorporated in Australia and a tax resident of Australia.

The Head Company's principal activities are the sale of a commodity.

Acquisition of the entity

The entity is an Australian retailer. The entity purchases from spot markets before on-selling to consumers.

The entity joined the income tax consolidated group, and the tax costs of the assets in the entity were reset in accordance with Subdivision 705-A of the ITAA 1997.

The 'in the money' derivative assets of the entity were allocated a tax cost base on joining the income tax consolidated group.

The consolidation rules that apply

In 2012 the Tax Law amendment (2012 Measures No 2) Act 2012 were passed. It determined that different rules (known as the pre rules, interim rules, prospective rules) would apply to joining entities depending broadly on when the subsidiary member joined the consolidated group. The rules have retrospective effect back to 2002.

The pre rules will apply in relation to the assets of the entity.

The Entity's use of swap contracts

At joining time the entity's balance sheet disclosed derivative assets. These derivative assets represent the in the money fixed forward commodity contracts (swap contracts) that the entity held for the purposes of managing interest rate and commodity spot price fluctuations.

The derivative contracts were recorded at fair value (that is, market value) in the accounts of the entity at the joining time. The derivative contracts with an expected positive cash flow (discounted to present value) were recorded as assets. As these contracts had expected positive cash flow they are referred to as 'in the money' derivatives.

Entering into derivative contracts was an important part of the entity's hedging strategy in order to manage its margin in the retail market.

As a retailer the entity is an intermediary between wholesale and end consumers. It entered into the derivative contracts for the purpose of hedging or managing financial risks associated with its business which requires it to purchase at a spot price.

That is, the contract price that it receives from retail customers is fixed, and this makes it necessary in order to ensure the viability of the business that the business fix the wholesale cost so that a positive margin can be maintained. Without the swap there would be exposure to the spot price for acquiring the commodity. The spot price would fluctuate such that the acquiring the commodity could be more than the price being charged to the retail customer.

The swaps are entered into in the ordinary course of business but are however not acquired for the purpose of gaining a profit from their sale or disposal. Entering the contracts is not linked to dealing in the underlying commodity.

The swaps are executed at market value between willing counterparties, such that the entity pays no amount in order to enter the swaps or acquire them.

Relevant legislative provisions

section 6-5 of the Income Tax Assessment Act 1997

section 8-1 of the Income Tax Assessment Act 1997

Part 3-90 of the Income Tax Assessment Act 1997

Subdivision 705-A of the Income Tax Assessment Act 1997

section 701-1 of the Income Tax Assessment Act 1997

section 701-5 of the Income Tax Assessment Act 1997

section 701-10 of the Income Tax Assessment Act 1997

section 701-55 of the Income Tax Assessment Act 1997

subsection 701-55(6) of the Income Tax Assessment Act 1997

section 701-63 of the Income Tax Assessment Act 1997

subsection 701-63(5) of the Income Tax Assessment Act 1997

subsection 701-63(6) of the Income Tax Assessment Act 1997

subsection 705-25(5) of the Income Tax Assessment Act 1997

paragraph 705-25(5)(b) of the Income Tax Assessment Act 1997

section 705-35 of the Income Tax Assessment Act 1997

subsection 705-35(1) of the Income Tax Assessment Act 1997

subsection 705-35(2) of the Income Tax Assessment Act 1997

section 705-60 of the Income Tax Assessment Act 1997

subsection 713-515(1) of the Income Tax Assessment Act 1997

subsection 713-515(2) of the Income Tax Assessment Act 1997

section 995-1 of the Income Tax Assessment Act 1997

Reasons for decision

All references are to the ITAA 1997 unless otherwise stated.

Question 1

Summary

The 'in the money' derivatives on the entity's balance sheet represent the net expected future cash flows from swap contracts. They are recognised in commerce and business as having an economic value to the entity at the joining time. As such the in the money derivatives are 'assets' for the purposes of Subdivision 705-A.

Detailed reasoning

Assets of joining entities

The term 'asset' is not defined in the Income Tax Assessment Act 1997. Paragraph 5.19 of the Explanatory Memorandum to the New Business Tax System (Consolidation) Bill (No.1) 2002 (the EM) states:

An asset, for the purposes of the cost setting rules, is anything of economic value which is brought into a consolidation group by an entity that becomes a subsidiary member of the group. This includes those assets which subsequently cease to be recognised as a consequence of the single entity rule whilst the asset is within the consolidated group.

Subdivision 705-A is contained in Part 3-90 and as such the guidance in Taxation Ruling TR 2004/13 Income Tax: the meaning of an asset for the purposes of Part 3-90 of the Income Tax Assessment Act 1997 (TR 2004/13) is relevant.

Paragraph 3 of TR 2004/13 states that:

The inclusion of a definition of a liability and the omission of a definition of an asset is consistent with the word 'asset' being given its ordinary commercial or business meaning.

Paragraph 5 of TR 2004/13 goes on to state:

Accordingly, an asset for the purposes of the tax cost setting rules is anything recognised in commerce and business as having economic value to the joining entity at the joining time for which a purchaser of its membership interests would be willing to pay. The business or commercial assets of a joining entity would include the things that would be expected to be identified by a prudent vendor and purchaser as having value in the making of a sale agreement in respect of all the membership interests in an entity and its business. These assets would also come within the scope of a due diligence examination undertaken on behalf of a prudent purchaser of such an entity and business.

Paragraph 28 of TR 2004/13 restates the definition of 'assets' contained in the The Macquarie Concise Dictionary, 1998, rev. 3^rd edn, The Macquarie Library Pty Ltd, NSW (Macquarie Dictionary):

1. Commerce resources available to a business or an individual for future economic benefits or service potential, and considering such items as real property, machinery, inventory, case and securities, etc (tangible assets), and of patents, trademarks and goodwill (intangible assets). 2. property or effects (opposed to liabilities). 3. Accounting the detailed listing of property owned by a firm and money owing to it. 4. Law a. property in the hands of an executor or administrator sufficient to pay the debts or legacies of the testator or intestate. b. any property available for paying debts, etc.

Whether the swap contracts are assets

The Australian Energy Market Operator (AEMO) in its publication Australian Energy Market Operator 2010, An Introduction to Australia's National Electricity Market July 2010, Australian Energy Market Operator, Melbourne defines the basic form of a hedge contract at page 20 as being:

where two parties agree to exchange cash so that a defined quantity of electricity over a nominated period is effectively valued at an agreed strike price. Under such an agreement, generators pay customers the difference when the spot price is above the strike price. When the spot price is below the strike price, customers pay generators the difference between the spot price and the strike price.

The entity's balance sheet shows that at joining time the entity held derivative contracts. These contracts are swap contracts for the purposes of managing interest rate and electricity and gas spot price fluctuations.

The swap contracts were recorded at fair value (that is, market value) in the accounts of the joining entity. In particular, the swap contracts with an expected positive cash flow (discounted to present value) were recorded as assets. It is these swap contracts with an expected positive cash flow that are referred to as 'in the money' derivatives.

The in the money derivatives are assets for the purposes of the tax cost setting rules because at the joining time the derivatives had an expected positive net future cash flow, as such it had an economic value which a purchaser of its membership interests would be willing to pay.

Conclusion

The 'in the money' derivatives represent the net expected future cash flows and are recognised in commerce and business as having an economic value to the entity at the joining time for which the head company would be expected to pay. Because of this feature the 'in the money' derivatives are 'assets' for the purposes of the tax cost setting rules including the reference to 'asset' in Subdivision 705-A.

Question 2

Summary

The in the money derivatives do not satisfy subsection 705-25(5) and therefore are not retained cost base assets. The in the money derivatives are not excluded assets under subsection 705-35(2). As a result the in the money derivatives are 'reset cost base' assets pursuant to subsection 705-35(1).

Detailed reasoning

Are the derivative contracts retained cost base assets

Section 995-1 states that a retained cost base asset has the meaning given by subsections 705-25(5), 713-515(1) and 713-705(2).

Retained cost base asset

705-25(5) A retained cost base asset is:

(a) Australian currency, other than *trading stock or *collectables of the joining entity; or

(b) a right to receive a specified amount of such Australian currency, other than a right that is a marketable security within the meaning of section 70B of the Income Tax Assessment Act 1936; or

Example: A debt or a bank deposit.

(c) a right to have something done under an *arrangement under which:

(i) expenditure has been incurred in return for the doing of the thing; and

(ii) the thing is required or permitted to be done, or to cease being done, after the expenditure is incurred.

(d) a right that is an *unbilled income asset if at the time the right was created:

(i) the *head company was the head company of a *consolidatable group; and

(ii) the joining entity was a *subsidiary member of the consolidatable group.

Relevantly, paragraph 705-25(5)(b) will apply if it is ascertained that the derivate constitutes 'a right to receive a specified amount of Australian currency'. Guidance can be found in the EM at paragraphs 5.22 and 5.23 which state:

5.22 To simplify compliance, a head company's cost for certain assets (retained cost base assets) is set equal to the joining entity's cost for those assets.

5.23 A retained cost base asset is Australian currency or a right to receive a specified amount of Australian currency (other than a right that is a marketable security with the meaning of section 70B of the ITAA 1936) or an entitlement that is subject to a prepayment. However, assets that are Australian currency and that are trading stock or collectables of a joining entity are not retained cost base assets.

Taxation Ruling TR 2005/10 Income tax: consolidation: retained cost base assets consisting of Australian currency or a right to receive a specified amount of such currency (TR 2005/10) states at paragraph 9 that:

Subject to the specific exemption for marketable securities within the meaning of section 70B of the ITAA 1936, a retained cost base asset in terms of paragraph 705-25(5)(b) of the ITAA 1997 is an indefeasible, present right to the actual or constructive receipt of a fixed, nominal amount of Australian currency.

In the case of the in the money derivatives held by the entity, any right to receive an amount of Australian currency will only come into existence if the party has a net receivable amount under the derivative agreement (a net profit). This is dependant on the movements in underlying gas or electricity prices. That is, the amount cannot be determined until termination of the derivative brought about by the maturity of the contract.

Therefore, the in the money derivate contracts held by the entity are not 'retained cost base' assets by virtue of 705-25(5)(b) as they represent merely contingent rights to Australian currency and therefore do not represent an 'indefeasible present right to the actual or constructive receipt of a fixed, nominal amount of Australian currency' within the meaning of paragraph 705-25(5)(b) as outlined in paragraph 9 of TR 2005/10.

Furthermore, the derivative contracts are not rights which are unbilled income assets. They do not constitute rights to future income per subsection 701-63(5) as they are not rights to receive an amount for the performance of work or services, or the provision of goods. As a consequence, they cannot satisfy the definition of unbilled income assets under subsection 701-63(6).

Are the derivative contracts reset cost base assets

Section 705-35 states that a reset cost base asset is not a retained cost base asset, unless it was excluded by subsection 705-35(2). Broadly, excluded assets are those that result in a reduction in the consolidated group's ACA, as calculated in the steps outlined in section 705-60.

The in the money derivatives will not result in a reduction in the consolidated group's ACA and will not be 'excluded assets'.

Subsections 713-515(1) and (2) are not applicable as the entity is not a life insurance company.

Conclusion

The 'in the money' derivatives do not satisfy subsection 705-25(5) and are not excluded assets under subsection 705-35(2). As a result, they will be 'reset cost base' assets pursuant to subsection 705-35(1).

Question 3

Summary

The derivatives are not rights to future income for the purposes of section 701-63 of the pre rules.

This is because the terms of the derivative contract show that the right under the contracts is not to an amount for performance of work or services, or to an amount for the provision of goods. This means that subsection 701-63(5) is not satisfied, and the requirements of section 701-63 are not met.

Detailed reasoning

Subsection 995-1(1) states a right to future income has the meaning given by subsection 701-63(5).

Subsection 701-63(5) states:

A right to future income is a valuable right (including a contingent right) to receive an amount for the performance of work or services or the provision of goods if:

(a) the valuable right forms part of a contract or agreement; and

(b) the *market value of the valuable right (taking into account all the obligations and conditions relating to the right) is greater than nil; and

(c) the valuable right is neither a *Division 230 financial arrangement nor part of a Division 230 financial arrangement.

One of the requirements of subsection 701-63(5) is that there is a right receive an amount for the performance of work or services, or the provision of goods.

Are the net amounts from the swap contracts for performance of work or services

The Macquarie Dictionary relevantly defines 'performance' as the '3. execution or doing, as of work, acts, or feats'. 'Work' is defined as the '1. exertion directed to produce or accomplish something; labour; toil'.

'Service' is relevantly defined as:

1.  an act of helpful activity.

2.  the supplying or supplier of any articles, commodities, activities, etc., required or demanded.

3.  the providing of, or a provider of, a public need, such as communications, transport, etc.

4.  the organised system of apparatus, appliances, employees, etc., for supplying a public need.

5.  the supplying or a supplier of water, gas, or the like to the public.

6.  the performance of duties as a servant; occupation or employment as a servant.

The derivative contracts entered by the entity are swap contracts. The key terms of each swap contract require the entity to pay amounts to the counterparty when the floating price is below the fixed price. Where the floating price is greater than the fixed price, the entity is entitled to receive amounts from the counterparty. Each calculation is made over a 30 minute period.

The cash flows under the swap contracts are determined based on the movement in the price of the commodity. That these cash flows are calculated based on the supply of the commodity does not signify that the contracts deal in it. The contract itself does not deal in the underlying commodity. Rather the entity enters into the swaps to hedge and manage the financial risks associated with its business as a retailer.

No work is performed by entering the swap contracts, nor are any services performed by entering the swap contracts. That is the swap contracts do not involve the delivery of the commodity. Therefore, the swap contracts are not for the performance of work or services by the retailer, as there has been no act that provides work or services to another party.

This interpretation is consistent with the comments by McTiernan J in Revesby Credit Union Co-operative Ltd V FC of T (1965) 112 CLR 564 who in commenting in the meaning of 'rendering of services' stated at 578:

I consider that 'rendering of services' should consist of the doing of an act for the benefit of another…'

Are the net amounts from the swap contracts for the provision of goods

The Macquarie Dictionary relevantly defines 'provision' as '2. the providing or supplying of something, as of food or other necessities' and ' 5. a supply or stock of something provided'.

Goods are defined as '27. (plural) possessions, especially movable effects or personal chattels 28. (plural) articles of trade; wares; merchandise, especially that which is transported by land. 29. an item of merchandise'.

The swap contracts do not deal in any underlying commodity or goods. Rather the entity enters into the swaps to hedge and manage the financial risks associated with its business as a retailer.

No goods are provided by entering the contracts, that is the contracts do not involve the actual delivery of the commodity. It is also considered that the financial stability provided to the business by the hedging so that the business can operate to deliver the commodity to customers is to remote to be considered to be for the provision of goods. Therefore, the derivative contracts are not a right to an amount for the provision of goods by the retailer.

Conclusion

The swap contracts are not contracts that create rights to an amount for performance of work or services, or an amount for the provision of goods. This means that the requirements of subsection 701-63(5) are not satisfied, and the contracts are not rights to future income.

Question 4

Summary

Gross amounts received under the swap contracts (including on maturity as any such amounts received on maturity are received under the contract) constitute ordinary income, therefore this is not a circumstance where it is appropriate to bring to account for tax purposes net amounts under the swap. Under the terms of each swap contract, there is an obligation to exchange cash flows. This gives rise to both the right to receive payments and the obligation to make payments. The cash flows receivable from the counterparty will be assessable as ordinary income for the purposes of section 6-5 when they are derived. Similarly, cash flows paid to the counterparty will be deductible for the purposes of section 8-1 when they are incurred.

Subsection 701-55(6) of the pre rules deems an asset's cost to be equal to its tax cost setting amount. Subsection 701-55(6) only operates where a provision is to apply in relation to the asset, independently of the subsection. Sections 6-5 and/or 8-1 have no application to the asset (the swap contract) as such; would not apply apart from the subsection; and insofar as they could be said to apply at all, apply to receipts and outgoings under the swap and not to its cost. That is, subsection 701-55(6) does not operate in relation to the swap contracts, or at the very least has no effect.

Moreover, the 'cost' of a swap contract does not constitute a cash flow payable to the counterparty under the swap contract. Consequently, an amount equal to the tax cost setting amount cannot be deducted under section 8-1 on this basis.

Futhermore, if contrary to above it was to be concluded that section 6-5 and/or 8-1 are to apply in relation to the swap contract, although subsection 701-55(6) deems the cost of the asset (being the swap contract) to be equal to its tax cost setting amount it does not deem there to be a loss or outgoing incurred by the head company equal to the tax cost setting amount at the joining time (or any other time), nor does it deem it to have been incurred to acquire the swap contract. As such, section 8-1 does not allow a deduction equal to the tax cost setting amount of the swap contracts in the income year that the entity joined the consolidated group.

In addition, when each swap contract matures, the head company does not incur any loss or outgoing for the purposes of section 8-1. Therefore, section 8-1 does not allow the head company to deduct any amount in relation to the entity's swap contract upon its maturity.

Detailed reasoning

The taxation treatment of the swap contracts

Taxation Ruling TR 2005/15 Income tax: tax consequences of financial contracts for differences (TR 2005/15) deals with the taxation treatment of receipts and outgoings arising out of financial contracts for differences. These include contracts where there is a fixed buy price and a floating sell price.

The derivative contracts of the entity are swap contracts, entered into under the terms of an ISDA master agreement. The key terms of each contract require the entity to pay the fixed price to the counterparty for a given quantity and the counterparty to pay the entity a floating price for the same quantity. Where the floating price is below the fixed price, the entity is required to pay the difference to the counterparty. Where the floating price is greater than the fixed price, the entity is entitled to receive amounts from the counterparty. Each calculation is made over a 30 minute period.

The swap contracts being typical ISDA swap contracts do not follow the form described at paragraph 6 in TR 2005/15, therefore the ruling does not apply to the swap contracts. The swap contracts, however, are similar to contracts for differences. As such, the principles in the ruling regarding the tax treatment of contracts for differences have been applied consistently to the swap contracts.

TR 2005/15 provides at paragraphs 11 and 12:

11. A gain from a financial contract for differences will be assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) where the transaction is entered into as an ordinary incident of carrying on a business, or where the profit was obtained in a business operation or commercial transaction for the purpose of profit making.

12. A loss from a financial contract for differences will be an allowable deduction under section 8-1 of the ITAA 1997 where the transaction is entered into as an ordinary incident of carrying on a business or in a business operation or commercial transaction for the purpose of profit making.

The entity entered into the swaps in the ordinary course of its business, for the purpose of hedging the financial risks of movements in the spot price for a commodity associated with its business. Consistent with TR 2005/15, any gains from the swaps will be assessable under 6-5 and any losses deductible under 8-1.

With regard to whether the assessable gains and deductible losses should be net amounts (calculated by netting off cash flows referable to the same period) or gross amounts (treating each cash flow separately), paragraph 18 of TR 2005/15 states:

18. Whether gross receipts and gross outgoings are respectively assessable income and allowable deductions, or whether it is the net profit or the net loss, will depend on the terms of the contract in each case. Some contracts create gross but offsetting liabilities; others provide for a liability for a net amount calculated by reference to notional gross amounts. However, for most taxpayers there will be no practical difference whether gross receipts are aggregated as assessable income and gross outgoings are deducted, or whether the net profits and net losses are brought to account. The terms of the contract will also determine the time at which each is assessable income or an allowable deduction, that is, whether it is daily because the contract is terminated at the end of each day and a new contract is opened the next day; or whether it is at the close out of a contract that is continued from day to day. Again, for most taxpayers there will be no practical difference, except at the end of the year of income.

All of the entity's swaps are governed by an ISDA master agreement. Under the terms of that agreement, each party has an obligation to make gross payments to the other. The contract then provides that these obligations may be discharged through making a net payment. That is, under the terms of the swap contracts, gross but offsetting liabilities arise, as opposed to net liabilities which are calculated by reference to notional gross amounts.

Accordingly, the gross receipts which the counterparty is required to provide to the entity are assessable gains under section 6-5. Similarly, the gross payments which the entity is required to make to the counterparty are deductible losses under section 8-1.

In addition to TR 2005/15, Taxation Ruling No. IT 2050 (as amended 20/7/83) "Interest - Swapping" transactions and Taxation Ruling IT 2682 Income tax: payments made under interest rate swap contracts: timing of income and deductions apply to interest rate swaps. Although the swap contracts are not interest rate swaps, they share many characteristics with interest rate swaps, in particular, they are entered into under an ISDA Master Agreement.

Per IT 2050 paragraph 8:

It is also accepted as a general principle that payments made by the parties in accordance with the interest swapping agreement are attributable to existing interest expenses and are themselves revenue in nature. As a consequence the payments would be assessable to the recipient and deductible to the payer as the case may be. The involvement of an intermediary would not alter the character of the payments.

Further, at paragraph 10:

Because the various incidental expenses which are associated with an interest swapping transaction relate to an existing interest expense they would ordinarily be deductible in accordance with section 51(1) of the ITAA 1936 in the same way as the incidental costs associated with a conventional interest hedging arrangement. Any payments which might be made by the parties upon early termination of the whole of the arrangements would also be of a revenue nature in the usual case, i.e. assessable or deductible to the parties as the case may be.

IT 2682 states at paragraph 10

10. The practical effect of entering into an interest rate swap transaction is to substitute liability for an interest rate regime (fixed or floating rate) with a regime of swap payments. However, a swap does not affect the underlying contractual liabilities of the swap counterparties. A counterparty remains legally obligated to its original lender to make loan repayments and to pay interest under the relevant loan agreement. Further, the rights and obligations of parties to swaps do not depend upon the existence of an underlying loan. It should therefore be noted that, while swap payments are calculated with reference to interest obligations, the swap payments themselves are not interest payments nor are they in the nature of interest. (See also IT 2050 at paragraphs 5 to 7).

This paragraph clarifies that although the payments and receipts under an interest rate swapping contract are on revenue account, this is not because they are in the nature of interest. Rather they are on revenue account in their own right as incidental costs and receipts which are relevant to the taxpayer's business.

Applying these principles to the head company, the cash flows under the entity's swap contracts are relevant to its electricity retail business. They were entered into in the ordinary course of its business, for the purpose of hedging the financial risks of movements in the spot price for a commodity associated with its business.

In this way, the payments that the entity are required to make under the swap contracts are revenue in nature and therefore deductible to the head company under section 8-1 when they are incurred. Similarly, the payments that the entity is entitled to receive from the counterparty are assessable to it as ordinary income under section 6-5 when they are derived.

The application of subsection 701-55(6) of the pre rules

The pre rules apply to the head company with regard to the entity for the relevant income years.

The phrase 'tax cost is set' (as used in section 701-10) is given meaning by section 701-55, which operates to deem certain facts regarding the asset's tax cost setting amount. Different facts are deemed depending on which provision of the Act outside of Part 3-90 is to apply in relation to the asset.

Subsection 701-55(6) applies where a provision of the Act, not mentioned elsewhere in section 701-55, is to apply in relation to the asset.

The pre rules version of subsection 701-55(6) states:

Other provisions

(6) If any provision of this Act that is not mentioned above is to apply in relation to the asset, the expression means that the provision applies as if the asset's cost at that time were equal to its tax cost setting amount.

Note: For specific clarification of the operation of this subsection in relation to bad debts, see Subdivision 716-S

If subsection 701-55(6) is triggered, it operates to deem the asset's cost to be equal to the asset's tax cost setting amount. It follows that, where the 'cost' of the asset is relevant to the calculation of the amount assessable or deductible under a provision of the Act not mentioned elsewhere in section 701-55, in accordance with subsection 701-55(6), the tax cost setting amount of the asset will be the amount taken into account.

A provision of the Act is to apply in relation to the asset

Subsection 701-55(6) only operates if at the time of joining, independently of the subsection, a provision 'is to apply in relation to the asset'. This requirement is not satisfied in these circumstances. Sections 6-5 and 8-1 are not provisions that apply to assets nor costs of assets as such; they apply respectively to 'income' and to 'losses and outgoings'. Sections 6-5 and 8-1 will apply to income derived and losses or outgoings incurred under the swap contracts but this is not considered a sufficient connection.

Furthermore, the swap contracts had no cost in the entity's hands. The cost of the swap contracts, if there were one, has no relevance to the determination of what is assessable or deductible under the swap contracts. Moreover, the entity does not enter into swap contracts for the purpose of deriving income from disposing of them. The entity does not receive amounts for the swap contracts, it only receives amounts under the swap contracts. Therefore, there is no provision of the Act that is not mentioned in the rest of section 701-55(6) that 'is to apply in relation to the asset.'

If it were to be considered that the application of sections 6-5 and 8-1 to income derived or losses or outgoings incurred under the swap contract is sufficient to trigger subsection 701-55(6), because the cost of the swap contracts has no relevance to the work that those sections do, subsection 701-55(6) will have no effect. This is discussed in further detail below.

Is an amount equal to the tax cost setting amount of the swap contract deductible under section 8-1 at the joining time

Since no provision is to apply in relation to the swap contracts, subsection 701-55(6) would not be triggered in relation to them. Consequently, the tax cost setting amounts of the swap contracts would fail to meet the requirements of deductibility under section 8-1. That is, they would not constitute a loss or outgoing incurred by the head company.

Even if subsection 701-55(6) could be said to have been triggered and the entity could be said to have incurred a cost for a swap contract, that cost is properly deductible when incurred and is not otherwise taken into account in the determination of what is either assessable or deductible under the swap contracts. Since the entity does not receive amounts for swap contracts (it only receives amounts under swap contracts), there is no question of needing to determine the proper treatment of such amounts or that the cost needs to be included in the calculation of such amounts in order to give a correct reflex of the taxpayer's true income.

That is, although the receipts the entity is entitled to receive under the terms of the swap contracts give rise to ordinary income and the payments it is obliged to make are deductible, the 'cost' of a swap does not constitute a payment made in accordance with the terms of the swap. It is therefore not deductible on this basis.

Furthermore, the cost of entering into a swap contract is different in nature to the payments made under the swap contract. The income tax law regards as separate the treatment of amounts received and paid under an asset from the treatment of any profit or loss on disposal of the asset (FC of T v Citibank Ltd & Ors 93 ATC 4691; Australian and New Zealand Banking Group Ltd v FC of T 94 ATC 4026 at 4042 per Hill J (Northrop and Lockhart JJ agreeing)).

Consequently, an amount equal to the tax cost setting amount of the swap contract cannot be deducted under section 8-1 because it has no relevance to payments made under the terms of the swap contract.

In terms of whether the cost of entering into a swap contract could be deducted in its own right, in the case of Visy the Full Federal Court considered whether an amount expended in entering into or acquiring a hedge contract would be deductible under section 8-1. The Court found that where an amount of expenditure was made to enter into an indemnity, which hedged against potential losses on another profit-making transaction, then that amount would be deductible under section 8-1, on the basis that the hedge was entered into in the course of carrying on the taxpayer's business (albeit not in the ordinary course of that business) (at [52], [60] and [75]).

The Full Federal Court also found that where such an amount satisfies the requirements of section 8-1, the amount will be deductible in the year it is incurred, regardless of whether it is part of a wider profit-making transaction.

When the entity joined the consolidated group, Part 3-90 of the ITAA 1997 operated to deem certain facts in relation to the swap contract.

For the purpose of working out the head company's income tax liability:

the single entity rule (section 701-1) applies to deem the entity to be part of the consolidated group, rather than a separate entity; and

the entry history rule (section 701-5) applies to deem everything that happened in relation to the entity to have happened in relation to the head company.

In addition, the tax costs of the entity's swap contracts are set at their tax cost setting amount under section 701-10.

Under the entry history rule, the swap contract is taken to have been entered into and held by the head company under the same circumstances as it was entered into and held by the entity before the joining time. Consequently, the head company is taken to have entered into the swap contract in the ordinary course of its business, for the purpose of hedging the financial risks of movements in the spot price of a commodity associated with its business.

In accordance with Visy, if any amount can be said to have been incurred by the head company in entering into or acquiring the swap contract, it would be deductible under section 8-1 at that time.

If section 8-1 was to apply in relation to the swap contract, subsection 701-55(6) of the pre rules would operate to deem each swap contract's cost to be equal to its tax cost setting amount. However, subsection 701-55(6) does not deem a loss or outgoing equal to the tax cost setting amount of the swap contract to have been incurred by the head company at the joining time nor, even if it did, does it deem the tax cost setting amount to have been incurred to acquire the swap contract. It is a principle of statutory interpretation that deeming provisions must be construed strictly and only for the purposes for which they are resorted to (FCT v Comber) 10 FCR 88 at 96).

There is nothing within the words of subsection 701-55(6) deeming the tax cost setting amount to be a loss or outgoing incurred in an income year that would give the head company an entitlement to a deduction under section 8-1. It is also not a necessary implication of deeming the 'asset's cost' at the joining time equal to the asset's tax cost setting amount that there has been a loss or outgoing incurred at the joining time or any other time.

Furthermore, the head company is taken to have acquired the swap contract when the entity acquired it. Subsection 701-55(6) does not deem the asset to have been acquired at the joining time. Nor is it open to imply such an acquisition, it not being a necessary implication of deeming what the asset's cost is. The swap contracts were acquired before the joining time; nothing within Part 3-90 allows the tax cost setting amount to be attributed to that event. Moreover such an attribution would not be for the purposes of working out the head company's income tax liability (rather, it would be for the purpose of working out the entity's liability before the joining time).

Consequently, section 8-1 does not allow a deduction for an amount equal to the tax cost setting amount of the swap contract in the income year that the entity joined the consolidated group.

Is there a loss under section 8-1 at the maturity of the swap contract

When the entity joined the consolidated group, Part 3-90 operated to deem certain facts in relation to the swap contract.

For the purpose of working out the head entity's income tax liability:

· the single entity rule (section 701-1) applies to deem the entity to be part of the consolidated group, rather than a separate entity; and

· the entry history rule (section 701-5) applies to deem everything that happened in relation to the entity to have happened in relation to the head company.

In addition, the tax costs of the entity's swap contracts are set at their tax cost setting amount under section 701-10.

Under the entry history rule, the swap contract is taken to have been entered into and held by the head company under the same circumstances as it was entered into and held by the entity before the joining time. Consequently, the head company is taken to have entered into the swap contract in the ordinary course of its business, for the purpose of hedging the financial risks of movements in the spot price of a commodity associated with its business.

Similarly after the joining time, under the single entity rule and the entry history rule, the head company is taken to hold and deal with the swap contract as the entity did.

A loss may be deductible under section 8-1 where the initial outlay in relation to an asset did not itself constitute a loss or outgoing incurred, and that asset is subsequently lost.

This is in accordance with Guinea Airways Ltd. v Federal Commissioner of Taxation [1950] 83 CLR 584, where the taxpayer paid for aircraft spare parts which were not deductible on purchase. The parts were stockpiled by the taxpayer and were later destroyed by bombing during the Second World War. The taxpayer sought a deduction for the destroyed parts upon their destruction. Latham CJ noted (at 589):

The claim of the company is not a claim for deduction of the amount expended in purchasing the spare parts and stores or of the value of those actually used. It is a claim in respect of their loss.

An asset is lost and a loss incurred where the benefit or value of the asset is forgone and cannot be recovered or realised, for instance, where an asset was destroyed, or where a debt is not recovered to its full value (paragraph 6.52 in Parsons, R.W. Income Taxation in Australia Principles of Income, Deductibility and Tax Accounting).

In contrast, when the swap contract reaches maturity, the benefits under the contract will have been fully realised by the entity. It has had the benefit of hedging the financial risks associated with its business for the entire time that the swap contract has been in place. Therefore, none of the value of the asset (the swap contract) can be said to have been lost. Rather, when the swap contract comes to an end the asset can be said to have run its course.

In this way, there cannot be said to be a loss to the head company upon the maturity of the swap contract.

Notwithstanding this, a loss may be deductible upon the ending of an asset where the asset is part of an entity's circulating capital.

In General Acceptance Gibbs J observed (at 377) that 'the line of distinction between fixed and circulating capital is not precisely drawn'. Mason J, however went further at 383:

The distinction between fixed and circulating capital was described by Jenkins L.J. in Reynolds and Gibson v. Crompton (1950) 33 T.C. 288 at p. 303, as ``debatable''. His Lordship went on to say that ``circulating capital'' is ``simply an expression used to denote capital expended in the course of the trade with a view to disposal at a profit of the assets produced or acquired by means of such expenditure, and represented at different stages of its career by cash, assets into which the cash has been converted, and debts owing from customers to whom those assets have been sold''. See the same case on appeal Crompton v. Reynolds and Gibson (1952) 1 All E.R. 888 at pp. 893-895.

However, it cannot be said that the swap contract here fits this description, as it is not an asset produced or acquired with a view to disposal at a profit. Rather, it was entered into for the purpose of managing the financial risk to the entity's business by hedging against movements in the spot price of a commodity.

By this definition, the swap contract is not part of the entity's circulating capital, meaning that no deductible loss will arise upon its maturity.

In addition, there is no outgoing when the swaps come to an end. No amount is paid, expended, outlaid or promised in respect of the ending of the swap contract.

Furthermore, if an amount were to be received by the head company on the maturity of the swap contract the gross amount received is properly characterised as ordinary income in its own right (Commercial and General Acceptance Ltd v FC of T (1977) 137 CLR 373 at 382-383 per Mason J; FC of T v Montgomery (1999) 198 CLR 639 at 675-6 [110] - [111] per Gaudron, Gummow, Kirby and Hayne JJ at [110] to [111]). Therefore, amounts incurred on entry into the swap contract or for acquiring the swap contract are not deferred and taken into account in calculating the profit or loss on maturity of the swap contract. Such outgoings are deductible in the year in which they are incurred (FC of T v Visy Industries USA Pty Ltd [2012] FCAFC 106 at [84] per Edmonds, Greenwood and Robertson JJ).

Therefore, section 8-1 does not allow the head company to claim that a loss has been made from, or deduct any amount in relation to, the entity's swap contracts upon its maturity. The condition in section 8-1 requiring there to be a loss or an outgoing has not been satisfied. It follows that the tax cost setting amount of the swap contract cannot be deducted under section 8-1 upon the maturity of the contract.