Edited version of your private ruling

Authorisation Number: 1012538069908

Ruling

Subject: Taxation treatment under Division 230 of the Income Tax Assessment Act 1997

Are foreign exchange losses in respect of the borrowings not allowable as a deduction under subsection 230-30(3) of the ITAA 1997, to the extent that the borrowed funds were used to recapitalise foreign subsidiary 1 and repay an existing borrowing that was used to recapitalise foreign subsidiary 2?

Answer

Yes.

Question 2

Are foreign exchange gains in respect of the borrowings not assessable income and not exempt income (NANE income) under subsection 230-30(2) of the ITAA 1997, to the extent that the borrowed funds were used to recapitalise foreign subsidiary 1 and repay an existing borrowing that was used to recapitalise foreign subsidiary 2?

Answer

Yes.

Relevant facts and circumstances

The taxpayer obtained foreign currency denominated borrowings (the borrowings). The borrowings were obtained for the purpose of recapitalising a foreign subsidiary (foreign subsidiary 1) and repaying an existing borrowing that was used to recapitalise another foreign subsidiary (foreign subsidiary 2).

The additional capital required by foreign subsidiary 1 was less than originally expected. As a result, very shortly after obtaining the borrowings the taxpayer used the borrowings to:

· recapitalise foreign subsidiary 1;

· repay an existing borrowing that was used to recapitalise foreign subsidiary 2; and

· fund general corporate activities that will solely produce assessable income for the taxpayer.

The shares in foreign subsidiary 1 and foreign subsidiary 2 are reasonably expected to produce dividends that will satisfy either section 23AI or section 23AJ of the Income Tax Assessment Act 1936 (ITAA 1936).

Division 230 of the ITAA 1997 applies to the taxpayer in respect of gains and losses in respect of the borrowings.

The taxpayer has made a general foreign exchange retranslation election under subsection 230-255(1) of the ITAA 1997. As a result, foreign exchange gains and losses in respect of the borrowings (including unrealised foreign exchange gains and losses) are recognised under Subdivision 230-D of the ITAA 1997.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 230-15(2)

Income Tax Assessment Act 1997 Subsection 230-15(3)

Income Tax Assessment Act 1997 Subsection 230-30(2)

Income Tax Assessment Act 1997 Subsection 230-30(3)

Income Tax Assessment Act 1997 Subsection 775-35(2)

Income Tax Assessment Act 1997 Paragraph 820-40(1)(a)

Income Tax Assessment Act 1997 Subparagraph 820-40(3)(b)(ii)

Income Tax Assessment Act 1936 Section 23AI

Income Tax Assessment Act 1936 Section 23AJ

Reasons for decision

Question 1

Summary

Foreign exchange losses in respect of the borrowings have a sufficient connection to the acquisition and holding of shares in foreign subsidiary 1 and foreign subsidiary 2, which are reasonably expected to produce NANE dividends. As a result, foreign exchange losses in respect of the borrowings are made 'in gaining or producing' NANE income.

Foreign exchange losses in respect of the borrowings are not allowable as a deduction to the taxpayer under any provision of the ITAA 1997 or the ITAA 1936 to the extent that they are made in gaining or producing NANE income (subsection 230-30(3) of the ITAA 1997). It is fair and reasonable to apportion foreign exchange losses in respect of the borrowings based on the extent to which the borrowed funds were used to recapitalise foreign subsidiary 1 and repay the existing borrowing that was used to recapitalise foreign subsidiary 2. Foreign exchange losses in respect of the borrowings are not allowable as a deduction to the taxpayer under any provision of the ITAA 1997 or the ITAA 1936 to extent that the borrowed funds were used to recapitalise foreign subsidiary 1 and repay the existing borrowing that was used to recapitalise foreign subsidiary 2.

Detailed reasoning

Generally, under Division 230 of the ITAA 1997 a gain you make from a financial arrangement is included in your assessable income (subsection 230-15(1) of the ITAA 1997). A loss you make from a financial arrangement is deductible to the extent that you make the loss in gaining or producing your assessable income, or you necessarily make it in carrying on a business for the purpose of gaining or producing assessable income (subsection 230-15(2) of the ITAA 1997).

However, subsection 230-30(3) of the ITAA 1997 provides that a loss made from a financial arrangement is not an allowable deduction to the extent it is made in gaining or producing exempt income or NANE income, unless the loss satisfies the description in subsection 230-15(3) of the ITAA 1997.

Subsection 230-15(3) of the ITAA 1997 is not applicable, as foreign exchange losses are not a cost in relation to a debt interest that is covered by paragraph 820-40(1)(a) of the ITAA 1997 (subparagraph 820-40(3)(b)(ii) of the ITAA 1997).

Similarly, subsection 230-30(2) of the ITAA 1997 provides that, despite section 230-15 of the ITAA 1997, a gain made from a financial arrangement will be exempt income or NANE income to the extent that, if the gain had been a loss instead (a 'hypothetical loss'), the hypothetical loss would have been made in gaining or producing exempt income or NANE income.

Foreign exchange gains and losses in respect of the borrowings are gains and losses made from a financial arrangement.

Taxation Ruling TR 2012/3 Income tax: taxation of financial arrangements - application of subsections 230-30(2) and 230-30(3) of the Income Tax Assessment Act 1997 to gains and losses relating to exempt income or non-assessable non-exempt income explains the principles that apply in deciding whether or not a loss you make, or hypothetical loss you would have made, from a financial arrangement is made in gaining or producing exempt income or NANE income for the purposes of subsections 230-30(2) and 230-30(3) of the ITAA 1997.

The principles are:

· The words 'in gaining or producing' require an examination of whether or not there is a sufficient connection between the identified loss and an income producing activity. Whether a sufficient connection exists will depend on the nature of the loss and the degree of its connection with the activities by which the taxpayer is gaining or producing the relevant income (paragraph 9 of TR 2012/3).

· The words 'in gaining or producing' have a wide application (paragraph 11 of TR 2012/3).

· A loss is made in gaining or producing exempt income or NANE income if the loss is incidental and relevant to the exempt income or NANE income producing activity of the taxpayer (paragraph 12 of 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 2012/3).

· Whether a loss has a sufficient connection to the gaining or producing of exempt income or NANE income is a question of fact and circumstances (paragraph 14 of TR 2012/3).

TR 2012/3 deals with the connection that a foreign exchange loss (made in relation to borrowings used to acquire a NANE income producing asset) has with the production of NANE income.

TR 2012/3 explains that the nature of a foreign exchange loss made in respect of a borrowing is akin to interest paid on the borrowing. Paragraph 133 of TR 2012/3 summarises the position in respect of the nature of such a loss and its connection to the production of NANE income:

A foreign exchange loss is akin to a cost of borrowing, or of obtaining and securing borrowed funds for use in the business. This characterisation of the loss being a cost of borrowing and having regard to the wide nature of the nexus test (assuming there is no issue of the expenditure being too soon or post-derivation) leads to the conclusion that such a loss is made in gaining or producing NANE income.

Paragraph 9 of Taxation Ruling IT 2606 Income tax: deduction for interest on borrowings to fund share acquisitions similarly states:

As a general rule, interest on money borrowed to acquire shares will be deductible under the first limb of subsection 51(1) where it is expected that dividends or other assessable income will be derived from the investment. Such an expectation will usually exist as shares by their very nature are inherently capable of generating dividends, whether in the short or long term. However, such an expectation must be reasonable and not a mere theoretical possibility; there must be a prospect of dividends or other assessable income being received.

Paragraph 20 of IT 2606 refers to the evidence before the Full Federal Court in FC of T v Total Holdings (Australia) Pty Ltd 79 ATC 4279 (Total Holdings). Paragraph 20 states:

The parent had a policy of requiring dividends to be remitted and it had sufficient control over the subsidiary to ensure that this policy was followed. This was sufficient evidence to show an expectation of income by the parent at some time in the future.

The recapitalisation of foreign subsidiary 1

In accordance with the principles identified above in TR 2012/3 and IT 2606, foreign exchange losses in respect of the borrowings are made 'in gaining or producing' NANE income. As a result, foreign exchange losses in respect of the borrowings are not allowable as a deduction under any provision of the ITAA 1997 or the ITAA 1936 to the extent that they are made in gaining or producing NANE income (subsection 230-30(3) of the ITAA 1997).

The facts and circumstances in respect of the recapitalisation of foreign subsidiary 1 are similar to Example 3 beginning at paragraph 32 of TR 2012/3. In Example 3, a resident company borrowed to acquire shares in a foreign subsidiary, and on repayment of the loan made a foreign exchange gain. There was a reasonable expectation that the shares in the foreign subsidiary would pay dividends that would satisfy section 23AJ of the ITAA 1936. Example 3 concludes that:

If an actual loss arose in these circumstances instead of the gain, such a loss would not be allowable as a deduction by virtue of subsection 230-30(3).

The explanation in paragraph 70 of TR 2012/3 is also relevant. Paragraph 70 states:

…a loss made in relation to the satisfaction of an obligation to pay interest on a loan, the funds from which were used to acquire an asset that produces NANE income, has a nexus with the production of NANE income.

As the view in TR 2012/3 is that a foreign exchange loss in respect of borrowings used to acquire a NANE income producing asset is akin to interest on the borrowings, such a foreign exchange loss will also have a nexus with the production of NANE income.

Finally, paragraph 85 of TR 2012/3 states that the principles discussed in TR 2012/3 will also provide some guidance in the context of Division 775 of the ITAA 1997, which has analogous provisions to section 230-30 of the ITAA 1997. Division 775 of the ITAA 1997 sets out the treatment for particular foreign currency losses where the losses are not subject to Division 230 of the ITAA 1997. In ATO Interpretative Decision ATO ID 2004/752 Income tax - Foreign exchange (Forex): Forex realisation loss on repayment of borrowings to acquire non-portfolio dividend a taxpayer made a foreign exchange loss in respect of the repayment of borrowings used to acquire foreign subsidiaries. The issue was whether the foreign exchange loss was disregarded under subsection 775-35(2) of Division 775 of the ITAA 1997. It is a requirement of the first limb of subsection 775-35(2) of the ITAA 1997 that the foreign exchange loss must be made 'in gaining or producing' NANE income. After referring to Total Holdings and recognising that the shares in the foreign subsidiaries 'are inherently capable of generating income', ATO ID 2004/752 concluded that the foreign exchange loss on repayment of the borrowing was made in gaining or producing NANE income (being dividends that will satisfy either section 23AI or section 23AJ of the ITAA 1936).

The refinancing of the existing borrowing that was used to recapitalise foreign subsidiary 2

As identified above, TR 2012/3 explains that the nature of a foreign exchange loss made in respect of a borrowing is akin to interest paid on the borrowing. Paragraph 133 states:

A foreign exchange loss is akin to a cost of borrowing, or of obtaining and securing borrowed funds for use in the business.

Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith outlines the implications flowing from the decision of the Full Federal Court in FC of T v. Roberts; FC of T v. Smith 92 ATC 4380; (1992) 23 ATR 494 (Roberts and Smith).

The issue in Roberts and Smith was whether interest incurred by a general law partnership in respect of borrowings used to repay partners' capital was deductible under subsection 51(1) of the ITAA 1936.

In the course of his judgement, Justice Hill stated (ATC at 4388; ATR at 504):

The funds to be withdrawn in such a case [where a partner calls up an amount owing as undrawn partnership distributions] were employed in the partnership business; the borrowing replaces those funds and the interest incurred on the borrowing will meet the statutory description of interest incurred in the gaining or production by the partnership of assessable income.

In principle, such a case is no different from the borrowing from one bank to repay working capital originally borrowed from another; the character of the refinancing takes on the same character as the original borrowing and gives to the interest incurred the character of a working expense.

As explained by paragraph 42 of TR 95/25:

Interest on a new loan will be deductible if the new loan is used to repay an existing loan which, at the time of the second borrowing, was being used in an assessable income producing activity or used in a business activity which is directed to the production of assessable income (Roberts and Smith ATC at 4388; ATR at 504).

Conversely, interest on a new loan will not be deductible if the new loan is used to repay an existing loan which, at the time of the second borrowing, was being used in a NANE income producing activity. The same principle applies to foreign exchange losses made in respect of a borrowing because foreign exchange losses made in respect of a borrowing are akin to interest paid on the borrowing, as explained by paragraph 133 of TR 2012/3.

The existing borrowing was used in a NANE income producing activity: it was used to acquire additional shares in foreign subsidiary 2 which are reasonably expected to produce dividends that will satisfy either section 23AI or section 23AJ of the ITAA 1936. At the time the borrowings were obtained (the new borrowings), the existing borrowing was still being used in a NANE income producing activity. As a result, foreign exchange losses in respect of the borrowings (the new borrowings) will also be made 'in gaining or producing' NANE income for the purpose of subsection 230-30(3) of the ITAA 1997. The character of the borrowings (the new borrowings) will take on the same character as the existing borrowing to the extent that the borrowings (the new borrowings) were used to repay the existing borrowing.

Apportionment

The expression 'to the extent that' in subsection 230-30(3) of the ITAA 1997 makes it clear that apportionment is required in relation to a loss where it:

· has a connection with an activity that produces both assessable income and NANE income, or

· has a connection with more than one activity, one of which produces assessable income and at least one other which produces NANE income.

Foreign exchange losses in respect of the borrowings fall within the second bullet point. They have a connection with the acquisition and holding of shares in foreign subsidiary 1 and foreign subsidiary 2, and general corporate activities. The shares in foreign subsidiary 1 and foreign subsidiary 2 are reasonably expected to produce NANE income. The general corporate activities wholly produce assessable income. As a result, apportionment of foreign exchange losses in respect of the borrowings between NANE income and assessable income is required.

An appropriate method of apportionment is a question of fact in each case. The method to be adopted must be 'fair and reasonable' in all the circumstances (Ronpibon Tin; Adelaide Racing Club Inc v Federal Commissioner of Taxation (1964) 114 CLR 517 at 526).

It is fair and reasonable to apportion foreign exchange losses in respect of the borrowings based on the extent to which the borrowed funds were used to recapitalise foreign subsidiary 1 and repay the existing borrowing that was used to recapitalise foreign subsidiary 2. Foreign exchange losses in respect of the borrowings are not allowable as a deduction to the taxpayer under any provision of the ITAA 1997 or the ITAA 1936 to extent that the borrowed funds were used to recapitalise foreign subsidiary 1 and repay the existing borrowing that was used to recapitalise foreign subsidiary 2.

Question 2

Detailed reasoning

Subsection 230-30(2) of the ITAA 1997 operates with reference to a 'hypothetical loss'. A foreign exchange gain in respect of the borrowings is NANE income to the extent that, if the foreign exchange gain had been a foreign exchange loss, it would have been made in gaining or producing NANE income.

It has been established above that foreign exchange losses in respect of the borrowings are made in gaining or producing NANE income to the extent that the borrowed funds were used to recapitalise foreign subsidiary 1 and repay the existing borrowing that was used to recapitalise foreign subsidiary 2. As a result, foreign exchange gains in respect of the borrowings are NANE income to the same extent.