Edited version of your written advice

Authorisation Number: 1012696228158

Ruling

Subject: Taxation of financial arrangement

Question 1

Will you need to complete an annual accrual calculation to account for the increase in value of your inflation-linked bond?

Answer:

Yes

This ruling applies for the following period(s)

Year ended 30 June 2014

The scheme commences on

1 July 2013

Relevant facts and circumstances

In 20XX, you acquired an inflation-linked (capital-indexed) bond which is indexed to the Consumer Price Index (CPI).

The bond has two sources of income, a quarterly interest (or coupon) component and, a quarterly adjustment to the principal amount of the bond to reflect the CPI movement in the previous quarter.

The bond has a remaining life after acquisition of more than 12 months

You have not made a tax-timing method election.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 159GP

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 Section 230-15

Income Tax Assessment Act 1997 Section 230-45

Income Tax Assessment Act 1997 Section 230-100

Income Tax Assessment Act 1997 Section 230-105

Income Tax Assessment Act 1997 Section 230-115

Income Tax Assessment Act 1997 Section 230-130

Income Tax Assessment Act 1997 Section 230-135

Income Tax Assessment Act 1997 Section 230-175

Income Tax Assessment Act 1997 Section 118-27

Reasons for decision

Under Division 230 of the Income Tax Assessment Act 1997 (ITAA 1997), the general rule is that gains and losses from financial arrangements will be on revenue account.

Gains and losses from financial arrangements are important for the purposes of Division 230 because the tax treatment of financial arrangements depends on gains and losses made from them and not, for example, on receipts and outgoings. Thus, a taxpayer subject to Division 230 may be required to include a gain in their assessable income and may be allowed a deduction for a loss where it is made in deriving or producing assessable income or in carrying on business for the purpose of deriving assessable income.

Qualifying securities

Subsection 159GP(1) of the Income Tax Assessment Act 1936 (ITAA 1936) defines a 'qualifying security' as:

"qualifying security" means any security:

(a) that is issued after 16 December 1984;

(b) that is not a prescribed security within the meaning of section 26C;

(ba) that is not part of an exempt series (see subsection (9A));

(c) the term of which, ascertained as at the time of issue of the security will, or is reasonably likely to, exceed 1 year;

(d) that has an eligible return; and

(e) where the precise amount of the eligible return is able to be ascertained at the time of issue of the security - in relation to which the amount of the eligible return is greater than 1½% of the amount ascertained by multiplying the amount of the payment or the sum of the payments (excluding any periodic interest) liable to be made under the security by the number (including any fraction) of years in the term of the security;

but does not, except as provided by subsection (10), include an annuity.

For the purposes of this Division, there shall be taken to be an eligible return in relation to a security if at the time when the security is issued it is reasonably likely, by reason that the security was issued at a discount, bears deferred interest or is capital indexed or for any other reason, having regard to the terms of the security, for the sum of all payments (other than periodic interest payments) under the security to exceed the issue price of the security, and the amount of the eligible return is the amount of the excess.

Effectively, paragraph (e) would only apply in relation to a fixed return security (that is, a security of which the redemption yield is able to calculated at the time it is issued).

Inflation-linked (or capital-indexed) bonds

Inflation-linked bonds are securities which promise a fixed coupon interest rate applied to a principal amount which is indexed to the Consumer Price Index (CPI). The important features of these bonds are that the nominal interest paid increases in line with inflation such that the real value of interest receipts is held constant over time. The adjustment of the principal amount, and repayment of that adjusted amount, compensates the holder for the decline in the real value of principal caused by inflation.

In your case, your inflation linked bond is a qualifying security as it satisfies all the necessary conditions under subsection 159GP(1) of the ITAA 1936.

Taxation of financial arrangements (TOFA) provisions

From 1 July 2010, the rules contained in the TOFA provisions of Division 230 of the ITAA 1997 apply to the taxation of certain qualifying securities.

Section 230-5 of the ITAA 1997 provides Division 230 does not apply to financial arrangements where you are an individual and either the arrangement is to end not more than 12 months after you start to have it, or, the arrangement is not a qualifying security.

In your case, your inflation linked bond had a remaining life after acquisition of more than 12 months and it is a qualifying security. Therefore, the TOFA provisions contained in Division 230 of the ITAA 1997 apply to your case.

Taxation treatment of qualifying securities

Section 230-15 of the ITAA 1997 provides, in general, subject to its exceptions, gains are assessable and losses are deductible in relation to a financial arrangement. Subsection 230-15(1) states your assessable income includes a gain you make from a financial arrangement. Subsection 230-45(1) explains that you have a financial arrangement if you have, under an arrangement, a cash settlable legal or equitable right to receive a financial benefit.

Under subsection 230-100(2) of the ITAA 1997, the accruals method applies to a gain or loss you make from a financial arrangement if:

a) the gain or loss is an overall gain or loss from the arrangement; and

b) the gain or loss is sufficiently certain at the time when you start to have the arrangement; and

Subsection 230-105(1) of the ITAA 1997 states that you have a sufficiently certain overall gain or loss from a financial arrangement at the time when you start to have the arrangement only if it is sufficiently certain at that time that you will make an overall gain or loss from the arrangement of:

a) a particular amount; or

b) at least a particular amount.

Often periodic returns are calculated with reference to a variable (such as an interest rate) or the rate of change of a variable (such as the consumer price index (CPI)). This feature, which can affect the quantum of financial benefits arising under a financial arrangement, will not of itself affect whether there is an overall gain or overall loss from the arrangement. This is because in calculating the relevant gain or loss on a financial arrangement, the taxpayer is required to assume that the variable or the rate of change of the variable affecting the quantum of the financial benefit will remain constant for the period of the arrangement (subsection 230-115(4) and 230-115(5) of the ITAA 1997).

In this sense, the fact that the variable or the rate of change of the variable may vary, and hence may practically affect the amount of the gain or loss, is overcome by the required assumption. Any discrepancy between the assumed variable rate and the actual variable rate, provided the difference is insignificant, will be brought to account under the running balancing adjustment mechanism (subsection 230-175(1) and 230-175(2) of the ITAA 1997).

Subsection 230-130(1) of the ITAA 1997 provides the period over which the gain or loss is to be spread is the period that: (i) starts when you start to have the arrangement; and (ii) ends when you will cease to have the arrangement.

Section 230-135 of the ITAA 1997 explains the gain or loss is to be spread, as follows:

The intervals to which parts of the gain or loss are allocated must:

(a) not exceed 12 months; and

(b) all be of the same length.

Paragraph (b) does not apply to the first and last intervals. These may be shorter than the other intervals.

For each interval:

(a) determine a rate of return; and

(b) determine an amount to which you apply the rate of return.

…in determining the amount to which you apply the rate of return for an interval, have regard to:

(a) the amount or value; and

(b) the timing;

of financial benefits that are to be taken into account in working out the amount of the gain or loss, and were provided or received by you during the interval.

A diagram was provided as an example of how the gain or loss is to be spread:

As you will have a sufficiently certain gain or loss from your financial arrangement, the accruals method will apply. Generally, to apply the compounding accruals method, a taxpayer estimates the rate of return (the discount rate) that equates the net present value of all relevant cash flows (financial benefits) to zero. A taxpayer applies that rate to the initial investment, to provide an estimated year-by-year gain which forms the basis for taxation. Although the discount rate is determined by reference to net present values, Division 230 applies to gains or losses so that the total nominal gains or losses are brought to account.

Subsections 230-175(1) and 230-175(2) of the ITAA 1997 provide running balancing adjustments must be made if the financial benefit received or to be received is less or more than the amount estimated under section 230-135.