Edited version of your written advice

Authorisation Number: 1012729392770

Ruling

Subject: Termination of Forward Foreign Exchange contracts

Question 1

On termination of a forward exchange contract, will the gain that AusCo makes which is calculated under the balancing adjustment method in Subdivision 230-G of the Income Tax Assessment Act 1997 (ITAA 1997) be included in its assessable income under subsection 230-15(1) of the ITAA 1997?

Answer

Yes

Question 2

On termination of a forward exchange contract, will the loss that AusCo makes which is calculated under the balancing adjustment method in Subdivision 230-G of ITAA 1997 be allowed as a deduction under subsection 230-15(2) of the ITAA 1997?

Answer

Yes

Question 3

Will, subject to Division 815 of the ITAA 1997, AusCo be entitled to an allowable deduction under section 8-1 of the ITAA 1997 for the amount payable to ForeignCo?

Answer

Yes but the amount allowable as a deduction under section 8-1 of the ITAA 1997 will be subject to the transfer pricing rules in Division 815 of the ITAA 1997.

This ruling applies for the following period:

Year ending 31 December 2014

The scheme commences on:

Year ending 31 December 2014

Relevant facts and circumstances

AusCo distributes the products that it purchases from ForeignCo.

ForeignCo is the ultimate parent company of AusCo and other subsidiaries (the Group).

The Group has recently implemented a new invoicing system.

In accordance with the Group's foreign exchange (FX) hedging policy before the implementation of this new invoicing system, AusCo was required to take out foreign currency exchange hedges using Forward Foreign Exchange contracts (FX contracts). The only purpose of this policy was to hedge AusCo's future foreign exchange liabilities for products purchased from ForeignCo.

AusCo's FX contracts were with ForeignSub which in turn took out identical back-to-back FX contracts with third party financiers.

In accordance with this policy, ForeignCo managed and controlled the hedging strategy.

The Group's transfer pricing policy

AusCo's target operating margin is governed by the Group's transfer pricing policy and regulated through the purchase price of the products which is set by ForeignCo.

In accordance with the Group's transfer pricing policy, this price must be adjusted to meet the target average operating margin of AusCo.

Before the implementation of the new invoicing system, the impact of the FX gains and losses on maturity of FX contracts on transfer prices can be described as follows:

• if the FX contract was in the money, increase the purchase price of the products equal to that FX gain to maintain the target operating margin; and

• if the FX contract was out of the money, decrease the purchase price of the products equal to that FX loss to maintain the target operating margin.

The new invoicing system

The implementation of the new invoicing system involving AusCo was initiated through the execution of an agreement between AusCo, ForeignCo and ForeignSub (the agreement).

The terms and conditions of the agreement include as follows:

• AusCo terminated each of its existing FX contract with ForeignSub and replaced each contract with identical FX contract. Each replacement contract was between ForeignCo and ForeignSub (replacement FX contract);

• where a terminated FX contract was in the money, ForeignSub had an obligation to pay AusCo an amount equal to the unrealised gain in the FX contract and AusCo had an obligation to pay ForeignCo an amount equal to the unrealised gain in the FX contract; and

• where a terminated FX Contract was out of the money, AusCo had an obligation to pay ForeignSub an amount equal to the unrealised loss in the FX contract and AusCo had a right to receive from ForeignCo an amount equal to the unrealised loss in the FX contract.

The new invoicing system was intended to align the Group's administrative processes with the functional profiles of ForeignCo and its subsidiaries. In the future ForeignCo will not only manage and economically bear the Group's FX risk, but also centrally administer the Group's hedging arrangements as the entrepreneur of the group. This will reduce overall administrative efforts, obtain greater oversight of the hedging function, and enhance the Group's financial forecasting abilities.

There will be no change in the transfer pricing policy post implementation of the new invoicing policy. For example, in respect of AusCo, the prices of future product purchases will be set by ForeignCo in Australian dollar (instead of ForeignCo's currency) for AusCo to earn a return within the target operating margin.

Relevant legislative provisions

Income Tax Assessment Act 1997

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Subsection 8-1(1)

Income Tax Assessment Act 1997 Paragraph 8-1(1)(b)

Income Tax Assessment Act 1997 Subsection 8-1(2)

Income Tax Assessment Act 1997 Paragraph 8-1(2)(a)

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 Section 230-15

Income Tax Assessment Act 1997 Subsection 230-45(1)

Income Tax Assessment Act 1997 Subsection 230-45(2)

Income Tax Assessment Act 1997 Subdivision 230-G

Income Tax Assessment Act 1997 Subsection 230-445(1)

Income Tax Assessment Act 1997 Paragraph 230-435(1)(b)

Income Tax Assessment Act 1997 Division 815

Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 sub-item 103(1) of Schedule 1

Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 sub-item 103(2) of Schedule 1

Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 sub-item 104 of Schedule 1

Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 sub-item 104(2) of Schedule 1

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise stated.

Question 1 & Question 2

Summary

On termination of a foreign exchange contract, the gain or loss that AusCo makes which is calculated under the balancing adjustment method in Subdivision 230-G will be included in its assessable income or allowed as a deduction under section 230-15.

Detailed reasoning

Sub-item 103(1) of Schedule 1 to the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 (Cth) (TOFA Act) provides that the taxation of financial arrangements rules in Division 230 (TOFA rules) will apply for income years commencing on or after 1 July 2010, or for income years commencing on or after 1 July 2009 where an election is made under sub-item 103(2) of the TOFA Act.

Sub-item 104 of the TOFA Act provides that the TOFA rules will apply only to financial arrangements which a taxpayer starts to have in their first applicable income year, or a later income year, unless a taxpayer makes an election under sub-item 104(2) of the TOFA Act to apply the TOFA rules to their existing financial arrangements.

As AusCo has not made any of the elections mentioned above, the TOFA rules will apply to AusCo for income years commencing on or after 1 January 2011.

AusCo has also not elected to apply any of the elective tax timing methods in Division 230 to its financial arrangements.

Having regard to the above provisions of the TOFA Act and subsections 230-45(1) and 230-45(2), the foreign exchange contracts are financial arrangements for the purposes of Division 230.

As part of the arrangement to which this ruling applies, if an FX contract that was terminated in accordance with the agreement was:

• in the money, AusCo was paid by ForeignSub an amount equal to the unrealised gain in the FX contract; and

• out of the money, AusCo paid ForeignSub an amount equal to the unrealised loss in the FX contract.

Under paragraph 230-435(1)(b), a balancing adjustment is made when the foreign exchange contracts are terminated in accordance with the agreement. The method statement in subsection 230-445(1) is used to calculate the gain or loss that AusCo will be taken to have made as a balancing adjustment. Any gain or loss will be assessable income or allowed as a deduction under section 230-15.

Question 3

Summary

AusCo will be entitled to an allowable deduction under section 8-1 for the amount payable to ForeignCo as part of the implementation of the new invoicing system. However the amount allowable as a deduction under section 8-1 will be subject to the transfer pricing rules in Division 815.

Detailed reasoning

An amount payable to ForeignCo by AusCo as part of the implementation of the new invoicing system will be an allowable deduction under section 8-1 if either of the positive limbs in subsection 8-1(1) are satisfied and it does not fall within any of the negative limbs in subsection 8-1(2). The relevant negative limb is paragraph 8-1(2)(a), which denies a deduction to the extent that the expenditure is capital, or of a capital nature.

Positive limb

Paragraph 8-1(1)(b) states that a loss or outgoing is deductible provided that 'it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.'

AusCo's business involves selling the products which it buys from ForeignCo. Before the implementation of the new invoicing system, AusCo took out foreign currency hedge agreements to hedge its future FX liabilities for these products.

The Commissioner accepts that entering into foreign currency hedge agreements is an ordinary part of a business to mitigate risk from exposure to currency fluctuations.

In accordance with the Group's previous transfer pricing policy, ForeignCo would adjust the price of the products as follows:

• if the FX contract was in the money, increase the purchase price of the products equal to that FX gain to maintain the target operating margin; and

• if FX contract was out of the money, decrease the purchase price of the products equal to that FX loss to maintain the target operating margin.

As a result, ForeignCo effectively accepted the risk in currency fluctuations borne by AusCo.

With the implementation of the new invoicing system, ForeignCo took over the hedging function by entering into replacement FX contracts and AusCo was required to pay ForeignCo for entering into these contracts as the net results of the FX contracts were in the money. As a result, ForeignCo was directly exposed to the currency fluctuations previously borne by AusCo. Therefore, in accordance with the invoicing policy and the agreement, adjustments to the purchase price of the products will no longer be required to reflect currency fluctuations.

This change in the invoicing policy therefore relieves AusCo of its hedging function and according to AusCo, has brought commercial benefits to its business operation notwithstanding ForeignCo would previously adjust the price of the products to reflect the foreign exchange gain or loss by AusCo.

Therefore, the payment of an amount to ForeignCo for entering into replacement FX contracts is considered necessarily incurred by AusCo in carrying on its business of selling the products.

Negative limb

When determining whether or not an outgoing is of a capital nature, it is the nature of the advantage sought by the taxpayer, and not the description given to the outgoing by the parties, which is the relevant issue.

The judgement of Dixon J in Sun Newspapers Ltd. and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers Case) is the leading authority on the distinction between revenue and capital expenditure. In Sun Newspapers, the general rule is found in the frequently quoted statement of Dixon J at 359, where he said:

The distinction between expenditure and outgoings on revenue account and on capital account correspond with the distinction between the business entity, structure, or organisation set up or established for the earning of profit and the process by which such an organisation operates to attain regular returns by means of regular outlays, the difference between the outlay and returns representing profit or loss.

In Sun Newspapers, Dixon J at 363 referred to what are now considered three principles to determining whether a loss or outgoing is of a capital or revenue nature:

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

In relation to the character of the advantage sought by the expenditure it is necessary to examine whether the expenditure secures an enduring benefit for the business. This test was outlined in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 at 213 - 214 by Viscount Cave where he stated:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

If expenditure produces some asset or advantage of a lasting character for the benefit of the organisation or profit-earning structure it will be considered to be capital expenditure. As stated in Anglo-Persian Oil Co. Ltd. v Dale (1932) 145 L.T at 262 per Rowland J; Sun Newspapers at 355 per Latham J, an enduring benefit does not require that the taxpayer obtain an actual asset, but a benefit which endures, in the way that fixed capital endures. In Foley Brothers Pty Ltd v. FC of T (1965) 13 ATD 562; (1965) 9 AITR 635, outgoings incurred for the purpose of altering the organisation or structure of the profit-yielding subject (including its demise) were considered to be of a capital nature.

Prior to implementing the new invoicing system, AusCo itself would bear the FX risk. However, ForeignCo adjusted the invoice price of the products effectively taking responsibility for that risk.

With the implementation of the new invoicing system, AusCo has ceased to perform this function and ForeignCo has begun to centrally administer the Group's hedging arrangement. Notwithstanding the financial benefit for AusCo was somewhat limited because ForeignCo effectively accepted the risk in currency fluctuations prior to the implementation of the new invoicing system the Commissioner has accepted that this transfer of the hedging function brought some commercial benefits to AusCo in the form of an efficiency gain in carrying out a function which was an ordinary part of their business.

The payment made to ForeignCo was not for the purpose of altering the profit-yielding structure of AusCo. It represented the net FX gain AusCo has made which would have otherwise been reflected in the invoice price of the products. Accordingly, ForeignCo will no longer be required to adjust the future invoice price of the products.

Further, the payment will not secure an enduring benefit as the Commissioner accepts that the intent of the new invoicing system is to have no net impact for AusCo's business.

The fact the payment made was a single payment and not recurrent will not alter the nature of the payment. As pointed out by Dixon J in the Sun Newspapers Case:

Recurrence is not a test, it is not more than a consideration the weight of which depends upon the nature of the expenditure.

Therefore, there is no enduring benefit from the payment and AusCo's payment to ForeignCo better reflects one of a revenue nature and not capital or of a capital nature.

Amount deductible subject to Australia's transfer pricing rules

Although an amount is deductible under section 8-1, this will be subject to the transfer pricing rules in Division 815 ("Australia's transfer pricing rules").

The purpose of Australia's transfer pricing rules is to ensure that for tax purposes taxpayers price their international related party dealings as truly independent parties would have done in the same situation. This is known as the arm's length principle.

It should be noted that the application of Australia's transfer pricing rules to the arrangement covered by this private ruling has not been fully considered. Specifically, this private ruling did not fully consider whether the payment payable by AusCo to ForeignCo under the terms of the agreement is in compliance with the internationally accepted arm's length principle.

Having regard to the commercial benefits claimed to be obtained from the transfer of the hedging function to AusCo's business operation and in particular the operation of the Group's transfer pricing methodology, any amount allowable as a deduction should be consistent with the arm's length principle, i.e, the amount allowable as a deduction should reflect the effort and savings which will actually occur after the implementation the new invoicing system.