Edited version of your written advice

Authorisation Number: 1013019997711

Date of advice: 27 May 2016

Ruling

Subject: Novation of an agreement

Question 1

Will the novation of the old agreement give rise to a loss or outgoing that is deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for A Co?

Answer

No

Question 2

Will the novation of the old agreement give rise to a loss that is deductible under subsection 230-15(2) of the ITAA 1997 for A Co?

Answer

No

Question 3

Will A Co be required to recognise gains and losses in relation to the new agreement under Division 230 of the ITAA 1997 in accordance with the 'accruals' method in section 230-100 of the ITAA 1997?

Answer

Yes

Relevant facts and circumstances

1. A Co entered into an agreement with B Co prior to 1 July 2010 (old agreement).

2. Post 1 July 2010, B Co and C Co entered into a novation agreement (new agreement) where C Co becomes the counterparty to the agreement (replacing B Co as counterparty to the old agreement).

3. A Co and B Co have been discharged from all further rights and obligations under the old agreement effective from the date of novation.

4. Under the new agreement, A Co and C Co acquire rights and obligations against each other broadly identical to the rights and obligations under the old agreement, effective from the date of novation.

5. A Co, B Co and C Co are not related entities and are dealing on an arm's length basis.

6. A Co is subject to the Taxation of Financial Arrangements (TOFA) provisions in Division 230 of the ITAA 1997 from the income year commencing 1 July 2010.

7. A Co has not made an election under sub-item 104(2) of Part 3 of Schedule 1 to the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 (the TOFA Act) to un-grandfather its pre-TOFA financial arrangements.

8. A Co has not made any elections to apply any of the TOFA elective methods to its financial arrangements (i.e. fair value, FX retranslation, hedging and financial reports method).

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

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

Income Tax Assessment Act 1997 section 230-100

Reasons for decision

Question 1

Will the novation of the old agreement give rise to a loss or outgoing that is deductible under section 8-1 of the ITAA 1997 for A Co?

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for any 'loss or outgoing' incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of producing such income except to the extent the loss or outgoing is capital, of a capital, private or domestic nature, incurred in relation to gaining or producing exempt or non-assessable non-exempt income, or prevented from being deductible under another provision of the Act.

While the concepts of a 'loss' and an 'outgoing' are central to the operation of section 8-1 of the ITAA 1997, those terms have received little judicial consideration. They therefore must be interpreted having regard to their ordinary meanings in the context they appear.

The Macquarie Dictionary (Online) relevantly defines the noun 'loss' as including '1. detriment or disadvantage from failure to keep, have or get… 2. that which is lost. 3. amount or number lost'. In the same dictionary, the noun 'outgoing' is defined to include '3. …an amount of money expended; outlay; expense'.

The meaning of the phrase 'losses and outgoings' in the context of paragraph 23(1)(a) of the ITAA 1922 was discussed by Latham CJ in Amalgamated Zinc (De Bavay's) Ltd v Federal Commissioner of Taxation (1935) 54 CLR 295; (1935) 9 ALJR 342; (1936) ALR 67. Relevantly, His Honour stated, at 303:

The phrase "losses and outgoings actually incurred in gaining or producing the assessable income" may, in relation to outgoings, be read as meaning that the outgoings must be an expenditure which has an effect in gaining or producing income, e.g., the purchase price of goods which are subsequently sold. But it is difficult to see how a loss, as distinct from an outgoing, can over gain or produce income. On the contrary a loss, as distinguished from an outgoing, simply and merely reduces income-or capital, as the case may be.

The terms of paragraph 8-1(1)(a) of the ITAA 1997 and its predecessors have not been regarded as materially different (Federal Commissioner of Taxation v Day 2008 ATC 20-064; [2008] HCA 53; (2008) 83 ALJR 68 at paragraph 20, per Gummow, Hayne, Heydon and Kiefel JJ). It follows that Latham CJ's comments in De Bavay's are of some relevance to the meaning of the words 'loss or outgoing' in section 8-1 of the ITAA 1997. Consistent with their ordinary meaning, Latham CJ's comments indicate that the words 'loss' and 'outgoing' in section 8-1 of the ITAA 1997 contemplate, at the very least, a reduction (by loss, outlay or otherwise) of income or capital.

In the present case, the transactions undertaken in relation to the novation of the old agreement and entry into the new agreement do not give rise to a loss or outgoing for A Co for the purposes of section 8-1 of the ITAA 1997. Having regard to the substance of the transaction, A Co is broadly subject to identical rights and obligation under the new agreement in substitution for its rights and obligation outstanding under the old agreement. A Co has not made any payment in relation to the discharge of its obligations under the old agreement.

Support for the conclusion that A Co does not make a loss or outgoing for the purposes of section 8-1 of the ITAA 1997 as a result of the novation can be found in the High Court case of Caltex Ltd v. Federal Commissioner of Taxation (1960) 106 CLR 205, (1960) 12 ATD 170, [1960] HCA 17 (Caltex).

In Caltex, the taxpayer incurred United States dollar denominated trade debts to a supplier of trading stock. The taxpayer subsequently discharged these debts with money lent to it by a new third party supplier. Having regard to the substance of the transaction, the High Court held that no foreign exchange loss was incurred as a result of these transactions as effectively there was no discharge of an indebtedness. One creditor had merely been substituted for another. It was stated by Fullagar J at page 228:

The substance and reality of what happened was simply that one creditor was substituted for another. That was what was intended, and that was what was achieved. The same result could have been achieved in other ways. It might have been achieved by a contract of novation, without any payment being made at all. If this course had been adopted, it would have been clear that no exchange loss was involved. In fact the transaction took another form, doubtless because it was considered simpler and more expeditious and convenient - and perhaps with a hopeful eye on Commonwealth income tax law. But the question whether an exchange loss arose from it cannot depend on the form which the transaction took. That question must depend on the substantial effect of what was done on the financial position of the company, and the essential facts are that the company's American indebtedness was not discharged, but remained unchanged, and the real financial effect on the company of exchange variations was not, in respect of the goods remaining to be paid for, definitively fixed and ascertained by payment and as at the date of payment. If we take our stand at the end of 1936, we find ourselves unable to say whether the company will if and when it does come to discharge finally its American indebtedness, make an exchange gain or an exchange loss. As at that time, no exchange gain has been derived, and no exchange loss has been incurred.

Accordingly, for these reasons, the novation of the old agreement does not rise to a loss or outgoing for A Co that is deductible under section 8-1 of the ITAA 1997.

Question 2

Will the novation of the old agreement give rise to a loss that is deductible under subsection 230-15(2) of the ITAA 1997 for A Co?

Detailed reasoning

In the absence of an election under sub-item 104(2) of Part 3 of Schedule 1 to the TOFA Act, the financial arrangements amendments apply to financial arrangements you start to have in the first applicable income year or a later income year (sub-item 104(1) of Part 3 of Schedule 1 to the TOFA Act). A Co's first applicable income year commenced on 1 July 2010.

A Co started to have the old agreement prior to 1 July 2010. Hence the old agreement is not a financial arrangement to which the financial arrangement amendments apply.

Therefore, it follows that the novation of the old agreement will not give rise to a loss for A Co that is deductible under subsection 230-15(2) of the ITAA 1997.

Question 3

Will A Co be required to recognise gains and losses in relation to the new agreement under Division 230 of the ITAA 1997 in accordance with the 'accruals' method in section 230-100 of the ITAA 1997?

Detailed reasoning

For Division 230 of the ITAA 1997 to apply to a gain or loss, it must arise from an arrangement which is a financial arrangement to which Division 230 of the ITAA 1997 applies. Subsections 230-45(1), 230-50(1) and 230-50(2) of the ITAA 1997 provide tests which specify when you have a financial arrangement.

Subsection 230-45(1) of the ITAA 1997 is the primary test. Under that provision, you have a financial arrangement if you have, under an arrangement, one or more cash settlable rights or obligations to receive or provide a financial benefit. Excluded from the general definition of financial arrangement under subsection 230-45(1) are arrangements under which you also have one or more rights or obligations either to receive or provide something that is not a financial benefit or which is not cash settlable (paragraphs 230-45(1)(d), (e) and (f) of the ITAA 1997), and those rights or obligations are significant compared to the cash settlable legal rights or obligations under the arrangement.

Section 230-50 of the ITAA 1997 provides two further tests for financial arrangement which are not presently relevant.

The timing of gains and losses you make from a Division 230 of the ITAA 1997 financial arrangement is determined under the relevant tax-timing method that governs the arrangement. In the absence of a choice to use any of the elective tax-timing methods, A Co will be required to recognise gains and losses in relation to the new agreement in accordance with Subdivision 230-B of the ITAA 1997 (accruals and realisation). The starting point is to determine the relevant arrangement.

Arrangement

An 'arrangement' is defined in subsection 995-1(1) of the ITAA 1997 as 'any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings'

Under subsection 230-55(4) of the ITAA 1997, the rights and obligations that form an arrangement is a question of fact and degree that is determined having regard to the following matters:

(a) the nature of the rights and/ or obligations,

(b) their terms and conditions (including those relating to any payment or other consideration for them);

(c) the circumstances surrounding their creation and their proposed exercise or performance (including what can reasonably be seen as the purposes of one or more of the entities involved);

(d) whether they can be dealt with separately or must be dealt with together;

(e) normal commercial understandings and practices in relation to them (including whether they are regarded commercially as separate things or as a group or series that forms a whole);

(f) the objects of the Division.

The matters referred to in paragraphs (a) to (f) are to be considered in relation to the relevant rights and/or obligation separately and also in combination with each other.

Section 230-85 of the ITAA 1997 applies for the avoidance of doubt to ensure that rights and obligations are treated as rights and obligations for the purposes of Division 230 of the ITAA 1997 even if they are subject to a contingency. Paragraph 2.65 of the Explanatory Memorandum to the Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2009 elaborates that a right or obligation to receive or provide a financial benefit will exist irrespective of whether the value or existence of the right or obligation is contingent on some event or other thing.

The new agreement on its terms creates rights and obligations between A Co and C Co. Having regard to the factors in subsection 230-55(4) of the ITAA 1997, A Co's rights and obligations under the new agreement will constitute an 'arrangement' for the purposes of subsection 995-1(1) of the ITAA 1997.

Financial Arrangement

Section 230-45 of the ITAA 1997 is the general test to determine whether you have a financial arrangement. Under subsection 230-45(1) of the ITAA 1997, the relevant rights and obligations under an arrangement comprise a financial arrangement to the extent they are 'cash settlable' legal or equitable rights or obligations to receive or provide financial benefits, and the arrangement does not consist of any other significant rights or obligations to receive or provide something which is not a financial benefit or cash settlable.

Relevantly, paragraph 230-45(2)(a) of the ITAA 1997 provides that a right to receive, or an obligation to provide a financial benefit is cash settlable if the benefit is money. The term 'money' in paragraph 230-45(2)(a) of the ITAA 1997 is not defined for the purposes of the Act but naturally covers Australian dollars.

A Co's rights and obligations under the new agreement are cash settlable legal rights and obligations to receive and provide financial benefits. None of the exceptions in paragraphs 230-45(1)(d) to (f) of the ITAA 1997 apply.

Accordingly, the new agreement is a 'financial arrangement' under section 230-45 of the ITAA 1997.

Accruals or realisation

Having identified the relevant financial arrangement, the next step is to determine the timing of any gains and losses from it. In the present case, A Co has not made a choice to apply any of the elective tax timing methods. As such, the tax timing of gains and losses from the new agreement will be determined under the provisions of Subdivision 230-B of the ITAA 1997.

Under Subdivision 230-B of the ITAA 1997, A Co must apply the compounding accruals tax-timing method to a gain or loss from the new swap if it is sufficiently certain that such a gain or loss will arise. In accordance with subsection 230-100(2) of the ITAA 1997, the accruals method provided for in Subdivision 230-B of the ITAA 1997 applies to a gain or loss from a financial arrangement if the gain or loss is an 'overall' gain or loss that is 'sufficiently certain' at the start of the arrangement.

From the facts it follows that it is sufficiently certain that A Co will make a loss on the new agreement.

Accordingly, A Co will be required to recognise gains and losses in relation to the new agreement under Division 230 of the ITAA 1997 in accordance with the 'accruals' method in section 230-100 of the ITAA 1997.