Edited version of your written advice

Authorisation Number: 1051260155076

Date of advice: 3 October 2017

Ruling

Subject: Foreign exchange gain or loss

Question 1

Is the foreign exchange gain or loss on repayment or capitalisation of Loan 1 assessable or deductible under subsection 230-30(2) of the Income Tax Assessment Act 1997?

Answer

No.

Question 2

Is the foreign exchange gain or loss on repayment or capitalisation of Loan 2 assessable or deductible under subsection 230-30(2) of the Income Tax Assessment Act 1997?

Answer

No.

This ruling applies for the following period:

The year ending 30 June 2018

The scheme commenced on:

The scheme has commenced.

Relevant facts and circumstances

The Company and its related group entities are in business.

The Company is the head company of a tax consolidated group with various wholly-owned entities in Country X, Country Y and Country Z. The aggregated turnover of the Company and its associates exceeds $XXX million.

The Company is a holding company for the overseas entities. Any dividends derived from the overseas entities would be non-assessable non-exempt (NANE) income on repatriation to Australia under section 768-5 of the Income Tax Assessment Act 1997 (ITAA 1997) and formerly under section 23AJ of the Income Tax Assessment Act 1936.(ITAA 1936) The Company has always had the expectation of deriving dividends from its overseas subsidiaries and has received dividends over the long term.

Loan to a Country Y Subsidiary (Loan 1)

The Company provided funds to Corporation C a Country Y related party (Loan 1). The sole purpose of the loan was to ultimately assist the Country Y subsidiary to further establish its business in the Country Y market, support working capital requirements, become profitable and ultimately pay dividends to Australia (which would be NANE income). This purpose was specifically noted in the Loan Agreement.

Corporation C was incorporated in Country Y to contract with a large customer. Both loan and equity funding was used for Corporation C. Interest was calculated each year on Loan 1 and withholding tax was also paid. The reason for this form of funding was because it was thought to be compliant with both Country Y and Australian authorities’ requirements. Country Y is also known to be a challenging environment in which to do business and therefore there was some initial uncertainty regarding the entry into this market.

In order to comply with international transfer pricing requirements, it was decided based on advice received that Corporation C was required to pay arm’s length interest on the loan each year at the rate determined by the analysis of the interest rates applied to comparable instruments.

However, it was not tax efficient for there to be interest paid on Loan 1 as the tax rate in Australia is 30% and the corporate income tax rate in Country Y is lower and Corporation C was in a tax loss position already. Interest was charged purely to satisfy the transfer pricing requirements.

The funding via Loan 1 continued despite continuous losses by Corporation C and the support of the parent, the Company. It remained in place because Corporation C would otherwise have been in serious financial difficulty.

Loan to a Country Z Subsidiary (Loan 2)

Subsequent to the provision of the initial funds from the Company to Corporation C the group was restructured.

An entity based in Country Z, Corporation F was acquired and a Country Z holding company, Corporation Q, was also established to hold both the new Country Z entity and also the Country Y business.

As part of this restructure process Corporation Q assumed the legal liability for the loan payable by Corporation C to the Company in exchange for shares in a Country X subsidiary Corporation N. In turn Corporation N was issued shares in Corporation C.

Therefore, the loan is now payable by the Country Z entity, Corporation Q. Despite this restructure, the Company has always retained the right to receive the full balance of the outstanding loan and the purpose for which the loan funds were provided has not changed (i.e. to support the business and growth of Corporation C).

Separately the Company also loaned an amount to Corporation Q (Loan 2). This was for the purpose of providing funding support for the Country Z operations in the start-up phase (especially after acquiring the new entity Corporation F). The ultimate aim once again was to increase profitability which would result in the receipt of NANE dividends by the Company, similarly to Loan 1.

At the time of the purchase of Corporation F the Company was aware of the existence of the quasi equity rules and therefore decided to fund the Country Z operations in this manner rather than with share capital, at least until a final decision was made on the capital structure. This allowed some flexibility, until the final structure was decided.

Loan 2 is interest free.

Decision to convert loans to shares

A decision has been made to convert to share capital the Loan 1 and Loan 2 amounts now that the overseas structure is established.

In considering the conversion of Loan 1 and Loan 2 between the Company and Corporation Q into share capital, it has become apparent that the change in the exchange rate since the funds were initially advanced could result in foreign exchange gains for the Company.

The conversion of the foreign currency denominated amounts is required by Item 6 or item 8 of the table in subsection 960-50(6) of the ITAA 1997 “to be translated to Australian currency at the exchange rate applicable at the time” of the receipt or payment respectively.

Information about the amount of interest derived by the Company in recent years from Corporation C, Corporation Q and other subsidiaries has been provided.

Information about the amount of NANE dividends derived by the Company in recent years from Corporation C, Corporation Q and other subsidiaries has been provided.

Relevant legislative provisions

Income Tax Assessment Act 1997

Section 6-23

Section 230-5

Section 230-15

Section 230-30

Subsection 230-30(2)

Paragraph 230-30(2)(b)

Subsection 230-45(2)

Subsection 230-435(1)

Paragraph 230-435(1)(d)

Subsection 230-445(1)

Subsection 230-455(4)

Section 701-1

Subsection 960-50(6)

Section 974-160

Subsection 995-1(1)

Reasons for decision

All legislative references are to provisions of the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise specified.

Question 1

Summary

The Company made Loan 1 to a subsidiary in Country Y and Loan 2 to a subsidiary in Country Z. The loans which commenced in 201X and 201Y respectively remain in place. Each loan is a financial arrangement within the terms of subsection 230-5(1).

The Company has an aggregated turnover of over $XXX million and accordingly the exceptions in subparagraphs 230-5(2)(a)(iv) and 230-5(2)(a)(iva) do not apply to exclude the financial arrangements from the application of Division 230.

The financial arrangements will cease upon each loan being converted to shares in an overseas subsidiary.

With respect to the treatment of gains and losses on financial arrangements this will be a trigger point requiring consideration as to whether a balancing adjustment is required in terms of paragraph 230-435(1)(d).

The calculation of the foreign exchange gain or loss on each loan that is made in terms of section 230-15 and the special translation rules in the table in subsection 960-50(6) would result in the inclusion of any foreign exchange gain in the assessable income of the Company or a deduction for any foreign exchange loss by the Company. This is unless subsection 230-30(2) applies to treat the gain or loss as referable to NANE income.

In order for subsection 230-30(2) to apply so that the gain is treated as NANE income that provision requires a situation where if the gain from the financial arrangement had been a loss, the loss would have been made in gaining or producing NANE income.

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 (TR 2012/3) is relevant as it contains a discussion of what would constitute a hypothetical foreign exchange loss.

In the present case:

1, if there had been a loss it would have been made in gaining or producing NANE income – that is, whether there is a nexus between the loss and the derivation of NANE income; and

2. the activities of the Company support the intention of the Company to render the subsidiary profitable and thus able to pay NANE dividends.

The foreign exchange gains that may arise from Loan 1 and Loan 2 ceasing upon conversion to shares under Division 230 will be treated as NANE income.

The Company’s arguments in support of its view are examined and it is concluded that a gain or loss arising from the cessation of each financial arrangement, that is, upon the conversion of Loan 1 and Loan 2 to shares in an overseas subsidiary of the Company, will be NANE income of the Company.

Accordingly, both question 1 and question 2 will be answered in the negative.

Detailed reasoning

The Company made Loan 1 to a subsidiary in Country Y and Loan 2 to a subsidiary in Country Z. The loans which commenced in 201X and in 201Y respectively remain in place. As each loan is a cash settleable arrangement with a financial benefit each loan is a financial arrangement within the terms of subsection 230-5(1).

In addition the Company has an aggregated turnover of over $XXX million.

Accordingly, the exceptions in subparagraphs 230-5(2)(a)(iv) and 230-5(2)(a)(iva) do not apply to exclude the financial arrangements from the application of Division 230. Therefore Loan 1 and Loan 2 are each subject to Division 230.

Division 230 requires net gains and net losses on Division 230 financial arrangements to be treated as arising on income account. Division 230 takes priority over other provisions such as those in Division 775 concerning foreign exchange gains and losses.

In the present case the financial arrangements will cease upon each loan being converted to shares. The gain or loss that results will be recognised using the realisation method. In addition the need to consider whether a balancing adjustment in terms of section 230-435 will be required to be made will arise at that time. This is discussed further below.

Given that the Company is the head company of an Australian tax consolidated group, the single entity rule in section 701-1 treats subsidiary members of the tax consolidated group as part of the Company.

Consequently, no matter which entity in the tax consolidated group makes a loan to an overseas subsidiary, it is taken to be a loan from the Company.

With respect to the treatment of gains and losses on financial arrangements, a trigger point occurs in various circumstances.

In terms of subsection 230-435(1):

A balancing adjustment is made under this Subdivision if:

(a) …

(b) …

(c) …

(d) an *arrangement that is a *Division 230 financial arrangement ceases to be a financial arrangement.

Therefore, a balancing adjustment will arise at the time of the capitalisation by the Company of Loan 1 and Loan 2. The calculation of the foreign exchange gain or loss on each loan that is made in terms of section 230-15 and the special translation rules in the table in subsection 960-50(6) would result in the inclusion of any foreign exchange gain in the assessable income of the Company or a deduction for any foreign exchange loss by the Company. This is unless subsection 230-30(2) applies to treat the gain or loss as referable to the derivation of NANE income.

In the circumstances of the present case it is anticipated that a foreign exchange gain from the financial arrangements represented by both Loan 1 and Loan 2 would arise upon cessation of each arrangement due to the Australian dollar value of the shares that are proposed to be issued having a higher value than the Australian dollar value of each loan at the time each loan was originally provided.

However, subsection 230-30(2) states:

230-30(2) Despite section 230-15, a gain that you make from a *financial arrangement:

(a) to the extent that, if it had been a loss, you would have made it in gaining or producing *exempt income – is exempt income; and

(b) to the extent to which, if it had been a loss, you would have made it in gaining or producing *non-assessable non-exempt income – is not assessable and is not exempt income.

The Company relies upon the Explanatory Memorandum to Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008 (Explanatory Memorandum) which accompanied the introduction of Division 230 into the ITAA 1997. In particular the argument is drawn from paragraph 3.14 of the Explanatory Memorandum.

In the Explanatory Memorandum at Chapter 3 “Tax treatment of gains and losses from financial arrangements” the following statement appears in paragraph 3.14:

3.14 A gain made from a Division 230 financial arrangement will continue to be exempt income or non-assessable non-exempt income to the extent the gain would have been exempt income or non-assessable non-exempt income by a provision outside Division 230 on the assumption Division 230 was not enacted. Also, a gain made on a Division 230 financial arrangement will be exempt income if, instead, the gain had been a loss and the loss would have been made gaining or producing exempt income. A similar rule is provided in respect of gains that are to be treated as non-assessable non-exempt income. …

It is noted that in the absence of Division 230, that is where Division 230 was not enacted, Division 775 concerning foreign exchange gains and losses would apply. Section 775-25 which treats certain forex realisation gains as NANE income is the relevant provision.

Section 775-25 relevantly reads:

775-25 A *forex realisation gain you make is *non-assessable non-exempt income to the extent that if it had been a *forex realisation loss it would have been made in gaining or producing non-assessable non-exempt income.

Section 230-15 requires a foreign exchange gain from a financial arrangement to be brought to account as assessable income. However, paragraph 230-30(2)(b) hypothesises a situation where instead of a gain there is a loss and that loss is made in gaining or producing NANE income then the gain is treated as NANE income. The Explanatory Memorandum refers to this in paragraph 3.14.

The Company considers and discusses whether in the present case a hypothetical foreign exchange loss has a sufficient nexus with the gaining or producing of NANE income in order to determine whether a foreign exchange gain will be NANE income in terms of subsection 230-30(2).

TR 2012/3 is relevant as it contains a discussion of what would constitute a hypothetical foreign exchange loss.

In TR 2012/3 the discussion appears under the heading “Losses made in gaining or producing exempt income or NANE income” beginning at paragraph 7 and also under the heading “Gains which, if they were losses instead, would be made in gaining or producing exempt income or NANE income” starting at paragraph 17.

Having regard to the above examination of the law which applies to the present case the potential gains that may arise from Loan 1 and Loan 2 ceasing upon conversion to shares will be treated as NANE income on the basis that:

1, if there had been a loss it would have been made in gaining or producing NANE income – that is, whether there is a nexus between the loss and the derivation of NANE income; and

2. the activities of the Company support the intention of the Company to render the subsidiary profitable and thus able to pay NANE dividends.

The following arguments are in support of that view.

1. Nexus between a loss or outgoing with the gaining or producing of NANE income

In determining whether a nexus with the derivation of NANE income exists, it is necessary to consider whether a hypothetical foreign exchange loss would have been made in gaining or producing the NANE income. In this situation regard must be had to matters beyond the specific right or obligation under the financial arrangement in respect of which the loss arose; the approach taken mirrors that used in determining the nexus for the purpose of general deductions under section 8-1.

In W Nevill & Co v FC of T [1937] HCA 9; (1937) 56 CLR 290; (1937) 1 AITR 67; (1937) 4 ATD 187; 1937 – 0308B – HCA it was held that a loss or outgoing is deductible if it is “incidental and relevant” to the activities carried on for the production of income.

In Magna Alloys & Research Pty Ltd v FC of T (1980) 49 FLR 183; (1980) 33 ALR 213; (1980) 11 ATR 276; (1980) 80 ATC 4542 the phrases “in the course of”, “incidental and relevant”” and “the occasion of“ concern a connection between the incurring of expenditure on one hand and the gaining or production of assessable income or the carrying on of a business for that purpose, on the other hand.

It follows that there must be a connection or nexus between the loss or outgoing and the activities regularly carried on for the production of income. Whether or not a loss or outgoing is incidental and relevant to an income producing activity requires consideration of the nature and character of the loss or outgoing as well as its connection with the operations that directly give rise to the gain or produce the assessable income.

It is accepted that a nexus exists between the making of Loan 1 and Loan 2 by the Company to the subsidiary in Country Y and Country Z respectively and the derivation of NANE income by the Company. The purpose of each loan was to assist the respective subsidiary in attaining profitability so that each subsidiary could remit dividends which would be NANE income in the hands of the Company.

2. Activities of the Company and the gaining or producing of NANE income

The facts of the present case in relation to the Company are comparable to those in FC of T v Total Holdings (Australia) Pty Ltd (1979) 43 FLR 183; (1979) 9 ATR 885; (1979) 24 ALR 401; (1979) 79 ATC 4279 (Total Holdings) although they are in reverse.

In this regard it is necessary to briefly review the facts and the decision in Total Holdings as they are presented by the Company below.

In Total Holdings the taxpayer used borrowed funds, which were subject to interest, to on-lend those funds interest free to a subsidiary. In finding that the taxpayer was entitled to deduct the interest expenditure in relation to the borrowed funds, the Federal Court held that the activities of the taxpayer, namely that of a holding company for subsidiaries, were designed to render the subsidiary profitable and to promote the generation of income by it and the subsequent derivation of that income by the taxpayer. In Total Holdings the liability for the interest was held to be incidental and relevant to the derivation of the taxpayer’s income due to the purpose of ensuring the subsidiary would be profitable as soon as possible and thus it would be able to pay dividends to the holding company; the dividends would be taxable in the hands of the holding company.

In the present case the Company loaned funds, Loan 1 with interest and Loan 2 without interest, to two of its overseas subsidiaries where the Company argues that each loan was designed to render the respective overseas subsidiaries profitable and to promote the generation of dividend income, which given the facts of the present case would be NANE income of the Company.

As such there is a similarity with the situation in Total Holdings in that the Company has at all times carried on the business of a group holding company in respect of its interactions with the Country Y subsidiary and the Country Z subsidiary as well as its other overseas subsidiaries.

The overseas operations allow the Company to expand its market share in an industry where conditions are becoming tougher in Australia. Therefore, the overseas investments are a key part of the Company’s business strategy and the holding company support to subsidiaries is provided by various means of funding.

The support provided by the Company throughout difficult times where the Country Y subsidiary would otherwise have struggled to obtain funds, demonstrates that the activities of the Company were undertaken to support the subsidiary and ensure it could one day return to profits and pay NANE dividends back to Australia.

However, in the present case, unlike the situation in Total Holdings, the Company loaned funds to an overseas subsidiary, where Loan 1 was at interest and Loan 2 was without interest. Nonetheless, both loans were designed to render each overseas subsidiary profitable and to promote the generation of dividend income, which would be NANE income of the Company.

The Company expands on this argument with the explanation of its motive and purpose as set out below.

In respect of Loan 1, as noted in the “Relevant facts and circumstances” above, the Company loaned funds to Corporation C to assist Corporation C to establish its presence within the Country Y market. A rate of interest was applied. The loan was advanced following considerable consultation between the Company and Corporation C. As part of the extensive market research initiated and undertaken by the Company, the Country Y market was identified as having previously untapped potential and at the time exhibited many indicators of being an area of potential significant growth.

However, the Company explained that, without the injection of the funds provided by way of Loan 1 from the Company to Corporation C in Country Y that Corporation C would not have had the capacity to weather the significant challenges posed as well as the economic environment at the time. Further, Loan 1 and the preceding considerable market research are both clear indicators of the Company’s attempt to establish itself, via Corporation C, as the leading supplier within Country Y. The ultimate aim of this was to produce strong profitable results which would be distributed back to Australia by way of NANE dividends.

It is the Company’s view that the interest income derived by the Company was merely a conservative measure to comply with tax laws and was not connected with the underlying purpose of the Company to support its subsidiary.

In respect of Loan 2, it was a shorter term funding arrangement that was interest free. The result of that loan is that the group is now well established and it is proposed the loan will be capitalised. The intention of Loan 2 was also to ensure the overseas group would be profitable and be able to pay NANE dividends. Therefore the Company argues the same intention and nexus exists as with Loan 1.

It is accepted that both Loan 1 and Loan 2 were made to assist the Country Y subsidiary and the Country Z subsidiary respectively to be in a position to achieve profitability and consequently to be able to pay NANE dividends to the Company. The actions that had been undertaken by the Company with respect to research into the Country Y market supported Corporation C in its attempt to achieve profitability.

Conclusion

The conclusion drawn from the above analysis is that the underlying purpose of Loan 1 was to establish Corporation C in Country Y with the intention that Corporation C would become profitable as soon as commercially feasible. The making of Loan 1 to Corporation C enhanced its income earning capacity, thereby strengthening the potential derivation of NANE dividend income by the Company from Corporation C.

It is noted that the Total Holdings case concerned funds loaned on an interest-free basis, whereas in the present case the Company charged interest on Loan 1. However, the primary purpose of the loan from the Company to Corporation C was to derive NANE income.

On the basis that the loan was provided to derive NANE income, it is considered that the requirements of paragraph 230-30(2)(b) are satisfied and thus where a foreign exchange gain arises as a result of the conversion of Loan 1 by the Company into shares in Corporation Q, that gain will be NANE income of the Company.

With respect to Loan 2 which is an interest free loan between the Company and Corporation Q, this loan was intended to be an interim funding measure until Corporation Q settled on a long term funding solution for its newly acquired Country Z operations which are in the start-up phase. The purpose of Loan 2 was to assist Corporation Q to achieve a profitable performance and in due course to pay NANE dividends to the Company.

On the basis that the loan was provided to derive NANE income, it is considered that the requirements of paragraph 230-30(2)(b) are satisfied and thus where a foreign exchange gain arises as a result of the conversion of Loan 2 by the Company into shares in Corporation Q, that gain will be NANE income of the Company.

Accordingly, both question 1 and question 2 will be answered in the negative.