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Edited version of private advice
Authorisation Number: 1051650635436
Date of advice: 02 July 2020
Ruling
Subject: Conduit foreign income
Question
In working out the Conduit Foreign Income of D Company Ltd (DCo) at a particular time when DCo declares a dividend in its distribution statement to be conduit foreign income (CFI), under Subdivision 802-A, does subsection 802-30(5) require the amount remaining after subsection 802-30(4) be reduced by unrealised foreign exchange (FX) losses in respect of net investments in foreign operations and related hedging arrangements?
Answer
No.
Background
All legislative references are to provisions of the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise indicated.
DCo is an Australian incorporated and tax resident company that is listed on the Australian Securities Exchange.
DCo and its subsidiaries carry on business.
DCo is the head company of an Australian income tax consolidated group.
Proposed scheme
DCo will pay a dividend and to declare a portion of any unfranked part of that dividend to be CFI.
The dividend will be a 'frankable dividend' in its entirety, within the meaning of section 202-40.
At the time DCo declares and pays a dividend, DCo will have at least that amount available to enable it to pay the dividend.
In DCo's audited consolidated financial statements for certain periods preceding the declarations, DCo recognised unrealised FX losses on its balance sheet in the foreign currency translation reserve (FCTR) in the following circumstances:
(a) During the relevant periods, the DCo consolidated group held investments in certain subsidiaries with foreign operations.
(b) Those investments were denominated in foreign currency.
(c) The DCo consolidated group also entered into hedging arrangements in respect of its foreign currency exposures arising in relation to those investments. Earnings from foreign operations were not hedged.
(d) The DCo Group's accounting policy, in accordance with applicable accounting standards, was at all relevant times (i) to recognise FX differences arising on translation of such investments in foreign operations, and FX differences on translation of arrangements that hedge such investments, in the FCTR, and (ii) to not recognise gains or losses accumulated in FCTR in the income statement until the time of disposition (if any) of the foreign operations.
(e) As at the balance date for each such period, the unrealised FX losses were recognised in DCo's audited consolidated financial statements for that period. In accordance with DCo Group's accounting policy described above, the unrealised FX losses were recognised on the balance sheet in the FCTR (and not in the income statement).
The DCo Group will maintain the above arrangements and accounting policy through to the time of declaration of the proposed dividend.
For the dividend, the time of declaration (which will be when DCo declares a dividend in its distribution statement to be CFI), of a portion of any unfranked part of the dividend as CFI will not coincide with a period end date for which DCo Group will prepare audited consolidated financial statements. In accordance with the above accounting policy and applicable accounting standards, any unrealised FX loss in respect of the net investments in foreign operations and related hedging arrangements that may be determined as at the time of such declaration would be recognised (in a balance sheet as at such time, if one were prepared) in the FCTR, and not in any income statement.
The DCo consolidated group has and will continue to treat any such unrealised FX losses in respect of net investments in foreign operations and related hedging arrangements as non-deductible items for the purposes of determining its taxable income.
The DCo Group has previously adopted AASB 9.
There are a number of foreign controlled entities forming part of the DCo's accounting consolidated group for which Net Investment in Foreign Operations (NIFO) hedging is undertaken.
DCo has recorded CFI credits for distributions received by DCo from overseas equity investments and from capital gains and other income in accordance with subsections 802-30(1) and 802-30(3) and not reduced by subsection 802-30(2) or 802-30(4). Those credits will be taken into account in making the declaration on or before the payment of the dividend.
The Group uses a combination of foreign denominated borrowings and foreign currency forward contracts to hedge its net investment in foreign entities.
As the level of hedging against the Group's net investment in foreign operations is less than 50%, the Group considers there is no ineffectiveness in the hedging and the entire gain or loss on the hedging instruments (excluding non-market related risk premiums) is taken up in the FCTR.
Accounting entries - foreign exchange differences
The foreign exchange variances on long-term borrowings and foreign currency forward contracts designated as a hedge of DCo's net investment in foreign operations are also reflected net of tax in the FCTR. To the extent a foreign currency variance is realised and assessable/deductible the tax effect is also recognised in the Provision for income tax payable. To the extent the gain or loss is unrealised the tax effect is recognised in deferred tax assets or liabilities as appropriate.
An example journal in the case of an exchange loss which is unrealised would be:
DR Foreign currency translation reserve (Gross impact)
CR Borrowing or Financial instrument (Gross impact)
DR Deferred tax asset (Tax Impact)
CR Foreign currency translation reserve (Tax impact)
Where a foreign entity is disposed of during the period, the accumulated FCTR in relation to that entity is transferred to profit and loss and reflected in the accounts as part of the gain/loss on disposal of that entity.
In the case of an accumulated credit in the FCTR the entry would be:
DR Foreign currency translation reserve
CR Profit/loss on sale of controlled entity
Unrealised foreign exchange losses are calculated as the difference between an amount at its inception rate and the closing exchange rate for the period. DCo does not hedge the earnings of its foreign operations, but does hedge the net investment of foreign Indian operations (where net investment represents the net assets of the foreign operations adjusted for any foreign currency intercompany loans payable to or receivable from Australian domiciled entities).
Unrealised and realised exchange variances on translation of long term borrowings, foreign currency forward contracts and the net assets of overseas entities are recognised in the FCTR on consolidation of the overseas entities.
Assumptions
1. At the time DCo declares in its 'distribution statements' the dividend to be CFI, DCo will not be required to recognise a foreign exchange loss in its Income Statement in accordance with accounting standards.
2. The date the dividend is declared in 'distribution statements' to be CFI and the payment date for that dividend both occur in the same year of income.
Does Part IVA apply to this ruling?
Part IVA of the Income Tax Assessment Act 1936 contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or DPT tax benefit in connection with an arrangement.
If Part IVA applies the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax.
We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.
If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.
For more information on Part IVA, go to our website ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: 'Part IVA: the general anti-avoidance rule for income tax'.
Reasons for decision
Summary
In working out the CFI of DCo at a particular time when DCo declares a dividend in its distribution statement to be CFI, under Subdivision 802-A, subsection 802-30(5) does not require the amount remaining after subsection 802-30(4) be reduced by unrealised FX losses in respect of net investments in foreign operations and related hedging arrangements.
Detailed reasoning
Calculation of conduit foreign income: section 802-30
Section 802-25 states:
An *Australian corporate tax entity's conduit foreign income at a particular time (the relevant time) is worked out by applying sections 802-30 to 802-55.
Subsection 802-30(1) states:
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Work out the amount of the entity 's *ordinary income and *statutory income derived by the entity that has been, is or will be included in an income statement or similar statement of the entity or of another entity and that would not be included in the entity ' s assessable income if the entity: (a) for a company or a *corporate limited partnership - were a foreign resident at the relevant time; ... Subsection 802-30(2) goes on to state that the amount at subsection 802-30(1) must be reduced by any part of that amount that is or will be included in the entity's assessable income (apart from section 802-20). That is, reduce the subsection 802-30(1) amount by any amount that is or would be included in DCo's assessable income, ignoring the CFI rules. Subsection 802-30(3) states that any amounts of unfranked distributions declared to be CFI, non-portfolio dividends that would be non-assessable but which have not been included in an income statement must be added to the remaining amount at subsection 802-30(2). Subsection 802-30(4) states that the remaining amount at Subsection 802-30(3) must be reduced by amounts that are non-assessable previously taxed under the accruals rules and amounts that are non-assessable foreign income to the extent they can be distributed fully-franked. Subsection 802-30(5) then states: Reduce the amount remaining after subsection (4) by any of the entity's expenses that are reasonably related to that amount, except expenses the entity has deducted or can deduct under this Act. In applying this subsection to an amount covered by paragraph (3)(a), assume that amount is *non-assessable non-exempt income. That is, the amount remaining at subsection 802-30(4) should be reduced by expenses that are reasonably related to that amount. DCo submits that in working out its CFI at a particular time when it declares a dividend in its distribution statement to be CFI under Subdivision 802-A, subsection 802-30(5) does not require that the amount remaining after subsection 802-30(4) be reduced by unrealised FX losses made in respect of DCo's net investments in foreign operations and related hedging arrangements. The Explanatory Memorandum to the Tax Laws Amendment (Loss Recoupment and Other Measures) Bill 2005 (EM) which was enacted to insert Division 802 into the ITAA 1997 explains the reference to the income statement: ... as a mechanism to restrict conduit foreign income to amounts of distributable profits. It further provides that: It is appropriate to use accounting concepts because these determine the actual amounts a company may distribute. The EM explains that the concepts of ordinary and statutory income are also used: In order to give more certainty to which of these amounts is to be included in conduit foreign income. Paragraph 5.25 of the EM states: 5.25 In order to give more certainty to which of these amounts is to be included in conduit foreign income, the basic tax concepts of ordinary and statutory income derived by the company are used. One intended effect of this is to exclude unrealised profits or gains and foreign exchange gains (except to the extent that the tax law explicitly deals with them). Using these tax concepts minimises compliance costs as an Australian company would be required to use this information to prepare its income tax returns. The meanings of ordinary and statutory income underpin Division 6. Thus, the two concepts of 'income' and 'income statement' are used to arrive at an amount that is ascertainable and available for distribution. Meaning of the term 'expenses' in subsection 802-30(5) The term 'expenses' is not defined in the legislation. Therefore, the term is interpreted to have its ordinary meaning in the context of the legislative provision in which it appears (see for example Project Blue Sky v. ABA [1998] HCA 28, at paragraph 69, and Stevens v. Kabushiki Kaisha Sony Computer Entertainment [2005] HCA 58 at paragraph 124). The specified rationale for subsection 802-30(5) is to ensure that the amount included in an entity's CFI represents an amount actually available for distribution. In explaining this, paragraph 5.49 of the EM states that the expenses to be included are those expenses that would 'normally' be taken into account in preparing the entity's income statement. In identifying the amount to be included in the calculation of an entity's CFI, subsection 802-30(1) relies on a combination of tax and accounting concepts, but ultimately requires that the amount will be included in an income statement or similar statement of the entity. Thus, the intent of the CFI calculation is to arrive at the amount of net foreign income that is available for distribution, availability being determined by the accounting profit. Therefore, consideration of the context of the subsection makes it appropriate to refer to the expenses recorded on the income statement or similar statement of an entity. In DCo's case, the Group's accounting policy is as follows: (i) to recognise FX differences arising on translation of net investments in certain subsidiaries with foreign operations, and FX differences on translation of arrangements that hedge such investments, in the FCTR, and (ii) to not recognise gains or losses accumulated in FCTR in the income statement until the time of disposition (if any) of the foreign operations. The Commissioner accepts that in DCo's circumstances, the journal entries as outlined under the heading Accounting entries - foreign exchange differences in the Relevant facts and circumstances accord with the requirements under AASB 9 Financial Instruments (AASB 9), which the Group has previously adopted. Unrealised FX losses not 'expenses' until disposition of net investments in foreign operations As DCo does not recognise gains or losses accumulated in the FCTR in the income statement until the time of disposition of foreign operations, any unrealised FX losses are not expenses under subsection 802-30(5). Accordingly, at the time DCo declares in its distribution statements the proposed dividend to be conduit foreign income, the amount remaining after subsection 802-30(4) is not required to be reduced by unrealised FX losses in respect of DCo's net investments in foreign operations and related hedging arrangements. |