Edited version of private advice

Authorisation Number: 1051795638786

Date of advice: 20 January 2021

Ruling

Subject: Taxation of financial arrangements

Question 1

Will an Internal Swap and the Corresponding Novated Swap constitute a single arrangement for X Co for the purposes of Division 230 of the Income Tax Assessment Act 1997 (ITAA 1997), having regard to the relevant matters contained in subsection 230-55(4) of the ITAA 1997?

Answer

No

Question 2

If the answer to Question 1 is 'No', has the Termination of an Internal Swap resulted in a balancing adjustment being made by X Co in accordance with section 230-435 of the ITAA 1997?

Answer

Yes

Question 3

If the answer to Question 2 is 'Yes', does Step 2(a) of the balancing adjustment method statement in subsection 230-445(1) of the ITAA 1997 for the balancing adjustment arising for X Co on the Termination of an Internal Swap include the value of the obligation to enter into the Corresponding Novated Swap?

Answer

Yes, where the value of the rights and obligations that have ceased under an Internal Swap are included in the calculation of the gain or loss under the Corresponding Novated Swap (see Questions 6 and 7).

Question 4

If the answer to Question 2 is 'Yes', does Step 1(a) of the balancing adjustment method statement in subsection 230-445(1) of the ITAA 1997 for the balancing adjustment arising for X Co on the Termination of an Internal Swap include the value of the rights and obligations that have ceased under that Internal Swap?

Answer

No, where the value of the rights and obligations that have ceased under an Internal Swap are included in the calculation of the gain or loss under the Corresponding Novated Swap (see Questions 6 and 7).

Question 5

If the answer to Question 2 is 'Yes', does the Termination of an Internal Swap give rise to any gain or loss for X Co that is taken into account under the accruals and realisation methods provided for in Subdivision 230-B of the ITAA 1997?

Answer

No, the Termination of an Internal Swap does not give rise to any gain or loss for X Co that is taken into account under the accruals and realisation methods where such gain or loss is taken into account under the balancing adjustment under Subdivision 230-G of the ITAA 1997 (see Question 2).

Question 6

If the answer to Question 1 is 'No', has X Co received a financial benefit under the Corresponding Novated Swap for the purposes of subsection 230-60(2) of the ITAA 1997 in respect of the Termination of an Internal Swap?

Answer

Yes

Question 7

If the answer to Question 6 is 'Yes' will the financial benefit identified in Question 6 be a financial benefit that is received under a leg of the financial arrangement under section 230-120 of the ITAA 1997 which is taken into account in working out a gain or loss for X Co under the Corresponding Novated Swap and accrued over the term of the Corresponding Novated Swap in accordance with Subdivision 230-B of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

Income years ended 30 September 2018 to 30 September 2023

The scheme commences on:

31 March 2018

Relevant facts and circumstances

X Co is an Australian resident company and the head company of an Australian income tax consolidated group, of which Sub Co is a subsidiary member (the X Co TCG).

Z Co is part of the same economic group but not a member of the X Co income tax consolidated group.

X Co had external floating rate debt and wished to enter into fixed/floating rate interest rate swaps. However, members of the X Co TCG could not enter into external interest rate swaps with third party banks directly because they did not have approved hedging lines in place at the time.

Instead, it was agreed that Z Co would enter into interest rate swaps with a third party bank and Z Co would then enter back-to-back intergroup interest rate swap agreements with Sub Co. It was understood that once Sub Co was in a position to enter into the swap agreements directly with the third party bank, Z Co would novate the executed interest rate swap contracts to Sub Co.

During the 2018 income year, Z Co entered into a number of fixed/floating interest rate swaps with third party bank (Bank) on specific terms (each an External Swap). Z Co also entered into corresponding back-to-back fixed/floating interest rate swaps for each of the External Swaps with Sub Co with the equal but opposite transaction details (each an Internal Swap).

During the 2019 income year, Sub Co established the relevant agreements and hedge lines with Bank. A Novation Agreement was entered into between Sub Co, Z Co and Bank under which the External Swaps were discharged and cancelled from the date of the agreement, and new swaps were entered into between Sub Co and Bank with the same transaction details (each a Novated Swap). The Internal Swaps and Novated Swaps that have the same transaction details are referred to as an Internal Swap and the Corresponding Novated Swap.

The transaction details shared by an Internal Swap, External Swap and Corresponding Novated Swap include the principal amount, interest rate, effective date, termination date and payment dates. There are however differences between the agreements governing the Internal Swaps and the Novated Swaps.

Sub Co and Z Co agreed to terminate the Internal Swaps with effect from the same date as the novation under a Termination Agreement.

The Internal Swaps and Novated Swaps were out-of-the-money for Sub Co at the time of termination and novation. An Internal Swap and the Corresponding Novated Swap had the same mark to market valuation.

Sub Co discharged its rights and obligations under each Internal Swap by entering into the Corresponding Novated Swap under the Novation Agreement.

Z Co discharged its rights and obligations under the Internal Swaps and External Swaps by entering into the Novation Agreement to novate the External Swaps to Sub Co.

No fees or any other amounts were payable or receivable by any party in relation to the termination of the Internal Swaps and novation of the External Swaps. The only payment rights/obligations were the usual periodic swap payments under the respective swaps.

The group chose not to allow the Internal Swaps to remain in place until expiry due to operational maintenance required for the back-to-back trades until the existing swaps mature. The group chose not to terminate the External Swaps and Internal Swaps and for X Co TCG to enter into new swap agreements on market with third party banks due to costs involved with terminating the External Swaps and entering into new swaps.

For financial accounting purposes, the gains and losses on the External Swap were recognised in the accounts of Sub Co. Upon termination and novation, it was not necessary for Sub Co or X Co to recognise any journal entries in relation to the termination and novation of the swaps..

The X Co TCG is subject to the taxation of financial arrangements (TOFA) rules in Division 230. The X Co TCG has not made any elections under Division 230. The X Co TCG recognised gains/losses on the Internal Swaps under TOFA.

All parties have dealt and will deal with each other on an arm's length basis and on arm's length terms and conditions.

All amounts payable and receivable under the Internal Swaps, External Swaps and Novated Swaps are/will be in Australian dollars and the calculations of those payment rights and obligations do not take into account any foreign currency elements.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 230-10;

Income Tax Assessment Act 1997 Section 230-15;

Income Tax Assessment Act 1997 Subsection 230-40(2);

Income Tax Assessment Act 1997 Section 230-45;

Income Tax Assessment Act 1997 Subsection 230-55(4);

Income Tax Assessment Act 1997 Section 230-60;

Income Tax Assessment Act 1997 Section 230-100;

Income Tax Assessment Act 1997 Section 230-105;

Income Tax Assessment Act 1997 Paragraph 230-110(2)(b);

Income Tax Assessment Act 1997 Section 230-120;

Income Tax Assessment Act 1997 Section 230-130;

Income Tax Assessment Act 1997 Section 230-435;

Income Tax Assessment Act 1997 Section 230-445;

Income Tax Assessment Act 1997 Section 701-1; and

Income Tax Assessment Act 1997 Section 974-160.

Reasons for decision

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

Question 1

Summary

An Internal Swap and the Corresponding Novated Swap will not constitute a single arrangement for the purposes of Division 230, having regard to the relevant matters contained in subsection 230-55(4).

Detailed reasoning

Division 230 deals with the tax treatment of gains and losses from financial arrangements. The Division provides for the recognition of gains and losses, as appropriate, over the life of a financial arrangement.

A 'financial arrangement' is defined in subsection 230-45(1). Subsection 230-55(4) lists the matters that are relevant to identifying whether a number of rights and/or obligations are themselves an 'arrangement' or are 2 or more separate arrangements for the purposes of Division 230. It is a question of fact and degree that is determined having regard to the following:

(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 this Division.

In applying subsection 230-55(4), regard must be had to the matters referred to in paragraphs (a) to (f) both in relation to the rights and/or obligations separately and in relation to the rights and/or obligations in combination with each other.

Taxation Ruling 2012/4 Income tax: the operation of subsection 230-55(4) of the Income Tax Assessment Act 1997 (ITAA 1997) in determining what is an 'arrangement' for the purposes of the taxation of financial arrangements under Division 230 of the ITAA 1997 (TR 2012/4) outlines the Commissioner's view on the matters in subsection 230-55(4).

The Internal Swaps and Novated Swaps are arrangements entered into by Sub Co, a member of the X Co TCG. Pursuant to the single entity rule under section 701-1, Division 230 applies as if X Co, being the head company of the group, is the relevant taxpayer (paragraph 11.62 of Explanatory Memorandum to the Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008 (EM)).

Each of the factors referred to in paragraphs 230-55(4)(a) to (f) are considered in turn below.

Paragraph 230-55(4)(a) - nature of the rights and/or obligations

This factor includes a consideration of the substance of the rights and/or obligations (paragraph 15 of TR 2012/4).

Paragraph 230-55(4)(a) also requires consideration of whether the rights and/or obligations are intrinsically linked, or, in substance, form part of a larger thing. In this assessment, links or interactions between them, such as contingencies on other rights and/or obligations, or conversion or redemption can be relevant (paragraph 154 of TR 2012/4).

In respect to rights and obligations arising from more than one contract, TR 2012/4 relevantly states:

156. Where the rights and/or obligations arise under more than one contract, it would typically be the case that each contract gives rise to a separate arrangement, but again, it will not necessarily be so.

157. The mere fact that one contract refers to another does not indicate that the rights and/or obligations under the contracts are to be combined. It is necessary to understand the nature of the relationship between the contracts. For example, mere incorporation by reference of generic terms as a means of drafting efficiency would not tend to suggest aggregation.

158. On the other hand, where the nature of the rights and obligations under individual contracts would make no sense on their own, but would only make sense if they operated together, this factor would point towards aggregation of the contracts.

The rights and obligations of Sub Co under an Internal Swap are set out under the relevant documentation for that Internal Swap. Sub Co has an obligation to make periodic interest payments to Z Co and Sub Co has a right to receive periodic interest payments from Zo Co pursuant to the terms of each Internal Swap.

There is no indication that X Co TCG has any rights or obligations under an Internal Swap as against Bank directly. Conversely, the back-to-back swaps were entered into because members of the X Co TCG did not have the necessary contractual relationships set up with Bank and could not enter into the swap transactions directly.

The Internal Swaps were terminated pursuant to the Termination Agreement. Under the Termination Agreement, Z Co and Sub Co released and discharged each other from further obligations under the Internal Swaps.

The rights and obligations of Sub Co under the Novated Swaps arose under the Novation Agreement, which was entered into after the Internal Swaps were created. The Novation Agreement does not contemplate an amalgamation of the rights and obligations of an Internal Swap with the rights and obligations of the Corresponding Novated Swap.

The rights and obligations of Sub Co under the Novated Swaps are governed by agreements in place between Sub Co and Bank. The relevant agreements with Bank did not exist at the time the Internal Swaps were entered into. Furthermore, the terms of the Novated Swaps specifically exclude the rights and obligations of Sub Co and Bank prior to the novation date.

The nature of the rights and obligations under each Internal Swap and Corresponding Novated Swap make sense on their own and do not necessarily need to operate together. The rights and obligations under an Internal Swap are not contingent upon the Corresponding Novated Swap, or vice versa.

As such, the form and substance indicate that an Internal Swap and the Corresponding Novated Swap do not form part of a single financial arrangement.

Paragraph 230-55(4)(b) - their terms and conditions (including those relating to any payment or other consideration for them)

This factor requires assessment of the legal expression of the arrangement (paragraph 160 of TR 2012/4).

An Internal Swap and the Corresponding Novated Swap contain the same transaction details with respect to principal amount, interest rate, effective date, termination date and payment dates. There are however other aspects of the terms and conditions that are different as between each Internal Swap and Corresponding Novated Swap.

As set out in paragraph 16 of TR 2012/4, this factor includes a consideration of the terms and conditions relating to payment and/or consideration. Where one amount is calculated and paid as consideration for a number of rights, it will tend to suggest aggregation of such rights. Where the consideration is calculated and paid separately for different rights, it will tend to suggest such rights are separate.

The consideration to be provided under the Internal Swaps were swap payments to Z Co as the counterparty in return for swap payments from Z Co. The consideration to be provided by Sub Co under the Novated Swaps are swap payments to Bank as the counterparty, in return for receiving swap payments from Bank under the Novated Swaps. The entry into a new swap with the same transaction details but different counterparties was settled through Sub Co discharging some rights and obligations and taking on others. Overall, having regard to the terms and conditions relating to payment and consideration can be understood as separate arrangements.

On the whole, whilst there are aspects of the consideration under paragraph 230-55(4)(b) which indicate that an Internal Swap and the Corresponding Novated Swap are part of a single financial arrangement, there are also aspects of the consideration which point otherwise. Therefore, consideration of this factor is neutral.

Paragraph 230-55(4)(c) - the circumstances surrounding their creation and their proposed exercise or performance (including what can reasonably be seen as the purposes of the entities involved)

Paragraph 230-55(4)(c) requires consideration of the context surrounding the life cycle of the rights and/or obligations from creation to what is proposed as exercise or performance (paragraph 17 of TR 2012/4). The relevant circumstances can include the commercial, regulatory and financial imperatives that shaped the transaction (paragraph 168 of TR 2012/4). This is an objective assessment of the purposes of the entities involved. In such assessment, evidence of the subjective purpose of such entities may be relevant, though not determinative (paragraph 18 of TR 2012/4).

In this regard, the intention of X Co was to hedge its underlying interest rate exposure. Such objective is set out under the internal transaction documents for the Internal Swaps. This objective was achieved by entry into the Internal Swaps and then subsequently the Corresponding Novated Swaps.

Z Co agreed to enter into the External Swaps and subsequently enter into the back-to-back Internal Swaps with members of the X Co TCG because members of the X Co TCG did not have approved hedging lines in place with Bank. It was understood within the group when the swaps were created that the External Swaps would be novated to a member of X Co TCG when it established the necessary hedging lines and contracts with Bank. The commercial rationale within the group was reflected in the terms of the Internal Swaps, which mirrored the conditions of the External Swaps.

While Bank was aware of the commercial rationale for the transaction, there was no obligation on Bank to enter into the Novated Swaps when the External Swaps were entered into. There is also no evidence to suggest that it was the intention of Bank when the External Swaps were created, that the rights and obligations under the Novated Swaps should be aggregated with the Internal Swaps that were entered into within the X Co group.

The Internal Swaps and Novated Swaps were entered into at different times. Sub Co could not enter into the External Swaps directly when the Internal Swaps were created. Furthermore, the Novated Swaps were separately arranged and agreed to at a later point in time. These circumstances would suggest they are separate arrangements.

In regards to the performance, the Internal Swap documents provided that the payments to be made to Z Co were to be made to Bank as the 'beneficiary'. This could indicate that the actual performance of the swap obligations had always been made to Bank (even under an Internal Swap). This aspect could support the conclusion that an Internal Swap is the same arrangement as the Corresponding Novated Swap.

Overall, there are aspects of this factor that tend to indicate that each Internal Swap and Corresponding Novated Swap are a single financial arrangement, however, the weight to be placed on this factor is limited by the consideration that this is the intention of the economic group, and there is no obligation or express intention of the third party (Bank) that an Internal Swap and the Corresponding Novated Swap are part of the same arrangement.

Paragraph 230-55(4)(d) - whether they can be dealt with separately or must be dealt with together

Paragraph 230-55(4)(d) requires the consideration of whether the rights and/or obligations can be dealt with separately or must be dealt with together in accordance with the term and conditions of the arrangement (paragraph 19 of TR 2012/4). Where the rights and/or obligations must be dealt with together, it will tend to suggest aggregation. The enquiry under this paragraph is as to legal, rather than commercial, constraint.

An Internal Swap and the Corresponding Novated Swap are governed by separate legal agreements. There is no specific reference to or provision for the Novated Swaps under the terms and conditions for the Internal Swaps. In addition, the agreement for the Novated Swaps does not contain provisions and conditions regarding the Internal Swaps.

The agreements are entered into with different counterparties. They have been created at different times and are not intended by the X Co TCG to exist concurrently. There is no suggestion that an Internal Swap and the Corresponding Novated Swap could be dealt with together.

Z Co and Sub Co entered into the Internal Swaps and dealt with each other in respect of the Internal Swaps under the relevant termination agreements independently of Bank and the Novation Agreement. The Internal Swaps could be dealt with by Sub Co independently of the Novated Swaps.

Therefore, this factor indicates that an Internal Swap and the Corresponding Novated Swap do not form part of a single financial arrangement.

Paragraph 230-55(4)(e) - normal commercial understandings and practices (including whether they are regarded commercially as separate things or as a group or series that forms a whole)

Paragraph 230-55(4)(e) requires the consideration of normal commercial understandings and practices in relation to rights and/or obligations (including whether they are regarded commercially as separate things or as a group or series that forms a whole) (paragraph 20 of TR 2012/4). Where normal commercial understandings and practices are to regard a number of rights and/or obligations as one aggregated whole, it will tend to suggest aggregation. Where normal commercial understandings and practices are to regard a number of rights and/or obligations as separate things, it will tend to suggest that they are separate.

Commercially, two swap transactions entered into with a different counterparty would generally be regarded as separate arrangements, each of which could be dealt with or assigned separately.

It is arguable that treating the Corresponding Novated Swap as a continuation of an Internal Swap reflects the commercial and economic substance of the transaction. The commercial understanding internally between members of the X Co group is that the Internal Swaps would be on identical back-to-back terms as the External Swaps and that the External Swaps would be novated to members of the X Co TCG once the necessary hedging lines were established with Bank. The external third party was also aware of the proposal. Economically, the X Co TCG would be in the same position under the Internal Swaps as it would under the Corresponding Novated Swaps.

For financial accounting purposes, Sub Co recognised gains and losses on the External Swaps directly in its accounts and no accounting recognition was required on termination and novation. However, as noted in TR 2012/4 that accounting treatment is an important commercial information source as to how things are recognised and measured, however, accounting treatment may not always be very helpful and the legislation under Division 230 has an explicit choice to use the broader (and different) term 'commercial' rather than 'accounting' (at paragraph 188).

However, although there is internal commercial understanding within the economic group and the accounting treatment of the swaps by the group, there is no evidence of commercial understanding as between the group and Bank, or more broadly in the industry, that the Novated Swap should be a continuation of an Internal Swap (not subject to the novation) entered into with different counterparties and at different times.

Overall, a consideration of this factor is neutral as to whether an Internal Swap and the Corresponding Novated Swap form part of a single financial arrangement.

Paragraph 230-55(4)(f) - the objects of Division 230

Paragraph 230-55(4)(f) requires the consideration of the objects of Division 230 as set out in section 230-10 (paragraph 21 of TR 2012/4). Broadly, the objects of Division 230 are:

•   to minimise tax distortions on commercial decision-making by, for gains and losses from financial arrangements, aligning tax recognition of such gains and losses with the reality of what gains and losses occur and when they occur;

•   to align tax and commercial recognition of gains and losses from financial arrangements by ensuring the time of recognition of those gains and losses is reasonable, and by generally recognising such gains and losses on revenue account; and

•   to appropriately take account of, and minimise, compliance costs.

From an accounting perspective, the gains and losses on the External Swaps had been recognised by Sub Co rather than Z Co. There is no recognition of a new swap transaction on termination and novation, nor any gain or loss in the accounts for Sub Co or X Co. However, in this regard it is noted that taking account of and minimising compliance costs is a goal that does not override or ignore the choices that the legislation makes to not have a direct link with accounting. That is, where the legislation expressly requires a treatment different from that in accounting, the compliance costs object cannot result in the express legislative requirement being ignored.

As noted in TR 2012/4, in having regard to the objects of Division 230, it may be necessary to consider how Division 230 would apply if the rights/obligations were aggregated, and if they were treated separately (paragraph 22 of TR 2012/4).

If an Internal Swap and the Corresponding Novated Swap are treated as separate arrangements, a balancing adjustment on ceasing to have a financial arrangement would be made by the X Co TCG under Subdivision 230-G when that Internal Swap was terminated. The gains and losses arising from the Novated Swap as a separate financial arrangement would be determined under the provisions of Division 230. Conversely, if an Internal Swap and the Corresponding Novated Swap are treated as a single arrangement, then no balancing adjustment would be made under Subdivision 230-G as the rights and obligations under the arrangement have not ceased.

There was no cash payment received or paid by members of the X Co TCG upon termination of an Internal Swap and entry into the Corresponding Novated Swap. From this perspective, it may suggest that treating an Internal Swap and the Corresponding Novated Swap as a single arrangement would align tax recognition of gains and losses with the reality of what gains and losses occur and when they occur.

However, in applying subsection 230-55(4), regard must be had to all of the matters referred to in paragraphs (a) to (f) and must include a consideration of how the matters interact (paragraph 13 of TR 2012/4).

In regard to all the factors discussed above, the gains/losses under an Internal Swap were in effect realised for the X Co TCG by the termination of that agreement with Z Co. Entering into a new obligation (the Novated Swap) under different contractual frameworks and with different counterparties is not the same arrangement or a continuation of the same arrangement such that the gains/losses on the terminated agreement should not be realised.

Therefore, treating an Internal Swap and the Corresponding Novated Swap as a single financial arrangement could potentially lead towards tax distortions on commercial decision-making and fail to deliver tax neutral and consistent outcomes which are the objectives of Division 230. As such, this factor, on balance, indicates that an Internal Swap and the Corresponding Novated Swap do not form part of a single financial arrangement.

Overall conclusion

The factors in paragraphs 230-55(4)(a) to (f) either point away or are neutral as to whether an Internal Swap and the Corresponding Novated Swap form part of a single arrangement. Therefore, having regard to those factors, an Internal Swap and the Corresponding Novated Swap do not form part of a single arrangement.

Question 2

Summary

The Termination of an Internal Swap has resulted in a balancing adjustment being made by X Co in accordance with section 230-435.

Detailed reasoning

An Internal Swap is a financial arrangement held by Sub Co, a member of the X Co TCG. Pursuant to the single entity rule under section 701-1, Division 230 applies as if X Co, being the head company of the group, is the relevant taxpayer.

Paragraph 230-435(1)(b) provides that a balancing adjustment is made under Subdivision 230-G if "all of your rights and/or obligations under a financial arrangement otherwise cease".

Under the Termination, Z Co and Sub Co were released and discharged from further obligations to each other in respect to the Internal Swaps, and cancelled their respective rights against each other.

As all the rights and obligations of Sub Co under an Internal Swap have ceased, the Termination of an Internal Swap has resulted in a balancing adjustment pursuant to paragraph 230-435(1)(b).

Furthermore, the rights and obligations that have ceased under the Termination are rights and obligations that are part of the financial arrangement (being an Internal Swap), therefore the exception under subsection 230-435(2) does not apply.

Question 3

Summary

The value of the obligation to enter into the Corresponding Novated Swap is included under Step 2(a) of the balancing adjustment method statement in subsection 230-445(1) for the balancing adjustment that is made by X Co on the Termination of an Internal Swap.

Detailed reasoning

Where paragraph 230-435(1)(b) applies (as per discussed above under Question 2), the balancing adjustment is worked out pursuant to the method statement set out under subsection 230-445(1).

Under the method statement set out in subsection 230-445(1), Step 2(a) takes into account 'the total of all the *financial benefits you have provided under the *financial arrangement'. As indicated by the note under Step 2(a), this would include financial benefits you provide in relation to the transfer or cessation because of the operation of section 230-60, that is, financial benefits that play an integral role in determining a gain or loss made from the financial arrangement within the meaning of paragraph 230-60(1)(c). Such financial benefits would be taken into account even if the entity to which you provide the financial benefits is not a party to the arrangement (subsection 230-60(1)(c)).

The definition of 'financial benefit' in section 974-160 includes anything of economic value, even if the transaction that confers the benefit on an entity also imposes an obligation on the entity.

What is considered essential or integral will be determined by the nature or purpose of the financial benefit that is taken to be provided or received under the financial arrangement. What is considered to be integral or essential to determining whether the taxpayer makes a relevant gain or loss from the financial arrangement can be determined by commercially accepted principles and the relevant facts and circumstances of each arrangement. However, the costs of, or proceeds from, the financial arrangement, where they are integral to the calculation of a gain or loss from the arrangement, need not necessarily be provided or received from parties to the particular financial arrangement (see paragraphs 3.36-3.38 of the EM).

In the current case, Sub Co entered into the Corresponding Novated Swap to discharge its rights and obligations under an Internal Swap. The obligation to enter into the Corresponding Novated Swap was something of economic value and a financial benefit provided by Sub Co in relation to the cessation of an Internal Swap.

Taking into account the circumstances of the Termination and Novation, the obligation to enter into the Corresponding Novated Swap is a financial benefit provided by Sub Co as part of terminating an Internal Swap and plays an integral role in determining the gains and losses of X Co under that Internal Swap. Therefore, the value of the obligation to enter into the Corresponding Novated Swap is included under Step 2(a) of the method statement under subsection 230-445(1) for the purposes of the balancing adjustment that is made by X Co on Termination of an Internal Swap.

Conversely, the value of the rights and obligations that have ceased under that Internal Swap will be included in the calculation of the gain or loss under the Corresponding Novated Swap (as discussed below under Questions 6 and 7).

Question 4

Summary

The value of the rights and obligations that have ceased under an Internal Swap is not included under Step 1(a) of the balancing adjustment method statement in subsection 230-445(1) for the balancing adjustment that is made by X Co on the Termination of that Internal Swap, where the value of the rights and obligations that have ceased under that Internal Swap are included in the calculation of the gain or loss under the Corresponding Novated Swap (see Questions 6 and 7).

Detailed reasoning

Where paragraph 230-435(1)(b) applies (as discussed above under Question 2), the balancing adjustment is worked out pursuant to the method statement set out under subsection 230-445(1).

Step 1(a) of the method statement under subsection 230-445(1) takes into account 'the total of all the *financial benefits you have received under the *financial arrangement'.

The definition of 'financial benefit' in section 974-160 includes anything of economic value, even if the transaction that confers the benefit on an entity also imposes an obligation on the entity. Subsection 974-160(2) also states that benefits and obligations are to be looked at separately and not set off against each other.

In the current case, Sub Co discharged its rights and obligations to Z Co under an Internal Swap by entering into the Corresponding Novated Swap under the Novation Agreement. This would be something of economic value and therefore the cessation of the rights and obligations under an Internal Swap could be a 'financial benefit' received by Sub Co.

However, as indicated by the note under Step 1(a), this step includes financial benefits you receive in relation to the transfer or cessation because of the operation of section 230-60, that is, financial benefits that play an integral role in determining the gain or loss made from the financial arrangement within the meaning of paragraph 230-60(2)(c).

As noted above under Question 3, the EM explains when a financial benefit is considered integral. In addition, paragraph 10.61 of the EM provides an example of the application of section 230-60 in the context of the balancing adjustment:

If the amount owed under the loan is 'waived' by the creditor then it could be said that the debtor has received a benefit in the form a 'waiver' being the release from payment under the loan. However, in applying the balancing adjustment calculation to this simple example the 'waiver' benefit itself would not be considered integral (in the context of section 230-60) to working out whether the debtor has made a gain or loss on the financial arrangement. The amount included in the balancing adjustment calculation in this situation would be the actual loan proceeds received by the debtor which is compared to any amounts provided by the debtor which in this example would be nil.

Taking into account the circumstances of the Termination and Novation, it is considered that the financial benefit from the cessation of the rights and obligations under an Internal Swap arises in connection with the entry into the Corresponding Novated Swap and has an integral role in working out the gains or losses on that swap (as discussed below under Question 6 and 7). With this context, it is not considered that this financial benefit has an integral role in working out the gains and losses on an Internal Swap.

Therefore, the value of the rights and obligations that have ceased under an Internal Swap would not be included under Step 1(a) of the balancing adjustment method statement on the Termination of an Internal Swap where they are taken into account in working out the gains and losses on the Corresponding Novated Swap.

Question 5

Summary

The Termination of an Internal Swap does not give rise to any gain or loss that is taken into account under the accruals and realisation method provided for in Subdivision 230-B where such gain or loss is taken into account under the balancing adjustment under Subdivision 230-G (refer to Question 2).

Detailed reasoning

Subsection 230-40(2) provides:

A gain or loss is not taken into account under any of the methods referred to in paragraphs (1)(a), (b), (c) and (e) to the extent to which it is taken into account under the method referred to in paragraph (1)(f) (balancing adjustment).

As discussed at Question 2 above, the Termination of an Internal Swap has resulted in a balancing adjustment being made by X Co under Subdivision 230-G in respect of that Internal Swap. Pursuant to subsection 230-40(2), the Termination does not give rise to any gain or loss under subdivision 230-B where such gain or loss has been taken into account under the balancing adjustment under Subdivision 230-G.

Question 6

Summary

X Co has received a financial benefit under the Corresponding Novated Swap for the purposes of subsection 230-60(2) in respect of the Termination of an Internal Swap.

Detailed reasoning

Section 230-60 determines when a financial arrangement has been provided or received under a financial arrangement for the purpose of working out any gain or loss from that financial arrangement. In particular, financial benefits that you receive (or have a right to receive) which play an integral role in determining whether a gain or loss is made from the financial arrangement, are also taken to be relevant financial benefits under that financial arrangement (subsection 230-60(2)). The definition of a financial benefit under subsection 974-160(1) includes anything of economic value.

Paragraphs 3.36-3.38 of the EM provides that whether a financial benefit is considered integral will be determined by the nature or purpose of the financial benefit that is taken to be provided or received under the financial arrangement. It can be determined by commercially accepted principles and the relevant facts and circumstances of each arrangement.

In the current case, Sub Co discharged its obligations under an Internal Swap by entering into the Corresponding Novated Swap under the Novation Agreement. Being released and discharged from the rights and obligations under an Internal Swap was something of economic value and a financial benefit received by Sub Co.

Taking into account the circumstances of the Termination and Novation, it is considered that the financial benefit arises in connection with the entry into the Corresponding Novated Swap and this financial benefit plays an integral role in determining the gains and losses under the Corresponding Novated Swap. Even though Z Co is not a party to the Corresponding Novated Swap, subsection 230-60(2) notes that there is a financial benefit received even if the entity providing the benefit is not a party to the financial arrangement.

Therefore, as head entity of the X Co TCG, X Co has received a financial benefit under the Corresponding Novated Swap for the purposes of subsection 230-60(2) in respect of the Termination of an Internal Swap.

Question 7

Summary

The financial benefit identified in Question 6 will be a financial benefit that is received under a leg of the financial arrangement under section 230-120 which is taken into account in working out the gain or loss for X Co under the Corresponding Novated Swap and accrued over the term of the Corresponding Novated Swap in accordance with Subdivision 230-B.

Detailed reasoning

X Co has not made any elections under Division 230, therefore Subdivision 230-B applies to determine the timing and recognition of the gains and losses under the Corresponding Novated Swap (subsection 230-40(4)).

The application of Subdivision 230-B is modified by section 230-120 for financial arrangements with a notional principal. Section 230-120 applies provided the test set out in subsection 230-120(1) is satisfied. If it applies, subsection 230-120(3) contains provisions for how the financial arrangement is to be taxed under Subdivision 230-B (Taxation Ruling TR 2016/2: Income tax: taxation of financial arrangements - how section 230-120 of the Income Tax Assessment Act 1997 applies to the taxation of swaps under the accrual/realisation rules in Subdivision 230-B of that Act (TR 2016/2), at paragraph 4).

Subsection 230-120(1) provides a test which must be satisfied if section 230-120 is to apply to a financial arrangement:

a) the arrangement consists of these things:

(i) a leg, the *financial benefits to be provided or received in respect of which are calculated by reference to, or are reasonably related to, a notional principal;

(ii) another leg, the financial benefits to be provided or received in respect of which also are calculated by reference to, or are reasonably related to, a notional principal;

(iii) if the arrangement includes one or more other things - those things; and

(b) when you start to have the arrangement, the value of the notional principal in relation to one leg is equal to the value of the notional principal in relation to the other leg; and

(c) all or part of the notional principal in relation to each leg is provided or received at a time, regardless of whether that time is different in relation to each leg.

The Corresponding Novated Swap, in substance or effect, and having regard to its pricing, terms and conditions, consists of a notional construct that satisfies the test in subsection 230-120(1).

Because the test under subsection 230-120(1) is satisfied, the gains and losses from the arrangement are worked out under subsection 230-120(3). The note under subsection 230-120(1) confirms that a swap contract as an example of a financial arrangement to which section 230-120 applies.

As explained in paragraphs 14-15 of TR 2016/2, the accruals and realisation methods of Subdivision 230-B apply at the level of each leg or thing (subparagraph 230-120(3)(b)(i)). The gains and losses produced by applying Subdivision 230-B at the level of each leg or thing are treated as being the gains and losses from the financial arrangement (subparagraph 230-120(3)(b)(ii)).

The accruals method applies where there is a sufficiently certain overall gain or loss, or if there is a sufficiently certain particular gain or loss (section 230-100). Where there is both sufficiently certain particular gains or losses and an overall gain or loss, X Co is able to choose under paragraph 230-100(2)(c) to apply the accruals method to the overall gain or loss, in which case the particular gains or losses are disregarded under paragraph 230-110(2)(b).

For a sufficiently certain overall gain or loss, the period over which the gain or loss is to be spread is from when X Co starts to have the arrangement and ends when X Co ceases to have the arrangement (subsection 230-130(1)).

For a sufficiently certain particular gain or loss under subsection 230-100(3) arising from the financial benefit identified under Question 6, the gain or loss would be spread over the period to which the gain relates, having regard to the pricing, terms and conditions of the arrangement (subsection 230-130(3)). The relevant period in this case would be the term of the Corresponding Novated Swap.