Edited version of private advice

Authorisation Number: 1051892784352

Date of advice: 2 September 2021

Ruling

Subject: Do unrealised or realised foreign exchange losses reduce conduit foreign income

Question 1

In working out the conduit foreign income (CFI) of the Aus Co Group at a particular time when Aus Co declares a dividend in its distribution statement to be CFI, does subsection 802-30(5) of the ITAA 1997 require the amount remaining after subsection 802-30(4) of the ITAA 1997 to be reduced by unrealised foreign exchange (FX) losses in respect of foreign denominated debt used to fund investments in foreign operations?

Answer

No.

Question 2

In working out the CFI of the Aus Co Group at a particular time when Aus Co declares a dividend in its distribution statement to be CFI, does subsection 802-30(5) of the ITAA 1997 require the amount remaining after subsection 802-30(4) of the ITAA 1997 to be reduced by realised FX losses, made in respect of foreign denominated debt used to fund investments in foreign operations, that are not yet recognised in the income statement of the Audited Consolidated Financial Statements of the Aus Group?

Answer

No.

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Aus Co and the Aus Co Group

1.            Aus Co is an Australian resident company that was incorporated in Australia. Aus Co is the head company of an Australian tax consolidated group Aus Co Group.

2.            Aus Co Sub (ACS) is an Australian incorporated and resident company. ACS is a wholly owned subsidiary of Aus Co and a subsidiary member the Aus Co Group.

3.            Aus Co Sub 2 (ACS2) is an Australian incorporated and resident company. ACS2 is a wholly owned subsidiary of Aus Co and a subsidiary member of the Aus Co Group.

The scheme

4.            Aus Co will pay a dividend which, all or a portion of any unfranked part of that dividend, will be declared as CFI.

5.            The dividend is a 'frankable dividend' in its entirety, within the meaning of section 202-40 of the ITAA 1997.

6.            Aus Co has invested in several overseas jurisdictions. It has received dividends from these foreign subsidiaries.

7.            The dividends were treated as non-assessable non-exempt income under section 23AJ of the ITAA 1936 or section 768-5 of the ITAA 1997.

8.            Aus Co has funded its overseas investments with a mix of debt and equity.

9.            The debt issued by the Aus Co Group to fund Aus Co's overseas investment is denominated in the underlying currency of the foreign investment.

10.         The debt has been issued by Aus Co or other subsidiaries in the Aus Co Group to external parties. ACS has issued foreign denominated debt that was then on-lent to Aus Co to fund Aus Co's overseas investments. These transactions occurred within the Aus Co Group and were ignored for Australian income tax purposes.

11.         Currently, only ACS has foreign denominated debt on issue.

Aus Co Group's Accounting Policies

12.         The Aus Co Group has adopted the hedging principles of AASB 9 Financial Instruments (AASB 9) (or the equivalent standard for prior periods). Aus Co treats its FX gains and losses in accordance with AASB 121, The Effects of Changes in Foreign Exchange Rates (AASB 121).

13.         In the audited consolidated financial statements of the Aus Co Group for periods preceding the proposed dividend, Aus Co recognised FX losses (realised and unrealised) on its balance sheet in the foreign currency translation reserve (FCTR) in the following circumstances:

a.            Investments in subsidiaries with foreign operations held by Aus Co were denominated in foreign currency.

b.            The debt used by Aus Co to fund a portion of its foreign investments was denominated in the foreign currency of the investment.

c.            Aus Co's accounting policy, in accordance with applicable accounting standards, was at all relevant times (i) to recognise FX differences arising on translation of such net investments in foreign operations, and FX differences on translation of foreign denominated debt arrangements that hedged such investments, in the FCTR, and (ii) to not recognise gains or losses accumulated in the FCTR in the income statement until the time of disposition (if any) of the foreign operations.

d.            As at the balance date for each relevant period, the FX losses were recognised in Aus Co's audited consolidated financial statements for that period. In accordance with Aus Co Group's accounting policy (AASB 121) described above, the FX losses were recognised on the balance sheet in the FCTR (and not in the income statement).

e.            The FX variances on foreign net investments and foreign denominated long-term borrowings designated as a hedge for the purposes of Aus Co's consolidated financial statements have been at times reflected net of tax in the FCTR.

14.         For the proposed dividend, the time of declaration of all or a portion of the unfranked part of the dividend as CFI will not coincide with a period end date for which Aus Co will prepare audited consolidated statements. In accordance with the above accounting principles, any FX losses in respect of the foreign net investments and related debt arrangements that may be determined at the time of the declaration would be recognised in the FCTR.

15.         For the purposes of the Aus Co stand-alone profit and loss statement, FX gains and losses in relation to Aus Co's foreign denominated debt are recorded through the profit and loss statement in accordance with AASB 121.

16.         ACS and ACS2 prepare individual balance sheets and profit and loss statements.

17.         The profit and loss statement and balance sheet of ACS, ACS2 and Aus Co (and other Australian members of the Aus Co Group) are included in accounts prepared for the purposes of calculating the taxable income of the Aus Co Group and are disclosed at the respective disclosure items in Aus Co's income tax return.

18.         For the purposes of calculating the taxable income of the Aus Co Group, the loan arrangements between ACS and Aus Co were ignored as occurring within the tax consolidated group. FX losses in respect of ACS's (or previously Aus Co's) external debt are treated as non-deductible either because the losses are unrealised or, if realised, derived in connection with non-assessable non-exempt foreign dividend income.

19.         Aus Co has recorded CFI credits for distributions received by Aus Co from foreign equity investments, capital gains and other income in accordance with subsections 802-30(1) to 802-30(4) of the ITAA 1997. Those credits will be taken into account in making the declaration on or before the payment of the dividend.

Assumption

The Commissioner makes the Private Ruling subject to the following Assumption:

1.            At the time the Aus Co Group declares in its 'distribution statements ' the dividend to be CFI, no exchange loss will be required to be recognised in the Income Statement of the Audited Consolidated Financial Statements of the Aus Co Group which are prepared in accordance with the accounting standards. Should a FX loss be required to the recognised in the income statement of the Audited Consolidated Financial Statements of the Aus Co Group in a future year the conduit foreign income will be reduced by that amount in that year

Relevant legislative provisions

Subdivision 802-A of the ITAA 1997

Reasons for decision

All references to legislation are reference to the Income Tax Assessment Act 1997 unless otherwise stated.

Issue 1

Question 1

In working out the conduit foreign income (CFI) of the Aus Co Group at a particular time when Aus Co declares a dividend in its distribution statement to be CFI, does subsection 802-30(5) of the ITAA 1997 require the amount remaining after subsection 802-30(4) of the ITAA 1997 to be reduced by unrealised foreign exchange (FX) losses in respect of foreign denominated debt used to fund investments in foreign operations?

Summary

In its accounting treatment of FX losses, Aus Co does not recognise gains or losses accumulated in the FCTR in its income statement until the time of disposition of foreign operations. This approach is consistent with accounting standards. Therefore, any unrealised FX losses are not an expense under subsection 802-30(5) of the ITAA 1997. Accordingly, Aus Co is not required to reduce the amount remaining after subsection 802-30(4) of the ITAA 1997 by any unrealised FX losses in respect of its 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:

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, the amount determined under subsection 802-30(1) is reduced by any amount that is or would be included in Aus Co'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 that were previously taxed under the accruals rules and amounts that are non-assessable foreign income to the extent they can be distributed in the form of fully-franked dividends.

Subsection 802-30(5) then allows the Australian Corporate Tax Entity (the Entity) to:

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) is to be reduced by expenses that are reasonably related to that amount.

Therefore in working out Aus Co's CFI at a particular time when it declares a dividend in its distribution statement to be CFI under Subdivision 802-A, it needs to be determined whether subsection 802-30(5) requires the amount remaining after subsection 802-30(4) to be reduced by any unrealised FX losses Aus Co made in respect of its net investments in foreign denominated debt.

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 Australian income tax 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. Paragraph 5.49 of the EM states:

Expenses that relate to the total amount included in conduit foreign income, as discussed so far, reduce conduit foreign income. There does not have to be actual matching of the individual expenses to individual amounts of the conduit foreign income. These would normally be expected to be expenses taken into account in preparing the company's income statement and would not necessarily be limited to expenses incurred solely in earning the conduit foreign income. Expenses should reduce the amount of conduit foreign income because the profit available for distribution that is sourced from foreign income is reduced. Correctly reducing the amount of conduit foreign income prevents other types of income being distributed as an unfranked distribution declared to be conduit foreign income.

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 EM, in reference to this latter condition in subsection 802-30(1) sets out at paragraph 5.24:

In respect of the third condition above, it does not matter whether the amount has been included in an income statement before it is derived for tax purposes or will be included in one after derivation. However, conduit foreign income can still only include amounts derived in income years that start after 30 June 2005. This condition is based on accounting concepts and is used as a mechanism to restrict conduit foreign income to amounts of distributable profits. It is appropriate to use accounting concepts because these determine the actual amounts a company may distribute.

Thus, the intent of the CFI calculation is to arrive at the amount of net foreign income that is available for distribution, the availability being determined by the accounting profit.

Therefore, although there is no explicit reference to an income statement in connection with the term 'expenses' in subsection 802-30(5), 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 accordance with the appropriate accounting policies.

Accounting policy

In Aus Co's case, the consolidated group has adopted the accounting policies outlined in AASB 9 Financial Instruments (AASB 9) and treats its FX gains and losses in accordance with AASB 121 (as dictated in AASB 9).

Aus Co adopts the following accounting policy in respect to FX differences:

(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.

Aus Co has provided an example of how FX differences are treated in its journal entries. The Commissioner accepts that in Aus Co's circumstances, the journal entries accord with the requirements under AASB 9 and AASB 121, which the Aus Co Group has adopted.

Unrealised FX losses are not 'expenses' until disposition of net investments in foreign operations

As Aus Co does not recognise gains or losses accumulated in the FCTR in its income statement until the time of disposition of foreign operations. This approach is consistent with accounting standards. As such, any unrealised FX losses are not expenses under subsection 802-30(5).

Conclusion

Therefore, Aus Co is not required to reduce the amount remaining after subsection 802-30(4) by any unrealised FX losses in respect of foreign denominated debt used to fund investments in foreign operations.

Question 2

In working out the CFI of the Aus Co Group at a particular time when Aus Co declares a dividend in its distribution statement to be CFI, under Subdivision 802-A, does subsection 802-30(5) require the amount remaining after subsection 802-30(4) be reduced by realised FX losses not yet recognised in the Aus Co Group income statement in respect of foreign denominated debt used to fund investments in foreign operations?

Detailed reasoning

Similar to Question 1, in order for Aus Co to work out its CFI at a particular time when it declares a dividend in its distribution statement to be CFI under Subdivision 802-A, it needs to determine whether subsection 802-30(5) requires the amount remaining after subsection 802-30(4) to be reduced by any realised FX losses Aus Co made in respect of its net investments in foreign denominated debt.

In order to determine CFI, section 802-25 provides that an Australian corporate tax entity must apply sections 802-30 to 802-55. Once an entity determines an amount under subsection 802-30(4) this amount can be reduced by expenses reasonably related to that amount in accordance with subsection 802-30(5).

In Question 1 it was noted that the term 'expenses' referred to the expenses recorded on the income statement or similar statement of the entity. These expenses are recognised by the relevant accounting standards. As Aus Co's accounting policies (which are in line with AASB 9 and AASB 121) accumulate realised FX gains or losses in the FCTR until the time of disposition of the foreign operations, the realised FX losses are not expenses under subsection 802-30(5).

Accordingly, Aus Co is not required to reduce the amount remaining after subsection 802-30(4) by any realised FX losses in the FCTR in respect of foreign denominated debt used to fund investments in foreign operations until such time as it disposes the foreign operations.