Edited version of private advice

Authorisation Number: 1051997722343

Date of advice: 22 June 2022

Ruling

Subject: Annual hedging costs

Question 1

Are annual hedging costs which Trust 1 reimburses its foreign capital provider periodically in return for retaining the capital invested and which Trust 1 has incurred to acquire an income producing property in Australia deductible under section 8-1 of the Income Tax Assessment Act 1997 (the "ITAA 1997")?

Answer

No.

Question 2

If the answer to question 1 is no, are the annual hedging costs reimbursed by Trust 1 to its foreign capital provider in return for retaining the loan capital invested (calculated on a reasonable allocation) deductible under s25-25 of the ITAA 1997?

Answer

Yes.

Question 3

If the answer to question 1 is no, are the annual hedging costs reimbursed by Trust 1 to its foreign capital provider in return for retaining the equity capital invested (calculated on a reasonable allocation) deductible under s40-880 of the ITAA 1997?

Answer

Yes.

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

Background

1.    Investment Fund W (W Fund) is a Foreign alternative investment fund governed by the laws of a Foreign jurisdiction. The W Fund is marketed as a retail fund and has more than 50 members who are primarily tax resident individuals of the Foreign jurisdiction with a few institutional resident investors.

2.    The investment manager of the W Fund is X Manager which, acts in its own name but on behalf of and for the account of the W Fund. X Manager is the real estate investment arm of the Y Group headquartered in the Foreign jurisdiction.

3.    In this Ruling, references to X Manager below means it is acting on behalf of and/or for the account of the W Fund.

4.    At the time of establishment, X Manager and an unrelated third-party investor together held all the units in Trust 1 an Australian unit trust.

5.    The purpose of setting up Trust 1 is set out in its Constitution as follows:

The Trust is set up for the object and purpose of, and the nature of the business to be conducted and promoted by the Trustee in its capacity as trustee of the Trust which is to acquire, improve, lease, maintain, own, operate, manage, finance, refinance, mortgage, hold, sell, exchange, administer and otherwise deal in and with Real Estate Investments and to engage in any other activities necessary, related or incidental thereto, including without limitation, holding and disposing of Ancillary Assets and within that objective and purpose, the Trust will acquire long term investments in real property with the intention to derive rental income.

6.    The trustee of Trust 1 is T Pty Ltd (the Trustee). The Trustee is a wholly owned subsidiary of X Manager and is incorporated in Australia.

7.    Trust 1 directly owns a 99-year Crown leasehold interest in an Australian commercial property (the Property).

8.    The Property was acquired for the primary purpose of deriving rental income in the long term. Trust 1 also owns other existing real estate investments in Australia.

Funding arrangements to acquire the Property

9.    Trust 1's direct investment in the Property was funded through a combination of:

•         a unitholder loan obtained from X Manager (the unitholder loan) and

•         equity capital provided by X Manager and the unrelated third-party investor in proportion to their relative unitholding in Trust 1 (the equity capital).

10.  The unitholder Loan Agreement provides that all costs arising from the conclusion and implementation of the Loan Agreement including the foreign currency hedging expenses and provision of the Securities shall be paid by the Trustee. The arrangement in relation to the payment of the foreign currency hedging expenses by the Trustee is described below.

The equity capital

11.  The equity capital funding arrangement is documented in the minutes of meeting of directors of the Trustee. This involves the subscription of ordinary paid units in the Trust by X Manager and unrelated third-party investor in proportion to their relative unitholding in Trust 1.

On-charging arrangement of third-party hedging costs incurred by X Manager to the Trustee

12.  The minutes of meeting of directors documents the intention of the Trustee, and X Manager, that the Trustee would reimburse X Manger for "the resulting hedging expenses". This was expressed to be a pre-condition for the unitholder loan and the equity capital.

13.  A retrospective On-charging Agreement between X Manager and the Trustee include the following terms:

•         The Trustee will pay X Manager certain hedging costs incurred by X Manager in relation to the unitholder loan and equity capital provided by X Manager to fund the acquisition of the Property (third party hedging costs).:

•         X Manager will issue invoices to the Trustee on an annual basis (or earlier in respect of a termination of a hedge), and the Trustee will pay the invoiced amount within 30 days of the date of the invoice.

Third party hedging contract

14.  The initial hedging contract was entered into for 2 years and the annual costs are charged in a linear way over the lifetime of the specific hedge.

15.  The third-party hedging costs is expected to be on-charged annually over the life of the investment whilst the capital continues to be deployed in Australia.

16.  The Trustee is not a party to (and does not have any liability, obligations or rights to) X's third-party hedging arrangement.

17.  The third-party hedging costs allocated to the unitholder loan and equity capital is worked out based on their respective proportion to which the specific hedging contract relates.

Management of X investments in Australia

18.  X Investments Australia Ltd (XIA) was appointed as the Manager to provide investment management services to the Trustee.

19.  XIA is a wholly owned subsidiary of Y Group.

20.  XIA holds an Australian Financial Services License that covers the provision of financial services (within the meaning of section 766A of the Corporations Act 2001) to wholesale clients (within the meaning of section 761G of the Corporations Act 2001).

21.  The obligations of XIA include as follows:

•         sourcing and recommending Australian investments to Trust 1, perform relevant analysis leading to providing recommendations as to whether to acquire the investment and manage the acquisition and perform or oversee the due diligence process (including undertaking negotiations with the relevant vendor),

•         following an acquisition, manage the property managers, keep assets under review, perform and oversee reporting at various levels and conduct performance analysis, and

•         reporting disposal opportunities and managing the disposal process.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 25-25

Income Tax Assessment Act 1997 Subsection 25-25(1)

Income Tax Assessment Act 1997 Subsection 25-25(4)

Income Tax Assessment Act 1997 Section 40-880

Income Tax Assessment Act 1997 Subsection 40-880(2)

Income Tax Assessment Act 1997 Subsection 40-880(3)

Income Tax Assessment Act 1997 Subsection 40-880(4)

Income Tax Assessment Act 1997 Subsection 40-880(5)(d)

Income Tax Assessment Act 1997 Subsection 40-880(6)

Income Tax Assessment Act 1997 Subsection 40-880(7)

Income Tax Assessment Act 1997 Subsection 40-880(8)

Income Tax Assessment Act 1997 Subsection 40-880(9)

Income Tax Assessment Act 1936 Section 67

Income Tax Assessment Act 1936 Subsection 67(1)

Reasons for decision

Question 1

Are annual hedging costs which Trust 1 reimburses its foreign capital provider periodically in return for retaining the capital invested and which Trust 1 has incurred to acquire an income producing property in Australia deductible under section 8-1 of the Income Tax Assessment Act 1997 (the "ITAA 1997")?

Summary

The hedging costs paid by the Trustee in relation to the capital invested in accordance with the on-charging arrangement of third party hedging costs are not deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

Section 8-1 allows a deduction for any outgoing to the extent that it is incurred in the course of carrying on a business except where the outgoing is of a capital nature (paragraph 8-1(2)(a)).

The judgement of Dixon J in Sun Newspapers Ltd. and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers) is the leading authority on the distinction between revenue and capital expenditure. In Sun Newspapers, the general rule is found in the frequently quoted statement of Dixon J at 359, where he said:

The distinction between expenditure and outgoings on revenue account and on capital account correspond with the distinction between the business entity, structure, or organisation set up or established for the earning of profit and the process by which such an organisation operates to attain regular returns by means of regular outlays, the difference between the outlay and returns representing profit or loss... As general conceptions it may not be difficult to distinguish between the profit yielding subject and the process of operating it. In the same way expenditure and outlay upon establishing, replacing and enlarging the profit-yielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue.

In Sun Newspapers, Dixon J at 363 referred to what are now considered three principles to determining whether a loss or outgoing is of a capital or revenue nature:

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

The character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure because it says the most about the essential character of the expenditure itself. The decision of the High Court in G P International Pipecoaters Pty Ltd v. Commissioner of Taxation (1990) 170 CLR 124 at 137; (1990) 90 ATC 4413 at 4419; (1990) 21 ATR 1 at 7 emphasised this, stating:

The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid: Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 C.L.R 337, at p.363....

In relation to the character of the advantage sought by the expenditure it is necessary to examine whether the expenditure secures an enduring benefit for the business. This test was outlined in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 at 213 - 214 by Viscount Cave where he stated:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

As noted above, when the matters stated by Dixon J in the Sun Newspapers Case are considered, the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid. The nature or character of the expenditure will therefore follow the advantage that is sought to be gained by incurring the expenditure. If the advantage to be gained is of a capital nature, then the expenditure incurred in gaining the advantage will also be of a capital nature.

It is then appropriate for the nature of the expenditure incurred by the Trustee on the hedging costs to be characterised by reference to the advantage that is sought to be gained by incurring the expenditure.

In this case, the ability of the Trustee to secure the capital was conditional on it paying the hedging costs incurred by the W Fund. The advantage that is sought to be gained by the incurring of the expenditure is the Trustee's ability to secure additional funding, thereby resulting in an enlargement of the profit yielding structure of Trust 1's business through the acquisition of the Property.

It is considered that the expenditure is correctly characterised as establishing and enlarging the profit yielding structure of Trust 1 rather than being a working expense. As pointed out in the Sun Newspapers Case, expenditure incurred by a business that establishes or enlarges the profit yielding structure of the business is considered to be capital in nature.

Further, it is considered that the expenditure incurred by the Trustee will secure an enduring benefit for Trust 1. The enduring benefit obtained is the ongoing ability to access capital funding to establish and expand Trust 1's business.

The advantage for which the expenditure on hedging costs was paid is of a permanent and enduring character and an indispensable part of the profit yielding structure of Trust 1.

The fact that the expenditure by the Trustee on the hedging costs is not a once and for all payment but is recurrent in the sense that expenditure is expected to be paid annually, will not prevent a conclusion that the expenditure in question is capital in nature.

It is not appropriate to place much weight on the mere fact that a type of expenditure is recurrent. As pointed out by Dixon J in the Sun Newspapers Case :

Recurrence is not a test, it is not more than a consideration the weight of which depends upon the nature of the expenditure.

For these reasons, the expenditure incurred by the Trustee will be capital in nature. Accordingly, the Trustee will not be entitled to a deduction under section 8-1 for the expenditure incurred by the Trustee on the hedging costs.

Question 2

If the answer to question 1 is no, are the annual hedging costs reimbursed by Trust 1 to its foreign capital provider in return for retaining the loan capital invested (calculated on a reasonable allocation) deductible under s25-25 of the ITAA 1997?

Summary

The hedging costs paid by the Trustee in relation to the unitholder loan in accordance with the on-charging arrangement of third party hedging costs are deductible under subsection 25-25(1).

Detailed reasoning

Subsection 25-25(1) allows a deduction for expenditure incurred for borrowing money to the extent the money is used for the purpose of producing assessable income.

Section 25-25 expresses the same intent as former section 67 of the Income Tax Assessment Act 1936 so that case law concerning section 67 also provides guidance on the application of section 25-25.

In Ure v. FC of T 81 ATC 4100 at ATC 4112; (1981) 11 ATR 484 at ATR 498, Deane and Sheppard JJ made the following comments on the operation of subsection 67(1) of the ITAA 1936:

The words 'expenditure incurred... in borrowing money' in the context of section 67(1) of the Act refer in our view, to the 'cost' of borrowing as distinct from the 'cost' of the money. The expenditure on account of legal expenses and valuation fees was plainly a 'cost' of borrowing: it was incurred in relation to the actual establishment of the relevant loan.

And further, at ATC 4113; ATR 498:

It seems to us to be preferable to interpret the reference to expenditure incurred in borrowing as including payment to be made during the life of the loan pursuant to a contractual obligation which was incurred at the time of borrowing as an incident of establishing the loan.

Under the terms of the Loan Agreement, the Trustee will pay all costs arising from the conclusion and implementation of the Loan Agreement including the foreign currency hedging expenses.

Under the terms of the On-charging Agreement, X Manager will issue invoices to the Trustee on an annual basis (or earlier in respect of a termination of a hedge), and the Trustee will pay the invoiced amount within 30 days of the date of the invoice.

Having regard to the terms of both of these agreements, the hedging costs paid by the Trustee in relation to the loan capital (determined on a reasonable allocation between the loan and equity capital) are deductible under subsection 25-25(1).

The method statement in subsection 25-25(4) is used for working out the amount of the deduction in a particular income year.

Question 3

If the answer to question 1 is no, are the annual hedging costs reimbursed by Trust 1 to its foreign capital provider in return for retaining the equity capital invested (calculated on a reasonable allocation) deductible under s40-880 of the ITAA 1997?

Summary

The hedging costs in relation to the equity capital is deductible under section 40-880.

Detailed reasoning

Subject to the limitations and exceptions contained in subsections 40-880(3) to (9), subsection 40-880(2) provides that you can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur:

(a)  in relation to your business; or

(b)  in relation to a business that used to be carried on; or

(c)   in relation to a business proposed to be carried on; or

(d)  to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

As the hedging costs are not deductible under section 8-1 because these expenditures are capital in nature, paragraph 2.18 of the explanatory memorandum to the Tax Laws Amendment (2006 Measures No. 1) Act 2006 (the EM) provides thattheir deductibility can be considered under subsection 40-880(2). Paragraph 2.18 of the EM provides as follows:

The provision only applies to business capital expenditure. What this amounts to in the context of an existing, former or prospective business is determined on a case by case basis having regard to the general principles established by the Courts. This includes expenditure that fails the general deduction provision of section 8-1 by reason only of being capital or of a capital nature.

Whether Trust 1 is carrying on a business

Subsection 40-880(2) requires the identification of a "business" in relation to which the relevant capital expenditure was incurred. To determine Trust 1's business it is relevant to reiterate the purpose of setting up Trust 1. This is set out in clause of its Constitution as follows (emphasis added):

The Trust is set up for the object and purpose of, and the nature of the business to be conducted and promoted by the Trustee in its capacity as trustee of the Trust which is to acquire, improve, lease, maintain, own, operate, manage, finance, refinance, mortgage, hold, sell, exchange, administer and otherwise deal in and with Real Estate Investments and to engage in any other activities necessary, related or incidental thereto, including without limitation, holding and disposing of Ancillary Assets and within that objective and purpose, the Trust will acquire long term investments in real property with the intention to derive rental income.

In general, the receipt of income from the letting of property to a tenant(s) does not amount to the carrying on of a business (Wertman v. Minister of National Revenue (1964) 64 DTC 5158; Federal Commissioner of Taxation v. McDonald (1987) 15 FCR 172;87 ATC 4541; 18 ATR 957 (McDonald's Case); Cripps v. FC of T 99 ATC 2428 (Cripps' Case); Case X48 90 ATC 384; (1990) 21 ATR 3389).

Whether the letting of property amounts to the carrying on of a business will depend on the circumstances of each case, (Californian Copper Syndicate (Limited and Reduced) v. Harris (1904) 5 TC 159). Generally, it is easier for a company that derives income from the letting of property to show that it carries on a business than it is for an individual (paragraph 3 of Taxation Ruling IT 2423).

The general indicators of a business, as developed by the Courts, are described in Taxation Rulings such as Taxation Ruling TR 97/11 - Income tax: am I carrying on a business of primary production? and Taxation Ruling TR 2019/1 - Income tax: when does a company carry on a business?

Legal cases on this issue have shown that the indicators with the greatest weighting are the scale or volume of operations and the repetition and regularity of the activities.

Having regard to these indicators, the following matters support the conclusion that Trust 1 is carrying on a business:

• the activities of Trust 1 are commercial in nature and performed with a profit making intention consistent with the conduct of carrying on a business;
• the activities of Trust 1 are carried out in a business-like manner; and

•         Trust 1 has significant assets under management. Trust 1 does not have any restrictions of the size of its investment portfolio provided the respective acquisition meets its investment strategy.

Whether the expenses were incurred in relation to the relevant business

The expenses need to be incurred in relation to the relevant business of Trust 1. Taxation Ruling TR 2011/6 - Income tax: business related capital expenditure - section 40 880 of the Income Tax Assessment Act 1997 core issues sets out the Commissioner's views on the interpretation of the operation and scope of section 40-880 (TR 2011/6).

In considering the deductibility of the hedging costs, paragraph 15 of TR 2011/6 provides that the expression 'in relation to' in subsection 40-880(2) denotes the proximity required between the expenditure on the one hand and the former, current or proposed business on the other. For capital expenditure to be 'in relation to' a business, there must be a sufficient and relevant connection between the expenditure and the business.

In the High Court decision of Perlman v Perlman (1984) 155 CLR 474 at 489, Justice Mason stated:

... the expression "in relation to" is one of wide and general import and should not be read down in the absence of some compelling reason for so doing.

In considering the phrase "in relation to" in the context of the Commercial Arbitration Act 1985 (NT), the High Court stated in PMT Partners Pty Ltd (In Liquidation) v Australian National Parks & Wildlife Service (1995) 184 CLR 301 at 313:

Inevitably, the closeness of the relation required by the expression 'in relation to' in s 48 of the Act, indeed, in any instrument - must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears.

It is therefore necessary to consider the legislative context of subsection 40-880(2) in order to determine whether there is a sufficient and relevant connection between the incurrence of the expenditure and Trust 1's business. In discussing the types of business capital expenditure to which subsection 40-880(2) applies, the Explanatory Memorandum to the Tax Laws Amendment (2006 Measure No.1) Bill 2006 states:

2.58 The character of the expenditure must be that connected with the business itself (eg, pertaining to the business structure, or its operations).

2.59 Put another way, the taxpayer would expect a return on that expenditure in the form of profits from the business. The expenditure need not of itself be directly productive of the taxpayer's assessable income.

2.60 The taxpayer does not need to be actually deriving income from the activity at the time the expenditure is incurred to qualify for the deduction.

X Manager has entered into hedging arrangements to mitigate any foreign currency fluctuation risks associated with the returns from its investments in foreign property assets including the Property. X Manager is liable to pay for hedging costs under these arrangements.

While the activities of foreign exchange hedging by Trust 1 do not form part of the business of Trust 1, the acceptance by the Trustee to pay for these costs was integral to the injection of capital which formed part of the structure of its busines.

The hedging costs in relation to the equity capital (determined on a reasonable allocation between the loan and equity capital) are deductible under section 40-880 in equal proportions over a period of 5 income years starting in the year in which they were incurred.

Is the hedging costs in relation to the 99-year Crown leasehold interest on the Property?

Paragraph 40-880(5)(d) provides that the taxpayer cannot deduct expenditure they incur to the extent that it is in relation to a lease or other legal or equitable right.

For paragraph 40-880(5)(d) to apply in this case, the hedging costs incurred by Trustee must be 'in relation to' the 99-year Crown leasehold interest on the Property.

Having regard to the views expressed in TR 2011/16 such as those outlined in paragraph 239 which state:

The legislative context of section 40-880 indicates that expenditure 'in relation to a lease or other legal or equitable right' must be relevantly related to a lease or right. To be relevantly related there must be an objective connection between the expenditure and the acquisition, creation, alteration or termination of the lease or right.

There is not a sufficient and relevant connection between hedging costs as a capital expenditure incurred by the Trustee and the 99-year Crown leasehold interest by Trust 1 on the Property. The hedging costs are considered not to have 'an objective connection to the acquisition, creation, alteration or termination of the lease.

Accordingly, the exclusion under paragraph 40-880(5)(d) does not apply.

Other limitations and exclusions contained in subsections 40-880(3) to (9) are not considered to apply.