Edited version of private advice

Authorisation Number: 1052051559161

Date of advice: 3 November 2022

Ruling

Subject: Self managed super fund - exchanged traded options

Question

Where a self managed superannuation fund (SMSF) trades exchanged traded options (ETOs), are the cost of closing out open sold positions deductible from premium received in the earlier income year under section 8-1 or section 25-40 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No. The cost of closing out open sold options is not allowable deduction to the SMSF under sections 8-1 or 25-40 of the ITAA 1997, and instead the CGT provisions will apply.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You are a self managed superannuation fund (SMSF or the Fund) that is a complying superannuation fund.

You were trading exchange-traded options (ETOs) on the ASX options market in the relevant income years.

You took or wrote an ETO to establish a position in the options market. This is referred to in the market as having an 'open position'. You then determine how best to realise that position by:

•         closing out' the position by entering into an equal but opposite position, that is, where you had originally bought an ETO you will offset it by selling an identical one, or where you had originally sold an ETO, you will offset it by buying an identical one

•         exercising the ETO you had originally bought, or

•         doing neither of the above and allowing the ETO you had originally bought to expire.

When you sold an ETO, you were entitled to receive a premium in return for writing the option at the time the option is written.

At the end of the 20XX income year, you had ETOs that remain in the option position as they have not been exercised, closed out, or expired. Some of the ETOs were exercised, closed out or expired in the following income year.

You received audited profit and loss statements from the trading platform Company A for the relevant income years. Tax Accounting Reconciliation statement for 20XX income year was prepared and submitted to ATO by a third party.

Assumption

For the purposes of this ruling, the following occurred during the period covered by this ruling:

•         Some ETOs remained opened at the end of 20XX income year and were exercised in the subsequent income years.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-40

Income Tax Assessment Act 1997 subsection 104-25

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 109-5

Income Tax Assessment Act 1997 section 295-85

Income Tax Assessment Act 1997 section 134-1

Further issues for you to consider

We have limited our private ruling to the questions raised in your application. There may be related issues that you should consider, including:

•         Did the ETO trading satisfy the relevant provisions of the Superannuation Industry (Supervision) Act 1993? and

•         Capital Gain Tax calculation.

You may apply for another private ruling on these or any other matters.

Does Part IVA apply to this private 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 diverted profits 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-avoidancerule for income tax'.

Reasons for decision

A loss made on a transaction would ordinarily be an allowable deduction under section 8-1 of the ITAA 1997 where the transaction is entered into as an ordinary incident of carrying on a business, or where the loss arose from a business operation or commercial transaction that was for the purpose of profit-making.

Alternatively, a loss made on a transaction would ordinarily be an allowable deduction under section 25-40 of the ITAA 1997 where the loss arises from the carrying on or carrying out of a profit-making undertaking or plan, and any profit from the transaction would have been included in assessable income under section 15-15 of the ITAA 1997.

However, paragraph 295-85(2)(a) of the ITAA 1997 provides that where a CGT event happens to a CGT asset of a complying superannuation fund, sections 8-1 and 25-40 of the ITAA 1997 will not apply, and instead the CGT provisions will apply.

An exception to this is contained in paragraph 295-85(3)(b) of the ITAA 1997 for CGT assets of the Fund that are

(i)      debenture stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security;

(ii)     a deposit with a bank, building society or other financial institution;

(iii)    a loan (secured or not); or

(iv)    some other contract under which an entity is liable to pay an amount (whether the liability is secured or not).

An option is a CGT asset as defined in subsection 108-5(1) of the ITAA 1997. Options are specifically cited as an example of a CGT asset (see Note 1 to subsection 108-5(2) of the ITAA 1997).

CGT Event D2 (granting of an option) will apply on the writing of an ETO by the Fund. The Fund as grantor of the option will make a capital gain (or loss) of the difference between the capital proceeds (that is, the premium receivable) and the cost of granting the option (for example, brokerage fees) at the time the option is granted under subsection 104-40(3) of the ITAA 1997 (see ATO ID 2009/110).

When the Fund opens a position by buying an ETO, no immediate taxation consequences arise. CGT Event C2 will happen to the Fund when its position under an ETO is closed out where the close-out results in the cancellation, release or discharge of the ETO (ATO ID 2005/164).

Therefore, unless an ETO falls within one of the exceptions listed in paragraph 295-85(3)(b) of the ITAA 1997, the CGT provisions will be the only provisions to apply.

An ETO does not satisfy either subparagraph 295-85(3)(b)(ii) or 295-85(3)(b)(iii) of the ITAA 1997. Further, an ETO is not one of the specifically listed instruments in subparagraph 295-85(3)(b)(i) of the ITAA 1997.

In relation to the phrase 'or other security' in subparagraph 295-83(3)(b)(i) of the ITAA 1997 it is necessary to look at the history of section 295-85 of the ITAA 1997 to determine what instruments are included within the meaning of the phrase.

Section 295-85 of the ITAA 1997 represents a rewrite of section 304 of the Income Tax Assessment Act 1936 (ITAA 1936). Subsection 303(1) of the ITAA 1936 set out the meaning of 'security' for the purposes of section 304 of the ITAA 1936. The Explanatory Memorandum to the Bill that introduced sections 303 and 304 of the ITAA 1936 provides that.

"security"...for these purposes is defined in a similar way in Division 16E."

The subsection 303(1) of the ITAA 1936 definition of security is now contained in paragraph 295-85(3)(b) of the ITAA 1997.

Paragraph 3.1 of the Explanatory Memorandum to Tax Laws Amendment (Simplified Superannuation) Bill 2006 that introduced section 295-85 of the ITAA 1997, states that the rewritten provisions in Subdivision 295-B of the ITAA 1997 (including section 295-85) do not change the law as it operated under the previous ITAA 1936 provisions. Therefore, subsection 295-85(2) of the ITAA 1997 will apply CGT as the primary code of taxation for superannuation funds unless the ETO is a security as understood for the purposes of Division 16E of the ITAA 1936.

The Explanatory Memorandum accompanying Tax Laws Amendment Bill (No.2) 1986 which introduced Division 16E of the ITAA 1936 provided:

"security" has been defined very widely...so as to encompass as many financial transactions as possible where there may be a deferral in the payment of income."

The Commissioner has previously stated in Taxation Ruling TR 96/14 Income tax: traditional securities (TR 96/14), that the Division 16E of the ITAA 1936 definition of 'security' contained in subsection 159GP(1) of the ITAA 1936 applies only to debt securities or contracts that create debt-like obligations.

Likewise, paragraph 295-85(3)(b) of the ITAA 1997 only encompasses debt securities or contracts that create debt-like obligations and therefore the phrase 'or other security' in subparagraph 295-85(3)(b)(i) of the ITAA 1997, covers only debt arrangements.

An ETO is a contract to buy or sell a financial product such as a share. The terms of an ETO are standardised and set by the ASX. ETOs are held until expiry or exercised, or are closed out by entering into an equal but opposite position. An ETO is not a debt security and therefore it will not fall within the meaning of the phrase 'or other security' for the purposes of subparagraph 295-85(3)(b)(i) of the ITAA 1997.

Subparagraph 295-85(3)(b)(iv) of the ITAA 1997 is broader than subparagraph 295-85(3)(b)(i) of the ITAA 1997. Like paragraph 159GP(1)(d) of the ITAA 1936 it includes a broad range of contracts under which there is a liability to pay an amount.

However, TR 96/14 states at paragraph 30 that, having regard to paragraphs (a), (b) and (c) of the definition of 'security' in subsection 159GP(1), only those contracts that have 'debt-like obligations' will usually fall under paragraph (d) of the definition of 'security'.

In accordance with TR 96/14, there are not sufficient debt-like obligations attaching to an ETO for it to fall under paragraph (d) of the definition of 'security'. Further, deferral of income is not a feature of an ETO arrangement.

Therefore, an ETO will not satisfy paragraph 295-85(3)(iv) of the ITAA 1997. Accordingly, an ETO is not an asset that falls within any of the exceptions listed in paragraph 295-85(3)(b) of the ITAA 1997.

Further, an ETO is not trading stock (ATO ID 2004/526). Therefore, the exception for trading stock in subsection 295-85(4) of the ITAA 1997 will not apply.

As no exceptions in either subsection 295-85(3) or 295-85(4) of the ITAA 1997 apply to the Fund, the CGT provisions will be the only provisions to apply. The cost of closing out open sold options by the Fund from the ETO trading is not an allowable deduction under either section 8-1 or 25-40 of the ITAA 1997.

CGT Treatment of options

The establishment of an ETO contract is referred to as opening a position (ASX Explanatory Booklet 'Understanding Options Trading'). A person who takes (buys) a call or put option as an opening position may cancel their right to exercise by writing (selling) an identical option. This is referred to as the close-out of an option or the closing-out of an opening position. Similarly, a person who writes (sells) a call or put option may close out their position by taking (buying) an identical call or put option in the same series.

When the Fund writes an ETO, CGT Event D2 (granting of an option) will apply on the writing of an ETO by the Fund under the section 104-40 of the ITAA 1997. The premiums receivable will be capital proceeds of the ETO under the CGT provisions. CGT event C2 happens to the fund when their position under an ETO is closed out where the close-out results in the cancellation, release or discharge of the ETO. Section 134-1 of the ITAA 1997 sets out the consequences of an option being exercised, and in situations where the option binds the grantor to dispose of the CGT asset, refers the grantor of the option to the effect in section 116-65 of the ITAA 1997. Subsection 116-65(2) states that the capital proceeds from the disposal of the CGT asset include any payment you received for granting, renewing or extending the option.

You would still make a capital gain at the happening of the CGT event D2 in the year the event occurs (the time the option is granted). That capital gain is disregarded when the option is exercised. Where the option is exercised in the subsequent tax year, the CGT event D2 gain is disregarded at that point. An amendment may be necessary to remove the gain previously included in taxable income for the year in which the CGT event D2 occurred.

When the Fund buys an ETO, they acquire an asset (the ETO) for the amount paid for it (that is, the premium) plus any additional costs such as brokerage fees and the Australian Clearing House (ACH) fee. These costs together form the cost base of the ETO (section 109-5 of the ITAA 1997). CGT event C2 therefore happens to a taxpayer when their position under an ETO is closed out where the close-out results in the cancellation, release or discharge of the ETO. The Fund makes a capital gain or loss equal to the difference between the cost base of the ETO and the amount received on its expiry or termination under subsection 104-25(3) of the ITAA 1997. A deduction for the premiums paid is not an allowable deduction under either section 8-1 or 25-40 of the ITAA 1997. This is the case regardless of the profit-making intention of the Fund in buying ETOs. Instead the premiums payable will form part of the cost base of the ETO.

At the end of the 20XX income year the SMSF was not under any obligation to close out their open ETO positions. The market value of the Fund's open ETO positions showed on the profit and loss statement was not a loss or outgoing incurred by the Fund as there is no presently existing liability to pay an amount to close out the ETOs. It is possible that the ETOs will never be closed out as they may be exercised by the buyer or expire unexercised.

For the options remained open at the end of the 20XX income year and exercised in the following financial years, you would still make a capital gain at the happening of the CGT event D2 in the 20XX income year the event occurs (the time the option is granted). That capital gain is disregarded when the option is exercised. Where the option is exercised in the subsequent tax year, the CGT event D2 gain is disregarded at that point. An amendment may be necessary to remove the gain previously included in taxable income for the year in which the CGT event D2 occurred.