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Despite having now been in effect for more than 15 years, the Taxation of Financial Arrangements (TOFA) rules contained in Division 230 of the Income Tax Assessment Act 1997 (ITAA 1997) are commonly misunderstood and frequently misapplied.
This Tax Insight seeks to clarify the general operation of the TOFA rules.
Scope
The TOFA rules represent a principle-based framework for the taxation of gains and losses from financial arrangements that seeks to reduce the influence of tax considerations on the structuring of financial arrangements and align the tax recognition of gains and losses therefrom with the commercial recognition thereof.
- The TOFA rules apply mandatorily to the following entities:
- Authorised deposit-taking institutions (ADI), securitisation vehicles or financial sector entities with an aggregated turnover[1] of at least $20m;
- Superannuation entities[2], managed investment schemes and similar schemes under a foreign law, with assets of at least $100m; and
- Other entities (excluding individuals) with:
- aggregated turnover of at least $100m;
- assets of at least $300m; or
- financial assets of at least $100m.
Whereas the value of an entity’s assets or financial assets must be determined in accordance with applicable accounting standards (or failing that, commercially-accepted valuation principles), TOFA applies to qualifying securities (as defined by subsection 159GP(1) of the Income Tax Assessment Act 1936) with a remaining life at the time of acquisition exceeding 12 months regardless of TOFA thresholds, including those held by individuals.
Entities not satisfying the above criteria, and individuals, may irrevocably elect into TOFA.
Application
The TOFA rules (subject to certain exceptions) provide for gains and losses from financial arrangements to be taxed on revenue account.
A ‘financial arrangement’ is the core unit upon which assessability and deductibility under the TOFA rules is determined. A prerequisite to the application of the TOFA rules is the identification and demarcation of a financial arrangement. It will also be necessary to consider whether any exception prescribed by Subdivision 230-H of the ITAA 1997, which are varied and can entail significant complexity (e.g., that pertaining to leases and similar property arrangements), applies.
The test for ascertaining the existence and perimeter of a financial arrangement is constituted by various provisions across Subdivision 230-A and involves consideration of rights and obligations under an arrangement. Rights and obligations will comprise a financial arrangement to the extent they are ‘cash settleable’ legal or equitable rights or obligations to provide or receive financial benefits[3], and the arrangement does not consist of any other not insignificant subsisting legal or equitable right to receive or provide something that is not a financial benefit or is not cash settleable. The following table provides some examples of arrangements that are and are not financial arrangements:
In addition to financial arrangements, Subdivision 230-J specifically includes foreign currency, non-equity shares, as well as commodities and offsetting commodity contracts held by traders, within the scope of the TOFA rules.
Operation
The TOFA rules contain the following six tax methods, two of which apply by default and four of which may apply on an elective basis:
Default Methods
Generally, where no elective method applies, the accruals and realisation methods apply by default.
Accruals
The accruals method applies in priority to the realisation method where there is a sufficiently certain particular or overall gain or loss from a financial arrangement at the time a taxpayer starts to have the arrangement, or a particular gain or loss later becomes sufficiently certain. For the purpose of determining sufficient certainty, regard must be had to financial benefits only to the extent that their amount or value is at the relevant time fixed or determinable with reasonable accuracy, with the legislation directing attention to the:
- Terms and conditions of the financial arrangement;
- Accepted pricing and valuation techniques;
- The economic or commercial substance and effect of the arrangement; and
- The contingencies that attach to the other financial benefits that are to be provided or received under the arrangement[5].
Prescribed assumptions must be made where a financial benefit depends on a rate of change to a variable based on certain indices.
Under the accruals method, sufficiently certain gains and losses are generally (though not invariably) spread using compounding accruals, which is conceptually derive from the effective interest method in AASB 139: Financial Instruments: Recognition and Measurement[6].
Realisation
Where no elective method and applies and there is not sufficient certainty under the accruals method, the realisation method will apply to allocate gains and losses for tax purposes to the income years in which they occur (e.g., when the relevant financial benefit constituting the gain or loss is due to be provided or received, as applicable).
Where terms or conditions of an arrangement are materially altered, or circumstances arise that materially affect the arrangement, it is necessary to re-assess which default method should apply to gains and losses from the arrangement. In certain circumstances under the accruals method, it may also be necessary to re-estimate relevant gains and losses.
Additionally, recognising that the accruals method represents only an estimation of cash flows that may differ from actual cash flows, running balancing adjustments must be made where the ultimate gain or loss on a financial arrangement differs from that which has been estimated.
Elective Methods
To be eligible to access an elective method, in addition to making an irrevocable election[7], taxpayers must have financial reports that are both prepared in accordance with relevant accounting standards and audited in accordance with relevant auditing standards.
When an elective method applies to a financial arrangement, subject to certain complexities pertaining to accounting consolidation, the gain or loss therefrom is equal to the amount that is required by the relevant accounting standards to be recognised for that financial arrangement in the taxpayer’s profit and loss statement.
Key features of each elective method, to which additional requirements apply, are summarised in the following table:
For the avoidance of doubt, the default methods will apply to the extent a financial arrangement is not covered by an election. For example, the foreign exchange retranslation method generally recognises gains and losses from the foreign currency component of a financial arrangement independently of gains and losses from the rest of the arrangement.
Finally, notwithstanding that elections are irrevocable, an elective TOFA method may cease to apply where a precondition (e.g., recognition of a financial arrangement in an audited financial report) is no longer satisfied. Where an election ceases to apply, a balancing adjust will need to be made.
Conclusion
This Tax Insight provides a very loose overview of how the TOFA rules apply and operate. Whilst many hold the view that the default methods under the TOFA rules arguably do not provide for tax outcomes that depart significantly from how gains and losses from financial arrangements would be taxed under other legislative provisions (erstwhile or otherwise), there is no doubt that the application of the TOFA rules entails significant complexity, including not only with respect to the elective methods, but also in relation to various other areas such as their application to deferred consideration, interactions with income tax consolidation rules, and identifying and dealing with exceptions therefrom.
It is also clear, from our experience, that in-scope taxpayers’ application of the TOFA rules is a key focus area of Australian Taxation Office (ATO) reviews. For example, we have frequently observed the ATO referencing TOFA income tax return disclosures and seeking objective assurance as to how financial arrangements have been identified and gains and losses thereon calculated. This is relevant to taxpayers’ tax risk management and governance structures.
The correct application of the TOFA rules requires deep expertise, and taxpayers are therefore encouraged to seek professional advice. Please contact your local RSM advisor if you require assistance.
FOR MORE INFORMATION
The correct application of the TOFA rules requires deep expertise, and taxpayers are therefore encouraged to seek professional advice. Please contact your local RSM advisor if you require assistance.
[1] Please refer to section 328-115 of the ITAA 1997 for the applicable definition of ‘aggregated turnover’.
[2] Including superannuation funds that are not a ‘superannuation entities’ within the meaning of section 10 of the Superannuation Industry (Supervision) Act 1993.
[3] The term ‘financial benefit’ is broadly defined by section 974-160 of the ITAA 1997 to mean ‘anything of economic value’ and include property and services.
[4] The TOFA rules have a limited and modified application to equity interests, which are deemed to be financial arrangements.
[5] Financial benefits must be treated as if they were not contingent if it is appropriate to do so having regard to the contingencies that attach to the other financial benefits that are to be received or provided under the arrangement.
[6] The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of a financial arrangement to the net carrying value of the corresponding financial instrument and is the same as the internal rate of return.
[7] Absent a transitional years election, financial arrangements held by a taxpayer prior to the income year in which an election is made will not be covered by that election.
