JOINT SUBMISSION BY. Institute of Chartered Accountants in Australia, CPA Australia, Taxation Institute of Australia, Taxpayers Australia

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1 JOINT SUBMISSION BY Institute of Chartered Accountants in Australia, CPA Australia, Taxation Institute of Australia, Taxpayers Australia Draft Taxation Determination TD 2004/D80 Income tax: consolidation: capital gains and losses: does a capital gain arise under CGT event C2 when the amount received in payment of a foreign currency denominated receivable exceeds its tax cost setting amount? Date: 31 January 2005 The Professional Bodies welcome the opportunity to comment on Draft Taxation Determination TD 2004/D80 ( the Determination ). SUMMARY Generally, TD 2004/D80 proposes that where an amount received post-consolidation for a foreign currency denominated trade receivable derived by a joining entity preconsolidation is in excess of the tax cost setting amount of the receivable, a capital gain will arise to the extent the excess is not attributable to a change in the currency exchange rates. Whilst TD 2004/D80 clarifies the capital gains tax ( CGT ) consequences of receiving an amount in excess of the tax cost setting amount of a foreign currency denominated receivable, it omits discussion on the income tax consequences where foreign currency gains and losses are attributable to currency exchange rate effects on payment of the foreign currency denominated receivable. As the Determination does not deal with currency exchange rate effects, it may be of limited guidance to taxpayers as it does not generally reflect what happens in practice. Therefore, we consider that there is a need for the Australian Taxation Office ( ATO ) to address issues relating to the treatment of foreign currency gains and losses arising on payment of foreign currency denominated trade receivables such that practical guidance is available to taxpayers when dealing with these issues. We understand that the ATO is separately considering the issue of foreign currency gains and losses arising on discharge of a foreign currency denominated receivable. We have therefore outlined a number of observations and recommendations that the ATO might consider when finalising the Determination and when issuing further guidance in relation to the treatment of foreign currency gains or losses arising on payment of a foreign currency denominated receivable.

2 GENERAL COMMENTS We consider that it is important for there to be a discussion on whether the tax cost setting amount of a foreign currency trade receivable is relevant for the purposes of Division 775 of the Income Tax Assessment Act 1997 ( ITAA 97 ). As noted above, the Determination omits consideration of the treatment of foreign currency gains or losses that may arise on discharge of a foreign currency denominated trade receivable. The Determination has therefore avoided an analysis of the interaction between Division 775 and subsection (6) of the ITAA 97, which is likely to be relevant to many taxpayers. Subsection (6) provides, broadly, that for the purposes of any provision of the ITAA 97 (other than the tax cost setting provisions relating to trading stock, qualifying security and capital gain and loss), the relevant provision (in this case Division 775 of the ITAA 97) applies as if the asset s cost at that time were equal to its tax cost setting amount. The issue that arises is whether, in treating the asset s cost as if it were equal to its tax cost setting amount, the asset s forex cost base should also be treated as if it were equal to the tax cost setting amount for the purposes of Division 775 of the ITAA 97. If the forex cost base were taken to be equal to the tax cost setting amount for the purposes of Division 775 of the ITAA 97, it would seem that any forex realisation gains or losses would be calculated with reference to the tax cost setting amount. However, an issue may arise from this interpretation. Division 775 of the ITAA 97 provides that the forex cost base is generally worked out at the tax recognition time. In the case where the right to receive foreign currency represents a right to receive ordinary income, the tax recognition time is when the ordinary income is derived, pursuant to subsection (7) item 1 of the ITAA 97. The forex cost base of a trade receivable is therefore determined at the time when income on the trade receivable is derived, generally when the trade receivable is first created. Accordingly, resetting the tax cost at the time of consolidation will not reflect the time at which income is derived. As a result, it is arguable that the difference between the tax cost setting amount and the amount received is not a forex realisation gain or a forex realisation loss, since the difference may not be attributable to a currency exchange rate effect as required under paragraph (3)(b) of the ITAA 97. Given the limited guidance currently available on the application of Division 775 of the ITAA 97 in the context of tax consolidation, the importance of this issue to many taxpayers and the relevance of the analysis in other areas, we consider that it would be worthwhile for the ATO to provide an analysis of the operation of Division 775 of

3 the ITAA 97 in the context of the tax consolidation regime, particularly the interaction between Division 775 and subsection (6) of the ITAA 97. [It is also noted as an aside that different treatments may apply to forex liabilities and forex assets in that forex liabilities are likely to be subject to revenue gains and losses whereas forex assets are likely to be subject to capital gains and losses. For a forex liability (say, a foreign currency denominated loan), it seems that the forex cost base is irrelevant in determining whether there is a forex realisation gain or loss. Rather, the starting point in working out whether there is a forex realisation gain or loss for a forex liability is to compare the proceeds for assuming the liability as at the relevant tax recognition time (i.e. at time 1 when the loan amount is received) with the amount paid in discharging the obligation to pay foreign currency (i.e. at time 3 when the loan is repaid). In this way, it is more likely for there to be currency exchange rate effects affecting forex liabilities than forex assets, if the interpretation is adopted that the forex cost base of a forex asset should be substituted with its tax cost setting amount such that no foreign exchange currency effect can arise. The ATO might therefore wish to give some consideration to the potential asymmetric outcomes that arise for forex liabilities and forex assets.] The issue the ATO should consider further is whether there is another provision in the law that could bring the difference into account as assessable income or an allowable deduction. Whilst we note that paragraph 6 of TD 2004/D80 provides that the amount received in excess of the tax cost setting amount of a trade receivable is not ordinary income, the ATO should provide further analysis for this conclusion. Some observations are as follows. As discussed above, subsection (6) provides, broadly, that for the purposes of any provision of the ITAA 97 (other than the tax cost setting provisions relating to trading stock, qualifying security and capital gain and loss), the relevant provision applies as if the asset s cost at the joining time were equal to its tax cost setting amount. One argument might be that the reference to for the purposes of any provision of the ITAA 97 could include sections 6-5 and 8-1 of the ITAA 97. Accordingly, the tax cost setting amount of the receivable arguably could be imputed into sections 6-5 and 8-1 of the ITAA 97 in working out the net amount of assessable income under section 6-5 or a loss incurred under section 8-1. Interestingly, TD 2004/D85 provides that the tax cost setting amount of work in progress may be taken into account where the estimated profits basis of returning assessable income is adopted under IT Specifically, paragraph 7 of TD 2004/D85 provides subsection (6) will operate so that the tax cost setting amount of the work in progress asset is the cost which the head company of the group may use to arrive at that part of the estimated profit from a particular contract that it is to return as its income after the joining time.

4 The ATO should provide further analysis on whether an assessable gain or deductible loss can arise on payment of a foreign currency denominated trade receivable, particularly having regard to the interaction between subsection (6) and sections 6-5 and 8-1 of the ITAA 97. We note that a detailed analysis of how the ATO perceives section (in particular, subsection (6)) interacts with other provisions of the ITAA 97 is also relevant in other areas, including treatment of assets like consumables, spare parts and certain contractual rights. In the example given in paragraph 10 of the Determination, it is stated that there are no currency fluctuations between time 1 and time 2. It is not explicitly stated, however, as to whether any currency fluctuations occur between time 2 and time 3. Clarification is sought from the ATO on whether the assumption in the example is that there are no currency fluctuations throughout all relevant times, i.e. between time 1 and time 2, time 2 and time 3 and time 1 and time 3. It is inferred from the title of the Determination that it deals with both capital gains and losses arising on payment of a foreign currency denominated trade receivable. However, the Determination itself only contains comments relating to capital gains and not capital losses. Clarification is therefore sought from the ATO as to whether the principles espoused in the Determination are also applicable to cases involving capital losses, for example, in a case where a trade receivable is forgiven and a capital loss is thereby incurred or in a case where the amount received is less than the tax cost setting amount of the receivable. We note that paragraph 4 of the Determination states that a foreign currency trade receivable is a CGT asset. Clarification is sought from the ATO as to whether a foreign currency trade receivable can only be a CGT asset if there is a recoverable debt, consistent with the views expressed in TD 2004/D85. We consider that the interaction between Division 775 of the ITAA 97 and the CGT provisions should also be clarified. It appears under subsection (4) of the ITAA 97, where payment of a trade receivable gives rise to a capital gain, as part of an overall forex realisation gain, the forex realisation gain will only be included in the taxpayer s assessable income under section of ITAA 97. Similarly, subsection (4) provides that where payment of a trade receivable gives rise to a capital loss, as part of an overall forex realisation loss, taxpayer can only deduct the forex realisation loss under section of the ITAA 97. However, more complex situations can arise. Consider the following example: At time 1, company B derives ordinary income of AUD100 by selling trading stock to company Z on credit for USD80 (which translates to AUD100).

5 At time 2, B joins a consolidated group that is headed by company A. As a result of applying the allocable cost amount ( ACA ) method, the trade receivable obtains a tax cost setting amount of AUD50 for the head company. At time 3, Z pays USD80 to B in settlement of its trade debt, which translates to AUD60. In the above example, there is, economically, a loss of AUD40, being the difference between the amount received (AUD60) and the original forex cost base of the receivable (AUD100). However, if the interpretation is adopted that the forex cost base of the receivable should be substituted with its tax cost setting amount such that no currency exchange effects would arise, there is also a capital gain of AUD10, being the difference between the amount received (AUD60) and the tax cost setting amount (AUD50). Clarification is therefore sought from the ATO on the appropriate outcome and the proper treatment of the excess received on a trade receivable when there is an overall economic loss owing to adverse currency exchange rate movements. The question is further complicated by the question of whether the forex realisation loss is to be determined with respect of the original forex cost base of the trade receivable or the tax cost setting amount, as discussed above. We consider that it would be worthwhile for an analysis to be given in respect of the treatment of forex realisation gains and losses when considered together with the CGT consequences of a foreign currency denominated receivable which has had its tax cost reset as part of the tax cost setting process. A similar issue arises under CGT event L7 as provided by section of the ITAA 97 which potentially affects forex liabilities. CGT event L7 can apply where a liability that has been included in the ACA calculation of a subsidiary member of a consolidated group is discharged for an amount different to that included in the ACA calculation. A capital gain or loss will arise if, had the revised amount of the liability instead been included in the ACA calculation, the total of the ACA would have been different. However, Division 775 of the ITAA 97 also applies in respect of the discharge of the same liability. The common features will be the liability itself and the time and Australian dollar value of the amount used to discharge it. However, and importantly, the cost base of the liability used in working out whether a forex realisation gain or loss arises is the Australian dollar amount of that liability when it was incurred. Thus, unless the liability was incurred at joining time, it is unlikely that the amount of the forex realisation gain or loss will equal the amount of the gain or loss arising under CGT event L7.

6 It is also unclear whether the amount of the gain or loss arising under CGT event L7 is a forex realisation gain or a forex realisation loss referred to respectively in the anti-overlap provisions of subsections (4) and (4) of the ITAA 97. It is noted that Treasury Paper 26 has provided that the scope of CGT event L7 will be modified to ensure that it applies only to amounts that are not recognised under another provision in the income tax law in determining a head company s tax liability. However, it is understood that no legislative amendment has yet been introduced to give effect to Treasury Paper 26. We submit that the ATO might give some consideration as to whether these matters warrant further discussions with Treasury, in particular, whether Treasury Paper 26 is intended to deal with the above issue. We submit that further consideration should be given to the question of whether there is a disposal of a traditional security following payment of a foreign currency denominated trade receivable. Paragraph 7 of the Determination states that payment of a foreign currency denominated receivable is not an amount received upon the disposal or redemption of a traditional security for the purposes of section 26BB of the Income Tax Assessment Act 1936 ( ITAA 36 ). However, no explanation is given for this conclusion. It is noted that the Federal Court has recently held that a waiver of the right to receive repayment of outstanding loans constituted a disposal of a traditional security in Rataplan Pty Limited v Commissioner of Taxation [2004] FCA 920 and Westrac Equipment Pty Limited v Commissioner of Taxation [2004] FC 921. The Federal Court considered that the language of section 70B was sufficiently clear not to require resort to the ejusdem generis principle for the purposes of construing the term dispose of in any way. Accordingly, the Federal Court considered that the definition of disposal should not be restricted in the way proposed by the ATO in TR 96/14. The Federal Court therefore considered that the meaning of disposal of a traditional security did not necessarily require an alienation of the security and that an extinguishment of the right to receive repayment upon waiver of the loan was sufficient to give rise to a disposal of a traditional security. On the basis of the reasoning adopted by the Federal Court, it is arguable that payment of a foreign currency denominated receivable can also give rise to disposal of a traditional security. Similar to the way the right to receive repayment is extinguished upon waiver of a loan, the right to receive foreign currency is also extinguished at the time of payment. Whilst no alienation of the right to receive foreign currency is involved, it is arguable that alienation is not a necessary element for there to be a disposal of a traditional security. It appears that an extinguishment of a right to receive foreign currency following payment might be sufficient to give rise to a disposal of a traditional security.

7 It is noted that, in 1992, subsection 70B(5) of the ITAA 36 was inserted to expressly exclude a waiver or release from giving rise to a disposal for the purposes of section 70B of the ITAA36. It is also understood that the above Federal Court cases involved income years prior to the insertion of subsection 70B(5) of the ITAA 36. However, we note that no comparable provision excluding a waiver or release from giving rise to a disposal appears to be applicable for the purposes of section 26BB of the ITAA 36. Accordingly, we submit that the principles espoused in the Federal Court decisions as noted above should be considered in determining whether there is a disposal of a traditional security upon payment of a foreign currency denominated receivable under section 26BB of the ITAA 36, despite the comments made by the ATO in TR 96/14. Confirmation is therefore sought from the ATO as to whether payment of a foreign currency denominated receivable can amount to a disposal of a traditional security for the purposes of section 26BB of the ITAA 36. Consideration should also be given to the potential asymmetric treatment arising under section 26BB (where payment of a receivable may be considered to give rise to a disposal) and under section 70B of the ITAA 36 (where payment of the receivable may not amount to a disposal given subsection 70B(5)). Recommendations We recommend that the ATO consider the following points and provide clarification before finalising the Determination and issuing further guidance on the issue: The treatment of foreign currency gains or losses that may arise on discharge of a foreign currency denominated trade receivable, particularly an analysis of the interaction between Division 775 and subsection (6) of the ITAA 97. The question of whether an assessable gain or deductible loss can arise upon payment of a foreign currency denominated receivable. The assumption that there are no currency fluctuations is applicable throughout all relevant times, i.e. between the time the receivable is created, the time of consolidation and the time the receivable is discharged. The treatment of capital losses arising on payment (or non-payment) of a foreign currency denominated trade receivable. The question of whether a trade receivable is a CGT asset only if it amounts to a recoverable debt. The interaction between Division 775 of the ITAA 97 and the relevant CGT provisions when operating in the context of tax consolidation.

8 The operation of Division 775 of the ITAA 97 in cases involving CGT event L7 where the subject liability is a foreign currency denominated liability. The question of whether there is a disposal of a traditional security following payment of a foreign currency denominated trade receivable.