What should you know if you’re a SME?

 Background to the TOFA reforms

 The TOFA reforms were first introduced in the 1992 Budget and were later taken up by the Review of Business Taxation (as recommended in the Ralph Report).  Stages one and two of these reforms were introduced in 2001 and 2003, respectively.  The recently introduced Division 230 (ITAA 1997) implements stages three and four of the TOFA reforms. 

In broad terms, the TOFA rules have been formulated with the intention that “financial arrangements” should be taxed in accordance with their economic substance.  Prior to the introduction of the reforms, the emphasis on legal form rather than economic substance resulted in inconsistencies between the tax treatments of different types of transactions (i.e. financial arrangements) that essentially had the same economic substance.  In part, this was contributed to by legal form-based rules that had not kept pace with financial markets and product innovations, creating tax deferral and arbitrage opportunities. 

The general rule is that a gain from a financial arrangement is assessable income; and a loss is an allowable deduction, to the extent it is made in the course of carrying on a business/ producing assessable income.  As a consequence, there is no longer a need for taxpayers to distinguish between gains and losses on revenue or capital account.

The four stages of the TOFA reforms deal with various concerns and purposes, as follows:

Stage 1 – new debt/ equity rules

Stage 2 – new foreign currency gains and losses rules

Stages 3 and 4 – new tax-timing rules for the taxation of gains and losses from financial arrangements; and hedging transactions (contained in Division 230) 

Division 230 provides a framework for the taxation of gains and losses from financial arrangements.  A set of principles and rules establish how to work out those gains and losses for each income year.

This article will specifically look at new Division 230 and what you should know if you’re a small or medium sized enterprise (SME) when applying the asset and turnover threshold tests and the consequences of the TOFA rules applying to you. 

The new rules will apply to financial arrangements that taxpayers start to have on or after 1 July 2010, unless they make a transitional election.  If a transitional election is made, the rules will apply to pre 1 July 2010 financial arrangements as well.

What is a “financial arrangement”?

In broad terms, a financial arrangement is one that involves a right to receive and/ or an obligation to provide a ‘financial benefit’ (i.e. anything of economic value).  Once the arrangement is defined, either it, or two or more separate arrangements, are then tested to determine if it is a financial arrangement to which Division 230 may apply, as discussed below. 

Section 230-45 provides that an entity has a financial arrangement if it has, under an arrangement, a ‘cash settlable’ legal or equitable right to receive or obligation to provide a financial benefit, or a combination of one or more such rights and obligations.  However, the arrangement is not a financial arrangement if under the same arrangement the entity also has a ‘not insignificant’ right or obligation to provide or receive something that is not a financial benefit, or not cash settlable.

Arrangements commonly regarded as financial arrangements are quite broad and include cash at bank, foreign currency, receivables, bonds, convertible notes, loans, interest rate and cross currency swaps, options, forward foreign exchange contracts, and shares in companies or units in unit trusts.

To determine if an arrangement is one to which Division 230 may apply, an entity (i.e. taxpayer) needs to work through the following steps:

Identify the financial arrangement/s

• Work out whether an exclusion provision applies to gains and losses from the financial arrangements
• Work out which tax-timing method will apply to the financial arrangement and, using that method, work out the gains and  losses from the financial arrangement for each income year
• Work out whether the gains and losses from the financial arrangement are assessable or deductible.

A key issue for SMEs will be determining whether an exclusion from the TOFA rules applies.

 Who is subject to TOFA? – Asset and turnover threshold tests

The application of Division 230 is mandatory for the following entities:

• Authorised Deposit-taking Institutions (ADIs), securitisation vehicles and financial sector entities, with an aggregated turnover of $20M or more in the previous income year
• Superannuation entities, managed investment schemes and foreign entities similar to managed investment schemes, if the value of their assets is $100M or more (worked out at the end of the previous income year)
• Other entities (not individuals) who meet any of the following thresholds in the previous income year
  • Aggregated turnover of $100M or more
  • Assets of $300M or more
  • Financial assets of $100M or more

(worked out at the end of the previous income year).

One or more of the above thresholds must be exceeded before the TOFA rules apply.

Once applied Division 230 will continue to apply to an entity even though the entity’s turnover or value of assets may subsequently fall below the relevant threshold.

If you are an SME you need to be aware of the following ‘traps’:

In applying the turnover threshold test,  in addition to your own turnover you will also need to take into account the turnover of any ‘connected entities’ and ‘affiliates’.  For example, if the taxpayer is a company that has received 40% or more of distributions of income or capital from a discretionary trust in a previous income year, the trust may be a connected entity of the company, such that the turnover of the taxpayer may include the turnover of the trust.

‘Turnover’ includes ordinary income derived from carrying on a business only, but it does not include amounts of ordinary income relating to dealings between the entity and entities that are connected with, or are an affiliate of, it.  Further, it does not include passive income, e.g. interest.

In applying the asset threshold tests, a taxpayer can use the values recorded in its accounts only if those accounts are prepared in accordance with applicable accounting standards.  If not, independent valuations will need to be obtained.

Regardless of the above threshold tests, Division 230 will apply to an arrangement held by the entity (including an individual) if the arrangement is a ‘qualifying security’ (e.g. promissory notes) with a remaining term of at least 12 months.

An entity (including an individual) can (irrevocably) elect to have Division 230 apply to it even if it doesn’t satisfy the above threshold tests.

In summary, these rules are complex and even if they don’t immediately apply to you they need to be tested annually.  Therefore, as your business grows, or in entering into new financial arrangements (i.e. qualifying securities) in the future, these rules may be applicable to you.

 So what if the TOFA rules apply?

 Division 230 contains a number of tax-timing methods that can be applied to work out when gains or losses that an entity makes from a financial arrangement should be brought to account for tax purposes.

If eligible, an entity can choose to apply one or more of the elective methods.  Otherwise, one of the default methods will apply to their financial arrangements.  The various methods (in order of priority) are as follows:

Elective methods

•  
  • Hedging financial arrangements
  • Reliance of financial reports
  • Fair value
  • Foreign exchange translation

Default methods

•  
  • Accruals
  • Realisation

These rules are complex and it is beyond the scope of this article to deal with the various scenarios and circumstances in which a particular elective method may be appropriate in preference to the application of a default method, to a particular financial arrangement.  To illustrate the options available to taxpayers, consider the following example.

 Example

Trading Co. enters into a foreign currency (FX) hedge contract on 29 June 2011, to hedge the Group’s FX exposure on the purchase of an item of machinery from a foreign supplier that is to be settled in FX on 29 July 2011.  For reporting purposes, the accounting standards require movements in the fair value of the contract to be recognised in Trading’s P&L for the accounting period.  Assume that Trading Co. is, and the FX hedge contract is a financial arrangement, subject to the TOFA rules.

If no tax-timing method election is made, any gain or loss on the FX hedge contract should be recognised (for tax purposes) when the purchase is settled.  This is no different to what would be required pre TOFA rules (i.e. Division 230). 

If a fair value election were made any fair value movements booked to the P&L would also be recognised for tax purposes.  For example, if the fair valuation of the contract at year end (30 June) resulted in a loss being recognised for accounting purposes, Trading would be entitled to claim a tax deduction for this loss in the income year ended 30 June 2011.  Conversely, if the fair valuation resulted in a gain, it would be included in its assessable income for tax purposes.

A fair value election would not be applicable if the contract was accounted for under hedge accounting rules.  In which case, Trading could make a hedging election, which would allow for the recognition of gains and/ or losses on the contract for tax purposes to be matched to gains and/ or losses on the underlying hedged item, which in this case, would be the effective life of the machinery acquired. For example, if Trading made a gain upon settlement of the contact of $100,000 and the effective life of the machinery is 10 years, it could elect to include $10,000 in its assessable income in each of the next 10 years, rather than recognise $100,000 in full in its assessable income upon contract settlement, in the income year ended 30 June 2012.

As can be seen, there are a potentially different outcomes depending on how a financial arrangement is accounted for and what tax-timing method elections can be made.

For a confidential discussion about how the TOFA rules may potentially apply to your business and its financial arrangements contact Pierre Wakim on 02 9683 7888.