TAXATION OF FINANCIAL ARRANGEMENTS

Abstract

This paper looks at the proposal by the Federal Government to introduce a new regime for the taxation of financial arrangements. Such a change has been on the Government's agenda for some time. In 1993, an initial proposal was put forward, but serious concerns were raised by the business community. The Government's proposal re-surfaced in December 1996 with some modifications to address the concerns raised to the initial proposal but in the writer's view, these modifications do not satisfactorily address the concerns.

The proposals basically seek to tax accrued and unrealised gains on financial arrangements such as foreign exchange loans and derivatives, including commodity derivatives. For instance, if a company has a foreign exchange loan, any unrealised foreign exchange gains at year end would need to be recognised for tax purposes, even though they may never be realised because of subsequent fluctuations in exchange rates.

To address the concern that unrealised gains may never be realised, the ATO has put forward a proposal that if the foreign exchange or other transaction is a hedge against changes in value of an underlying transaction, unrealised gains do not need to be recognised for tax purposes until the underlying transaction is realised. For instance, if a company borrows in US dollars because its future revenue stream is in US dollars, unrealised foreign exchange gains would not need to be recognised until the revenue is derived.

However, there is a major flaw in these hedging rules. If the hedging transaction is rolled over, any gain at the time of rollover needs to be recognised, even though the revenue that is being hedged has not been realised. Debt instruments and derivatives are often rolled over as part of the financial management of a large resource company and therefore, the new proposals in their current form would cause serious problems in that financial management.