A number of important amendments were announced in relation to the Taxation of Financial Arrangement provisions, including important changes to the tax hedging provisions as well as an announced extension of the functional currency provisions to certain trusts and partnerships.

Tax hedging

Under the tax hedging provisions contained in TOFA, a gain or loss on a hedging instrument for tax purposes can be matched against a gain or loss on the hedged item.  Under the current rules, where the hedge is effective (within the accounting 80% to 125% threshold), the whole gain or loss on the hedging instrument is taken to be 100% effective for tax purposes.  Accordingly the whole gain or loss can be deferred and matched against the underlying hedged item.  This differs to the accounting rules, which only allow matching of the effective portion. For taxpayers who are not interested in aligning tax with their accounts and are interested in tax hedging strategies, this outcome provides an appropriate tax result. 

The Government has announced a slight change to the effectiveness rules (retrospective to the start of the TOFA provisions), so that the ineffectiveness of a hedge for tax purposes will follow the accounting treatment only if the taxpayer also makes a financial reports election.  We are glad that this announcement is limited, as it will have no impact on those taxpayers seeking to obtain a fully effective tax hedge, especially where that taxpayer is not interested in aligning their tax position to the accounting profit or loss amounts.

A minor technical amendment was also announced to ensure that the tax hedging rules apply appropriately to hedges of firm commitments (especially where the hedged item is different for tax and accounting purposes).  This amendment has been due to the ATO taking a view that a hedge of trading stock did not work properly for tax purposes.  The package of reforms also restated pre-announced extensions of time to comply with the tax hedging documentation requirements (where the accounting requirements are already satisfied) and the introduction of a Commissioner’s discretion to accept the late lodgement of transitional elections. 

Functional currency election

The Government also announced its long awaited extension of the functional currency provisions to certain trusts and partnerships.  The functional currency provisions allows certain entities (that prepare their accounts predominantly in a foreign currency) to elect to use that foreign currency in calculating their Australian taxable income and tax liability.  For example, if a qualifying taxpayer prepares its accounts in US dollars, it can choose to calculate its taxable income in US dollars and convert the single amount at year end to Australian dollars. 

The election helps to simplify the calculation of foreign exchange gains and losses in the entity for any income year.  The election also avoids the crystallisation of gains and losses in the entity for amounts held in that functional currency and can therefore provide an appropriate hedging strategy at an entity level. 

While the announcement is positive, it is stated to be limited to “certain” trusts and partnerships.  The announcement follows submissions requesting an extension of the functional currency rules to foreign hybrid partnerships, controlled foreign trusts and Australia resident trusts required to prepare accounts under the Corporations Act.  In our view, it would be unfortunate if this measure were limited only to those types of entities and are not extended to closely held entities in the middle market space.  The measure will only apply prospectively from the date of Royal Assent.