Treatment of excepted financial arrangements under the financial arrangements rules
Clause 33B
The bill introduces an amendment to the tax rules that allows a taxpayer to elect to treat excepted financial arrangements as financial arrangements. The change will remove an overreach problem caused by the election rule, while still preserving the original policy intent behind the rule. The policy behind the rule is to reduce compliance costs to taxpayers who have debts outstanding relating to goods or services supplied in the ordinary course of their business, valued in a foreign currency.
Issue: Amendment to treatment of short-term agreements for sale and purchase
Submission
(Corporate Taxpayers Group)
The submitter supports the rationale behind the amendment, ensuring the financial arrangements rules work as intended.
Recommendation
That the submission be noted.
Issue: Clarification of drafting
Submission
(Ernst & Young, Corporate Taxpayers Group)
The drafting should be clarified to better reflect the policy intent.
It is not clear whether the modification applies to the underlying short-term agreement that is transferred or to the transfer agreement itself. (Ernst & Young)
Comment
Officials agree that the drafting could be clarified to better reflect the policy intent.
The policy intent behind allowing taxpayers to elect to treat certain excepted financial arrangements as financial arrangements was to reduce compliance costs when short-term trade credits denominated in a foreign currency were valued at balance date spot rates for financial reporting purposes, and at transaction date spot rates for tax purposes. Further, when the short-term trade credit was hedged, there was a mismatch.
The excepted financial arrangements that can be treated as financial arrangements are:
- agreements for the sale and purchase of property or services;
- short-term agreements for sale and purchase;
- short-term options;
- travellers’ cheques; and
- certain variable principal debt instruments.
Officials consider that removing the ability to elect to treat these excepted financial arrangements as financial arrangements will reduce the potential “overreach” of the current election rule.
However, it is still necessary to address the issue of the mismatch between the tax valuation of excepted financial arrangements denominated in a foreign currency (the tax rules require taxpayers to value these excepted financial arrangements at the spot rate applicable at the date of sale or purchase) and the accounting valuation.
Therefore, officials recommend that a provision in the bill (clause 33B) be re-drafted to address this mismatch. Accordingly, the bill proposes that, for the five excepted financial arrangements listed above, taxpayers be allowed to use the valuations they use for their financial statements for tax purposes, if they are denominated in a foreign currency. More specifically, taxpayers who, for their financial statements, determine foreign exchange values at balance date for such debts (that are excepted financial arrangements) would be allowed to use this balance date foreign exchange value for tax purposes. This should address the compliance cost concern that underpinned the introduction of the election rule (section EW 8 of the Income Tax Act 2007).
The rule is optional. However, once a taxpayer elects into the rule for an excepted financial arrangement, they will not be allowed to revoke the election. A taxpayer’s decision to elect into the rule will be reflected in the tax position they take in their return of income for each tax year – no prior notice of election is required.
The new approach therefore means that taxpayers will no longer be able to elect to treat the five excepted financial arrangements outlined above as financial arrangements.
The bill proposes a transitional rule that will operate for taxpayers who have previously elected to treat an excepted financial arrangement as a financial arrangement under section EW 8. These taxpayers will be treated as having valued their foreign currency-denominated excepted financial arrangements at the spot date used for their financial statements, on the date that the new rules come into force.
There will be no change to the application date for the amendment (see next submission).
Recommendation
That the submission be accepted.
Issue: Amendment should be limited in scope or, alternatively, addressed as part of a wider review of the financial arrangements rules
Submission
(Ernst & Young)
The submitter states that the proposed amendment should be deleted or alternatively re-worded to limit its scope. The submitter is concerned that the amendment may have broader application than intended. Taxpayers may elect to treat short-term agreements for sale and purchase, such as their trade receivables or payables as financial arrangements in the ordinary course of business (for example, if they are denominated in a foreign currency). On a literal reading of the proposed new section EW 32B, it is possible that it might apply to such taxpayers.
It is further submitted that any changes to the financial arrangements rules should be addressed as part of a comprehensive review of the rules, rather than on an ad hoc basis.
Comment
The amendment addresses a specific concern with the election to treat excepted financial arrangements as financial arrangements in a targeted manner.
The rationale behind allowing a taxpayer to elect to treat a short-term agreement for sale and purchase as a financial arrangement was to reduce compliance costs by allowing any short-term debt under the agreement to be treated for tax purposes as it is for accounting purposes – for example, in the situation outlined by the submitter. However, the rule has unanticipated overreach – for example, taxpayers being able to convert what would otherwise be capital sums into deductible amounts.
The change proposed above addresses the compliance cost issue raised by the submitter by allowing taxpayers with trade receivables or payable denominated in a foreign currency to use their financial reporting valuations for tax purposes.
The issue required addressing as soon as practicable because it presented a potential fiscal risk. Accordingly, officials did not consider it appropriate to wait for a review of the overall financial arrangements rules before amending the rules. No review is planned. In proposing the change, officials have taken into consideration the overall scheme of the financial arrangements rules.
Recommendation
That the submission be declined.
Issue: Application date
Submission
(Ernst & Young)
The application date should be changed so that the amendment only applies to transactions occurring after the date the bill is enacted.
Comment
The revised amendment outlined above applies to all excepted financial arrangements that a taxpayer elects to treat as a financial arrangement from 27 September 2012. However, there is a “savings” provision for short-term agreements when the taxpayer has taken a tax position or obtained a binding ruling before 27 September 2012 (the date the proposed change was announced by the Minister of Revenue).
Officials consider the application date is justifiable because of the potential fiscal risk from the loophole in the existing rules.
Recommendation
That the submission be declined.