Fair dividend rate (FDR) foreign currency hedges
Issue: Create a FDR hedging fund
Submission
(Financial Services Council, AMP Capital)
A “FDR hedging fund” should be introduced that would have all its hedges taxed on the same basis as the fair dividend rate (FDR) method. Many funds are single-sector funds, investing in only one type of asset (such as international equities taxed under FDR). A FDR hedging fund approach would be easier for such funds.
Comment
In developing these rules, officials were concerned about the possible revenue risk if they could be misused. As such, the rules require certain calculations to ensure that they can only be used as intended. These rules were developed with significant consultation with the industry and officials are confident they are workable.
Nevertheless, this submission suggests that, for certain types of funds (those that invest only into FDR assets and that only enter into foreign exchange derivatives for the purpose of hedging) the rules could be redesigned to be simpler yet still provide the necessary comfort that they cannot be misused.
Officials understand the submitters’ point. However, this would require a redesign of aspects of the rules and development of technical details, such as how to define a fund that only enters into foreign exchange derivatives for the purpose of hedging. As noted above, there is a risk that these rules could potentially be misused, so a cautious approach is justified.
Such a change could, however, potentially be considered for inclusion in the Government’s tax policy work programme.
Recommendation
That the submission be declined.
Issue: Out of fund hedging
Submission
(Financial Services Council, AMP Capital, Ernst & Young)
The rules should be modified to also cater for funds that do not invest directly, but rather invest through other managed funds.
Comment
In theory, funds that do not invest directly into FDR assets should be able to “look through” wholesale funds they invest into and access the rules on the basis of those wholesale funds’ investments.
However, in order to prevent misuse, there are a number of detailed factors that officials consider would need to be worked through before such a change is considered. For example, a restriction would need to be put in place to ensure that if a wholesale fund were to use this look-through rule it would not be able to arbitrarily start and stop doing so. Questions also arise over which types of funds would be able to benefit from such a modification, in what specific circumstances, and where the onus of proof would lie.
As with the issue of creating an FDR hedging fund noted above, this is a complex area and there are risks that the rules could potentially be misused, so a cautious approach is justified. For these reasons, officials’ preference is that the issue of out of fund hedging instead be potentially considered for the Government’s tax policy work programme.
Recommendation
That the submission be declined.
Issue: Associated persons and fair value requirements
Submission
(Financial Services Council, Ernst & Young)
For a hedge to be eligible for the new rules, it must not be entered into with an associated person and the hedge must have a fair value of zero when it is first entered into.
These two criteria should be replaced with a requirement that a hedge must be entered into on arm’s-length terms.
Comment
Officials’ concerns with an “arm’s-length” test is that they are difficult to apply in practice. It can be very hard to prove that a transaction was not carried out at arm’s length.
Officials do not agree that the rules should apply to hedges that have a fair value not equal to zero, even if that hedge was entered into on commercial terms. It would then be possible for taxpayers to select when to use these new rules in order to minimise their tax liability.
Recommendation
That the submission be declined.
Issue: Closing hedges out early
Submission
(Financial Services Council)
The rules should be amended to allow hedges to be closed out early by entering into an equal and opposite hedge transaction.
Comment
Officials agree, provided that the foreign currency contract used for this also meets the definition of a “hedge” under section EM 3. For example, it must begin with a fair value of zero.
Recommendation
That the submission be accepted.
Issue: Ability to make generic elections
Submission
(Financial Services Council, KPMG, AMP Capital)
Elections for the FDR hedging rules to apply to a hedge should be able to be done on a generic or portfolio basis.
Comment
Officials agree. It is noted, however, that an election for a hedge to be covered under the FDR hedging rules includes an election of a “FDR hedge portion” – that is, the extent to which the hedge should be covered by the rules.
Recommendation
That the submission be accepted.
Issue: Treatment of mistaken elections
Submission
(Financial Services Council, KPMG)
An election for the FDR hedging rules to apply is currently irrevocable. An exception should be made for genuine errors.
Comment
Officials disagree. The rationale for the up-front election is to ensure that taxpayers cannot choose which tax treatment to apply to a hedge based on what would give the most favourable tax treatment. It would be difficult to legislate a sufficiently strong definition of what constitutes a “genuine error”, as taxpayers may have incentives to characterise some elections as an “error” for tax reasons.
Recommendation
That the submission be declined.
Issue: Apply calculations on a portfolio basis
Submission
(Financial Services Council)
The calculations in section EM 5 should be able to be performed on a portfolio of hedges, as opposed to a hedge-by-hedge basis.
Comment
Officials agree, subject to being able to adequately establish a reasonable and workable method of measuring assets at the time a hedge is entered into.
Recommendation
That the submission be accepted, subject to officials’ comments.
Issue: Proxy hedge rules
Submission
(Financial Services Council)
It is impractical for a fund to hedge every currency it is exposed to. Funds therefore enter into “proxy hedges”, hedging exposure to less common currencies (such as the Brazilian Real) with hedges for more common currencies (such as the US dollar). The current FDR hedging rules allow this but the following minor changes are required:
• In the calculation, the value of “proxied currency asset” must be zero if the fund has a hedge denominated in the “proxy currency”. This restriction should be removed.
• Some funds will hedge an uncommon currency with hedges in multiple common currencies (for example, hedge an exposure to the Brazilian Real with hedges in both the US dollar and British pound). The rules should be amended to allow this.
Comment
On the first matter, this restriction is not intended. Officials recommend that, to the extent possible, the legislation be amended to reflect this.
On the second matter, the use of proxy hedges is complex. Nevertheless, the rules do allow some amount of proxy hedging. Officials accept that some funds will attempt to “proxy hedge” with a portfolio of currencies. However, given the complexity of the area, the difficulty in amending the legislation, and the fiscal risks associated with misuse, this issue should potentially be considered further. Officials’ preference, therefore, is that this issue is potentially considered for the Government’s tax policy work programme.
Recommendation
That the submission be accepted, subject to officials’ comments on the second matter.
Issue: New Zealand shares listed on AUX
Submission
(Financial Services Council, AMP Capital)
The FDR hedging regime should extend to New Zealand shares that are acquired on the Australian stock exchange (AUX) and denominated in Australian dollars.
Comment
Officials disagree. It is considered that a New Zealand company listed on the AUX and denominated in Australian dollars (AUD) will largely be “naturally hedged” back to New Zealand dollars (NZD) because the assets and profits of the New Zealand company will largely be denominated in NZD. As an example, say the AUD strengthens. The value of the company to Australians should fall, as its NZD-denominated assets and profits are now worth less when converted to AUD. However, the strengthening AUD also means the NZD-value of the shares on the AUX will be higher than they were before. These two effects should largely cancel out.
Recommendation
That the submission be declined.
Issue: Time limit for adjustment
Submission
(Financial Services Council, AMP Capital)
The reference to days in section EM 7(4) should be changed to “working days”.
Comment
Officials agree.
Recommendation
That the submission be accepted.
Issue: Allow profit participation policies (PPPs)
Submission
(Financial Services Council)
For a life insurer, the current rules will only apply to separately identifiable funds where the benefits are directly linked to the value of investments held in the fund. For insurers who hold their investment assets within the life insurer, this will mean that the new rules will apply only to their unit linked savings products. It will not apply to profit participation policies (PPPs).
Comment
It is not clear to officials at this stage whether PPPs are, in fact, consistent with the underlying approach taken in respect of life insurers or, if so, whether the proposed rule under section EM 2 adequately deals with such a situation already. Further work would need to be undertaken to establish this. Officials’ preference, therefore, is that this issue is instead potentially considered for the Government’ tax policy work programme.
Recommendation
That the submission be declined.
Issue: Allow longer unit valuation periods
Submission
(Financial Services Council, PricewaterhouseCoopers, KPMG)
The FDR hedging rules are currently restricted to taxpayers that perform daily unit valuations. This should be extended to taxpayers that calculate unit prices less frequently.
Comment
Officials agree, provided every hedge is subjected to the tax calculation in section EM 6 at least once. In practice, this means that a fund’s unit valuation period must be shorter than the contract period of the hedges the fund enters into.
Hedge contracts can also be cancelled before they are due to expire. This means if a fund has a unit valuation period of greater than a day, a tax calculation under EM 6 will also need to be performed when a hedge contract is cancelled.
Recommendation
That the submission be accepted.
Issue: Rolling hedges
Submission
(PricewaterhouseCoopers)
The FDR hedge portions should be set when a hedge is taken out but not re-set when hedges are rolled.
Comment
Officials disagree. The purpose of calculating FDR hedge portions is to ensure that foreign currency derivative contracts are, in fact, hedges for FDR assets – that is, they must protect against currency risk a person is exposed to. The purpose of the required calculations is to ensure that this is the case.
When a hedge is rolled, how much currency risk a person is exposed to may be different from when they first entered into the hedge. For example, they may have purchased new FDR assets (or sold old ones), or the values of their assets may have changed. It is therefore important for FDR hedge portions to be set when hedges are rolled.
Recommendation
That the submission be declined.
Issue: Extension to other portfolio investors
Submission
(Law Society, KPMG)
The FDR hedging regime as currently drafted is available only to managed funds and other widely held investment vehicles. However, the problem that the regime is designed to resolve – the mismatch in tax treatment between certain offshore assets and hedges for those assets – is not unique to managed funds. The regime should be extended to other portfolio investors.
Comment
Officials disagree. In developing these rules, officials were concerned about the possible revenue risk if they could be misused. It is believed that a restriction to widely held investment vehicles would help mitigate this risk. Such funds are not controlled by any investor, disclose their hedging strategy, and should have systems in place to comply with the requirements of these new rules (such as the need to make an up-front election). It is also generally difficult for a managed fund to take an aggressive tax position due to investor equity issues. Investors can leave and join funds, so the investors who benefit from the tax position may be different to the investors who would have to bear the consequences of any subsequent audit.
It is also noted that other portfolio investors have a method, albeit an imperfect one, of solving the tax mismatch between hedges and FDR assets (grossing up the amount hedged). This method is much less effective for managed funds.
Recommendation
That the submission be declined.
Issue: Clarify interaction with the financial arrangement rules
Submission
(KPMG, Ernst & Young)
The interaction between the FDR hedging rules and the financial arrangement rules needs clarification.
Comment
Officials agree. The intention is that, to the extent the FDR hedging rules apply to a hedge, the financial rules should not apply. Conversely, to the extent the FDR hedging rules do not apply to a hedge the financial arrangement rules do apply.
This means that if a fund is required to adjust its FDR hedge portions under the quarterly test of section EM 7, the adjusted portion should be taxed under the financial arrangement rules from the date of the quarterly test.
Officials recommend clarifying these points in the legislation.
Recommendation
That the submission be accepted.
Issue: Consequences of breach/quarterly calculation
Submission
(KPMG, Ernst & Young)
Given the volatility of international capital markets and foreign currency fluctuations, it is quite possible that a taxpayer will inadvertently breach the quarterly test in two consecutive quarters. As currently drafted, this will result in the taxpayer being excluded from the FDR hedging regime for up to 18 months. This is too penal. The taxpayer should only be excluded from the regime in the following two quarters.
Comment
Officials agree. The taxpayer should only be excluded from the regime for the following two quarters.
Recommendation
That the submission be accepted.
Issue: Overhedging rule in section EM 5(9)
Submission
(KPMG)
Section EM 5(9) provides an unfair result in certain circumstances. If a new hedge pushes the result of the formula to above 1.05 the FDR hedging regime cannot be used for that hedge. This would be particularly unfair if a taxpayer was previously well below the 1.05 threshold and entered into a single large hedge that only subsequently pushed them over the limit.
Instead, the extent to which the FDR hedging rules can apply to the new hedge should be reduced so that the result of the formula in section EM 5(9) is 1.05.
Comment
Officials agree. It is noted that the same result to what is requested could in fact be achieved by entering into two separate hedges: one that results in the formula in section EM 5(9) being equal to 1.05 (which would be eligible for the rules).
Recommendation
That the submission be accepted.
Issue: Minor drafting amendments
Submission
(KPMG)
There are two minor drafting errors that should be fixed:
• section EM 1(1)(a)(i) should refer to “excluded income” rather than “exempt income”; and
• the formula in section EM 5(9) is inverted.
Comment
Officials agree.
Recommendation
That the submission be accepted.
Issue: Application to existing hedges
Submission
(Ernst & Young)
The new rules should be able to be applied to hedges that were entered into before the application of the regime.
Comment
Officials disagree. There needs to be an election in place when hedges are entered into – this prevents selective election to minimise tax payments.
Recommendation
That the submission be declined.
Issue: Application date
Submission
(Matter raised by officials)
The application date of the FDR hedging regime should be changed to the date of Royal assent.
Comment
Due to delays in the planned timeframes of this bill, the planned date of application for these rules (the beginning of the 2013–14 income year) has already passed. Officials therefore recommend the application date be changed to the date the bill receives Royal assent.
Recommendation
That the submission be accepted.