2012 changes to certain excepted financial arrangements under the FA rules reduce compliance costs and remove a potential 'overreach'.

Sections ED 4 and EW 8 of the Income Tax Act 2007

Changes have been made to the treatment of certain excepted financial arrangements under the financial arrangements rules. The changes ensure that the legislation conforms more closely to the policy intent of reducing compliance costs for taxpayers and removes the previous rule's potential "overreach".

Background

The previous election rule allowed a taxpayer to elect to treat five categories of excepted financial arrangements as financial arrangements. These five types of excepted financial arrangements are contained in subsections EW 5(21)-(22):

  • agreements for the sale and purchase of property or services where all of a party's sales or purchases are prepaid and the total value of prepayments is $50,000 or less;
  • short-term agreements for sale and purchase;
  • short-term options;
  • travellers' cheques; and
  • variable principal debt instruments, if the total value of such instruments is $50,000 or less.

The policy rationale for allowing taxpayers to elect to treat these excepted financial arrangements as financial arrangements under section EW 8 was to reduce compliance costs, particularly in the context of trade payables and receivables denominated in foreign currency in the ordinary course of a taxpayer's business. Ordinarily, the tax rules value these at the spot rate applicable at the date of sale or purchase, whereas accounting rules for financial statements value these at the spot rate applicable at balance date. Therefore, the ability to elect to treat trade payables and receivables denominated in a foreign currency (being excepted financial arrangements) as financial arrangements meant that taxpayers could use the value reported in financial statements for tax purposes.

However, the issue is that the election rule had the unintended consequence of allowing taxpayers to obtain a deduction for the purchase price of acquiring a short-term agreement for sale and purchase (being an excepted financial arrangement) by applying the financial arrangements rules. Outside of the financial arrangements rules, an amount paid to purchase a short-term agreement for sale and purchase would ordinarily be on capital account.

Key features

Section EW 8 has been amended so that only certain short-term agreements can be elected to be treated as financial arrangements. These are short-term agreements acquired in the course of a business of purchasing or having assigned to them short-term agreements with debts outstanding, for the purpose of collecting the debts outstanding. For example, it will apply to a debt collection agency acquiring overdue telephone accounts in order to collect the debts owing without recourse to the seller of the debts. It will also apply to debt factoring where the factor acquires the debts without recourse to the seller of the debts.

In addition, new section ED 4 provides that when a taxpayer has one of the five excepted financial arrangements listed above, denominated in a foreign currency, they may choose to value any debts outstanding under the excepted financial arrangement at the same spot exchange rate they use in preparing financial statements. The intention behind this new section is to minimise compliance costs for taxpayers.

Detailed analysis

The issue of the potential "overreach" of section EW 8 has been addressed by limiting the ability to elect to treat excepted financial arrangements as financial arrangements to short-term agreements for sale and purchase that are acquired in the course of a debt-collecting business.

In addition, the original policy rationale underlying section EW 8 of reducing compliance costs is achieved by introducing new section ED 4. Section ED 4 allows taxpayers with trade receivables or trade payables denominated in a foreign currency (that is, excepted financial arrangements), and who determine foreign exchange values at balance date for amounts outstanding in their financial statements, to use this balance date foreign exchange value for tax purposes.

The rule is optional but once a taxpayer elects into the rule for an excepted financial arrangement, they must continue to apply the rule to all of their excepted financial arrangements that are of the same type. A taxpayer's decision to elect into the rule will be reflected in the tax position they take in their return of income for the income year. No prior notice of election is required.

Application date

The amendments apply to tax returns filed on or after 27 September 2012, being the date that the changes were announced. They do not apply to taxpayers who have taken a tax position or obtained a binding ruling or determination for an excepted financial arrangement before 27 September 2012.