2013 legislation provides a rule allowing eligible taxpayers to apply Fair Dividend Rates to foreign currency hedges rather than the financial arrangement rules.

Sections CV 18, DV 25, EM 1 to 8 and YA 1 of the Income Tax Act 2007

There can be a mismatch in the tax treatment of foreign currency hedges and certain offshore assets - those that are taxed under the fair dividend rate (FDR) rules and certain ASX-listed shares. This mismatch can make it more difficult to effectively hedge investments in certain offshore assets.

To address the mismatch, the new legislation provides an optional rule that effectively allows eligible taxpayers to apply FDR to their foreign currency hedges rather than the financial arrangement rules. The new rule is designed to, as much as possible, eliminate the tax mismatch.

To ensure the new rule is robust, there are restrictions on when it can be applied to ensure it is used as intended.

Background

Under the FDR rules, changes in an asset's value are not taxed. Instead, FDR assets are generally taxed on an imputed return of 5%. Conversely, changes in a hedge's value are fully taxed under the financial arrangement (FA) rules. This mismatch in treatment means that a hedge that is effective in removing the impact of unexpected currency fluctuations before tax ceases to be effective after tax.

To illustrate, say a person has an offshore asset portfolio worth US$10,000 and the NZD/USD exchange rate unexpectedly rises from $0.75 to $0.80. The person's asset portfolio is taxed under the FDR rules. In New Zealand dollars, the portfolio's value falls from NZ$13,333 to NZ$12,500 (rounded to nearest dollar). If the person had used a foreign currency hedge to completely remove the exchange rate risk, before tax is taken into account, the hedge will increase in value by NZ$833, exactly cancelling the change in their portfolio's value. The hedge is totally effective before tax.

The story is different after tax. The offshore assets have lost NZ$833 of value. However, under the FDR rules, no deduction is given for this decrease. Despite this, the $833 increase in the hedge's value is taxable. After tax, the person has lost NZ$833 from their asset portfolio but gained only NZ$600 from their hedge; the shortfall of $233 is created by the tax payment.

The mismatch does not arise with all types of foreign currency-denominated investments. Many assets denominated in foreign currencies are taxed on the same or similar basis to foreign currency hedges. This underpins why the new rule applies only in relation to certain assets.

Key features

New subpart EM provides for a new tax calculation method for certain foreign currency hedges entered into for assets taxed under FDR or ASX-listed shares that are not subject to the foreign investment fund (FIF) rules, provided the sale of those shares would not be taxable.

The new rule is optional. Eligible taxpayers can elect what hedges it applies to, and to what extent it applies for each hedge (subject to thresholds) to ensure the use of the new rule is appropriate.

The new rule only applies to widely held entities to help ensure it is used only as intended. These entities generally have muted incentives to take aggressive tax positions, have investment mandates and other documentation that disclose investment strategies.

Detailed analysis

New calculation for income or deductions from a hedge

New section EM 6 is the core of the new rule. It provides that an eligible taxpayer who has elected to use the new rule has income or an expense of:

FDR portions value x 0.05 x valuation period
                  days in the year

FDR portions value is the current market value of a taxpayer's hedges to the extent that the taxpayer has elected for this rule to apply to those hedges.

Valuation period is how often a taxpayer values their offshore assets (for example, each day, each week, each month). This period must be shorter than the term of the hedges a taxpayer enters into, to ensure the calculation is carried out at least once per hedge entered into.

This section therefore aligns the tax treatment of FDR assets (and some ASX-listed shares) with hedges of those assets for eligible taxpayers that have elected to use this new rule. Both assets and hedges will be taxed at approximately the same rate and with a common valuation period.

New sections CV 18 and DV 25 provide that the income or expense calculated using the above formula is taxable or deductible (as applicable). Note that section DV 25 does not override the general permission; any deemed expense that arises under section EM 6 must be related to a taxpayer's business in order for it to be deductible. The capital limitation is overridden to ensure that a negative result of the above formula arising due to eligible ASX-listed shares held on capital account is still deductible.

Financial arrangement rules will not apply

New section EM 1(3) provides that the financial arrangement rules do not apply to a hedge to the extent a taxpayer has elected for this new rule to apply (that is, its fair dividend rate hedge portion). Tax on the hedge is calculated solely under subpart EM.

The financial arrangement rules apply as usual to the remainder of the hedge.

Eligible assets

The new tax calculation method is available in relation to hedges used to hedge:

  • assets that are taxed under the FDR method; and
  • shares listed on the ASX exchange which are not subject to the FIF rules, provided the sale of those shares would be exempt under section CX 55 or would be a capital receipt as the shares are held on capital account.

The purpose of the new rule is to align the tax treatment of foreign currency hedges with the assets those hedges are entered into for. This mismatch is most significant for hedges entered into for the asset types listed above. For other assets the mismatch is either much less pronounced or does not exist, so the current treatment is more appropriate.

Eligible entities

The new rule for taxing hedges is designed to apply only to widely held investment funds and other similar entities. This restriction is intended to help ensure the new rule will be used only as intended. Widely held funds generally have muted incentives to take aggressive tax positions and have investment mandates and other documentation that disclose investment strategies.

This restriction is provided by new section EM 2, which largely mimics the widely held entity criteria in the Portfolio Investment Entity (PIE) rules (sections HM 14 and HM 15, together with the exemptions in sections HM 21 and HM 22 of the Income Tax Act 2007).

Eligible hedges and hedge portions

The new rule can only be used in relation to genuine foreign currency hedges - financial arrangements that are entered into with the sole purpose of offsetting exposure to foreign currency exchange movements in the value of their assets.

To reflect this, new section EM 3 provides the criteria for an eligible hedge. For example, a hedge must not be entered into with an associated person and, when it is first entered into, must have a fair value of zero.

An eligible hedge will not automatically be subject to the new tax calculation. A taxpayer must choose this option. This choice can be made for a specific hedge on the day the hedge is entered into or can be made for all hedges entered that will be entered into in the future.

This new method of calculating tax can be applied to part or all of a hedge. Accordingly, the taxpayer's choice needs to include the portion of the hedge or hedges to be subject to the new calculation (the fair dividend rate hedge portion of the hedge). There are limits on this, which are described below.

There is no prescribed way for how this decision is to be made, but sufficient records must be kept in order to satisfy the general record-keeping requirements placed on taxpayers.

Hedges of hedges

The definition of a "hedge" for the purposes of subpart EM includes a hedge of a hedge - that is, a foreign currency hedge that effectively cancels out another foreign currency hedge. This can be used to close out a hedge early.

The rules requiring an election for subpart EM to apply, as well as the limits on maximum fair dividend rate hedge portions, apply to hedges of a hedge in the same way as they apply to a hedge.

Maximum fair dividend rate hedge portions

The intention of the new rule is that it should only apply to hedges entered into for certain types of offshore investment - in other words, those assets where the tax mismatch is most significant. It is appropriate that hedges entered into for other types of offshore investment continue to be taxed as they are currently. Accordingly, new section EM 5 provides rules that set out the maximum fair dividend rate hedge portion that a taxpayer can elect.

There are two possible methods that a taxpayer can use to determine this maximum. The taxpayer is required to use the same calculation method for all of its hedges. The first method is designed to be accurate but is complicated to apply. The second method is simpler but may be less accurate. To balance this, the latter method is more restrictive.

These calculations need to be performed only on the day a hedge is first entered into. There is an additional quarterly test, described below, to ensure that a hedge's initial fair dividend rate hedge portion remains appropriate over time.

Method one

The first calculation method uses the formula:

1.05 x (eligible currency assets + proxied currency assets) - FDR hedges amount
                                 calculation hedge amount

Eligible currency assets refers to the eligible assets (as described above) denominated in the same currency as the hedge being entered into (the calculation currency).

Proxied currency assets refers to the eligible assets denominated in a different currency but the taxpayer hedges that currency with the calculation currency.1In the formula, all amounts should be expressed in the calculation currency.

FDR hedges amount refers to the amount of the calculation currency that is hedged by the taxpayer's hedges, excluding the hedge that the calculation is being carried out for (the calculation hedge), to the extent that they have elected for this new tax calculation method to apply (that is, each hedge's fair dividend rate hedge portion).

Calculation hedge amount refers to the amount of foreign currency that is hedged by the calculation hedge.

Example  

Z has a portfolio of:

  • US$20,000 worth of shares in US-based companies (eligible assets, worth NZ$40,000)
  • AU$10,000 worth of shares in Australian companies (eligible assets, worth NZ$15,000)
  • AU$20,000 worth of Australian bonds (non-eligible assets, worth NZ$30,000).

Z currently has two foreign currency hedges:

  • A hedge for US dollars with a foreign amount hedged of $20,000 (equivalent to NZ$40,000) and a fair dividend rate hedge portion of 0.50.
  • A hedge for Australian dollars with a foreign amount hedged of $20,000 (equivalent to NZ$30,000) and a fair dividend rate hedge portion of 0.25.

Z is looking to enter into a new hedge for AU$10,000. The maximum fair dividend rate portion for the hedge would be 0.55:

1.05 x (AU$10,000 + $0) - (AU$20,000 x 0.25)  =  0.55
                              AU$10,000

Method two

The second calculation method uses two formulas. A taxpayer's maximum fair dividend rate hedge portion is the lesser of the two.

The first formula is:

1 - non-eligible currency assets
           hedges amount

Unlike method one, this formula includes a taxpayer's assets regardless of the currency they are denominated in, not just the calculation currency. This may make it simpler for some taxpayers.

Non eligible currency assets refers to the total value of a taxpayer's foreign assets excluding eligible assets, converted to New Zealand dollars. Hedges amount refers to the total amount of foreign currency that is hedged by a taxpayer's hedges, including the calculation hedge, again converted to New Zealand dollars. Importantly, this is not the amount of New Zealand dollars hedged; it is the amount of foreign currency hedged expressed in New Zealand dollars at the day's prevailing exchange rate.

The second formula is:

1.05 x eligible currency assets - FDR hedges amount
             current hedge amount

Eligible current assets refers to the market value of a taxpayer's eligible assets.

FDR hedges amount refers to the total amount of foreign currency that is hedged by a taxpayer's hedges to the extent the taxpayer has elected for subpart EM to apply to that hedge.

Current hedge amount refers to the amount of foreign currency that is hedged by the hedge currently being entered into.

All amounts in the formula should be converted to New Zealand dollars.

If the result of the first formula is less than zero, the person's maximum fair dividend rate hedge portion is zero.

The objective of this second method is to allocate a taxpayer's hedges to their non-eligible assets first. The rationale is that subpart EM is designed to reduce the fluctuations in the after-tax position of someone who hedges. Currency fluctuations will affect the tax position of non-eligible assets far more than it will affect the tax position of eligible assets. Allocating hedges to non-eligible assets first therefore provides the largest reductions in fluctuations in the after-tax valuation of a taxpayer's portfolio caused by currency movements.

Example  

Z from the example above decides instead to use the second method to calculate the maximum fair dividend rate portion for its new $10,000 Australian dollar hedge. This hedge is equivalent to NZ$15,000.

The value of Z's non-eligible assets (in New Zealand dollars) is $30,000 and the value of Z's eligible assets (in New Zealand dollars) is $55,000. Z currently has a total of $70,000 foreign currency hedged (expressed in New Zealand dollars); after entering into this new Australian hedge its amount of total foreign currency hedged will be $85,000.

Result of first formula

1 - NZ$30,000  =  0.65
     NZ$85,000

For the second formula, Z's US hedge has a fair dividend rate portion of 0.50 and hedges the equivalent of NZ$40,000. Z's Australian hedge has a fair dividend rate portion of 0.25 and hedges the equivalent of NZ$30,000. The item FDR hedges amount in the second formula is therefore NZ$27,500 (= 0.50 x NZ$40,000 + 0.25 x NZ$30,000).

Result of second formula

1.05 x NZ$55,000 - NZ$27,500  =  2.02
            NZ$15,000

The lesser result from the two formulas is 0.65. Z's maximum fair dividend rate portion for its new Australian dollar hedge is therefore 0.65.

Quarterly test

The two apportionment methods described above provide appropriate initial maximum fair dividend rate hedge portions. The quarterly test described below ensures that, going forward, the fair dividend rate hedge portions for a taxpayer's hedges remain appropriate.

The formula below provides a taxpayer's quarterly FDR hedging ratio:

FDR hedges amount
eligible currency assets

FDR hedges amount refers to the total amount of foreign currency that is hedged by a taxpayer's hedges to the extent the taxpayer has elected for this tax calculation to apply to those hedges (that is, the fair dividend rate hedge portion of each hedge), converted to New Zealand dollars. This is not the amount of New Zealand dollars hedged but is the amount of foreign currency hedged, expressed in New Zealand dollars at the day's prevailing exchange rate.

Eligible currency assets refers to the total value of the taxpayer's eligible assets, also converted to New Zealand dollars.

If a person's quarterly FDR hedging ratio is greater than 1.05 they must adjust the fair dividend rate hedge portion to the result of the formula below:

                 0.85                    x FDR hedge portion
quarterly FDR hedging ration

The effect of this formula is to bring an entity's quarterly FDR hedging ratio to 0.85. This adjustment must be carried out, at the latest, five working days after the end of the quarter.

If a taxpayer breaches the threshold in two consecutive quarters, it will not be able to use this new tax calculation method for currency hedges for the next two quarters.

Example  

At the end of a quarter, the value of Y's portfolio is:

  • US$10,000 worth of shares in US-based companies (eligible assets, worth NZ$20,000)
  • AU$20,000 worth of shares in Australian companies (eligible assets, worth NZ$30,000).

Y has currently has a single foreign currency hedge: a hedge for US dollars with a foreign amount hedge of $20,000 (equivalent to NZ$40,000) and a fair dividend rate hedge portion of 0.80.

In the first formula, the FDR hedges amount is NZ$32,000 (= $40,000 x 0.80) and eligible currency assets is NZ$50,000 (= $20,000 + $30,000). The result under the formula is 0.64:

NZ$32,000  =  0.64
NZ$50,000

Y will therefore pass the quarterly test.

Next quarter the value of Y's shares fall, and they are only worth US$5,000 and AU$10,000 for the US and Australian shares, respectively. Assume for simplicity that exchange rates have not changed, so the US shares are now worth NZ$10,000 and Australian shares worth NZ$15,000.

In the formula FDR hedges amount remains at NZ$32,000 but the amount of eligible currency assets has fallen to $25,000. The result under the formula is now 1.28.

NZ$32,000  =  1.28
NZ$25,000

This exceeds 1.05, so Y will have to adjust its two hedges based on the formula below. This means Y will have to change its fair dividend rate hedge portion on its US dollar hedge so it is 0.53.

US dollar hedge

0.85 x 0.80  = 0.53
1.28

Application date

The new rules apply from 17 July 2013.

1It is generally impractical to hedge every currency a fund is exposed to. Funds therefore often do what is referred to as "proxy hedging". They find correlations between the smaller currencies and larger ones (such as the USD), and hedge their exposure to the smaller currencies using the larger ones.