What is TOFA?
TOFA (Taxation of Financial Arrangements) is a tax framework that focuses on taxing the gains and losses from financial transactions based on their actual economic impact, rather than just their legal structure. In simpler terms, it ensures that the taxation of financial gains and losses accurately reflects their true financial significance.
The key goals of TOFA are as follows:
Minimise Distortion: TOFA aims to reduce any distortions that may occur in trading, financing, investment decisions, risk management, and other business activities due to the way financial gains and losses are taxed. It strives to prevent tax considerations from unduly influencing these important business decisions.
Align Tax and Commercial Recognition: Another objective is to bring the tax treatment of financial gains and losses more in line with how they are recognised in the business world. This means that the tax treatment should closely match how these transactions are viewed in commercial terms, ensuring fairness and consistency.
Reduce Compliance Costs: TOFA also seeks to lower the costs associated with complying with tax regulations. By providing a clear and principle based framework, it simplifies the tax treatment of financial arrangements, making it easier for businesses to understand and follow tax rules.
The TOFA rules start affecting an entity’s tax return when it enters into financial arrangements during its first income year, beginning on or after July 1, 2010.
Entities Required to Comply with TOFA Rules
TOFA rules are applicable to specific types of entities based on certain criteria:
These entities must use TOFA rules if they are obligated to register under the Financial Sector (Collection of Data) Act 2001 and have an aggregated turnover of $20 million or more. This requirement targets financial institutions in the banking and finance sector meeting this threshold.
Large Investment Entities
Superannuation funds, managed investment schemes, and foreign entities similar to managed investment schemes are subject to TOFA rules if the value of their assets reaches $100 million or more. This rule is intended to encompass large investment entities.
Other Entities (Excluding Individuals)
Entities (excluding individuals) with either an aggregated turnover of $100 million or more, assets amounting to $300 million or more, or financial assets totalling $100 million or more are also under the scope of TOFA rules. This category includes various businesses and organisations engaged in substantial financial activities.
Once an entity meets the relevant criteria, it is required to continue applying TOFA rules, even if its turnover or asset value falls below the threshold later. This ensures consistent application of the rules.
In cases involving tax consolidated groups, TOFA compliance is assessed at the level of the head company, which encompasses all its subsidiary members. Transactions and assets within the tax consolidated group are not considered when determining the group’s turnover or asset value.
Regardless of the specified thresholds, TOFA rules will be relevant for any entity, including individuals, that holds a qualifying security.
A qualifying security is a financial instrument with particular characteristics, such as a term exceeding one year and expected payments that exceed the issue price by a certain percentage for fixed return securities. This means that specific financial instruments are subject to TOFA rules irrespective of an entity’s size or status.
Thus, the TOFA rules impact an entity’s tax return in Australia based on the timing of when it enters into financial arrangements, starting from July 1, 2010, unless an earlier election is made. These rules apply to various types of entities based on their size, nature, and the specific financial instruments they hold, ensuring a comprehensive and fair application of taxation principles in the financial sector.
Opting for the TOFA (Division 230) Framework
Taxpayers who are not automatically subject to TOFA mentioned above have the choice to voluntarily apply these rules to all their financial transactions.
They can do this by filling out a specific form known as the TOFA 3 & 4 election for Division 230. Essentially, this means that even if an entity is not initially required to follow Div 230, they can opt to do so.
Importantly, taxpayers who make this election are not obligated to inform the authorities about their decision. However, it is recommended that they retain a copy of the completed election form as part of their tax records.
This documentation serves as a reference and proof of their choice to apply Div 230 to their financial arrangements.
A crucial point to understand is that once a taxpayer chooses to apply TOFA to their financial arrangements by making this election, they cannot reverse or revoke this decision. It becomes a permanent commitment.
Application to Financial Arrangements
The election to apply TOFA covers all financial arrangements that the taxpayer initiates during the income year when the election is made.
Additionally, it extends to all future income years. In essence, it has a lasting impact on how financial gains and losses from these arrangements are taxed.
Reasons for Making the Election
Taxpayers may have various motivations for choosing to make this election. One significant advantage is the ability to recognise losses on financial arrangements earlier. This can be beneficial for tax planning purposes.
Additionally, applying TOFA allows for the alignment of gains and losses arising from hedging financial arrangements with those arising from the underlying assets or liabilities. This consistency in tax treatment can simplify financial reporting and provide certain tax benefits.
Thus, we can say that decision to make this election may be driven by the desire to recognise losses earlier and align gains and losses in hedging arrangements with the underlying assets or liabilities.
What are Financial Arrangements?
Within the framework of TOFA under Australian tax regulations, the term financial arrangements pertains specifically to what are known as TOFA financial arrangements. These are arrangements where individuals or entities possess legal or equitable rights to receive or provide a financial benefit, and notably, these rights can be settled in cash.
It is crucial to be aware of certain exclusions. An arrangement will not be classified as a TOFA financial arrangement if the cash settled rights and obligations within that arrangement are deemed insignificant in comparison to other rights and obligations present within the same arrangement.
Moreover, if the cash settled rights and obligations cease to exist within the arrangement, it would no longer fall within this category.
Extension to a Diverse Range of Instruments and Contracts
The scope of TOFA, explained within Division 230, is not confined to a narrow set of financial arrangements. Instead, it encompasses a wide array of financial instruments and contracts. This includes, but is not limited to:
- Loans: Any type of lending arrangement, whether between individuals or entities, falls under this definition.
- Bonds: Both government and corporate bonds, representing debt instruments, are encompassed.
- Derivatives: This includes a comprehensive array of financial derivatives, such as forwards, futures, options, swaps, and similar contracts.
- Promissory Notes: Promissory notes, which are written promises to pay a specified amount, are also included.
- Bills of Exchange: Bills of exchange, which are negotiable instruments used in trade transactions, are regarded as financial arrangements.
- Shares: Various types of shares in companies, be they equity or non equity, fall within TOFA’s scope.
Extension to Specific Categories
In addition to these instruments, TOFA, within Division 230, extends its applicability to specific categories, treating them as if they were rights constituting financial arrangements. These categories encompass:
- Foreign Currency Transactions: Transactions involving foreign currencies for exchange or trade purposes are incorporated.
- Non Equity Shares in Companies: Any transactions involving non equity shares in companies are considered financial arrangements.
- Commodity Contracts: Certain commodity contracts held by traders are subject to TOFA’s provisions.
- Offsetting Commodity Contracts: Similarly, specific offsetting commodity contracts held by traders are also included.
Even internal derivatives used by multinational banks may potentially fall within the definition of financial arrangements under TOFA in particular circumstances.
Exemptions from TOFA
There are certain financial arrangements that are not governed Division 230 provisions. Here’s a breakdown of the financial arrangements that are exempt from TOFA:
- Short Term Cash Settlable Arrangements: This exclusion applies to financial arrangements related to the acquisition or provision of goods, property, or services that can be settled in cash within a year, excluding derivative financial arrangements. For instance, short term trade credit arrangements are included in this category.
- Leasing and Licencing Arrangements: Most leasing and licencing agreements are not governed by TOFA. This includes luxury car leases, hire purchase agreements, and assets utilised for tax preferred purposes.
- Interests in Partnerships and Trusts: Financial arrangements linked to interests in partnerships and trusts are exempt from TOFA.
- Certain Insurance Policies: This exemption covers specific rights or obligations under life insurance policies and general insurance policies.
- Worker’s Compensation Arrangements: Certain worker’s compensation arrangements are not subject to TOFA.
- Guarantees and Indemnities: Unless a fair value or financial reports election is made, guarantees and indemnities are excluded. Notably, a term deposit provided as security for a performance bond does not fall under guarantees or indemnities.
- Personal Arrangements and Personal Injury: Financial arrangements related to personal matters, such as receiving maintenance payments, and those associated with personal injury are not governed by TOFA.
- Superannuation and Pension Benefits: TOFA does not apply to superannuation and pension benefits.
- Controlled Foreign Companies: Specific interests in controlled foreign companies are exempt from TOFA.
- Proceeds from Business Sales: This exemption covers proceeds from certain business sales, including earn outs.
- Farm Management Deposits: Farm management deposits that are deductible under the Division 394 are outside the scope of TOFA.
- Deemed Interest Payments: Deemed interest payments to owners of offshore banking units are not regulated by TOFA.
- Forestry Managed Investment Schemes: TOFA does not extend to forestry managed investment schemes.
- Mining Sector Exploration Benefits: Exploration benefits provided under farm in farm out arrangements in the mining sector are not covered by TOFA.
- Other Arrangements as Specified by Regulation: Any other arrangement specified by regulation is also exempt.
Additionally, TOFA does not apply in specific scenarios:
- When losses result from ceasing to hold a marketable security due to the belief that the other party cannot fulfil its obligations.
- When gains arise from the forgiveness of commercial debts, which are regulated by Div 245.
- Gains in the form of franked distributions or rights to receive such distributions remain taxable.
- When gains or losses are subject to the value shifting regime.
- To gains and losses arising from retirement village residence contracts, retirement village services contracts, or arrangements for residential or flexible care, as these typically involve non insignificant non cash settlable rights and obligations.
- To former registered emissions units.
Cash Settlable Arrangements
Division 230 financial arrangements include arrangements where there are legal or equitable rights to receive or obligations to provide a financial benefit, and these rights or obligations can be settled in cash. A financial benefit is considered cash settlable when:
- The benefit is in the form of money or a money equivalent.
- The entity intends to settle the right or obligation using money, a money equivalent, or by initiating or terminating another financial arrangement (excluding equity interests).
- The entity has a history of settling similar rights or obligations as mentioned in (b), whether or not the intention is to settle them in that manner.
- The entity engages with the right or obligation, or similar ones, to profit from short term price fluctuations or dealer margins or both.
- The entity has the capability to settle the right or obligation mentioned in (b), regardless of whether the intention is to settle it that way, and the primary or dominant purpose for entering into the arrangement is not to receive or deliver the financial benefit as part of its usual purchase, sale, or usage requirements.
- The financial benefit is readily convertible into money or a money equivalent, there exists a highly liquid market for it, and either:
- The financial benefit is not significantly at risk of losing value for the recipient.
- One of the entity’s intentions for entering the arrangement is to raise or provide finance or to convert it into money or a money equivalent (except as part of regular purchase, sale, or usage requirements).
- Cash settlable financial arrangements under TOFA include various financial instruments such as derivatives and debt instruments like bonds, loans, bills of exchange, and promissory notes, regardless of whether they are denominated in Australian or foreign currency.
However, specific capital support payments made by a parent company to its subsidiary are not deductible under TOFA, as they do not qualify as losses from a financial arrangement due to the subsidiary’s significant non cash settlable right.
Equity Interests under TOFA
Equity interests under TOFA, which include shares in a company or interests in a trust or partnership, are considered financial arrangements.
Rights to receive equity interests and obligations to provide equity interests, or combinations thereof, are also categorised as financial arrangements under TOFA, provided they are not cash settlable financial arrangements or part of such arrangements.
When an arrangement possesses characteristics of both being cash settlable and an equity interest, it is treated as an equity interest for the purposes of applying TOF. This distinction is vital because an equity interest is subject to TOFA only when the taxpayer makes specific tax timing elections:
- A fair value election for equity interests held by the taxpayer (not applicable when the equity interest is issued by the taxpayer).
- A financial reports election for equity interests held by the taxpayer.
- A hedging financial arrangements election concerning an equity interest issued by the taxpayer, particularly when it functions as a foreign currency hedge.
Identifying a Financial Arrangement under TOFA
An arrangement under TOFA may consist of one or multiple financial arrangements, or several arrangements may collectively form a single financial arrangement.
For instance, a convertible note that pays coupons throughout its term and converts into shares at maturity is considered a single arrangement. Similarly, a loan facility with multiple drawdown stages is treated as a single arrangement.
The assessment of whether an arrangement qualifies as a financial arrangement is made at the time the arrangement comes into existence or begins to be held. TOFA also allows for periodic assessments throughout the arrangement’s life.
Determining Profits and Losses from Financial Arrangements
Division 230 places a priority on accounting for net gains and net losses related to Div 230 financial arrangements over other taxation provisions including those related to foreign exchange gains and losses. These net gains and losses are determined using specific tax timing methods as discussed below.
It’s important to keep in mind that if you have a deductible loss, the thin capitalisation rules may restrict the full deductibility of that loss. If a gain or loss is not covered by TOFA, different tax rules may apply.
The application of TOFA to gains and losses depends on the perspective of the taxpayer involved. Holders and issuers of financial arrangements may be treated differently under TOFA.
For example, one taxpayer may be subject to TOFA while another may not, or parties in a financial arrangement may use different tax timing methods, resulting in different tax treatments.
Within TOFA, gains or losses from a financial arrangement are calculated by comparing costs (financial benefits provided) against proceeds (financial benefits received). Rules regarding cost attribution determine which costs should be subtracted from which proceeds.
To address potential disputes regarding cost attribution rules, amendments have clarified that taxpayers should consider financial benefits they might receive or provide when determining gains or losses from a financial arrangement.
This means that even uncertain financial benefits can be treated as either costs or proceeds for the purpose of calculating gains or losses.
Treatment of Gains and Losses
TOFA generally treats gains as assessable income and allows for the deduction of losses from assessable income.
However, there are exceptions, especially in the case of hedging financial arrangements. In such cases, gains and losses are characterised based on the tax characterisation of the underlying hedged item. This means they can be categorised as capital gains, income, assessable, exempt, or non assessable non exempt.
Additionally, gains and losses from financial arrangements related to the generation or production of exempt income or non assessable non exempt income are disregarded under TOFA. This also applies to gains or losses of a private or domestic nature.
In specific situations, a loss made by an Australian resident in deriving non assessable non exempt income under various tax provisions may be deductible, provided it is associated with a debt interest issued by the taxpayer and qualifies as a debt deduction.
TOFA and Tax Residency
For individuals or entities that are not considered tax residents of Australia, TOFA only applies to gains generated from financial arrangements with an Australian source. This means that only income arising from Australian based financial dealings falls under the TOFA regulations.
Change of Tax Residency Status
When a person transitions to becoming an Australian tax resident, TOFA treats this change as if they have acquired existing financial arrangements at their current market value. Conversely, when a person ceases to be an Australian resident for tax purposes, TOFA treats this as if they have disposed of existing financial arrangements at their market value at that point.
TOFA and PAYG (Pay As You Go)
Under TOFA, net gains (profits) made on financial arrangements subject to TOFA regulations are included in a taxpayer’s instalment income. However, net losses are not subject to this treatment.
TOFA and Consolidation
When entities holding financial arrangements subject to TOFA become part of or leave a consolidated group or MEC (Multiple Entry Consolidated) group, specific rules come into play to ensure the interaction between the consolidation rules and TOFA regulations works smoothly. These are known as TOFA consolidation interaction provisions, and they follow four primary principles:
Joining a Consolidated Group: When an entity becomes part of a consolidated group or MEC group, TOFA is applied as if the joining time is the end of an income year.
Treatment by the Head Company: The head company of the consolidated group applies the consolidation rules and TOFA as if it directly acquired assets that are part of financial arrangements from the joining entity.
Leaving a Consolidated Group: If an entity leaves a consolidated group or MEC group, the head company applies TOFA as if the leaving time is the end of an income year.
Treatment of Leaving Entity: A leaving entity, with financial arrangement gains and losses falling under TOFA, applies TOFA as if it took the financial arrangements with it at the leaving time.
Liabilities Under Different Tax Timing Methods
Retrospective amendments have been introduced to ensure consistent treatment of liabilities subject to various tax timing methods when an entity joins a consolidated group. These amendments specify deemed amounts based on the accounting value of the liability at the joining time.
Tax Value for Intra Group Assets or Liabilities
When intra group assets or liabilities that are part of Div 230 financial arrangements emerge from a consolidated group because a subsidiary member leaves, specific adjustments are made. These adjustments aim to align the tax treatment with the economic substance of transactions, preventing inappropriate assessments or deductions.
TOFA’s value shifting rules target scenarios where value is shifted away from equity or loan interests through a scheme. Gains eliminated or losses enlarged in this manner are disregarded, to the extent of the excess, under Division 230 of TOFA. These rules primarily apply to unrealised gains and losses from financial arrangements.
Arm’s Length Rules
Division 230 of TOFA incorporates arm’s length rules similar to those applied to arrangements not covered by the division. When a taxpayer acquires or provides something as consideration for a financial arrangement, the benefit’s amount is taken as the market value of the arrangement when the taxpayer initially acquired it.
This amount may be relevant for applying tax provisions related to capital gains, capital allowances, or trading stock. These arm’s length rules are self executing, meaning taxpayers must self assess, and the Commissioner does not need to exercise discretion.
Tax Exempt Entities in Privatisation: Integrity measures prevent tax exempt entities transferred to the private sector after May 8, 2018, from claiming tax deductions on the repayment of the principal of a concessional loan.
These deductions could arise due to complex interactions between the Taxation of Financial Arrangements (TOFA) rules and rules dealing with deemed market values for tax exempt entities that become taxable. Concessional loans entered into by tax exempt entities that become taxable must be valued as if they were originally established on commercial terms.
These interactions and integrity measures ensure that TOFA Division 230 functions effectively in the context of various other tax provisions and prevents unintended tax consequences.
TOFA Tax Timing Methods
TOFA offers six tax timing methods for recognising gains and losses on financial arrangements. These methods determine how and when financial benefits are accounted for tax purposes. The chosen method must be applied consistently for the financial arrangement and all similar arrangements in future income years.
Accruals Method: This method applies when overall gains or losses from an arrangement or specific gains become sufficiently certain at the arrangement’s commencement or during its life. Sufficiently certain means the entity reasonably expects to receive or provide a financial benefit, and some of the amount is fixed or determinable.
Realisation Method: When no method election is made and gains or losses are not sufficiently certain, the realisation method applies. It allocates gains and losses when the last financial benefit is provided.
Fair Value Method: An elective method that calculates gains or losses based on changes in the arrangement’s fair value between two points in time, typically the start and end of the income year, adjusted for amounts paid or received during the period.
Foreign Exchange Retranslation Method: For arrangements denominated in foreign currency or tied to foreign currency fluctuations, this elective method aligns with AASB 121 or equivalent foreign standards for foreign exchange gains and losses.
Hedging Financial Arrangement Method: An elective method that matches the timing and character of gains and losses on hedging financial arrangements with the items being hedged. It’s applicable to derivatives or foreign currency hedges.
Financial Reports Method: Another elective method that allows relying on financial reports to recognise gains and losses, provided certain criteria are met.
To use elective methods, specific documentation and effectiveness requirements must be met. Records must be kept and made soon after the creation, acquisition, or application of the arrangement.
Priority of Elections: When multiple methods may apply, the order of application is as follows: hedging financial arrangements method, financial reports method, fair value method, and foreign exchange retranslation method.
Balancing Adjustments: When rights and obligations under an arrangement are transferred, cease, or the arrangement is no longer considered financial, a balancing adjustment is made to account for outstanding gains or losses from the arrangement. Various exceptions apply to this rule.
Reliance on Financial Reports: This method permits relying on financial reports to account for gains and losses but has specific criteria, including unqualified audit reports and no adverse assessments of accounting systems in recent years.
Recent changes aim to enhance access to hedging rules on a portfolio basis but are deferred beyond the initial start date.
These methods provide flexibility in recognising gains and losses on financial arrangements, allowing businesses to choose the most suitable approach while adhering to specific criteria and documentation requirements. Balancing adjustments ensure proper accounting for any outstanding gains or losses when arrangements change or cease.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.