PCG 2016/6 – practical guidance on determining the source of hedging gains for the purposes of the cap on ‘Foreign Income Tax Offsets’

On 15.4.2016, the ATO issued Practical Compliance Guideline PCG 2016/6 (Determining source of certain hedging gains for the purposes of s770-75).

It sets out the ATO’s compliance approach to working out the source of certain hedging gains for the purposes of calculating the foreign income tax offset limit in s 770-75 of the ITAA 1997.

The Guidelines apply to foreign currency hedging transactions undertaken as part of a hedging strategy relating to a portfolio of assets for the purposes of s 770-75. The Commissioner explains the statutory context of Division 770 as follows.

7. As set out in TR 2014/7, the FITO rules in Division 770 provide relief from the double taxation that may arise where a taxpayer pays foreign tax on income that is also taxable in Australia. A non-refundable tax offset for foreign income tax paid is allowed in respect of amounts which are also included in assessable income.

8. Section 770-75 provides for a FITO limit which operates to limit the offset to the amount of Australian tax otherwise payable on the net foreign income (or other amounts in respect of which the taxpayer has paid foreign income tax) included in assessable income (the offset limit calculation). The offset limit calculation requires you to establish amounts which have either borne foreign tax or are not from an Australian source.

This is practical guidance as to where the source of various hedging gains would be. The Commissioner notes that, strictly, this would be determined according to the common law meaning of source and broadly, this is the place where acceptance of the offer is received by the offeror (paras 9 – 12).

The core of this guidance is in paras 22 and 23 where the Commissioner sets out the practical ways to determine where acceptance of the offer is received.

22. The method of trading determines who receives communication of the offer. The main methods of trading are:

• Manual Trading – where the trade is conducted over the phone, by email or by an instant messaging service.
• Electronic Trading – where the trade is conducted over an electronic platform whether provided by the liquidity provider or a third party:
  1. Request for Price (RFP) – where the liquidity provider presents a price capable of being accepted by the Australian entity and, upon acceptance of that price and absent a ‘last look’ contractual term to the contrary, the liquidity provider is bound.
  2. Request for Streaming (RFS) – where the liquidity provider, via an automated process, presents a live price, the Australian client can select the price and, absent a ‘last look’ contractual term to the contrary, the liquidity provider is bound.
  3. Algorithmic Trading – where a trade order is filled by reference to a pre-determined set of rules allowing automated execution of a number of smaller trades aggregated to complete the order.

23. In determining who is making the offer, we will accept an approach based on the following assumptions:

• In  manual trading, the liquidity provider makes the offer. The contract is formed in the location of the person within the liquidity provider receiving the communication of the acceptance.
• In  electronic trading without a ‘last look’ clause the liquidity provider makes the offer and the Australian entity accepts. The contract is formed in the location of the person within the liquidity provider receiving the acceptance.
• However, in  electronic trading with a ‘last look’ clause – where the contractual agreement governing the use of the electronic platform contains a clause the effect of which is that the liquidity provider may refuse to act on any instruction from the Australian entity – the Australian entity makes the offer and the liquidity provider accepts. The contract would be formed in the location of the person, who is acting to bind the Australian entity contractually, who receives the communication of the acceptance. (This may be an employee of the Australian entity, or it may be an employee of an agent acting on behalf of the Australian entity.)
• In  algorithmic trading, the smaller trades entered into to make up the trade order may be a combination of contracts both with ‘last look’ and without ‘last look’. The location of where the individual contracts are formed is determined as above.

Some of these practical approaches will lead to there being a variety of places of likely source, and the Commissioner will accept an approximation based on a representative sample (paras 13 – 16).

The ATO noted that taxpayers do not have to rely on the Guidelines, but if they do, it will give some comfort that they won’t be audited. This guidance will apply from 1 July 2015, but given this is mid-way through the year, there may be other methods taxpayers can choose to demonstrate reasonable compliance (per TR 2014/7).

 [TT Summary] [PCG 2016/6] [LTN 71, 15/4/16]