Wednesday, 11 March 2009
Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008
Debate resumed from 12 February, on motion by Senator Sherry:
That this bill be now read a second time.
I rise to indicate that the coalition will be supporting the Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008. This bill clarifies the tax treatment of financial arrangements such as futures, options and forward contracts which have been developed over the last two decades. This bill is the final part of the former coalition government’s taxation reforms into financial arrangements. The reforms were modelled in four stages. Stages 1 and 2 were legislated under the coalition government. Legislation for stages 3 and 4 was introduced by the coalition government but lapsed due to the 2007 election.
The bill provides certainty on the tax treatment of financial arrangements. Currently the tax treatment of financial arrangements is based on the legal definition rather than the economic reality of the financial arrangement. The differential tax treatment between revenue and capital often causes financial arrangements with a similar economic outcome to in fact be treated differently. This has reduced the efficiency of financial markets as some financial arrangements are more attractive due to their more favourable tax treatment. Currently there are no specific rules for treating financial arrangements for tax purposes. Entities must determine whether a financial arrangement is capital or revenue according to the legal nature of the arrangement. This can often be different to the way the arrangement is treated for accounting purposes. This bill removes the requirement to make such a distinction. This bill introduces rules for treating financial arrangements for tax purposes. As a result of this bill, financial arrangements will be taxed based on their economic substance rather than requiring a complex legal distinction between capital and revenue. This will align the tax treatment of financial arrangements with the accounting treatment of financial arrangements used by entities.
Financial arrangements may be entered into for revenue purposes or capital purposes. To use an example, shares purchased and sold by a bank may be treated as revenue or capital depending on the purpose and legal form of the arrangement. Generally, the shares would be treated as revenue for accounting purposes. However, often the shares are legally determined as capital for tax purposes. This results in a discrepancy between the accounting treatment and the tax treatment of shares. This occurs because the tax law as it currently stands has not accommodated the evolution of financial arrangements and their use. This bill will remove this discrepancy by aligning the tax treatment with the accounting treatment of the shares—that is to say, the shares would be treated as revenue for tax purposes and accounting purposes.
The bill provides six methods for determining the treatment of gains and losses arising from financial arrangements. The bill removes the distinction between revenue and capital as the deciding factor in determining tax treatment of financial arrangements. These are broken down into two general classes: elective and non-elective. There are four elective methods and two non-elective methods. The four elective methods are the elective hedging method, the elective financial reports method, the elective fair value method and, finally, the elective foreign exchange retranslation method. For those who do not choose to make an election, the non-elective methods apply and they are the accruals method or the realisation method. These reforms will be compulsory for some taxpayers, such as approved deposit-taking institutions and superannuation funds and managed investment schemes that have assets over $100 million. Taxpayers who are not required to adopt the TOFA rules may elect to do so voluntarily.
As mentioned previously, these reforms were initiated by the previous coalition government. The whole TOFA process of reform is a decade in the making. Stage 1 of these reforms, which related to debt and equity measures, was legislated back in 2001. Stage 2, which related to foreign currency conversion rules and the realisation of foreign currency gains and losses, was legislated in 2003. The previous coalition government released the draft legislation for the final stages in 2005 and then engaged in an extensive consultation process with relevant taxpayers, industry groups and professional associations.
As the Senate will appreciate, this is a very complex and somewhat esoteric area of the tax law that has taken some time for stakeholders and successive governments to progress to this final stage. The final reforms were introduced in a bill into the other place in September 2007. As mentioned, however, the previous bill lapsed because of the federal election. So there have been a number of years of extensive consultation. They have been necessary and have resulted in the reforms that this bill seeks to finalise. These reforms reflect the coalition’s longstanding commitment to ensuring the integrity of the operation of our tax system.
I will mention very briefly an issue that I know my colleague Senator Joyce may raise further in more detail shortly. The coalition, whilst we are supporting this bill, do flag a concern about the broadening of the aggregated turnover threshold test. As noted in the coalition senators’ additional comments in the report of the Standing Committee on Economics into this bill:
Coalition Senators are concerned that the expansion of this test into three threshold tests may unintentionally burden small to medium sized entities (SMEs) with increased compliance costs. As many SMEs across Australia are currently challenged by the fallout of the Global Financial Crisis, it would be wrong for government to burden them further with inappropriate reporting requirements.
So I do flag these concerns for the attention of the Minister for Superannuation and Corporate Law, Senator Sherry, and ask that during the committee stage he indicate the rationale for broadening the aggregated turnover threshold test. I would also ask him, if he would, to detail for the chamber what assessment of the regulatory burden has been undertaken by the government and/or Treasury in this regard. That being said, and as I have said before, this is a supported piece of legislation and I commend the bill to the Senate.
I am going to give one of the briefest speeches in the history of the parliament. I would just like to concur with the comments made by Senator Coonan on the Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008. I look forward to the committee stage of the bill for reasons of fleshing out some of the issues that she brought up.
As Senator Coonan said, the taxation of financial arrangements has been a longstanding area of reform for consecutive governments. The changes in the taxation of income from financial arrangements were first announced by the Keating government in 1992. Then in 1999 the review of business taxation, the Ralph review, recommended that the taxation of financial arrangements be changed. Stage 1 of those reforms, distinguishing between debt and equity, was introduced in 2001. Stage 2 of the reforms, clarifying the taxation of foreign currency gains and losses, was introduced in 2003. Further reforms recommended by the Ralph review concerning the tax treatment of commodity hedges were announced in 2005. The Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008 implements stages 3 and 4 of the taxation of financial arrangements reforms dealing with hedges and tax timing of other arrangements. It is a complicated but important part of fiscal law. Treasury believes it will bring our treatment of taxation of financial arrangements up to par with other major developed countries.
For the purposes of this bill, a ‘financial arrangement’ is a right to receive or an obligation to provide a benefit that is monetary in nature, non-monetary in nature but may be settled by money or a money equivalent or is in substance and effect monetary in nature. The above definition seeks to cover the elements common to a wide range of modern financial instruments such as futures, options, credit swaps, forward agreements and other financial products. It also covers more established arrangements like loans, promissory notes and debentures. Notwithstanding some of the problems that those instruments have created recently, I am sure that the financial markets will make full use of these and other instruments in future. New financial products have been devised and used by business and industry at a rapid pace over the past two decades. The use of modern financial instruments such as futures, or hybrid debt/equity securities, has increased as business has sought new ways to protect itself from the risks of an increasingly global market. It is recognised that innovations in financial markets have outpaced the taxation framework governing them and that what is required is a reform of tax laws that shifts the emphasis from the legal form to the substance of financial arrangements. The current emphasis on the legal form of the arrangements has favoured the use of some types of financial arrangements over others due to more favourable tax treatment, adversely affecting pricing, risk management and the efficient allocation of financial resources.
This bill amends the Income Tax Assessment Act 1997 so that the taxation of various financial arrangements occurs by an appropriate method. I will not go into the specific ways in which the legislation does this. I simply say that the legislation does not generally apply to individuals or superannuation funds with assets under $100 million. It does not apply to authorised deposit-taking institutions with an annual turnover under $20 million and other entities with an annual turnover under $100 million, financial assets under $100 million and total assets under $300 million. The ATO estimates that there are around 1,800 businesses with turnover exceeding $100 million to which this legislation will apply. Whilst they may incur some initial costs in changing software and paying advisers, they should also reap gains from aligning tax and accounting reporting and from hedging arrangements being less subject to disruptive tax effects.
The committee considered the impact of this legislation on smaller businesses. Government members of the committee think that these kinds of arrangements and the limits set are sufficient to deal with concerns expressed during the committee process. The government undertook an extensive consultation process over a 12-month period before the committee process. The government listened during that consultation period and that resulted in a number of changes to the legislation that effectually dealt with a lot of the concerns arising out of the bill. The bill is very complex; however, it affects only large taxpayers and, given the extensive consultation process that was implemented, those affected will have gained some familiarity with it. The ATO is putting in place procedures to advise on and assist taxpayers in complying with the new requirements.
Most of the people consulted during the committee process were very supportive of the immediate passage of the bill. Many submitters to the Senate Standing Committee on Economics inquiry noted that some review process of the bill should occur after implementation to allow for later technical amendments. This has been acknowledged by the government, with the minister noting that, given the complexity of the law, monitoring the implementation of the reform would be required and any refinements needed would be dealt with as they arose. The Tax Laws Amendment (Taxation of Financial Arrangements) Bill introduces a comprehensive new framework for the taxation of financial arrangements. It is designed to reduce tax induced distortions in investment and financing, facilitate efficient risk management and reduce compliance and administration costs. It is a significant bill which will provide certainty, clarity and equity to the tax treatment of financial arrangements. It represents the final stage of reform in this area undertaken by two previous governments. I commend the bill to the Senate.
in reply—I thank senators for their contribution to this debate. The Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008 represents an important reform of Australia’s financial taxation system. Firstly, the passage of this bill will enhance efficiency in financial decision making by taxing financial arrangements according to their economic substance rather than their legal form. Secondly, it will reduce tax distortions to managing financial risk by introducing extensive tax-timing and character-hedging rules. Thirdly, it will reduce compliance costs by increasing the certainty of tax treatment of financial arrangements and by more closely aligning tax and financial accounting outcomes. The TOFA rules will not be applied on a mandatory basis to individual and small-business taxpayers, except where significant tax deferral is involved.
The bill has benefited from extensive consultations with industry and professional associations and is much anticipated by the business sector. As Senator Coonan touched on in her contribution, the bill had its genesis under the former Liberal government. We acknowledge the extensive work that commenced, as I recall from Senator Coonan’s contribution, as far back as 2003. So there have been some five to six years from the original announcement of these proposals through to the very extensive consultation. One of the results of recent consultation was the government’s decision to implement a soft and hard start date. Entities keen to receive the benefits of the reduction in compliance costs can elect to apply the new tax rules for the income year starting on or after 1 July 2009. Other entities may need more time to prepare for the new rules, which will apply to affected entities on a mandatory basis for income years starting on or after 1 July 2010.
This is a significant bill which will provide improved and needed coherence to the tax treatment of financial arrangements. As has been pointed out by Senator Coonan and other contributors to this debate, the bill is a complex one, and it will need very careful monitoring. There are likely to be issues that need to be considered. Certainly industry in their consultation, while broadly welcoming and supporting the legislation and the detail, nevertheless rightly pointed out that, as is often the case with changes to tax treatment, there is a series of complex issues that will need careful consideration. The government understands this and industry understands it. Those who wish to apply the rules do understand the complexities of the process that is going to flow as a consequence of this legislation.
I think it was Senator Joyce—I was not here but Senator Coonan flagged it and I want to take this opportunity to discuss the issue—who expressed the concern of the coalition, the Liberal and National parties, whilst supporting this particular piece of legislation, of the broadening of the aggregated turnover threshold test and the related issue of the compliance application and the impact that would have on business as a consequence of the broadening of that aggregated turnover threshold test.