Chapter 10 - Financial Arrangements
10.1 - Overview
The Financial Arrangements or Accrual Rules are a detailed set of rules relating to the tax treatment of debts and debt instruments and transactions including debt related aspects.
Common examples of financial arrangements include:
Loans between parties
Forgiveness of debts
Foreign currency denominated loans and forward cover
Deferred property settlements
10.2 - Application (ITA Subpart EW)
10.2.1 - Financial Arrangements / Accrual Rules
10.2.2 - Capital Gains and Losses
10.2.3 - Common Financial Arrangements
10.2.4 - Recognise Income Under a Financial Arrangement (ITA ss EW 12 - EW 27)
10.2.5 - Cash Basis Persons (ITA ss EW 54 - EW 63)
10.2.6 - Lending and Borrowing Transactions
10.2.6.1 - Points for the Lender
10.2.6.2 - Points for the Borrower
10.2.7 - Deferred Property Settlements (ITA ss BD 3, BD 4, EZ 48)
10.2.8 - Debt Forgiveness
10.2.9 - Short Term Trade Credit
10.2.10 - Foreign Exchange (Determination G9A)
10.3.1 - Lowest Price Clause
10.3.2 - Foreign Exchange Contracts (Determination G9A)
10.2 - Application (ITA Subpart EW)
10.2.1 - Financial Arrangements / Accrual Rules
Before the introduction of the accrual rules, a business had an opportunity to defer income tax and advance deductions for expenditure.
The accrual rules were introduced to:
• spread the income and expenditure over the term of the arrangement and
• improve consistency between accounting and tax treatment
• include (in some circumstances) realised and unrealised gains in income
Example
If you invest $10,000 in say government or local authorities bonds and upon maturity receive $10,500, the $500 gain is assessable under the financial arrangement rules.
This book only discusses the financial arrangements most applicable to small and medium sized businesses. These include the financial arrangement consequences of lending and borrowing money and the consequences of deferred property transactions.
A whole range of transactions is specifically excluded from the financial arrangement rules. Those most frequently encountered by small and medium sized businesses include:
• a short-term trade credit (see election option referred to below)
• a lease (although finance leases entered into after 1 April 1998 will be treated as financial arrangements)
• any short term agreement for sale or purchase of property
• a private or domestic agreement for sale or purchase of property
10.2.2 - Capital Gains and Losses
All gains on financial arrangements are subject to tax. However, not all losses relating to financial arrangements are deductible. If the loss is of a capital nature it may not be deductible.
Example
You may make a loan to a non-related party. If that other party defaults on the loan, the principal amount lost by the lender will not be deductible unless the lender was in the business of providing or dealing in loans. (The amount forgiven will however be taxable to the borrower.) Alternatively, if the dealer receives more back on the loan than expected, for example a foreign exchange gain, this will be assessable.
10.2.3 - Common Financial Arrangements
Common Financial arrangements include:
All debts. Under the accruals rules, the lender’s income will include all interest and also any additional amount received from the borrower.
Foreign currency loans. Under the accruals rules, the lender will account for interest, additional receipts (if any) and foreign currency movements.
Deferred property settlements. Where a property is sold on a deferred settlement basis, i.e., an interest is transferred (e.g. right to possession) before the price is paid for the property, the accruals rules will deem part of the sale price of the property to be interest. Therefore part of the seller’s receipt will be deemed to be taxable interest. A purchaser who uses the property for earning taxable income will been titled to a deduction for this deemed interest.
10.2.4 - Recognise Income Under a Financial Arrangement (ITA ss EW 12 - EW 27)
A number of methods are specified for recognising income under a financial arrangement. In summary, these include:
Straight line method. Any taxpayer (business or individual) whose total interests in all financial arrangements is less than $1.85 million may be able to spread income from a financial arrangement on a straight line basis.
Yield to maturity method. Persons not able to apply the straight line method must adopt a yield to maturity method of calculating income or expenditure under the financial arrangement. Essentially, the yield to maturity approach is a time value of money method of calculation.
These methods do not always apply and the IRD has issued a series of determinations for calculating income under different types of financial arrangements. In some cases market value may be used but only if certain criteria apply.
10.2.5 - Cash Basis Persons (ITA ss EW 54 - EW 63)
In some cases taxpayers are allowed to recognise financial arrangement income/expenditure on a receipts (cash) basis, i.e. you pay tax as you receive cash. This greatly simplifies the tax compliance requirements.
You qualify as a cash basis person if the difference between your income calculated on a cash basis and on an accruals basis is $40,000 or less and:
the absolute value of all of your transactions (income received + expenditure incurred) in relation to all of your financial arrangement in an income year is $ 100,000 or less; OR
the total value of all your financial arrangements is $1 million or less at all times during the year.
The Commissioner may overturn this if it an arrangement has been structured so as to defer tax.
Example
You invest in a coupon with a face value of $150,000 maturing in two years for which you outlay $120,000. Under the accrual rules, the income of $30,000 would have to be spread over the term of the arrangement, i.e., two years, until maturity. However, if you are a cash basis holder, you will only return the income when it is received. You should consult your financial advisor if you believe this concession may be relevant to you.
10.2.6 - Lending and Borrowing Transactions
Any transaction involving the lending or borrowing of money is a financial arrangement.
10.2.6.1 - Points for the Lender
The lender is the person providing the money to another party. So if you invest in bonds, you are the lender as you provide the money. The taxable gain is calculated as all amounts, whether interest or otherwise, repaid by the borrower less the amount originally lent to the borrower.
The financial arrangement rules also regulate the timing of income from a financial arrangement.
Example
You invest $700,000 into a six-month company debenture. The compounding interest is payable in a lump sum upon maturity of the debenture. At balance date the debenture has another three months to run. Should your tax return disclose any income on the financial arrangement at balance date, when you have not received any interest payment?
The financial arrangement rules will require accrued income at balance date to be disclosed in the year-end return even though you have not received any cash/interest at this time. The method used to calculate financial arrangement income is rather complex. However, various concessions are available to simplify these calculations. You should consult with your professional advisor.
10.2.6.2 - Points for the Borrower
The borrower is the person who receives the money from the lender. The borrower’s costs in relation to the financial arrangement can be calculated as, all monies repaid to the lender less all monies received from the lender.
In general terms, financial arrangement expenditure is deductible if the expenditure is incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business. The timing of the interest deductions is determined on an accruals basis. This may be different to the time the interest is paid.
10.2.7 - Deferred Property Settlements (ITA ss BD 3, BD 4, EZ 48)
Deferred property settlements can give rise to financial arrangement consequences. In general terms, a deferred property settlement occurs when benefits in the property pass to the purchaser prior to the purchase price being settled in full.
Example
Sale of trading stock on credit of say three months is a deferred property settlement. The purchaser obtains the benefit of the trading stock prior to settling the purchase price. This can also apply to sales of a large asset, e.g. machinery or a residential or commercial dwelling.
However, not all deferred property settlements are financial arrangements, in particular:
short-term trade credit (payable within 63 days)
a short term agreement for sale and purchase of property (payable within 93 days for real property, 63 days for other property)
private or domestic agreements for sale and purchase of property if the purchase price is less than $750,000 for real property or $250,000 for other property and settlement is required within 365 days
If you enter into a deferred property settlement that is not excluded, the financial arrangement rules will give rise to a deemed interest in the sale price. This will result in gross income for the vendor (undesirable if receipts are capital gains) and interest deduction for the purchaser (desirable if payments are for capital assets).
Example
You may be prepared to sell a commercial building for $12 million if you receive cash today. A potential purchaser approaches you and makes an offer. The purchaser requires possession of the building in one month’s time but will settle the full purchase price one year from now. While you are prepared to accept the offer, you realise that cash in one year’s time is worth less to you than cash today. You agree to sell the building for $13 million.
The financial arrangement rules will operate to treat a portion of the purchase price (approximately $1million) as interest. This deemed interest amount would be assessable to the vendor. This will surprise the vendor who thought the sale of the building would only generate a capital gain. The deemed interest component will be deductible to the purchaser if the building is used for business purposes or for deriving assessable income.
The deemed interest consequences can often be eliminated by inserting a “lowest price clause” into the agreement (See 10.3.1).
10.2.8 - Debt Forgiveness
If loans owed by a borrower are not fully repaid and the outstanding debt (whether in part or whole) is remitted, the borrower will be deemed to receive assessable income equivalent to the amount forgiven (except in certain limited circumstances).
When the creditor is associated with the debtor, the creditor is denied a bad debt deduction. The result is one-sided taxation of income to the debtor, but no corresponding deduction to the creditor.
Example
If a family trust makes a loan to a business conducted by family members, then a deemed forgiveness of debt may occur in circumstances where the loan is not commercial and adequate documents relating to repayments are not kept. In this instance, the family business may be deemed to derive assessable income equivalent to the amount of the loan that the IRD considered to be forgiven.
An exclusion from these assessable income consequences on forgiveness occurs where a natural person (or, in limited circumstances, trustees) forgive a loan for natural love and affection.
Example
If a father provides a loan to his son and later forgives this loan, the debt forgiveness will not be treated as assessable income to the son.
It is important that professional advice be sought in any matter concerning potential forgiveness of debts.
Lenders and borrowers should not agree to transactions that involve debt forgiveness without first seeking professional assistance. The rules and issues in this area are complex and unforeseen tax liabilities can arise. In particular, the lender may be denied a deduction that may otherwise have been available. The borrower may be assessed on the amount forgiven.
10.2.9 - Short Term Trade Credit
A short term trade credit (being a debt for the supply of goods or services where payment is required within 63 days after supply of goods or services) is treated as an excepted financial arrangement meaning foreign exchange or interest accruals did not have to be returned for tax purposes until they were realised.
A taxpayer can however elect to have short-term trade credit treated as a financial arrangement. A taxpayer will generally make this election where they adopt accrual accounting for their financial statements and the election lowers their compliance costs.
10.2.10 - Foreign Exchange (Determination G9A)
Under the accruals rules regime, foreign exchange gains arising from financial arrangements denominated in a foreign currency (whether realised or unrealised, capital or revenue) are included as gross income. Foreign exchange losses (realised and unrealised) are deemed to be interest and provided the losses meet the deductibility criteria, a tax deduction should be available.
10.3 - Practical Hints
10.3.1 - Lowest Price Clause
This clause specifies that the price stated in the agreement is the lowest price that would have been agreed upon at the time of the agreement on the basis of payment in full at the time at which the first right in the property is to be transferred.
If you are a vendor entering into any significant sale and purchase contract, you should ensure that the contract contains a lowest price clause. This clause may save part of your capital gain from being treated as a deemed or assumed interest amount.
If you are a purchaser entering into a significant sale and purchase transaction, it may be advantageous for you not to have a lowest price clause in the sale and purchase agreement. This is because you may be able to deduct part of the purchase price as a deemed or assumed interest amount. In all cases, you should seek professional assistance on these matters.
10.3.2 - Foreign Exchange Contracts (Determination G9A)
Taxpayers who have a forward exchange contract open at year end are required to return the foreign exchange gain or loss on the contract on an unrealised basis. Conventional accrual accounting does not often calculate such a gain or loss and so an adjustment is required on the taxpayer’s tax return.