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On the repayment of a loan used by the taxpayer to acquire preference shares in a foreign company that are reasonably expected to pay non-portfolio dividends which are non-assessable non-exempt income under section 23AJ of the Income Tax Assessment Act 1936 (ITAA 1936), will any gain made be non-assessable non-exempt income under paragraph 230-30(2)(b) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes. A gain made on the repayment of a loan used to acquire preference shares in a foreign company will be non-assessable non-exempt income under paragraph 230-30(2)(b) of the ITAA 1997.

The taxpayer is the head company of a consolidated group with effect from 1 July 2002 and is an Australian resident for tax purposes.

The taxpayer acquired preference shares in a foreign company. It is reasonably expected that the foreign company will pay non-portfolio dividends, as defined in section 317 of Part X of the Income Tax Assessment Act 1936 (ITAA 1936), that are non-assessable non-exempt income (as defined in section 6-23 of the ITAA 1997) to the taxpayer.

To fund the acquisition of the preference shares, the taxpayer entered into an agreement prior to 1 July 2010 to borrow an amount of foreign currency equivalent to their cost (the loan). Under the loan the taxpayer has an obligation to repay amounts borrowed and to pay interest to the financier.

The loan is a financial arrangement for the purposes of Division 230 of the ITAA 1997.

The taxpayer intends to make an election under sub item 104(2) of Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 to bring existing financial arrangements into Division 230 of the ITAA 1997 from 1 July 2010.

The taxpayer has not elected to apply any of the elective tax timing methods in Division 230 of the ITAA 1997 to its financial arrangements.

All legislative references are to the ITAA 1997 unless otherwise indicated.

Under Division 230,a gain you make from a financial arrangement is included in assessable income and a loss you make from a financial arrangement is deductible to the extent it is made in gaining or producing assessable income, or it is necessarily made in carrying on a business for that purpose (see subsections 230-15(1) and 230-15(2)).

However, a gain is not assessable income and is not exempt income if, had it been a loss, it would have been made in gaining or producing non-assessable non-exempt income (see paragraph 230-30(2)(b)). Similarly, a loss you make from a financial arrangement is not allowable as a deduction to the extent that you make it in gaining or producing non-assessable non-exempt income (see paragraph 230-30(3)(b)).

The proposition that a foreign exchange loss in relation to the repayment of a loan is a cost of borrowing, akin to the cost of obtaining and securing the use of the borrowed funds finds support in the judgement of Dixon J in Texas Co (Australasia) Ltd v. Federal Commissioner of Taxation (1940) 63 CLR 382 and generally in Avco Financial Services Ltd v. Federal Commissioner of Taxation (1982) 150 CLR 510; 82 ATC 4246; (1982) 13 ATR 63 and Australian National Hotels Ltd v. Federal Commissioner of Taxation (1988) 19 FCR 234; 88 ATC 4627; (1988) 19 ATR 1575.

Viewed as a cost of borrowing, or obtaining and securing the use of borrowed funds, the conclusion that a gain is made in the course of gaining or producing non-assessable non-exempt income relies on there being a sufficient nexus or connection between the gain and the operations or activities that more directly gain or produce non-assessable non-exempt income.

To determine the link or nexus between a gain that could arise on a complete or partial repayment of the loan, and what it is 'made in gaining or producing', the purpose for, or use to which, the taxpayer put the loan proceeds must be considered (see Fletcher v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613 and Kidston Goldmines Ltd v. Federal Commissioner of Taxation (1991) 30 FCR 77; 91 ATC 4538; (1991) 22 ATR 168.

The taxpayer used the loan to acquire preference shares in a foreign company. It is the acquisition of the preference shares which is productive of non-assessable non-exempt income because the preference shares are reasonably expected to generate non-portfolio dividends for the taxpayer, which are non-assessable non-exempt income under section 23AJ of the ITAA 1936.

It is considered that there would be a sufficient nexus between a gain arising on complete or partial repayment of the loan and the generation of non-assessable non-exempt dividend income from the preference shares.

Therefore, the gain, (to the extent to which if it had been a loss), would have been made in gaining or producing non-assessable non-exempt income by the taxpayer and is therefore not assessable income and is not exempt income under paragraph 230-30(2)(b).