Financing Arrangement: commitments obtained by cash or letters of credit

Does the obtaining of commitments by cash or letters of credit fall within the definition of financing arrangement for the purposes of section 974-130 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. The obtaining of commitments by cash or letters of credit does not fall within the definition of financing arrangement for the purposes of section 974-130 of the ITAA 1997.

The taxpayer provides wholesale payment and back-office services to financial sector customers in the cash and derivative markets.

The taxpayer is both buyer and seller to its customers and carries the credit risk that either or both parties may not settle a contract.

In managing this financial risk, the taxpayer has obtained commitments from its key customers to share certain financial risks, for which it pays a fee. The fee is calculated on the amount of the commitment - not the amount of any cash deposited.

Critically, customer's commitments are not required in cash. What is required is the assurance that these resources will be available if required, to cover a loss occasioned by, or arising from, the default of a customer. This assurance is achieved by requiring customers to back up their commitment in cash, or other form, including bank letters of credit. Critically, again, the form of the commitment required is exercised at the option of the customer, there being requirement by the taxpayer as to what portion must be contributed in cash (which is left to the customer).

The cash from the commitments is part of the risk management process. It is not required for working capital and is merely invested in short term securities. The taxpayer, upon which it pays a market rate of interest on the cash commitments it received.

Whilst the taxpayer has the power to set the fee, that power is limited by commercial constraints which both recognise and compensate customers for the assumption of risk. If the fee is set too low, customers would determine that the return was not commensurate with the risk and terminate the relationship. If the rate is excessive, management is failing in its duty to maximise shareholder returns.

Part of the taxpayer group's capital base is specifically set aside to meet the risk of customer default. It has had a positive cash position for the past 10 years. It has not borrowed money from external sources during this period for operational reasons. It has funded significant capital expenditure from internally generated cash, - the only exception being minor capital expenditure on computer hardware, which was leased for other reasons.

For the past six years the proportion of customers commitments held in cash, as opposed to other forms including letters of credit, has varied from 27% to 50%.

Section 974-130 of the ITAA 1997 defines a financing arrangement. Paragraph 974-130(1)(a) provides: A scheme is a financing arrangement for an entity if it is entered into or undertaken: (a) to raise finance for the entity (or a connected entity of the entity) ....

Although cash is certainly lodged, which is a liability on the balance sheet and adds to the capital base of the taxpayer group and it earns a return on same, the holistic factual arrangements have been considered, including the following matters: (a) the consistent profitability of the taxpayer (b) the overall capital situation (c) the taxpayer's consistent liquidity (d) funds held in cash reserves (e) the taxpayer's objective indifference to the customers' commitment being given in cash or some other form including bank letters of credit (f) the fundamental and clear commercial reality of the prudential motivation and objectives of the arrangement rather than to raise finance, and (g) the 'unique' facts and circumstances of the arrangements described and the actual business operations, circumstances and environment of the taxpayer and the customers it deals with.

The taxpayer derives most of its income from the fees it charges for the provision of its services provided. Thousands of transactions are conducted each year and these funds are derived by the taxpayer outright. The small market rate of interest which is retained or the amount otherwise retained from customers' commitments deposited as cash funds presently exercised entirely at the option of customers, would not appear to be a major motivation to the taxpayer but rather arises from prudential and financial security needs.

Having regard to the above factual circumstances, it is considered reasonable and appropriate to respond to the holistic fact pattern and unique circumstances of the arrangements described, together with their fundamental prudential motivation and genesis. Accordingly, it is reasonable to conclude that the arrangements described are not 'to raise finance'.

Rather, what we have here is a suite of measures put in place to effectively manage a holistic arrangement and the financial risk of customers defaulting on either end of a transaction. Basically, it is a security arrangement to ensure the economic and financial position and responsibilities of the taxpayer and customers in the event of such a default. The risk falls on the taxpayer to meet the credit shortfall and it manages this by spreading the risk via a strategy that includes a combination of investments of cash funds held on deposit, together with other securities and third party insurance. Critically, there is no obligation on customers to deposit funds in cash. The form of commitment required is optionally exercised by the customer and includes letters of credit from a bank which is acceptable to the taxpayer's prudential requirements.

A fee is paid to customers in respect of the commitment they make in relation to the Guarantee/Assurance Fund. Specifically this is the defaulting customer's commitment and customers' commitments respectively of this fund. Where the commitment is satisfied by an amount of cash deposited by a customer, an additional amount is returned to the customer which is based on a market rate of interest. The total average return is calculated each month. The taxpayer pays the earnings rate less the spread.

The commitment funds are not used for any capital fund raising, as the taxpayer has significant and substantial funds held in cash reserves together with large sums presently allocated to the Guarantee/Assurance Fund.

Accordingly, the obtaining of commitments by cash or letters of credit does not fall within the definition of financing arrangement for the purposes of section 974-130 of the ITAA 1997.