Foreign Exchange (Forex): Forex realisation loss on repayment of borrowings to acquire non-portfolio dividend

Will any foreign exchange (forex) realisation loss made on the repayment of borrowings used to acquire shares in certain foreign companies, be disregarded under subsection 775-35(2) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes. A forex realisation loss made on the repayment of borrowings used to acquire shares in certain foreign companies will be disregarded under subsection 775-35(2) of the ITAA 1997.

The taxpayer is an Australian resident company. The taxpayer acquired certain foreign companies. These foreign companies 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 partly fund the acquisition of these companies, the taxpayer entered into an agreement to borrow foreign currency. The agreement comprises an obligation to repay amounts borrowed and to pay interest on the borrowings to a financier.

Amounts borrowed by the taxpayer under the agreement (the borrowings) were only used to acquire shares in the foreign companies.

Forex realisation event 4 occurs when the obligation to pay the borrowings is discharged by way of payment.

Under the borrowing agreement, the taxpayer received foreign currency. In return for receipt of this foreign currency, the taxpayer incurred an obligation to repay foreign currency to the financier.

When the taxpayer repays all or part of the borrowings, its obligation to pay foreign currency to the financier will cease to the extent of that repayment.

Since the taxpayer's obligation to repay foreign currency was incurred in return for receiving an amount of foreign currency, forex realisation event 4 (FRE 4) will happen each time the taxpayer repays some or all of the borrowings (paragraph 775-55(1)(a) and subparagraph 775-55(1)(b)(ix) of the ITAA 1997 apply). FRE 4 will happen at the time of each repayment, pursuant to subsection 775-55(2).

Whether a FRE 4 arising on a repayment of some or all of the borrowings, gives rise to a forex realisation gain (under subsection 775-55(3) of the ITAA 1997) or a forex realisation loss (under subsection 775-55(5)), requires a comparison to be made between: (a) the amount the taxpayer repays, translated into Australian currency at the exchange rate applicable at the time of repayment (pursuant to subsection 960-50(6) item 11 of the ITAA 1997),

and (b) the amount of that part of the borrowings repaid, translated into Australian currency at the exchange rate applicable at the time when the foreign currency borrowed was received by the taxpayer (pursuant to section 775-95, subsection 775-55(7) item 8(a) and subsection 960-50(6) item 11 of the ITAA 1997).

Where the amount in paragraph (a) above exceeds the amount in paragraph (b) above, so much of that excess that is attributable to a currency exchange rate effect (as defined in section 775-105 of the ITAA 1997), is a forex realisation loss of the taxpayer (pursuant to subsection 775-55(5) of the ITAA 1997).

A forex realisation loss made by the taxpayer under FRE 4 on a complete or partial repayment of the borrowings will be disregarded under subsection 775-35(2) of the ITAA 1997 to the extent that: • it is made in gaining or producing exempt income or non-assessable non-exempt income (the first limb), and • the obligation to repay the borrowings, or that part of the borrowings, does not give rise to a deduction (the second limb).

The forex realisation loss must satisfy the condition that it is 'made in gaining or producing exempt income or non-assessable non-exempt income' (pursuant to paragraph 775-35(2)(a) of the ITAA 1997). This is the first limb of the test in subsection 775-35(2).

To determine the link or nexus between a forex realisation loss that arises on a complete or partial repayment of the borrowings, and what it is 'made in gaining or producing', the purpose for, or use to which, the taxpayer put those borrowings must be considered (see Fletcher v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613, Kidston Goldmines Ltd v. Federal Commissioner of Taxation (1991) 30 FCR 77; 91 ATC 4538; (1991) 22 ATR 168). This is because the taxpayer only incurred the obligation in relation to which any forex realisation loss arises (the obligation to repay the borrowings) in return for receiving the amount of those borrowings.

The taxpayer used the borrowings to acquire shares in the foreign companies. The shares which the taxpayer acquired, like those considered in Federal Commissioner of Taxation v. Total Holdings (Australia) Pty Ltd 79 ATC 4279; (1979) 9 ATR 885 , are inherently capable of generating income (see in particular Lockhart J at ATC 4282-4284; ATR 890). The taxpayer will only be paid non-portfolio dividends that are non-assessable non-exempt income from its shareholdings in the foreign companies.

Non-portfolio dividends paid to the taxpayer from the foreign companies will be non-assessable non-exempt income of the taxpayer under either: • section 23AI of the ITAA 1936, where the dividend is paid out of profits that have been previously attributed to the taxpayer under Part X of the ITAA 1936, or • section 23AJ of the ITAA 1936 in other cases.

(Note that any dividends paid by the foreign companies will be treated as first paid from profits that have been attributed to the taxpayer, and then from other profits.)

Therefore, the borrowings will be used in gaining or producing non-assessable, non-exempt income of the taxpayer.

John Fairfax & Sons Pty Ltd v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 11 ATD 510; (1959) 7 AITR 346 tells us that an outgoing can be incurred in gaining or producing income despite being an outgoing of a capital nature. A repayment of the borrowings, while itself an obligation of a capital nature, is an outgoing the taxpayer will incur in gaining or producing non-assessable non-exempt income.

Any forex realisation loss arising on a complete or partial repayment of the borrowings will similarly be made by the taxpayer in gaining or producing non-assessable non-exempt income, satisfying the nexus requirement in paragraph 775-35(2)(a) of the ITAA 1997.

A forex loss made in gaining or producing non-assessable non-exempt income must also satisfy the second limb of subsection 775-35(2) of the ITAA 1997, to be disregarded. Paragraph 775-35(2)(b) requires that the obligation, or part of the obligation, (in this case, to repay the borrowings), should not give rise to a deduction.

As the obligation to repay borrowings used to acquire shares in the foreign companies is capital in nature, it will not give rise to a general deduction under section 8-1 of the ITAA 1997 (paragraph 8-1(2)(a) applies).

Nor will a specific statutory deduction arise from the taxpayer's obligation to repay the borrowings. In particular, section 25-90 of the ITAA 1997 will not apply to allow the taxpayer a deduction in relation to its obligation to repay the borrowings, as this obligation is to repay the principal amount of a loan, which is not interest or in the nature of interest as required by paragraph 25-90(c) (see also the definition of debt deduction in paragraph 820-40 (1)(a) of the ITAA 1997).

As the obligation to repay the borrowings does not give rise to a deduction, paragraph 775-35(2)(b) of the ITAA 1997 is satisfied.

As both limbs of subsection 775-35(2) of the ITAA 1997 are satisfied, any forex realisation loss arising when the obligation to repay the borrowings is discharged in full or in part, will therefore be disregarded.