Deductibility of losses incurred by a resident from carrying on a business as a trader in futures listed on the futures exchange in the United States of America

Are the losses incurred by a resident taxpayer from carrying on a business as a trader in futures listed on the futures exchange in the United States of America (USA) through a broker or agent located in either Australia or the USA allowable deductions under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. The losses incurred by a resident taxpayer from carrying on a business as a trader in futures listed on the futures exchange in the USA through a broker or agent located in either Australia or the USA are not allowable deductions under section 8-1 of the ITAA 1997 as the losses are foreign losses which are subject to the quarantining rules under section 79D of the Income Tax Assessment Act 1936 (ITAA 1936).

The taxpayer is a resident individual of Australia for income tax purposes.

The taxpayer is carrying on the business of buying and selling futures listed on the futures exchange in the USA.

The taxpayer engaged the service of a futures broker located in either Australia or the USA for the purpose of buying and selling futures listed on the futures exchange in the USA.

The taxpayer opens an account with the futures broker.

The futures broker provides the taxpayer with trading software that enables trades to be executed online.

The taxpayer places the trade or sells the trade on-line. The transaction is routed through the futures broker's server in Australia or the USA to the futures exchange in the USA.

The taxpayer makes all the decisions in buying and selling of futures.

The taxpayer has not sought advice from the futures broker or any other party.

The futures broker has no power to conclude contracts binding the taxpayer without the taxpayer's approval.

The taxpayer incurs losses from the sale of futures.

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income or a provision of the ITAA 1936 or ITAA 1997 prevents the deduction.

Subsection 8-1(2) of the ITAA 1997 provides that some provisions of the ITAA 1936 or the ITAA 1997 prevent or limit deduction of an otherwise deductible amount.

The provisions which prevent or limit an otherwise deductible amount are listed in section 12-5 of the ITAA 1997. Included in this list is section 79D of the ITAA 1936 which deals with limitation on deductions relating to foreign income.

Under section 79D of the ITAA 1936 where a taxpayer incurs foreign income deductions in relation to a class of assessable foreign income, and the amount of these deductions exceeds the amount of foreign assessable income of that class, then the deduction is limited to the amount of income received. The term 'foreign income deduction' has the same meaning as in section 160AFD of the ITAA 1936 (subsection 79D(2) of the ITAA 1936).

Subsection 160AFD(9) of the ITAA 1936 defines 'foreign income deduction' in relation to a class of assessable foreign income to mean, subject to certain exclusions, any deduction allowed or allowable from the assessable income, to the extent that the deduction relates to assessable foreign income of that class of any year of income.

The phrase 'any deduction....allowed or allowable' in subsection 160AFD(9) of the ITAA 1936 refers to any deduction allowable under the ITAA 1936 or the ITAA 1997 - both general (section 8-1 of the ITAA 1997) and specific deductions (section 8-5 of the ITAA 1997).

The term 'assessable foreign income' is defined in subsection 160AFD(9) of the ITAA 1936 to include foreign income that is included in the assessable income of the taxpayer.

Subsection 6AB(1) of the ITAA 1936 provides that a reference to 'foreign income' is a reference to income derived from sources in a foreign country or foreign countries. In determining whether, for the purposes of section 6AB of the ITAA 1936, income has or has not been derived from a source in a foreign country, no legislative rules are provided in section 6AB itself.

Under subsection 160AFD(8) of the ITAA 1936, each of the following kinds of assessable foreign income constitutes a single class: • interest income • modified passive income • offshore banking income, and • all other assessable foreign income.

In determining whether the income received by a taxpayer is foreign sourced, it is necessary to consider not only the income tax laws but also any applicable double tax agreement contained in the International Tax Agreement Act 1953 (Agreements Act).

Section 4 of the Agreements Act incorporates that Act with the ITAA 1936 and ITAA 1997 so that those Acts are read as one. The Agreements Act effectively overrides the ITAA 1936 and ITAA 1997 where there are inconsistent provisions (except for some limited provisions).

Schedule 2 and 2A to the Agreements Act contains the Double Tax Agreement and the Protocol between Australia and the United States of America (the US Convention).

The futures broker located in the USA has no power to conclude contracts binding the taxpayer without the taxpayer's approval and the taxpayer makes all the decisions in buying and selling of futures. The broker is merely acting in the ordinary course of their business as a broker of independent status. In view of this, it is considered that there is no permanent establishment in the USA in accordance with the definition of the term provided under the domestic law or the US Convention and that the tax consequences would be similar to the situation where the taxpayer is trading through a broker located in Australia.

As the term 'source' is not defined in the ITAA 1936 or ITAA 1997 and the US Convention fails to provide assistance in determining the source, reliance is placed on the general common law source rules as they relate to income.

In Nathan v. Federal Commissioner of Taxation (1918) 25 CLR 183 at 189-190, Isaacs J said that the term 'source' meant not a legal concept, but something which a practical man would regard as a real source of income. In FC of T v. Efstathakis 79 ATC 4256; (1979) 9 ATR 867 Bowen CJ stated 'the answer is not to be found in the cases, but in the weighting of the relative importance of the various factors which the cases have shown to be relevant.'

In Cliffs International Inc v. FC of T 85 ATC 4374; (1985) 16 ATR 601 Kennedy J stated, 'there is no simple universal rule which can be applied to identify the source of any particular income. In some cases particular features may be determinative. In others, they may not.'

In Australian Machinery and Investments Company Ltd v. Deputy Commissioner of Taxation (WA) (1946) 180 CLR 9; (1946) 3 AITR 359; (1946) 8 ATD 81, it was held that where shares are situated outside Australia and sold outside Australia, the profit on sale is derived wholly from a source outside Australia.

In the Commissioner of Inland Revenue v. Hang Seng Bank Ltd (1991) 1 AC 306, at pp322-323, Lord Bridge of Harwich stated: ....the question whether the gross profit resulting from a particular transaction arose in or derived from one place or another is always in the last analysis a question of fact depending on the nature of the transaction. It is impossible to lay down precise rules of law by which the answer to that question is to be determined. The broad guiding principle, attested by many authorities, is that one looks to see what the taxpayer has done to earn the profit in question. If he has rendered a service or engaged in an activity such as the manufacture of goods, the profit will have arisen or derived from the place where the service was rendered or the profit making activity carried on. But if the profit was earned by the exploitation of property assets as by letting property, lending money or dealing in commodities or securities by buying and reselling at a profit, the profit will have arisen in or derived from the place where the property was let, the money was lent or the contracts of purchase and sale were effected.

Where, as in this case, the business is one of buying and selling futures, the relevant processes which contribute to the earning of the profit are the making of contracts for the purchase and sale of futures.

In such cases, it may be that more weight should be put on the place of the contract for the purchase and sale. Although the skill and judgement exercised by the taxpayer in the purchase and sale of futures contributed to the profits, they are of minimal weight in determining the source, since the question is not why but where the profits are made (D & W Murray Ltd v. Commissioner of Taxation (WA) (1929) 42 CLR 332).

The purchase and sale of futures normally involve entering into contracts and the contract is formed where the final act regarded as completing the contract occurs (Tallerman and Co Pty Ltd v. Nathan's Merchandise (Vic) Pty Ltd (1957) 98 CLR 93). Thus, where the postal acceptance rule applies, the contract is considered to be made in the place where the acceptance is posted, and in other cases the contract is made at the place where acceptance is communicated to the offeror.

When the process of purchase and sale of futures are examined, weighting needs to be given to the following factors in determining the source of the profits: • the essence of the taxpayer's business. In this case, the essence of the taxpayer's business is regularly entering into contracts for the purchase or sale of futures • activities that actually realise the profit that is, sale of futures • place where the contracts for purchase or sale of futures are concluded that is, contracts are concluded in the USA, and • location of the commodities whose futures are traded that is, USA.

Though the taxpayer makes the decision as to when to purchase or sell the futures, it has minimal weighting in determining the source as the question is where the profits are made. It is the buying and selling of futures undertaken in the USA where the contracts are concluded, that actually realise the profit.

As all the important factors relating to the realisation of the profit take place in the USA, it follows that the source of the profit is from the USA. The income forms part of 'all other assessable foreign income' class under subsection 160AFD(8) of the ITAA 1936.

When the amount of deductions relating to the taxpayer's business in the USA exceeds the amount of foreign assessable income of that class, the deduction is limited, under section 79D of the ITAA 1936, to the amount of income received. Section 160AFD of the ITAA 1936 then picks up those quarantined foreign losses and permits them to be carried forward to be used by way of set off against later year foreign income of that class.

Accordingly, the losses incurred by the taxpayer from carrying on a business as a trader in futures listed on the futures exchange in the USA through a broker or agent located in either Australia or the USA are not allowable deductions under section 8-1 of the ITAA 1997.