Related payments rule: SPI Futures contracts

Does the notional payment under a written SPI Futures contract in respect of a portfolio of Australian shares held by a taxpayer, give rise to a related payment under section 160APHN of the Income Tax Assessment Act 1936 (ITAA 1936) if the risk exposure of the physical investment portfolio (or any part) is greater than 0.3 at all times?

No. A notional payment made in connection with a SPI Futures contract will not be a related payment under section 160APHN of the ITAA 1936, where there is not a sufficiently close correlation between the physical shares in the portfolio (or any part) and the shares reflected in the SPI.

The taxpayer proposes to write SPI Futures contracts to balance the risk profile of its total investment portfolio which comprises a diverse range of asset classes including Australian shares. The taxpayer will not employ any other risk reduction strategies.

The investment portfolio is outsourced to investment managers, who seek to outperform either the S&P/ASX 200 Accumulation Index or the S&P/ASX 300 Accumulation Index by investing in a subset of the stocks included in the indices. The investment managers do not seek to reflect or replicate the share price index.

The delta of the taxpayer's total investment portfolio, as well as the investment portfolios managed by each manager, will at all times be 0.3 or greater.

There is no part of the taxpayer's physical investment portfolio (even across investment managers) that can be said to closely correspond to the shares reflected in the SPI Futures contract.

Part 3-6 of the Income Tax Assessment Act 1997 (ITAA 1997) contains the imputation provisions. To be eligible for franking benefits under the imputation system, paragraph 207-145(1)(a) of the ITAA 1997 states that the entity receiving the franked distribution must be a 'qualified person' for the purposes of Division 1A of Part IIIAA of the ITAA 1936. Generally, a taxpayer is a qualified person if they have held their ordinary shares at risk for 45 days in a particular period. There is a more stringent test that must be satisfied where a taxpayer makes a related payment.

A related payment is any arrangement whereby the taxpayer or an associate of the taxpayer passes on the benefit of a dividend or distribution to another party. Under subsections 160APHN(2) and (3) of the ITAA 1936, a related payment will be taken to have been made where an amount is calculated by reference to, is equal to or approximates the amount of the dividend or distribution credited or notionally credited (explained below) to a party to the arrangement.

The effect of subsection 160APHN(6) of the ITAA 1936 is that a notional crediting is taken to have occurred where the extent of a person's obligation under an arrangement, such as a futures contract, is determined by a formula which is calculated by reference to the amount of the dividend.

The taxpayer's investment strategy will include the use of SPI Futures contracts to balance the risk profile of its total investment portfolio. Purchasing an SPI Futures contract provides an investor with an exposure to Australia's top 200 companies (a long position). Conversely, the writing of a futures contract has the effect of hedging the taxpayer's long position attributable to the holding of the physical stocks, resulting in an offsetting short position.

The pricing of an SPI Futures contract is based upon the value of the index at a particular time, adjusted downward to reflect a reduction in the index as a result of shares going ex-dividend over the course of the contract. As the consideration received in respect of the sale of the futures contract is influenced by dividends that may be received in respect of the physical portfolio of shares represented on the index, a related payment under paragraph 160APHN(3)(b) of the ITAA 1936 will be taken to have been made if it can be demonstrated that a close correlation exists between the shares comprising the index, and the physical holding. This is supported by paragraph 4.105 of the Explanatory Memorandum to Taxation Laws Amendment Act (No. 2) 1999.

Therefore, the larger the absolute value of a derivative's delta in relation to a share, the greater will be its sensitivity or correlation to any movement in the price of the underlying share. Accordingly, the larger the absolute value of the delta, the closer will be the correlation between the underlying physical shares and the shares represented in the SPI Futures contract.

Having regard to the net delta of the taxpayer's total investment portfolio (as well as the investment portfolios managed by each manager), the extent of the divergence between the shares represented by the index and the physical holding (or any part of it), and all the surrounding circumstances, there is no related payment in respect of the SPI Futures contract. This conclusion is consistent with the Explanatory Memorandum to Taxation Laws Amendment Act (No. 2) 1999, at paragraph 4.104, which suggests that a material diminution in risk amounts to a sufficiently close correlation and when accompanied by the passing of the benefit (as defined in subsection 160APHN(3) of the ITAA 1936) associated with a dividend, would constitute a related payment.

This conclusion is reliant on the exposure being constantly measured.