Foreign exchange losses: loss incurred upon closing forward contract

Can a loss that is incurred by an ADI (authorised deposit-taking institution) upon the close of a foreign currency forward contract entered into in relation to an amount of forecast earnings of a foreign subsidiary, be deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes. A loss incurred by an ADI upon the close of a foreign currency forward contract entered into in relation to an amount of forecast earnings of a foreign subsidiary, can be deductible under section 8-1 of the ITAA 1997.

The taxpayer is an ADI as defined in subsection 995-1 of the ITAA 1997. It holds a 100% interest in a foreign subsidiary from which it regularly receives foreign currency denominated dividend income. The foreign subsidiary in turn holds a 100% interest in Company A, a foreign subsidiary that operates profitably in that foreign country.

The dividend income received by the taxpayer is non-assessable non-exempt (NANE) income under section 23AJ of the Income Tax Assessment Act 1936 .

The taxpayer's hedging strategy provides that foreign currency exposure can be hedged where there is a strong view that the foreign currency is either under or over valued in comparison with the Australian dollar (A$). The taxpayer formed the view that the foreign currency was overvalued and would depreciate against the A$ over the course of the income year.

The taxpayer was required to prepare consolidated financial statements. A depreciating foreign currency would have resulted in lower reported earnings in A$ for the group because of the need to restate the earnings of Company A.

In order to offset this anticipated decline in its A$ reported earnings, the taxpayer entered into a number of foreign currency forward contracts with a third party. The contracts hedged 80% of the remaining forecast earnings of Company A.

All contracts were closed out by the end of the income year.

The taxpayer anticipated making revenue profits from entering into these contracts.

The taxpayer realised revenue gains and losses upon closing out the foreign currency forward contracts. The gains were returned as assessable income.

Section 775-170 of the ITAA 1997 specifically exempts an ADI from the operation of Division 775 of the ITAA 1997. Therefore, the question of whether the foreign exchange losses are deductible is to be determined under section 8-1 of the ITAA 1997.

Section 8-1 of the ITAA 1997 allows a deduction for losses or outgoings to the extent that they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, paragraph 8-1(2)(c) of the ITAA 1997 denies a deduction for a loss or outgoing to the extent that it is incurred in relation to the gaining or producing of NANE income.

Section 8-1 of the ITAA 1997 requires an identification of the income producing activities of the taxpayer with which the hedging loss might be connected. In this case, it is the entry into the forward contracts (themselves capable of yielding assessable income) and the activities that give rise to NANE dividends.

As a general proposition, whether a loss or outgoing is incurred in gaining or producing assessable income will depend upon it being incidental and relevant to the income-producing activity of the taxpayer - see, for example, Ronpibon Tin NL and Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431 ( Ronpibon Tin ).

In Ronpibon Tin, the High Court stated that 'the words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income.' And further: ... to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income.

The question of whether or not a particular loss satisfies the positive limb of section 8-1 of the ITAA 1997 is a question of fact and degree. In Charles Moore & Co (WA) Pty Ltd v. Federal Commissioner of Taxation (1956) 95 CLR 344; (1956) 6 AITR 379; (1956) 11 ATD 147, the High Court explained that in deciding whether or not a loss was incidental and relevant to an income-producing activity it is necessary to look at its 'connection with the operations which more directly gain or produce the assessable income.'

The purpose of entering into the contracts was to hedge the translation of foreign currency denominated revenue where there was a risk of lower reported A$ income. This risk arose from the possibility that the foreign currency would not remain strong in relation to the A$ during the earnings period.

Each forward contract was capable of producing a gain or a loss. The occasion for the loss was the entry into a contract that was expected to produce a gain that would be included in the assessable income of the taxpayer. The entry into the forward contracts themselves is the income producing activity with which the hedging loss finds a direct connection.

Although the entry into the contracts took place against the background of a subsidiary carrying on activities that produce earnings that might eventually be received as NANE income by the taxpayer, they were not entered into in respect of known or expected dividends. They were entered into in respect of a proportion of forecast earnings of Company A and do not bear any real relationship to the dividends ultimately received from those operations.

In these circumstances, the connection that the losses have with the operations that more directly produce the NANE income is too remote to come within paragraph 8-1(2)(c) of the ITAA 1997.

The losses are wholly deductible under section 8-1 of the ITAA 1997.