Foreign exchange (forex) gains and losses: bond maturity

Can the redemption at maturity of a foreign currency denominated bond give rise to a currency exchange gain or loss for the purposes of former Division 3B of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) where the bond is redeemed by paying the redemption amount in the same foreign currency that was received on issue of the bond?

No. The redemption of a foreign currency denominated bond will not give rise to a currency exchange gain or loss for the purposes of Division 3B of Part III of the ITAA 1936 where the bond is redeemed by paying the redemption amount in the same foreign currency that was received on issue of the bond.

The taxpayer raised funds denominated in foreign currency by issuing a foreign currency denominated bond. On the bond's maturity date, it was redeemed by payment in the same foreign currency.

The funds raised were used to strengthen the capital structure of the taxpayer's business.

The bond which effected the foreign currency borrowing was an 'eligible contract' within the meaning of Division 3B of the ITAA 1936.

The bond was issued prior to the taxpayer's applicable commencement date (within the meaning of Division 775 of the Income Tax Assessment Act 1997 (ITAA 1997). It was redeemed after the taxpayer's applicable commencement date.

Under Division 775 of the ITAA 1997, forex realisation event 4 happens when a foreign currency denominated bond is redeemed as the taxpayer ceases to have an obligation to pay foreign currency. However, any forex realisation gain or loss arising as a result of forex realisation event 4 will be disregarded as the obligation arose under an eligible contract (within the meaning of Division 3B of the ITAA 1936) that was entered into before the taxpayer's applicable commencement date and the taxpayer did not make a transitional election under section 775-150 of the ITAA 1997 (subsection 775-165(4) of the ITAA 1997).

Division 3B of the ITAA 1936 was repealed by the New Business Tax System (Taxation of Financial Arrangements) Act (No 1) 2003 . However, it continues to apply to eligible contracts entered into before the taxpayer's applicable commencement date (within the meaning of Division 775 of the ITAA 1997).

Generally speaking, for a gain to be assessable or loss to be deductible under Division 3B of the ITAA 1936 the gain or loss must be: • made or incurred, respectively, under an eligible contract (paragraphs 82V(2)(a) and 82V(2)(b) of the ITAA 1936) • attributable to currency exchange rate fluctuations (subsection 82V(1) of the ITAA 1936, and • of a capital business nature (subsection 82U(1) of the ITAA 1936.

The character of any currency exchange gain or loss that may arise on redemption of the bond is determined by reference to the purpose of the issue ( FC of T v. Hunter Douglas Ltd 83 ATC 4562; (1983) 14 ATR 629 ( Hunter Douglas )). Should any currency exchange gain or loss arise in these circumstances, it would be of a capital nature as the purpose of the issue was to raise funds to strengthen the entity's capital structure ( Commercial and General Acceptance Ltd v. Federal Commissioner of Taxation (1977) 137 CLR 373; 77 ATC 4375; (1977) 7 ATR 716; Hunter Douglas ).

Division 3B of the ITAA 1936 does not set out how a currency exchange gain or loss should be determined. Nor does it specify whether an actual conversion of currencies is required to realise the gain or loss. Accordingly, whether there is a relevant gain or loss that is realised under an eligible contract is generally a matter of fact to be decided in particular circumstances.

The High Court made the following findings in Federal Commissioner of Taxation v. Energy Resources of Australia Limited (1996) 185 CLR 66 at 79; 96 ATC 4536 at 4542; (1996) 33 ATR 52 at 58-59 ( ERA ): Where a taxpayer borrows money on capital account in US dollars and repays the loan in US dollars, it makes no revenue profit or loss from the borrowing even though the exchange rate may be different at each date. Indeed, arguably it makes no profit or loss. If it converts the US dollars that it receives into Australian dollars and then converts Australian dollars into US dollars to repay the loan, it may make a profit or loss on the transaction. But the profit or loss results from the exchange transaction and not from the borrowing.

In considering the application of Division 3B of the ITAA 1936 to the circumstances of that case, the High Court found at CLR 81; ATC 4543; ATR 56: Furthermore, for the reasons we have already given, the taxpayer made no currency gain or loss. The unit of account and the unit of payment under the contract or contracts involved in this case were US dollars. The taxpayer made no gain or loss that was 'attributable to currency exchange rate fluctuations.

While the existence of any realised currency exchange gain or loss, and whether any such gain or loss is realised under an eligible contract are to be decided in particular circumstances, the findings in ERA are relevant to the instant matter.

In particular, the decision in ERA established that the law neither required nor permitted a notional conversion of foreign currency to Australian dollars to calculate a gain or loss for the purposes of the Division where a borrowing and repayment took place on capital account in the same foreign currency.

The foreign currency debt that arose on issuing the bond was discharged on redemption of the bond by a payment in the same foreign currency. The bond was the eligible contract. However, as the unit of account and unit of payment were in the same foreign currency, on redemption the taxpayer did not realise a gain or loss under the eligible contract that was attributable to any currency exchange rate fluctuation. Therefore the taxpayer did not realise a gain or loss under Division 3B of the ITAA 1936 on redemption of the bond.