Derivation of an amount received on the cash settlement of an exercised option

When is an amount received on the cash settlement of an exercised option derived for the purposes of section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

An amount received on the cash settlement of an exercised option is derived for the purposes section 6-5 of the ITAA 1997 when the option is exercised.

The taxpayer, a commodity producer, is exposed to fluctuating prices on the sale of its commodities.

In order to offset the risk of fluctuating prices the taxpayer adopts various hedging strategies designed to ensure its commodity sales revenue, together with any gains or losses on its hedging transactions, is within an acceptable range. These strategies involve the sale and/or the acquisition of commodity options, or the use of commodity option transactions in combination with other derivatives.

As part of this strategy the taxpayer acquired an option which gave the taxpayer the right, but not the obligation, to sell a certain quantity of a particular commodity at a fixed price (the strike price) on the expiry date of the option.

The option was exercised on the expiry date. The contract was cash settled, as intended by the parties and provided for under the contract, with the counterparty agreeing to pay an amount equal to the difference between the strike price and the market price of the commodity on the expiry date. The payment was made 12 days after the expiry date.

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year.

Derivation of income depends on whether a gain has 'come home' to the taxpayer. In Brent v. Federal Commissioner of Taxation (1971) 125 CLR 418 at 427-428; 71 ATC 4195 at 4200; (1971) 2 ATR 563 at 569-570, Gibbs J, in considering the meaning of the word 'derived' said: The word "derived" is not necessarily equivalent in meaning to "earned". "Derive" in its ordinary sense, according to the Oxford English Dictionary, means "to draw, fetch, get, gain, obtain (a thing from a source)". It has become well established that unless the Act makes some specific provision on the point the amount of income derived is to be determined by the application of ordinary business and commercial principles and that the method of accounting to be adopted is that which "is calculated to give a substantially correct reflex of the taxpayer's true income" (Commissioner of Taxes (South Australia) v Executor, Trustee and Agency Company of South Australia Limited (Carden's Case) (1938), 63 CLR 108, at pp 152-4; 1 AITR 416, at pp 441-2).

His Honour then quoted Dixon J, with whom Rich and McTiernan JJ concurred, in Carden's Case : Speaking generally, in the assessment of income the object is to discover what gains have during the period of account come home to the taxpayer in a realised or immediately realisable form.

The option acquired by the taxpayer as part of its hedging strategies is an integral part of its business, designed to protect its revenue in the event of a fall in the price of the commodity it produces for sale. The amount received on cash settling the option represents ordinary income derived by the taxpayer from carrying on its business.

For the purposes of section 6-5 of the ITAA 1997, the amount received on cash settling the option is derived at the time the option is exercised. This is the time when the amount has come home to the taxpayer in a realisable form.