Functional currency choice: repayment of principal amounts on loans denominated in a non-AUD currency which later becomes the 'applicable functional currency'

Is a repayment of a principal amount, which occurs after the effective date of a functional currency choice, on a loan denominated in the non-AUD currency which later becomes the 'applicable functional currency', an amount that needs to be translated under the two step translation in section 960-85 of Subdivision 960-D of the Income Tax Assessment Act 1997 (ITAA 1997)?

No, a repayment of a principal amount, which occurs after the effective date of a functional currency choice, on a loan denominated in the non-AUD currency which later becomes the 'applicable functional currency', is not an amount that needs to be translated under the two step translation in section 960-85 of Subdivision 960-D of the ITAA 1997.

The taxpayer is the head company of a consolidated group.

The taxpayer has been preparing its financial statements in USD and is intending to make a functional currency choice under Item 1 of subsection 960-60(1) of the ITAA 1997 to use USD, with effect from 1 July 2010.

The taxpayer has not previously chosen to use a non-AUD 'applicable functional currency'.

The taxpayer entered into various loan agreements prior to any functional currency choice under which it assumed various obligations.

Some of these loans agreements were denominated in USD.

Section 960-85 Special rule about translation - events that happened before the current choice took effect Australian resident required to prepare financial reports under section 292 of the Corporations Act 2001 960-85(1 ) If : (a) as the result of a choice (the current choice ) made by you under item 1 of the table in subsection 960-60(1), subsection 960-80(1) requires that an amount be translated to the *applicable functional currency; and (b) the amount is attributable to an event that happened, or a state of affairs that came into existence, at a time (the event time ) before the current choice took effect; the table has effect: Special rule about translation Item In this case ... this is the result ... 1 at the event time, no previous choice made by you under item 1 of the table in subsection 960-60(1) was in effect the amount is to be translated first to Australian currency at the exchange rate applicable at the event time, and then to the *applicable functional currency at the exchange rate applicable when the current choice took effect. ...

Special rule about translation

Item | In this case ... | this is the result ...

1 | at the event time, no previous choice made by you under item 1 of the table in subsection 960-60(1) was in effect | the amount is to be translated first to Australian currency at the exchange rate applicable at the event time, and then to the *applicable functional currency at the exchange rate applicable when the current choice took effect.

Taxation Ruling TR 2007/5 'Income tax: functional currency - when is an amount not in the 'applicable functional currency'?' (TR 2007/5) states at paragraphs 26, 33, 34, 37 and 91 that 26. The two step translation rule in section 960-85 applies only to relevant 'pre-choice' amounts - that is those 'pre-choice' amounts that are directly relevant to determining an entity's tax relevant net amount and so need to be translated into the 'applicable functional currency'. 33. Section 960-85 is concerned with amounts which are 'attributable to an event that happened, or a state of affairs that came into existence in a prior year', (a 'prior year event'), being a year in which the use of the 'applicable functional currency' did not occur. The concept of 'applicable functional currency' in this respect is purely an income tax law one. In the absence of a valid choice under subsection 960-60(1) to use this currency, there is no 'applicable functional currency' and the appropriate currency required to be used for income tax purposes is Australian currency. 34. It is considered that amounts which are 'attributable to' a 'prior year event' in a year in which the use of the 'applicable functional currency' did not apply, are thereby amounts which are not in the 'applicable functional currency'. This is so even where the amounts (or their elements), are denominated in the relevant source in the non-Australian currency that subsequently becomes the 'applicable functional currency'. 37. A requirement for section 960-85 to apply is that an amount is 'attributable to' an event or a 'state of affairs' that predates the time the choice to use the 'applicable functional currency' takes effect. Such an amount will be attributable in this sense where there is a sufficient causal connection between it and the relevant event or 'state of affairs'. 91. The primary purpose of section 960-85 can thus be summarised as one of translating amounts that require conversion from the previous unit of account, being either Australian currency or any previous 'applicable functional currency', to the current 'applicable functional currency' - in a way that recognises any exchange rate fluctuation between the old unit of account and the new one.

TR 2007/5 emphasises that section 960-85 of the ITAA 1997 applies only to an event or state of affairs that took place in a year of income prior to the effective time of a functional currency choice. Therefore, section 960-85 has no application to an event that happens or a state of affairs that comes into existence after a change to (or a change of) functional currency.

Section 960-85 of the ITAA 1997 is essentially targeting relevant amounts in existence, and events that have already happened, at the effective time of a functional currency choice. That is, elements in the calculation of post choice amounts of assessable income and allowable deductions, that are 'attributable to an event that happened, or a state of affairs that came into existence at a time before the current choice took effect', are the amounts that are targeted by section 960-85.

In effect, section 960-85 of the ITAA 1997 takes a 'snapshot' of these amounts at one point in time (the effective time of the functional currency choice) - being the date of transition to the 'applicable functional currency'. These amounts are then translated to the 'applicable functional currency' under the two step translation process. It is important to note that, after this point in time, section 960-85 has no further application - unless there is a subsequent change in the 'applicable functional currency'.

The amounts (elements) subject to translation under section 960-85 of the ITAA 1997 are generally either assets such as borrowing expenses (a prepaid expense for income tax purposes), depreciating assets, CGT assets, trading stock on hand, traditional securities, etcetera, or liabilities such as the amount of principal outstanding on a loan received.

The post functional currency choice repayment of principal amounts, on loans denominated in the non-AUD currency which later becomes the 'applicable functional currency', are all events that occur following the effective time of the functional currency choice. They are all 'post-choice' events and so give rise to post functional currency choice amounts. As such, these repayments of principal are clearly not subject to the two step translation under subsection 960-85(1) of the ITAA 1997.

In any case, the ' post -choice' principal repayments of loans denominated in the non-AUD currency (USD) which later becomes the 'applicable functional currency' - will all be repayments of amounts that are now in the 'applicable functional currency' (of USD). Thus, these repayments of principal cannot be subject to translation under either subsection 960-80(1) of the ITAA 1997 or section 960-85 of the ITAA 1997.

In contrast, the principal loan balance in the non-AUD currency which later becomes the 'applicable functional currency' (USD), and which is outstanding at the effective time of the functional currency choice, is an amount that is not in the 'applicable functional currency'; refer again to paragraphs 33-34 of TR 2007/5. This is also the case if the principal loan balance has been translated to AUD for income tax purposes prior to the effective time of the functional currency choice, that is, pursuant to subsection 960-50(1) of Subdivision 960-C of the ITAA 1997.

Further, the amount of the principal loan balance outstanding at the effective time of the functional currency choice is clearly an amount 'attributable to an event that happened, or a state of affairs that came into existence', prior to the effective time of the functional currency choice - unlike the USD repayments of principal made after this time.

Conclusion

A repayment of a principal amount, which occurs after the effective date of a functional currency choice, on loans denominated in the non-AUD currency which later becomes the 'applicable functional currency', is not an amount that needs to be translated under the two step translation in section 960-85 of Subdivision 960-D of the ITAA 1997.