Foreign income tax offset: foreign exchange gains and losses: whether 'reasonably related to'

Are foreign currency hedging losses (FX losses), arising from transactions entered into to hedge exposure to foreign currency movements from holding international equity investments in foreign currencies, 'reasonably related' for the purposes of paragraph 770-75(4)(b)(ii) of the Income Tax Assessment Act 1997 (ITAA 1997) to foreign currency hedging gains (FX gains) in relation to the same investments?

Yes. These FX losses are reasonably related for the purposes of paragraph 770-75(4)(b)(ii) of the ITAA 1997, to the FX gains.

An Australian resident taxpayer holds a diverse asset portfolio with particular classes of assets, including international equity investments which are held in foreign currencies but are recorded in Australian dollars in the taxpayer's financial statements.

The taxpayer adopts a mark to market accounting system.

In relation to the international equity investments only, the taxpayer entered into foreign currency hedging transactions to hedge its exposure to currency risk in respect of the underlying capital value of these investments through an actively managed currency strategy applicable to those investments.

The taxpayer realises assessable FX gains and incurs FX losses arising from these foreign currency hedging transactions.

No foreign income tax was paid on the FX gains.

The FX gains and FX losses are from a foreign source.

Under section 775-80 of the ITAA 1997, the taxpayer made a choice not to have the short-term forex realisation gains and losses provisions in sections 775-70 and 775-75 of the ITAA 1997 apply.

Section 770-70 of the ITAA 1997 provides that the amount of a foreign income tax offset is the amount of foreign income tax paid that counts towards the offset for that year, subject to the offset limit. Subsection 770-75(2) of the ITAA 1997 provides that the offset limit is the greater of $1000 and an amount calculated as the total amount of Australian income tax payable in the income year less the amount of income tax that would be payable if certain assumptions in subsection 770-75(4) of the ITAA 1997 were made.

For present purposes, subsection 770-75(4) of the ITAA 1997 states: Assume that: (a) your assessable income did not include: (i) so much of any amount included in your assessable income as represents an amount in respect of which you paid *foreign income tax that counts towards the *tax offset for the year; and (ii) any other amounts of *ordinary income or *statutory income from a source other than an *Australian source; and' (b) you were not entitled to any deductions that: (i) ... (ii) are deductions (other than debt deductions) that are reasonably related to amounts covered by paragraph (a) for that year.

From the facts, the FX gains are amounts of ordinary or statutory income from a foreign source under subparagraph 770-75(4)(a)(ii) of the ITAA 1997. Accordingly, the FX gains are 'amounts covered by paragraph (a)' for the purposes of subparagraph 770-75(4)(b)(ii).

In determining under subparagraph 770-75(2)(b)(ii) the amount of tax that would be payable by you for the income year if the assumptions in subsection 770-75(4) were made, paragraph 770-75(4)(b) of the ITAA 1997 requires you to assume that you were not entitled to deductions (other than debt deductions) that are reasonably related to the amounts covered by paragraph 770-75(4)(a) of the ITAA 1997.

In the present case, the issue is whether the FX losses are 'reasonably related to' the FX gains which are, in the present case, amounts covered by subparagraph 770-75(4)(a)(ii) of the ITAA 1997

The legislation does not specify what is meant by a deduction being 'reasonably related to' amounts covered by paragraph 770-75(4)(a) of the ITAA 1997. This term or its elements have been considered judicially.

In Airservices Australia v. Canadian Airlines International Ltd [1999] HCA 62, the High Court considered whether charges were ' reasonably related to' expenses incurred by the Civil Aviation Authority in the provision of services and facilities. McHugh J at 245, expressed the following on the meaning of 'reasonably related': The concept of 'reasonableness' is a category of indeterminate reference. Its application in a given factual situation cannot depend upon a logical formulation. In one sense, the appearance of the word 'reasonable' or a variant in a statutory provision is, as Oliver Wendell Holmes Jr pointed out, nothing more than a direction to the court applying the provision '[to derive] the rule to be applied from daily experience'. The requirement that the charges be reasonably related to the expenses as described above at least requires that there be some rational relationship between the charges and the expenses. But once this rather low threshold is met, the degree of closeness of the relationship which is required in order for the statutory requirement to be satisfied cannot be described in the abstract. It depends on the application, to the circumstances of a particular case, of the fact-value complex that the word 'reasonably' invokes.

The term 'relates to' was discussed in the Federal Court decision of HP Mercantile Pty Ltd v. Commissioner of Taxation (2005) 143 FCR 553; 2005 ATC 4571; (2005) 60 ATR 106, where Hill J (with whom Allsop and Stone JJ agreed) stated that: ... the words 'relates to' are wide words signifying some connection between 2 subject matters. The connection or association signified by the words may be direct or indirect, substantial or real. It must be relevant and usually a remote connection would not suffice. The sufficiency of the connection or association will be a matter for judgment which will depend, among other things, upon the subject matter of the inquiry, the legislative history, and the facts of the case. Put simply, the degree of relationship implied by the necessity to find a relationship will depend upon the context in which the words are found. ...

Consistent with the reasoning above, paragraph 1.145 of the Explanatory Memorandum to the Tax Laws Amendment (2007 Measures No. 4) Bill 2007 that inserted Division 770 into the ITAA 1997 states that whether a deduction reasonably relates to the disregarded income will be a question of fact depending on the circumstances of the taxpayer.

From the above analysis, the phrase 'reasonably related' refers to a relationship that may either be direct or indirect that exists between items, provided that the relationship consists of a real connection.

Whether two items are reasonably related to each other is a question of fact to be determined having regard to the circumstances of the particular case, the nature of the transaction and the legislative context.

Deductions being 'reasonably related to' income indicates that there can also be relationships in existence at the same time between the deductions and other types of income. However, on the wording of subparagraph 770-75(4)(b)(ii) of the ITAA 1997, it is not a matter of determining that to which the FX losses are most reasonably related.

The taxpayer's FX gains and FX losses arise from currency transactions that are entered into as part of its strategy to hedge its exposure to foreign currency fluctuations affecting the underlying value of its international equity investments. A currency hedging transaction by its nature will result in FX gains and FX losses. These are a function of the direction in which the foreign currency moves against the Australian dollar.

The FX losses are reasonably related to the FX gains in this instance by being part of the hedging strategy implemented by the taxpayer in relation to its international equity investments to limit its exposure to FX risks.

Accordingly, for the purposes of subparagraph 770-75(4)(b)(ii) of the ITAA 1997, FX losses that are part of a hedging strategy are reasonably related to FX gains covered by subparagraph 770-75(4)(a)(ii) of the ITAA 1997 that are part of the same hedging strategy.