|Submission No. 182||Back to full list of submissions|
|Download in either PDF or RTF format|
FINANCE AND TREASURY ASSOCIATION
A PLATFORM FOR CONSULTATION
Issued February 1999
Prepared by the Finance and Treasury Association
For further information or clarification please contact:
Finance and Treasury Association
The Finance and Treasury Association (FTA) welcomes the opportunity to make comment on "A Platform for Consultation". The FTA was formerly known as the Australian Society of Corporate Treasurers (ASCT).
FTA will only be making comment in respect to Chapters 5, 6 and 7 the Taxation of Financial Arrangements by relaying the experiences and views of treasury and finance practitioners. FTA has actively been involved in consultation with government since The Consultative Document in this area.
FTA acknowledges A Platform for Consultation has outlined some of the proposals and reservations FTA had previously submitted in its submissions to "The Consultative Document" and "An Issues Paper".
FTA endorses A Platform for Consultation for being more receptive to ideas than An Issues Paper was.
The objectives of the FTA are:
Key Policy Issues Relating to Tax Timing
Is there a need for hedging rules?
Debt/equity hybrids and synthetic arrangements
Transitional Arrangement (Chapter 5 page 152)
As rightly highlighted in A Platform for Consultation, the application of new rules could impact unfairly on commercial outcomes and could involve significant compliance costs. Therefore, so corporates can bring all their financial assets and liabilities under the new framework, FTA proposes that a "balancing charge" similar to the recommendation in the Issues Paper be introduced. The Issues Paper indicated a balancing charge period of four (4) years. The FTA believes that four years is reasonable in most cases. However, the FTA recommends that in certain cases the Commissioner be granted discretion to extend the balancing period where a taxpayer is clearly committed to an instrument of a longer period. The FTA notes that there are some financial products in the market, which have a period considerably longer than four years.
There would be minimal (and likely to be no) adverse revenue implications associated with allowing individual taxpayers to make an application to the Commissioner for an extended balancing period where it was adequately shown that the taxpayer was committed to the financial instrument prior to the introduction of the proposed regime.
Key Policy Issues Relating to Tax Timing (Chapter 6, pages 157 - 193)
How would the proposed timing adjustment apply?
FTA stands by the principle that a "timing adjustment" or "benchmark test" should not lead to onerous taxpayer compliance, and acknowledges A Platform for Consultation recognising this at point 6.5. Therefore, the FTA supports the notion that an "exclusion" may be appropriate for less sophisticated taxpayers.
FTA supports the combined reasonableness and benchmark approach (combination tests) proposed in An Issues Paper which allows the tax payer to use the method used in audited financial statements as well as the timing adjustment approach outlined in "A Platform for Consultation". Both these methods are significant and positive steps away from the daily compounding accruals method outlined in The Consultative Document.
A downside of a reasonableness and benchmark approach would be when it is a requirement to individually assess each financial transaction. For those financial arrangements that differ from the benchmark, lets say by more than 10%, be treated differently (yield to maturity approach). This would require a significant amount of resources and be difficult to document and comply. As regularly mentioned in this submission, best practice is for risk to be managed on a portfolio approach.
Consistent with the concept of best practice, the availability of a "safe harbour of 10%" benchmark on a portfolio basis, (rather than on an individual transaction as proposed by the Issues Paper) would result in minimal (if any) adverse implications to the revenue base and would fit comfortably within the framework of balancing tax payers compliance burden.
How would the proposed timing adjustment apply?
FTA supports Option 3: A combination of approaches, for the reasons outlined at 6.55.
Is there a need for hedging rules?
The FTA supports the adoption of hedging rules within a framework for financial arrangements, only if the rules are practical and workable, that is, the rules do not expose corporates to an unreasonable high level of expectations, compliance and "compliance risk" as the regime proposed in An Issues Paper would have. Despite the regime in An Issues Paper having some practical shortcomings, the recommendations in "The Consultative Document" should not be considered.
Previous work in the area of hedging rules has restricted the application of these rules to derivatives and risks associated with foreign currency debt. The FTA requests if hedging rules are to be developed the rules accommodate a wide range of commercial risk management activity.
On the issue of identifying hedges in a portfolio of risks the latest risk management software does have fields for coding of transactions which can be used to identify whether a transaction is hedging a financial or non-financial risk and by what proportion. However, such software packages are generally cost prohibitive and used only by larger corporates and fund managers. The results from FTA, Ernst and Young and ANZ 1996 Corporate Treasury Survey illustrate this. The results of the survey showed:
The notion of inverse correlation as a cornerstone for hedge treatment is well established in accounting standards and on face value is a reasonable approach to be adopted for tax purposes. On the whole, most corporates enter into financial transactions for funding, liquidity and hedging purposes (either pro-active or reactive hedging). The FTA, Ernst and Young and ANZ Corporate Treasury Survey support this.
That is, 92% of non-financial industry treasuries do not rely on actively trading to boost profit. The survey is supported by anecdotal evidence of little or no trading of treasury instruments by non-financial institutions.
The decision not to trade is often encompassed in an organisations Treasury Policy and Procedures Manual, therefore, removing the latitude or motivation to trade or realise transactions to suit a desired tax result.
The problem with the inverse correlation test is the subjectivity of what a high degree of inverse correlation actually constitutes and how is it to be measured? In reality there are many different instruments to hedge risk with. While inverse correlation between the hedging instrument and the underlying risk is a major factor in choosing an appropriate hedge, there are other considerations like liquidity, "spreads" and efficiency.
It is not unusual to hedge a long term fixed rate interest rate exposure with the next 90 day Bank Bill Futures contract or by a Bank Bill Futures strip instead of a 3 year or 10 year Bond Futures contract. As well as interest rate swaps agreement which do have a higher degree of inverse correlation with a long-term fixed interest rate exposure. The corporate values the greater liquidity of the next Bank Bill Futures contract and the greater safeguards of an exchange traded futures market more than the less liquid bond contracts or the "less safe" over the counter derivatives market.
A corporate that has receipts in many different Asian currencies may sacrifice some degree of inverse correlation by not hedging each currency individually, but instead use a more liquid currency or a "cocktail" of liquid currencies as a proxy hedge. The gains associated with higher liquidity and therefore tighter pricing and efficiencies from a portfolio approach are greater than the degree of possible loss from less inverse correlation.
Therefore, before developing hedging rules, what is outlined below would need to be carefully considered.
As a majority of Australian corporates do not enter into trading activities, the motivation to manipulate transactions to take advantage of the hedging rules would not be common. It therefore follows, an inverse correlation test will just burden corporates with a high level compliance and "compliance risk" for no significant revenue gain to the Government.
The same burdens and logistical limitations of an inverse correlation test would also be imposed on corporates if contemporaneous record keeping were required. The FTA recognises the need for documentation and identification, however, what was proposed in An Issues Paper would be unreasonable. That is, to document all hedging transactions to the degree outlined in An Issues Paper. Corporate Treasury Risk Managers would spend a lot of their time documenting rather than pro-actively managing risk. The outcome of this would be treasury functions having to employ more risk managers or expose the corporate to greater risk as the risk manager is now in a position to less pro-actively manage risk.
To provide the probable level of comfort of revenue protection required by the Government, FTA recommends that an auditors report as part of the companys identification program for hedge instruments and as support for the Risk Management Policy. Risk Management Policy is a proprietary issue, therefore hedge tax treatment rules should be flexible enough to respect management decisions.
The ability to automate the identification and details of a hedge would only be in the realm of large corporates. An Issues Paper proposed, that taxpayers would have to document at the time of the transaction is entered into to qualify for hedge treatment. In practice this will be very difficult for most large corporates with a large number of derivatives used for hedging. The FTA would recommend that an identification period of 30 to 60 days be provided to allow an internal treasury sufficient time to identify the hedge. This policy would also be consistent with current internal management reporting practices.
In the case of anticipated transactions, and as mentioned beforehand, corporates do not as a general rule enter into trading activities, the motivation to manipulate transactions to take advantage of the hedging rules is therefore not widespread. For the reasons outlined in great detail above (inverse correlation test and contemporaneous book keeping), what is considered in A Platform for Consultation at 6.69 is not appropriate for corporates.
That is to say by default, corporates would only enter into an anticipated transaction if there were a high degree of probability it will enter into a transaction giving rise to a risk. A better approach would be including in a corporate Risk Management Policy the treatment of anticipated hedge transactions.
As an alternative method to an inverse correlation test and contemporaneous book keeping, FTA proposes that corporates as a part of the regular review of their Treasury Policy Manual outline their risk management philosophy as well as products that can be used and when. As a part of the normal audit process, a signed auditors report would identify the hedges and the corresponding underlying risk as a support for the risk management policy. This will reduce the compliance burden and allow corporates the flexibility of exercising the best practice of managing risk for their organisations needs and at the same time provide the Government with a high degree of comfort.
The existence of a Treasury Policy Manual and appropriate senior level approval and Board reporting is very high. The results of the 1996 Corporate Treasury Survey showed:
For example, the Treasury Risk Management Policy could explicitly enunciate:
In the course of normal business activity where an unusual hedging transaction is required or new hedging techniques or product has been developed, the Treasury Risk Management Policy would be updated between regular reviews.
FTA promotes the adoption of an approved Treasury Policy and Procedures Manual with regular reviews for all corporates.
With the disclosure requirements of AASB1033 Accounting Standard, this will provide additional framework for all corporate treasuries to have a documented detailed risk management policy with the appropriate senior level reporting and approval processes. Auditors in their duty of enforcing standards of disclosure, be also required to examine hedging activities of the corporate were consistent with their Risk Management Policy.
An Issues Paper proposed different tax treatment of the hedge depending on whether the underlying transaction was a financial instrument or not. FTA seeks the hedge approach requiring "the tax treatment of financial arrangements that is a hedge to be determined by reference to the tax treatment of the transaction being hedged" to be extended to include the hedging of non-financial assets.
FTA recommends the continuation of the current law in-respect to non-financial arrangements, where the gain or loss on a hedge not be taxed until the corresponding loss or gain on the underlying position is realised.
Often it is very difficult to achieve good pricing or there is no market for longer dated hedging instruments. This is very often the case in non-Hong Kong, Singapore and Japanese Asian currencies. Therefore, a risk manager has the only option in a number of cases of hedging the foreign exchange risk of a non-financial arrangement out to a maximum 180 days and in many cases only 90 days. In this example, if the risk manager wanted to hedge the risk for two years, it can only achieve this by doing a series of rolling hedges every 90 or 180 days. On the other hand, a risk manager with U.S. dollar exposure on non-financial arrangement can obtain very good pricing past one year and be able to enter into the hedge transaction.
Previous work, in particular An Issues Paper discriminated against organisations that may have exposure in less liquid currencies by exposing them to accelerated tax liabilities. FTA requires taxpayers be treated the same as each other.
In respect to general hedges and breaking down the underlying risk exposure hedged by a general hedge into its non-financial and financial arrangements will be imposing and complex and would result in large compliance requirements on corporates, a majority of who would not be in a position to be able to carry it out. As mentioned above, the ability to run exception reports and special coding is the domain of large corporates.
Alternatively, a reasonable benchmark level should be allowed to approximate the underlying portfolio.
An issue the An Issues Paper did not address was the treatment of option premia i.e.: swaptions, in either hedging of financial or non-financial arrangements, when the option is not exercised. Accruing the option premium is not the answer as there may not always be an underlying risk position to accrue the premia. This would need to be addressed. FTAs recommendation is to treat all option premia on a cash basis.
This would also address the complications that would arise from treating the option premia if the hedge was closed out early.
The negative impact of taxing unrealised gains is no better illustrated than what is proposed in An Issues Paper for foreign currency debt that is not used as a hedge or that has not been hedged. The impact of such a proposal was further compounded by not allowing carry back provisions.
The treatment of foreign currency denominated debt that is not used as a hedge or that has not been hedged will have the effect of making taxable income more volatile and therefore creating associated cash-flow difficulties. The effect of taxing unrealised gains or losses with no carry back provisions is likely to adversely affect the ability to manage franking accounts. Correspondingly, a company exposed to fluctuations in its franking account because of unhedged foreign currency denominated debt may suffer adverse share price fluctuations.
FTA rejects the notion to tax foreign currency denominated debt on a realised basis if it is a natural hedge of a non-financial arrangement. To identify whether or not a foreign currency denominated debt is a hedge or being hedged is in the realm of all corporate treasuries. The proposed position appears inconsistent with the general theme of An Issues Paper. That is, financial instruments should be treated for tax purposes in accordance with their stated and intended "purpose". In denying a taxpayer to differentiate between foreign currency denominated debt for different purposes FTA is concerned that unnecessary inequities will arise for many corporate taxpayers. Accordingly, FTA considers that foreign currency debt, which is used as a natural hedge, should be provided with hedge treatment under the proposed hedging regime.
FTA proposes where a corporate is required to recognise foreign denominated debt on an unrealised basis, carry-back provisions should be available to smooth out fluctuations. FTA notes that such carry back provisions are common in other jurisdictions and involve minimal adverse revenue implications to the revenue authorities.
As noted in An Issues Paper "Financial Institutions usually segment their treasury function into a specialised business unit or units", but this is also quite common within large non-bank groups striving for efficiency and reporting gains. Consequently, two sides of an internal deal could use different accounting methods within non-banks as well.
The safeguards outlined in A Platform for Consultation in Appendix D appear to be more than sufficient and to comply with would not impose the application of a great level of resources. Corporates that use internal deals would be expected to be the same ones who have treasury systems capable of identifying such deals. As a part of the normal audit process, a signed auditors report should be sufficient to identify the internal deals and check to see the deals comply with safeguards.
An Issues Paper did not specifically address the issue of providing hedging regime treatment to a group of companies that centralise and manage their risks within a separate group member (in-house finance company) or within the parent company. Managing the risk of different business units or divisions within one central location so as to obtain efficiency and management gains is quite common. So is managing the risks of corporate group members, for the same reasons. Often a financial risk of one corporate group member can offset the risk of another group member, therefore it is good practice and corporate governance to centralise the collection and management of risks. The centralisation of risks can occur either in an Australian or international context. Also, the in-house finance company in most cases receives only the net positions from the other tax paying entities of the group.
The FTA would recommend that corporate groups identify the internal function by supplying a list of inter-group companies and the company where the group risk is managed. This would be included in the groups Treasury Policy and Procedure and Risk Management Manual.
FTA would like to comment that the International Accounting Standards Committee recently issued accounting standard IAS 39, Financial Instruments: Recognition and Measurement. "A Platform for Consultation" at C.4 and C.5 acknowledges a Joint Working Group has been established to produce an accounting standard on the recognition and measurement of financial instruments and Australia may adopts its recommendations.
FTA outlines below examples of the incompleteness and possible consequences of IAS 39, if it were to be adopted in Australia.
Debt/equity hybrids and synthetic arrangements (Chapter 7, pages 197 - 212)
FTA welcomes symmetrical tax treatment for issuers and investors when an instrument is recategorised.
FTA supports a "blanket approach" only after legal form and a relevant focussed "facts and circumstances" approach fails to categorise a hybrid instrument. It would be fair to say, financial markets would be willing to trade off hybrid issuance "at the margin" for certainty. That is to say, issuers would want certainty when going to the market. Also, investors would want the same level of certainty when considering buying a hybrid instrument.
As mentioned above, The FTA supports a focussed and relevant "fact and circumstance" test and not the one proposed in An Issues Paper. The FTA could not agree with An Issues Papers high weighting to repayment of investment, stipulated return, non-contingent payments, participation in gains and losses, priority of wind up, and ownership and control. The FTA agrees with A Platform for Consultations summary at 7.17.
In arguing against the weightings outlined in An Issues Paper the FTA would like to bring to your attention the following.
While the main factors are generally important in ascertaining the nature of an instrument, in practise, it is highly unlikely that a party will wish to take a debt risk in consideration for a debt return unless the lender has certainty with respect to:
In this respect it is the "other factors" set out in "An Issues Paper" pages 74 80 and A Platform for Consultations 7.16 that are essential in determining debt from equity. That is, such factors as redemption (automatic or at the holders option); security; guarantees; letters of credit; put options; and significant retained earnings are absolutely critical in ascertaining whether an instrument has the character of debt or equity.
The features of security, guarantees, letters of credit etc are in fact the machinery in which the main factors are enforced. FTA is concerned that this fundamental tenant in distinguishing debt from equity is not properly highlighted. It appears inconsistent with established concepts that non-redeemable, cumulative preference shares with fixed dividend rights could be considered to be debt (as suggested in An Issues Paper) unless the instrument is supported by some of the "other factors". Such instruments would, in normal circumstances, carry those risks which are normally attendant to instruments of equity (not, as suggested, by An Issues Paper, as instrument of debt). However, if such an instrument was backed by a letter of credit with a put option which guaranteed an effective yield to the holder the instrument would be more likely to carry the characteristics of debt rather than equity.
In addition, "An Issues Paper" differentiates the treatment of non-redeemable preference shares with fixed dividend rights solely on the basis if they are cumulative or non-cumulative "because the initial investment is expected to be recouped". On a forced wind up of a company, the implications and benefits as to whether the non-redeemable preference shares were cumulative are, more or less, insignificant. So to differentiate the two on such an event (initial investment is expected to be recouped) indicates a high level of subjectivity and uncertainty of weighting the proposed factors.
In light of the above analysis, it is clear that the debt test needs to reconsider the importance of the "other factors" before classifying an instrument as debt for taxation purposes.
Preference shares are primarily used for their flexibility and to improve the balance sheet of a company. An example of improving balance sheet strength was Westpac in 1993 issuing fully franked preference shares for tier 1 capital when its balance sheet suffered from a high exposure to bad debts. In this situation, fixed dividend preference shares highlight the need for such instruments in the market to encourage subscription to capital which may not otherwise have been be available.
An example of flexibility is the use of redeemable preference shares in joint ventures particularly within the mining industry. This allows equity contributors in large-scale projects to agree and assign risk entitlements and reward. Further, when restructuring equity it is much easier to cancel preference shares than ordinary shares.
In respect of the classification of debt and equity it is worth noting the following considerations:
As rightly acknowledged in A Platform for Consultation at 7.25 but dismissed by An Issues Paper legal form is not necessarily irrelevant when categorising hybrid instruments.
Therefore, FTA supports legal form as the starting point for determining debt or equity tax treatment. The instrument then could be recategorised based on a relevant and focussed "facts or circumstances test". The weightings given to each determinant of the "facts and circumstances test" be consistent with the arguments above that highlighted the flaws in "An Issues Paper". If the "facts and circumstances test" still failed to categorise a hybrid instrument, a default or blanket approach would come into play. The "blanket approach" determination would be legislative. The taxpayer could then ask for a determination or ruling is they were still unsatisfied.
The FTA welcomes the proposal in "A Platform for Consultation" at 7.30. That is the after an instrument has been recategorised, the taxation treatment for the holder and the issuer should be symmetrical. "An Issues Paper" rejected symmetrical taxation treatment.