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JOINT SUBMISSION TO THE
REVIEW OF BUSINESS TAXATION
Concerning the Taxation of Financial Liabilities
AUSTRALIAN GOLD COUNCIL
MINERALS COUNCIL OF AUSTRALIA
Index1. Executive Summary
2.1 Previous consultation on the taxing of financial arrangements
3. Foreign Exchange Gains and Losses
4. Commodity Derivatives
4.1 The importance of hedging to the gold industry
5. Commodity Loans and Commodity Based Loans
6. Controlled Foreign Company Rules
7. Deemed Source Rules
8. Other Compliance Matters and Timing of Introduction
A. Executive Summary of the Minerals Council of Australias June 1997 Submission
on the ATO/Treasury Issues Paper
B. Letter to the ATO from the International Banks and Securities Association of Australia, 22 May 1998
1. EXECUTIVE SUMMARY
The minerals industry acknowledges that there may be sound taxation principles supporting the general approach proposed for the taxation of financial arrangements (TOFA) which others accept.
The industry does not agree that these general principles can be applied to the hedging of mineral commodities. In particular, the impact of the TOFA rules - and particularly the substantiation requirements - on the mineral commodity sector should not interfere with the commercial hedging practices of mineral producers.
There are sound reasons why mineral commodity transactions are different. These have been subject to ongoing discussions with government and further negotiation is required to arrive at an outcome that does not adversely affect the normal commercial use of these instruments by the industry. The option of exempting commodity derivatives from the TOFA proposals is proposed if a satisfactory approach cannot be agreed.
Large resource projects require significant amounts of long-term capital which must be raised in public markets, often overseas. The outputs from such projects are commodities which are priced and sold in world markets, generally in foreign currencies. The cash flows inherent in resource projects are large and irregular and require careful cash management. For these reasons, the economic viability of such projects depends upon financial arrangements which minimise risks associated with movement in currencies, interest rates and commodity prices. Resource companies are not traders or dealers in financial risk instruments. They use such instruments only to manage the primary risks presented by their businesses.
Australian gold producers have become world leaders in the use of financial instruments to develop and grow their mining businesses. They have very successfully hedged their future gold production and achieved gold sales revenue far in excess of the spot price in recent years. Many gold projects would not be able to be financed and therefore not proceed but for the ability to hedge future production by way of hedging instruments.
In this context we welcome the Review position that a principle to be applied in developing rules for taxing financial assets and liabilities is that normal commercial practices in the minerals sector and particularly in the gold industry - will not be adversely affected.
Considerable flexibility is necessary to satisfactorily hedge expected mineral production because of the particular characteristics and circumstances of mineral commodity producers, especially in the gold sector:
This joint submission makes the following points in respect of the following issues:
Clarification is also sought on whether the proposed rules relating to financial arrangements are to be extended to the taxation of controlled foreign companies.
Clearly, sufficient time would need to be available for mineral producers to adapt to any new set of rules relating to the taxation of financial arrangements. Equally clearly, it will be important to ensure adequate consultation with interested parties is provided for in the development of policy and associated legislation.
Representatives of both the Australian Gold Council and the Minerals Council of Australia would welcome the opportunity to discuss this submission and other relevant aspects of the Review of Business Taxations policy development and legislative drafting approaches concerning the taxation of financial arrangements as they impact on the minerals sector.
This submission by the Australian Gold Council and the Minerals Council of Australia focuses on the taxation of financial liabilities. Both organisations are providing separate submissions on other aspects of the Second Discussion Paper, A Platform for Consultation, released by the Review of Business Taxation.
2.1 Previous Consultation on the Taxing of Financial Arrangements
In 1996, the Australian Taxation Office and the Federal Treasury issued Taxation of Financial Arrangements: An Issues Paper for public comment. The Minerals Council provided a number of submissions to the ATO/Treasury on that Paper and met with officials on a number of occasions to discuss the concerns of the minerals sector. The policy options presented in the Reviews Discussion Paper take into account the outcomes of the consultative process on the proposals outlined in the Issues Paper.
It is helpful to start by summarising the minerals industry submissions made on the Issues Paper and then to determine what matters are still at issue. The Minerals Councils key concerns were as follows (a copy of the executive summary of the first submission is provided in Attachment A):
3 FOREIGN EXCHANGE GAINS AND LOSSES
The Review acknowledges the inappropriateness of taxing unrealised gains on loans denominated in a foreign currency. It accepts the argument that such gains do not accrue over time but result from movements in the price of currencies that are inherently unpredictable.
Therefore, any new rules regarding the taxation of financial assets and liabilities will not require the accruing of unrealised gains and losses on foreign currency denominated instruments unless a taxpayer elects a mark to market regime which minerals companies would generally not do.
A matter of concern in relation to foreign exchange gains and losses relates to the discussion of the concept of realisation of such gains and losses and the hedging proposals which seek to deal with any unfairness resulting from changes in this concept. The current law allows foreign currency denominated instruments to be rolled over without there being a realisation for tax purposes. The Review suggests that a taxing point should occur at the rollover point (subject to relief under hedging rules).
Such a proposition contradicts the earlier statement in the Review that foreign exchange gains and losses and other unpredictable gains and losses should not be taxed on an accruals basis.
A taxpayer can only be said to have made a gain or a loss once a foreign currency denominated transaction is completed. The point at which the relevant instrument is rolled over will generally not represent the completion of the relevant transaction. Though in legal terms, the taxpayer has a choice as to whether to realise any gain or loss at the point of rollover, the commercial reason for the transaction needs to be examined to determine whether there is any commercial choice as to whether to rollover or not.
For instance, to take the example mentioned in paragraph 6.58 of A Platform for Consultation (PFC), the taxpayer may use a rolling foreign exchange hedge to reduce the currency exposure of an overseas shareholding. At the point of each rollover, the taxpayer has a legal choice as to whether to continue with the hedge or realise any gain or loss. However, from a commercial point of view, the taxpayer will need to leave the hedge in place to achieve the commercial objective of matching the exposure under the overseas shareholding. Therefore, it would be incorrect to describe each rollover point as a point of realisation calling for taxation consequences. The current concept of realisation as established by case law more accurately pinpoints the time of realisation as it focuses on the point at which foreign exchange gains or losses come home to the taxpayer.
This case law recognises that any fluctuations in the value of the currency that have occurred since the instrument was first taken out could easily be reversed and in no sense could there be said to be any gain or loss that has accrued or come home to the taxpayer at the point of rollover.
A consequence of a general rule treating rollovers as realisations is that hedging rules are then necessary to defer the taxing point beyond a rollover. The PFC notes that such rules would be complex and would carry a significant compliance burden because of the need to document in advance what transaction has been hedged. This complexity can be avoided if the current concept of realisation is left alone.
4 COMMODITY DERIVATIVES
In its submission on the Issues Paper, the Minerals Council argued that it was inappropriate for commodity derivatives to be included as financial instruments when used by mineral producers. Technically, they represent contracts of sale of trading stock rather than financial instruments in the conventional sense. Mineral producers use these contracts to protect their revenue base and thus help to sustain a viable operating business.
The PFC does not address the specific need to include commodity derivatives in any regime for the taxation of financial arrangements but seems to have assumed that such derivatives would be regarded as financial instruments under any such regime. If they are to be included, it is imperative that mineral producers are not restricted in their commercial hedging activities. The importance of these activities cannot be overstated.
For example, gold producers generally maintain a portfolio of gold derivatives to hedge the future value of their gold production. Such hedging is an integral part of the financing of gold projects as the derivatives allow future revenue from the project to be predicted. Hedging has allowed many gold mines of modest grade to be developed. In the absence of hedging instruments, such deposits would be very sensitive to declines in the value of gold and would not find finance and support from equity investors.
Gold derivatives are generally rolled on a regular basis. Therefore, hedging instruments are maturing on a very regular basis and replaced with further hedging instruments. It would be highly damaging to the viability of projects if unrealised gains on such instruments were subject to tax each time they were rolled over. In any event unrealised gains reflecting the difference between the price obtainable under the gold derivative and the spot price cannot be isolated from the business of the gold producer. If the spot price of gold declines and so hedging instruments become valuable, no real gain is made by the gold producer, and it is essential that only the net hedged proceeds are brought to tax. Fluctuations in the spot price of gold do not affect the financial position of the gold producer at all in relation to gold production that has been hedged.
Commodity derivatives fluctuate in value in an unpredictable way, as is the case of foreign currency denominated instruments. For this reason the PFC notes that it would be inappropriate to bring unrealised gains and losses under such instruments to account at balance date. Therefore the question at issue is what should be the point of realisation for tax purposes for hedging derivatives. As noted above in relation to foreign exchange gains and losses, the PFC suggests that realisation for tax purposes should occur upon rollover.
It is submitted that, as in the case of foreign currency denominated instruments, the need for hedging rules can be avoided by retaining the current concept of realisation. This concept works appropriately and as far as we are aware, there is no evidence of the concept being abused by taxpayers.
4.1 The Importance of Hedging to the Gold Industry
The importance of hedging to the gold industry was illustrated at the meeting held between Federal Treasury and Australian Taxation Office officials and representatives of the minerals industry in Melbourne on 3 April 1998. At that meeting, a presentation was given from figures prepared by J B Were & Son that indicated that the $380 million in profits that the major gold producers made in the 1997 financial year would have been a very significant loss had those producers sold their gold production in the spot market and not under their hedging instruments.
Hedging instruments are also important in establishing good quality cash flows to potential lenders and investors in the gold industry. The gold industry is categorised by relatively short mine lives of perhaps around five to ten years. These mine lives are often extended by on-going exploration activity. The majority of minerals sector exploration expenditure is in the gold sector.
If gold producers are to raise sufficient money to build a gold project, they must show adequate security to potential lenders and investors. This is achieved by establishing levels of future production and a guaranteed level of revenue from that future production by the use of hedging instruments. Many projects would not be able to be financed and therefore not proceed but for the ability to hedge future production by way of hedging instruments.
The gold industry has undergone significant growth in the last 10 years and this growth can in large part be attributed to the ability of Australian gold producers to use hedging instruments and use them in an innovative way. Australian gold producers have become world leaders in the use of financial instruments to develop and grow their mining businesses. In order to maintain the industry, and the associated leading edge Australian financial services industry,1 gold mining companies will need to maintain and further develop the use of hedging instruments. To do this, they must be given sufficient flexibility to be able to manage their portfolio of hedging instruments efficiently. This is for commercial not tax driven reasons.
In this context we welcome the Review secretariat, ATO and Treasury position that a principle to be applied in developing rules for taxing financial assets and liabilities is that normal commercial practices will not be adversely affected.
4.2 Hedging gains cannot be isolated
It is inappropriate to regard the mark to market value of hedging instruments as "gains" that should be subject to tax. Mines are established and hedging instruments are put in place at a particular time. The forward prices obtainable under those instruments are based on the spot price of the commodity at the time the instruments are taken out. The viability of the mine is based on the forward prices available under those instruments.
If the spot price declines, these hedging instruments may acquire a mark to market value based on the difference between the new spot price and the price obtainable under the instruments. However, as a matter of practice mineral producers will not realise this value as they do not typically buy minerals at spot for delivery under the hedging instruments. Rather, the particular commodity is produced and then sold under the hedging instrument and the mineral producer obtains exactly the revenue on which the viability of the mine was based.
The mine may not have been profitable at the now lower spot price and may have never been opened if the spot price is at that level. This is illustrated by the statistics produced by J B Were & Son referred to above in relation to gold production for the financial year 1997. These statistics show that the gold industry would have made significant losses had the gold production been sold at spot. Therefore to regard the mark to market value of hedging instruments as a "gain" does not reflect the reality for mineral producers.
4.3 The Need for Flexibility
The management of a portfolio of hedging instruments often involves the rollover of those instruments to optimise the price available under the hedging instrument. For instance, gold companies often take out what are known as "spot deferred" contracts that are continuously rolled and are available for delivery of gold at any time. Also, interest rates may be such that short term contracts are more attractive than long term contracts even though such contracts are used to hedge long term production.
One of the underlying fundamentals of gold hedging is the gold lease rate. This is the rate at which central banks and other lenders of gold will make their gold available to support hedging programs. A loan of gold is essential to enable hedge contracts to be provided by bullion dealers. However central banks will typically lend on a short term basis, usually three months. They are prepared to lend on a longer term basis but at rates that are uneconomic for gold producers. Therefore gold loans that support hedging instruments will be rolled over on roughly a three month basis.
The rate charged by the central banks will be determined by market forces and there can be considerable volatility in this interest rate. Because of the long term nature of gold hedging instruments, this borrowing rate can have a significant impact on the economics of hedging. For instance, if gold lease rates rise to a certain level, forward prices might be at a significant discount to the current spot price. In these circumstances, gold producers would generally react by shortening the length of hedging contracts or closing them out.
Though bullion dealers act as intermediaries between gold producers and the central banks, they do not take the risk of fluctuations in the gold lease rate. They pass that risk on to gold producers and therefore gold producers need to be in a position to react to adverse fluctuations in the gold lease rate. Thus there needs to be flexibility to change the term of forward instruments either by extending them or bringing them forward.
Another significant fundamental in the hedging market is the price of gold which affects the credit exposure of gold producers to bullion dealers and vice versa. For instance, if forward prices of the hedging portfolio are significantly above spot prices, gold producers become concerned about the credit exposure to the bullion dealers. Bullion dealers comprise Australian, European, US and Japanese banks. If difficulties arose in any of the banking markets of the world, gold producers may wish to move their hedging positions from certain banks either wholly or in part. This is likely to require a restructure/rollover of the contracts.
The reverse situation occurs if spot prices rise above forward prices in relation to a particular hedging portfolio. The bullion dealers then become concerned that the credit exposure to the gold producer is too high and they may force a change to the profile of the hedging portfolio. They may force the gold producer to close out certain positions or change their duration.
A further issue that can arise in relation to hedging portfolios is merger activity in the gold industry. Where gold producers merge or demerge, hedging portfolios may need to be altered to extend the delivery date of certain instruments or bring forward the delivery date of certain instruments.
In terms of the production of gold producers, there can be many factors that cause future production to change. Exploration success and acquisitions can affect the level of production for which a portfolio is available. For instance, if a gold producer makes a significant acquisition of a gold mine, hedging instruments may be extended to spread the hedging portfolio evenly over the gold assets of the company. Likewise, if the reserves available at an existing mine or mines have been found to be less or more than anticipated, the hedging portfolio may need to be restructured to provide a suitable level of hedging for all the reserves of the company.
Gold mining is characterised by significant changes to available reserves. Many of the major mines currently operating in Australia have gone through various fluctuations in the available reserves. To give a few examples, the Boddington mine in Western Australia opened with a mine life of four or five years. It has been continuing now since 1987 and potential developments may see it continuing for many years yet. Further exploration around the mine has opened up additional reserves and hedging undertaken by the owners of the mine has had to be adjusted to take account of additional reserves that have become available.
The reverse situation can also occur. For example, in the case of one gold mine, there was a significant reduction of the level of reserves thought to be available because the costs of extraction were found to be much higher than first thought. The mine was anticipated to produce 400,000 ounces per year a number of years ago but is now only producing say 100,000 ounces per year. Hedging contracts taken out for the mine obviously needed to be adjusted to be spread over a longer period.
There can be many reasons for these changes in addition to exploration success or failure. Metallurgical problems can arise so that existing treatment facilities cannot effectively extract economic quantities of gold. Weather conditions may hamper extraction and treatment operations. Water is an important requirement of the treatment process. If there is insufficient water during a particular period, production may decline rapidly.
Changes in the gold price also cause changes to expected production. If the gold price declines, the level of reserves that are economically recoverable may decline. Even in times of a stable gold price, mine plans may be revised to extract greater quantities of ore in upgraded treatment facilities to generate economies of scale in the extraction process. Since the Reserve Bank of Australia announced it had sold significant quantities of its gold holdings and given the price fall in gold over the ensuing period, a number of mines have closed or their cut-off grades, have been increased thereby reducing mine life. This will have had some consequences for hedging positions.
Financial conditions while having an effect on production techniques and quantities, can also bring about changes to the profile of a company's hedging portfolio. For instance, if a company is under financial pressure, its lenders may require hedging contracts to be structured in a particular way to guarantee cash flow over a certain period. Lenders may also require a company's production plans to be trimmed so that lower production at a higher margin is available. All these factors can cause hedging instruments to be extended or brought forward to match the requirements of lenders and investors in a gold company.
Also, a company's hedge policy may demand changes in the maturity date of hedging instruments. Hedge policies will often require a certain percentage of anticipated production to be hedged, for instance, 50% of mineable reserves. However, once production becomes available for delivery, the company may choose to deliver 100% of gold production into forward contracts and therefore there will be a constant process of bringing forward the date of maturity of commodity derivatives. Equally, commodity derivatives may be rolled over as mineable reserves continue to be proved up in later years. If the spot price rises above the price obtainable under forward instruments, those instruments may be rolled over to match production in future years.
All of these factors mean that an exact and permanent matching of hedging instruments with anticipated delivery dates of particular mine production is impractical. Companies would be forced to adopt sub-optimal hedging practices.
4.4 The PFC Proposals
As indicated above in relation to foreign exchange gains and losses, the point of rollover cannot reliably be assumed to be a point of realisation for commodity producers. The maturity date of particular hedging instruments has more to do with current interest rates, lending practices of central banks and the view a company takes on future price and interest rate movements than on the anticipated date of future production of the commodity being hedged. Therefore, to treat rollover as a point of realisation would be inappropriate and force commodity producers to alter their hedging practices to avoid any adverse tax consequences and therefore make transactions tax driven.
The PFC discusses the possibility of putting hedging rules in place that will allow the rollover of hedging instruments without tax consequences. However, these rules necessarily assume that a link can be made between particular hedging instruments and particular production and that this link can be maintained. We believe that such a set of rules would impose unreasonable constraints on the management of hedging portfolios by mining companies. Hedging contracts may be taken out as an unallocated pool and allocated once anticipated production becomes more certain in terms of timing and quantity. Even when a link is established between particular hedging instruments and particular expected production, this link may be broken by changes in expected production levels and changes in the financial needs of the company concerned.
Paragraph 6.69 of the PFC lists what would be the requirements of a matching of hedging instruments with particular underlying production. Apart from the matching itself, it indicates that there may need to be restrictions on the maximum length of the nominated term of the hedging instrument. In recent years, some gold hedging programs have become very long term, over 12 years but this is rare.
Such hedging programs have been necessary due to a number of factors. For example, this includes: lower gold prices; altered expected life of mine(s)/cut-off grades; reduced exploration expenditure and other impacts on recoverable reserves; or, in short, to allow companies to continue their operations with the support of their lenders and investors. With long term hedging programs in place that allow secure cashflows to be generated over a long period of time, companies can continue to trade in difficult conditions. However, these various factors noted above necessitate constant monitoring/management of the impact on risk management of the overall hedging position. It can have a significant effect on positive and negative values of contracts which accentuates the impact of restricting the ability to hedge over a long term. This would potentially damage the viability of the gold industry and make long term operations particularly difficult.
4.5 The Definition of Hedging and Hedging by Company Groups
In the Minerals Councils submission in relation to the Issues Paper, it was argued that a broader definition of what constitutes hedging should be considered. In particular, put and call options may be used in combination. It cannot be said that both instruments reduce risk. The put option allows the mineral producer to sell the commodity at a minimum price and the call option is given to the same counter party to pay for the put option. Clearly, both instruments are taken out to manage risk but they need to be seen as a whole in order to reach this conclusion.
The PFC defines hedging in the glossary as a commercial risk management tool whereby a business seeks to use an asset or liability to offset the risk in relation to another asset or liability. This definition needs to be broader to encompass combinations of instruments which, seen as a whole, represent risk management tools.
The Issues Paper did not recognise the practice of using one company in a group to undertake hedging on behalf of several mineral producers in the group. No mention is made of the need for special rules in this regard in the PFC chapter dealing with financial assets and liabilities presumably because the proposal in relation to consolidation would allow matching between any asset or liability within a group. This needs to be clarified.
4.6 A Purpose Test for Commodity Producers
Hedging rules do not need to be complex. A purpose-based test could be established for commodity producers. Provided commodity producers take out financial instruments for the purpose of hedging their future production, rollovers of the instruments should be permitted without tax consequences.
An analogy can be made with the existing tax provisions dealing with controlled foreign companies. These provisions distinguish between taxpayers that deal in commodity contracts for their own sake and producers of the commodity that use such contracts to eliminate or reduce the risk of adverse financial consequences that might result from fluctuations in the price of the commodity. In this context, it was seen as appropriate to apply stricter rules to taxpayers who deal with the contracts for their own sake. This distinction could form the basis of an appropriate hedging rule allowing rollover of financial instruments used for hedging purposes.
The relevant provision is section 317 of the Income Tax Assessment Act 1936 and the definition therein of "tainted commodity investment" which reads as follows:
"tainted commodity investment", in relation to a company, means: (a) either of the following contracts:
(a) either of the following contracts:
(i) a forward contract in respect of a commodity;
(b) a right or option in respect of such a contract;
except where either of the following conditions is satisfied:
(c) both of the following subparagraphs apply:
(i) the company carries on:
(A) a business of producing or processing the commodity; or
(ii) the contract, right or option relates to the carrying on of that business;
(d) both of the following subparagraphs apply in relation to the contract:
(i) the contact was entered into by the company for the sole purpose of eliminating or
reducing the risk of adverse financial consequences that might result for the company,
under another contract, from fluctuations in the price of the commodity;
5 COMMODITY LOANS AND COMMODITY BASED LOANS
In the Minerals Councils submission in relation to the Issues Paper, it was recommended that such loans should not be included in the proposed regime for the taxation of financial arrangements. In the Issues Paper, submissions were invited on the question of whether such loans should be included. However, the issue is not discussed in the PFC.
At paragraph 5.1, it is indicated that financial assets and liabilities include "Australian dollar and foreign currency denominated debt, equity, hybrids and derivatives". A commodity loan or commodity based loan does not appear to come within any of these concepts though clarification is sought in relation to these issues.
6 CONTROLLED FOREIGN COMPANY RULES
The Issues Paper proposed extending the regime for the taxation of financial arrangements to the taxation of controlled foreign companies. The Minerals Councils submission on the Issues Paper argued against this proposal. No comment is made in the PFC on this question. Clarification is sought on whether the proposed rules relating to financial arrangements are to be extended to the taxation of controlled foreign companies.
7 DEEMED SOURCE RULES
The Issues Paper proposed radical changes to the deemed sourcing rules that operate in Australia. No mention is made of these rules in the discussion on the taxation of financial assets and liabilities in the PFC. However, some discussion on these issues is contained in Chapter 33 of the PFC dealing with the allocation of worldwide taxable income between countries. It seems that the source rules discussed in Chapter 33 of the PFC are far less radical than those proposed in the Issues Paper and therefore we will not make a submission on the PFC in this respect at this time.
8 OTHER COMPLIANCE MATTERS AND TIMING OF INTRODUCTION
In the Minerals Councils submission on the Issues Paper, it was indicated that the taxation of financial arrangements should as far as possible use accounting information that is available in relation to financial transactions. The PFC discusses more broadly the adoption of accounting principles in determining taxable income. On this basis, we do not wish to make any further comment.
Clearly, sufficient time would need to be available for mineral producers to adapt to any new set of rules relating to the taxation of financial arrangements. Equally clearly, it will be important to ensure adequate consultation with interested parties is provided for in the development of policy and associated legislation.
EXECUTIVE SUMMARY OF THE MINERALS COUNCIL OF AUSTRALIAS JUNE 1997 SUBMISSION ON THE ATO/TREASURY ISSUES PAPER
The rules proposed in the Issues Paper are clearly inappropriate for resource companies in a number of important respects, which we summarise as follows:
Timing of the introduction: The proposed rules are complicated and will require major systems changes to be prepared and implemented by resource companies and other affected taxpayers. It is imperative that sufficient lead-time be allowed for and that the changes become effective at the commencement of a year of income (including a substituted year), rather than during a year of income. This will avoid the possibility of two regimes applying which would greatly increase compliance costs and create specific difficulties for companies.