The determination of the source of income is a practical, hard matter of fact, having regard to all of the facts and circumstances of a particular case … or so it would seem, until the release of the latest addendum to Taxation Ruling TR 2014/7.
The addendum effectively reinstates (apparently retrospectively) most of the original drafting around the determination of the source of a currency hedging contract for the purpose of applying the foreign income tax offset (FITO) limit in Division 770 (which was previously withdrawn by the Australian Taxation Office (ATO) for reconsideration in June 2015).
Whilst the Ruling deals specifically with the issue of source of currency hedging contracts for the purpose of determining the FITO limit in Division 770, the rules around the determination of source for these purposes are no different to the determination of source for any other purpose.
The ATO considers that the activity which is most important in producing the currency hedging gain is the entering into and conclusion of the contract itself. Therefore, the place where each currency hedging contract is formed is the most important element in determining the source of any resulting gain. In reaching this view, the other relevant factors, such as the decisions as to how to best manage the currency risk, the instructions on the management of that risk and where the taxpayer and its agents actually conduct these business activities are effectively relegated to incidental or ancillary elements to the production of any currency hedging gain that results and are therefore non-determinative.
The Ruling further concludes that a currency hedging contract is considered to be formed (and therefore sourced) where the communication of the acceptance is received. However, what was clear from the consultation process, is that the place where communication of acceptance is received can be different depending on the method of trade (ie phone, email, online platform, etc).
Putting to one side the resulting practical difficulties for superannuation funds and other investment vehicles (and their custodians and hedge managers) in extracting the transaction level data sufficient to confirm place of acceptance, of equal concern are the broader implications of the view expressed in the Ruling. For example, the fact that the ruling is also relevant to managed funds in the context of determining their overall net foreign income position. Also, the potential extension of the principles around the determination of source to other derivative contracts or financial arrangements more broadly.
Adopting a prescriptive view on source which is dependent on one factor, rather than a relative weighting of all relevant factors, inherently results in unintended outcomes and the potential for manipulation. However, given that the effect of the addendum is to essentially reinstate the original drafting of the ruling, we are left to embrace the guidance that we now have and hope that the Commissioner will not seek to broaden its application.