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Australian tax treatment of derivatives creates bias towards onshore providers

The Australian Taxation Office has released a ruling that may create a tax bias against foreign hedge providers with no operations in Australia.

ATO Ruling

The ruling, released in December 2014, indicates that Australian taxpayers that conclude hedging contracts with offshore parties will suffer potentially severe limitations on the amounts of foreign tax credits they are able to claim (an explanation of how this result arises is set out further below). The reasoning in the ruling that leads to this result is questionable, but it represents the ATO's considered view. Consultation is taking place, but if the view remains unchanged, it may encourage taxpayers with substantial foreign tax exposures to ensure that all hedge contracts are concluded onshore to mitigate this effect. This will create bias among taxpayers, such as Australian fund managers, towards concluding hedging contracts with Australian banks, or with the Australian branches of foreign banks. Hedge booking systems may need to be radically overhauled to meet this demand, and changes need to be made to the relevant legal documentation.

It may also be impacted by the proposed new derivatives clearing rules. The position is worse for offshore providers with no Australian branch, as they may be shut out of part of the market entirely (any hedge clients with significant exposure to foreign taxes).

Banks that provide hedging services to Australian counterparties are potentially affected.

The relevant rules are complex, but the result arises because a taxpayer's ability to claim foreign tax credits is dependent on its net foreign income/foreign loss position being positive. Under the ruling, losses incurred on hedging contracts with offshore parties will be deemed to be foreign losses – even if the trade is a hedge for a purely domestic transaction. Any losses under the hedging contract, although economically offset by gains on the hedged item, will negatively impact the net foreign income/foreign loss position, and thus the ability of the taxpayer to claim credits.