The taxation of financial arrangements under TOFA rules


Background to the TOFA reforms

The TOFA reforms were first announced in the 1992 budget and were later taken up by the Review of Business Taxation. The review’s final report – A Tax System Redesigned (the Ralph report) – made various recommendations about the taxation of financial arrangements.

While some of the recommendations made in the Ralph report were rejected, several of the concepts proposed have been implemented progressively over the years. Stages one and two of these reforms were introduced in 2001 and 2003 respectively.

The recently introduced Division 230 implements stages three and four of the TOFA reforms.

TOFA is intended to reduce the influence of tax considerations on how financial arrangements are structured, emphasising other factors, such as risk, when making financing decisions.

Although TOFA provides a comprehensive and overarching framework to address the economic substance of arrangements, it is not an exclusive code for the taxation of gains and losses from financial arrangements.

Unless otherwise specified, other provisions of the Income Tax Assessment Act 1936 (ITAA 1936) or the Income Tax Assessment Act 1997 (ITAA 1997) still deal with gains or losses from financial arrangements where TOFA does not.

(All legislative references in this guide are to provisions of the ITAA 1997 unless otherwise specified.)

Problems with how tax law applied to financial arrangements before TOFA

Before the TOFA reforms, the income tax law placed too much emphasis on legal form rather than the economic substance in the context of financial arrangements. This resulted in inconsistencies between the tax treatments of different types of transactions that have similar economic substance.
Also, the inflexible, form-based rules did not keep pace with financial innovation, creating opportunities for tax deferral and tax arbitrage.
Income and deductions from financial arrangements were often dealt with on a realisation basis, although some income and deductions from financial arrangements were dealt with on an accruals basis. This meant that the income tax law did not adequately take into account the time value of money or provide for an appropriate allocation of income over time.
Previously, the way tax law applied to financial arrangements resulted in tax-timing and tax-status mismatches between revenue and capital items. Also, the law did not address the tax-timing treatment of emerging hybrid instruments or new structured products, including those with fixed and contingent returns.
The piecemeal approach to amending the law to address a new product or fix a problem resulted in complex law that was a combination of both general and specific provisions.

Click to view more details about the tax treatment of gains and losses, hedging and general information about the TOFA reforms visit the ATO website

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