30 September 2011

Indemnity fee on a forward contract

In a matter that came before the Federal Court of Australia in Melbourne, Visy Industries USA (Pty) Limited (Visy USA) v Commissioner of Taxation [2011] FCA 1065, the Court had to consider whether a one-off indemnity payment made by a taxpayer to a related company to mitigate its losses in respect of a series of forward exchange contracts was deductible. Based on the circumstances it was held that the indemnity fee was in fact deductible.

The case related to financial structuring done at the end of the 1990's, when Visy USA which was the holding company of paper, packaging and recycling businesses of the group in the United States, but was itself an Australian holding company, had sought to create a natural hedge for its US assets, when the group finance company (Pratt Finance) borrowed $400 million through the issue of senior unsecured notes. These notes were placed with institutional investors resident in the United States repayable from 15 to 18 years. When entering into the forward exchange contract, Visy USA would agree to deliver Dollars to Pratt Finance on maturity dates between 2015 and 2017 in exchange for Australian Dollars at a fixed rate. This was an alternative to Pratt Finance going into the market and entering into currency swaps. The intra group financial arrangements were effectively trying to create a neutral hedge within the group in respect of their US Dollar/Australian Dollar translation risk. Any loss arising to Visy USA if the Australian Dollar devalued against the US Dollar would be offset by the gain in the value of Visy USA's US Dollar denominated assets. Because of the long term duration of the forward exchange contract, the parties considered that Visy USA would be likely to profit from the contract at some point over its term with minimal cost and risk. That would be the scenario where the value of the Australian Dollar increased against the US Dollar.

In 1999 there was a slump in the value of the Australian Dollar. As such, the company executives sought to get out of the transaction to mitigate any possible future losses in Australia. In order to do so, in April 1999 it entered into a forward agreement between Pratt Investments and Visy USA such that Pratt Investments agreed to indemnify Visy USA against any and all losses arising under the contract with Pratt Finance in consideration for a payment of A$27 million (which is described as an indemnity fee).

The question before the Court was whether Visy USA was entitled to deduct the amount of the indemnity fee from its assessable income in accordance with the Australian Tax legislation. According to the Australian Tax Legislation (which has some similarities to the South African Income Tax Act), the issue was whether the forward exchange contract and the steps taken by Visy USA to mitigate potential loss by entering into the forward agreement (for which it paid the indemnity fee) was a 'profit making undertaking', such that it amounted to a commercial transaction or an adventure in the nature of trade. It being accepted that, the notion of gaining or producing income within the meaning of the section is regarded as being wider than those activities which may be said to earn income.

There was a debate before the Judge whether the forward exchange contract which Visy USA had entered into represented a commercial dealing like you would see in the marketplace where independent third parties are dealing. The Judge said that this was a misconceived debate, as the important statutory question was whether the indemnity fee was incurred in the course of an income producing activity. Thus, did Visy USA enter into the agreement which was capable of producing and which was intended to produce a profit (determined by objective criteria)? The Court indicated that the following objective factors showed a number of mechanics or tools available to Visy USA to realise a profit:

  • Visy USA would profit under the forward exchange contract if the exchange rate of the AUD was higher than the agreed fixed USD rate;
  • Pratt Finance had been assigned an investment grade credit rating of BBB+ by a reputable credit rating agency and was therefore an appropriate counterparty from a commercial perspective; and
  • If Pratt Finance repudiated the contract or failed to take delivery of or pay the USD amounts at maturity, Visy USA would be entitled to compensation from Pratt Finance.

Before leaving this aspect, the Judge noted that there was no suggestion in this case that the transaction was artificial or attracted the operation of Part IV A of the Income Tax Assessment Act 1936 (the Australian equivalent of our Section 80 A).

Interestingly, Visy USA then contended that the forward exchange contract was analogous to a wager. Gains made from wagering in an entirely commercial context would then be on revenue account. The Judge pointed out that the forward exchange contract and the forward agreement had been entered into for commercial purposes and the existence of a profit making intention. This was clearly different to a person engaging in recreational gambling or punting.

Ultimately, the Judge was satisfied that the indemnity fee was deductible on the basis that it had been incurred to decrease the potential loss to Visy USA under the forward exchange contract. As the value of the Australian Dollar was collapsing as a result of the Asian crisis, Visy USA's liability would have grown exponentially. The indemnity fee had been paid to escape from the provisions of the forward exchange contract. However, expenditure incurred for the purpose of reducing or avoiding losses or outgoings is not prevented from being incurred in gaining or producing assessable income, what must be examined is the purpose of the losses or outgoings reduced or avoided (W Nevill and Co Ltd v FCOT (1937) 56 CLR 290 at 307). As such, the indemnity fee had been incurred for the purpose of mitigating a deductible loss that would have been incurred by Visy USA as a result of its profit making undertaking, being the forward exchange contract.

Lastly, on the issue of whether the indemnity fee was a loss or outgoing of a capital nature, the Judge's view was that the forward agreement formed part of a broader commercial transaction which had its origin in the forward exchange contract and needed to be determined in the light of that factual matrix. At para 130, the Judge concludes that:

"It was a one-off, lump sum payment. It was not recurrent. However, the nature of the payment was not dissimilar to a payment for insurance. Yes, the payment secured an enduring benefit in Visy USA and the Pratt Group's accounts (Sun Newspapers at 363) but it did so in the same way that as payment, for example, for business interruption insurance."

Alastair Morphet

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