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New Business Tax System (Thin Capitalisation) Bill 2001

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1998-1999-2000-2001

 

THE PARLIAMENT OF THE COMMONWEALTH OF AUSTRALIA

 

 

 

HOUSE OF REPRESENTATIVES

 

 

 

NEW BUSINESS TAX SYSTEM (THIN CAPITALISATION) BILL 2001

 

 

 

 

 

EXPLANATORY MEMORANDUM

 

 

 

 

 

(Circulated by authority of the

Treasurer, the Hon Peter Costello, MP)

 



T able of contents

Glossary                                                                                             1

General outline and financial impact.............................................. 3

Chapter 1      Overview and key concepts of the thin

capitalisation regime.................................................. 7

Chapter 2      Inward investing entities (non-ADI)........................ 31

Chapter 3      Outward investing entities (non-ADI)..................... 69

Chapter 4      Inward investing entities (ADI)................................ 97

Chapter 5      Outward investing entities (ADI)........................... 111

Chapter 6      Resident thin capitalisation groups...................... 125

Chapter 7      Control of entities................................................... 143

Chapter 8      Calculating average values.................................. 169

Chapter 9      Financial statements for Australian permanent establishments      183

Chapter 10   The arm’s length tests for non-ADIs and ADIs... 189

Chapter 11    Regulation impact statement................................ 207

Index                                                                                               223

 



The following abbreviations and acronyms are used throughout this explanatory memorandum.

Abbreviation

Definition

A Platform for Consultation

Review of Business Taxation: A Platform for Consultation

A Tax System Redesigned

Review of Business Taxation: A Tax System Redesigned

AASB

Australian Accounting Standards Board

ADI

authorised deposit-taking institution

ANTS

Government’s Tax Reform Document: Tax Reform: not a new tax, a new tax system

APRA

Australian Prudential Regulation Authority

ATO

Australian Taxation Office

CFC

controlled foreign company

CFT

controlled foreign trust

Commissioner

Commissioner of Taxation

DTA

double tax agreement

ITAA 1936

Income Tax Assessment Act 1936

ITAA 1997

Income Tax Assessment Act 1997

non-ADI

not an authorised deposit-taking institution

OB

offshore banking

OBU

offshore banking unit

OECD

Organisation for Economic Cooperation and Development

Part X

Part X of the ITAA 1936

REPO

reciprocal purchase agreement

TAA 1953

Taxation Administration Act 1953

TC

thin capitalisation

 



Thin capitalisation

This bill inserts Division 820 into the ITAA 1997 which contains the new thin capitalisation regime. It also makes consequential amendments to both the ITAA 1997 and the ITAA 1936 as a result of new Division 820. The measures in this bill will:

·       apply to both foreign entities investing in Australia, and to Australian entities investing overseas;

·       set a limit on the amount of debt that can be used to finance the Australian operations of non-ADIs;

·       set a minimum level for the amount of equity capital that is required to be used to finance the Australian operations of ADIs;

·       require certain non-resident entities carrying on business through permanent establishments in Australia (Australian permanent establishments) to prepare financial statements;

·       repeal the existing thin capitalisation regime;

·       repeal the existing debt creation regime;

·       repeal the existing provisions dealing with the capitalisation of foreign bank branches;

·       amend the existing provisions that deal with the deductibility of interest expenses for outward investors;

·       amend section 389 of the ITAA 1936 to ensure the new thin capitalisation provisions are excluded from the calculation of attributable income;

·       amend the record-keeping provisions of the ITAA 1936 to include records that must be kept for the purposes of the new thin capitalisation regime;

·       amend section 128F of the ITAA 1936 to allow Australian permanent establishments to gain access to the interest withholding tax exemption under that provision; and

·       amend section 128F to replace the definition of the term associates.

Date of effect :  The dates of effect of the measures are as follows:

·       the new thin capitalisation regime will apply from the start of a taxpayer’s first year of income beginning on or after 1 July 2001;

·       Australian permanent establishments will be required to prepare financial statements from the start of their first year of income beginning on or after 1 July 2002;

·       the current thin capitalisation regime, the current debt creation regime, and the current provisions dealing with the capitalisation of foreign bank branches, will be repealed as of 1 July 2001 but will continue to operate for our income year commencing before 1 July 2001;

·       the amendments to the provisions that deal with the deductibility of interest expense for outward investors will take effect from an income year beginning on or after 1 July 2001;

·       the amendment to allow Australian permanent establishments to gain access to section 128F will apply to debentures issued on or after 1 July 2001; and

·       the amendment to section 128F to replace the definition of the term associates will apply from 1 July 2001.

Proposal announced :  This proposal was originally announced in Treasurer’s Press Release No. 74 of 11 November 1999 (in particular, refer to Attachment G of that Press Release). Changes to the proposal were announced in Treasurer’s Press Release No. 38 of 22 May 2001.

Financial impact :  The financial impact of these measures will be a gain to the revenue as outlined in the following table:

2001-2002

2002-2003

2003-2004

2004-2005

$10 million

$395 million

$350 million

$350 million

Compliance cost impact :  A separate regulation impact statement is available for the measures in this bill.

Summary of regulation impact statement

Regulation impact on business

Impact :  The measures contained in this bill are part of the Government’s broad ranging reforms that will give Australia a New Business Tax System. These reforms are based on the recommendations of the Review of Business Taxation that the Government established to consider reforms to Australia’s business tax system.

Any increase in compliance costs will be offset by broader economic benefits from increasing the integrity of the tax system.

Main points :

·       The objective of the thin capitalisation regime is to ensure that multinational entities do not allocate an excessive amount of debt to their Australian operations. This is to prevent multinational entities taking advantage of the differential tax treatment of debt and equity to minimise their Australian tax. More generally, as a measure introduced as part of the New Business Tax System it will also contribute to the fairness and equity of the tax system, by maintaining the integrity of the Australian tax base.

·       The New Business Tax System will provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs and improved savings. The measures in this bill will contribute to that end by improving the integrity of the tax system by preventing multinational taxpayers who are able to shift debt around the world from obtaining an unfair competitive advantage by doing so.

·       Potential compliance, administrative and economic impacts of the measures contained in this bill have been carefully considered by the Review of Business Taxation and the business sector. Substantial consultation with the business sector was undertaken both as part of the Review of Business Taxation and the ongoing development and finalisation of the measures.

·       The measures will contribute significantly to the fairness and integrity of the tax system by reducing the opportunities to avoid tax which arise from complexities and certain anomalies in the current thin capitalisation legislation.

 



C hapter

Overview and key concepts of the thin capitalisation regime

Outline of chapter

1.1         This chapter provides an overview of Division 820, which contains the new thin capitalisation regime. Division 820 limits the allowance of debt deductions arising from debt used to finance the Australian operations of certain multinational investors. It applies to:

·          Australian entities that operate internationally and some of their associates;

·          Australian entities that are foreign controlled; and

·          foreign entities that operate in Australia.

1.2         Division 820 operates when the amount of debt used to finance the Australian operations exceeds specified limits. It disallows a proportion of the finance expenses (such as interest) attributable to the Australian operations of both Australian and foreign multinational investors.

1.3         For non-banks the tests set a maximum debt level. For ADIs, (principally banks), the tests are framed as a minimum requirement for equity capital. The requirement for ADIs is based on prudential regulatory requirements.

1.4         There is a de minimis protection from the effects of the Division for taxpayers whose annual finance expenses do not exceed $250,000.

1.5         The New Business Tax System (Debt and Equity) Bill 2001 contains a definition of a debt interest. This concept forms the basis for measuring debt levels as well as being used to determine what deductions may be disallowed under the thin capitalisation regime. That bill also contains the rules for determining what constitutes an equity interest.

Context of reform

1.6         The new thin capitalisation regime is aimed at improving both the integrity and fairness of the income tax law. It will do that by preventing multinational entities allocating an excessive amount of debt to their Australian operations. The bill implements Recommendations 22.1 to 22.9 and 22.11 (b) and (c) of A Tax System Redesigned.

1.7         The existing thin capitalisation regime is deficient as it:

·       only applies to foreign controlled Australian operations and non-residents deriving Australian assessable income; and

·       only seeks to limit debt borrowed from a foreign controller or from other foreign parties related to the controller, and (in the case of companies) third-party debt guaranteed by a related party.

1.8         As the current regime does not cover all debt of entities, foreign multinationals can choose the level of debt funding of their Australian operations within the constraint of the overall gearing at which markets will permit them to operate globally.

1.9         The current provisions that regulate the deductibility of interest expenses for outward investors are also deficient. These rules rely on tracing the use of borrowed funds. It is relatively easy to circumvent their operation by establishing a use of funds that ensures deductibility. Another problem with the rules is that they apply only on a single entity basis, and it is possible to circumvent them by using interposed entities to separate foreign income from the expenditure.

1.10       The current provisions dealing with the capitalisation of foreign bank branches operate arbitrarily. Further, it is arguable that the definition of interest is not broad enough to capture all finance expenses and the provisions could, because of their nature, give rise to double taxation.

1.11       The new thin capitalisation regime applies to income years beginning on or after 1 July 2001. From that date it replaces the current thin capitalisation regime, the provisions dealing with the capitalisation of foreign bank branches and the debt creation rules. Amendments will also be made to the provisions that govern the deductibility of interest expenses for entities with offshore investments.

1.12       The bill will also amend section 128F of the ITAA 1936 to allow Australian branches of non-residents access to the withholding tax exemption for interest paid on certain types of debentures. This change will:

·       remove the cost of operating special Australian subsidiaries currently used to gain access to the exemption;

·       provide branches with direct access to section 128F funding; and

·       remove the need for ongoing special rules to avoid the double application of the thin capitalisation rules where funds raised under section 128F are on-lent by a subsidiary to a branch.

1.13       Chapter 4 contains a detailed explanation of the section 128F amendment.

Summary of new law

1.14       The new thin capitalisation regime represents 2 significant changes from the old regime:

·       it expands the application of the measures to include the Australian operations of both inbound and outbound investors; and

·       it limits the deductions relating to the total debt of the Australian operations of those investors, rather than the foreign debt only.

1.15       The following summarises key features of Division 820.

To whom will this Division apply?

The Division applies to:

·       Australian entities that are foreign controlled and foreign entities that either invest directly into Australia or operate a business at or through an Australian permanent establishment (inward investing entities); and

·       Australian entities that control foreign entities or operate a business at or through overseas permanent establishments and associate entities (outward investing entities).

All types of entities (companies, trusts, partnerships and individuals) are covered.

A de minimis rule prevents the Division from denying deductions for entities that, together with associate entities, claim no more than $250,000 in debt deductions in a year of income.

What will this Division do?

For non-ADIs, debt deductions will be reduced where the amount of debt used to fund an entity’s Australian operations exceeds the maximum amount of debt specified by the Division.

For ADIs, debt deductions will be reduced where the equity capital used to fund the Australian operations is less than the minimum equity requirement specified by the Division.

What debt is relevant for thin capitalisation purposes?

Debt interests are defined broadly to include all financial arrangements from which an entity receives funds and because of which it has a non-contingent obligation to repay. Examples of debt are a loan, a bill of exchange and a promissory note.

What are debt deductions?

Debt deductions include any costs that are incurred directly in connection with such debt. Examples include interest payments, discounts, fees and the loss in respect of a repurchase agreement. Some costs are explicitly excluded.

What is equity capital?

Equity capital is the total amount of the entity’s owners’ funds and includes capital contributions, retained earnings and reserves.

What is the maximum amount of debt for a non-ADI?

The maximum amount of debt that may be used to fund an entity’s Australian operations depends upon whether the entity concerned is a financial entity, and whether the entity is an inward or outward investing entity.

The debt funding of entities that are not financial entities may be up to three-quarters of the value of their Australian assets. The same limit applies to the non-lending business of an entity that is a financial entity, although it can use a higher amount of debt to fund its lending business.

All non-ADIs are able to have a higher debt amount where they can demonstrate that their debt level is justifiable under an arm’s length test.

What is the minimum amount of equity capital for an ADI?

The minimum amount of equity capital required for the Australian operations of an ADI depends on whether it is an inward or outward investing entity.

An inward investing ADI is required to have capital equal to 4% of its Australian risk-weighted assets.

An outward investing ADI is subject to the same minimum requirement, but must also have capital to match certain other Australian assets.



All ADI entities are able to have a lower capital amount where they can demonstrate that their capital level is justifiable under an arm’s length test.

How do the rules apply to groups?

The thin capitalisation rules apply where Australian entities choose to form a resident group. Australian branches of foreign banks may also be members of a group.

They apply as if the group had been one company for that income year.

The rules that apply to that group are determined by the characteristics of the entities which make up the group at the end of the income year.

When do the rules apply?

From the beginning of an income year of the taxpayer that starts on or after 1 July 2001. However, in the first year of operation, the taxpayer only has to meet the tests at the end of the income year.

What financial statements have to be prepared by Australian permanent establishments of foreign entities?

A permanent establishment of a foreign entity must prepare a balance sheet and a profit and loss statement in accordance with Australian accounting standards. However, this requirement will only apply to income years that begin on or after 1 July 2002.

Comparison of key features of new law and current law

New law

Current law

Thin capitalisation rules will apply to foreign entities investing in Australia and foreign controlled Australian entities, as well as to Australian multinational enterprises with controlled foreign investments.

Thin capitalisation only applies to foreign controlled Australian entities and foreign investors deriving Australian assessable income.

A de minimis rule will protect entities from the effects of the new regime if, together with associate entities, they claim $250,000 or less in debt deductions in a year of income.

No such de minimis rule applies.

The new regime will apply to all debt, including related-party debt, third party debt, and both foreign and domestic debt.

The current regime only applies to foreign related-party debt and (in the case of companies) foreign third-party debt guaranteed by a related foreign party.

Generally, 50% ownership by 5 or fewer entities is required for control. The new measures adopt similar control tests for inward and outward investment.

Current control tests require 15% control of voting power, 15% entitlement to capital or profits, or capacity to gain such control or entitlement.

Outward investing entities (non-ADI) will have their debt deductions reduced if their debt level exceeds a maximum level.

Outward investing entities (ADI) will have their debt deductions reduced if their equity capital is less than a minimum level.

Either a safe harbour, worldwide amount, or an arm’s length test sets the maximum level of debt or the  minimum level of capital respectively.

The debts of an outbound investor are traced to an end use to determine the treatment of the interest expense.

The interest expense can be either denied or quarantined when it is incurred in earning foreign income.

For non-ADI entities, a safe harbour debt to equity ratio of 3:1 will apply to general investors. For financial entities, the 3:1 safe harbour gearing ratio will apply only to the non-lending business, after the application of an on-lending rule. An overall safe harbour gearing ratio of 20:1 applies to the total business of financial entities with some exceptions.

Current safe harbour gearing ratio is 2:1 for general investors. Financial entities are subject to a safe harbour gearing ratio of 6:1.

The 3:1 safe harbour debt amount is calculated as three-quarters of the assets of an entity’s Australian operations.

Currently, the safe harbour debt amount is calculated by multiplying qualifying equity amounts by 2.

For Australian multinational enterprises that control foreign entities, an additional test is available. This test allows an enterprise to gear its Australian operations at up to 120% of the gearing of its worldwide operations. An equivalent test, based on capital ratios, applies to Australian ADIs.

There is no comparable test in the existing rules.

The new regime includes an arm’s length test, to be applied at the entity’s option.

There is a limited arm’s length test dealing only with guaranteed foreign debt in certain circumstances.

The new thin capitalisation regime for ADIs is based on risk-weighted assets and also includes an optional arm’s length test.

There are no specific thin capitalisation rules for ADIs, except for foreign bank branches.

Foreign bank branches have their debt deductions reduced if they do not maintain a minimum level of capital that is based on the amount of their risk-adjusted assets.

Either a safe harbour or an arm’s length calculation sets the minimum capital level.

The interest expense of a foreign bank branch is either reduced by 4% to reflect that a proportion of the branch’s funding is from capital sources, or an amount of capital is allocated to the branch in accordance with the business profits article of the relevant DTA.

The regime will apply to a group as if it were a single entity.

Limited grouping rules are contained in the existing thin capitalisation regime.

Australian permanent establishments of foreign entities will be required to prepare balance sheet and profit/loss statements.

No equivalent.

For thin capitalisation purposes, debt deductions include the cost of debt capital, which incorporates interest and amounts that function as interest. This provides greater clarity and coherence than the current law.

The focus of the current thin capitalisation provisions is on the concept of ‘interest’, whose determination may be influenced more by legal form than economic substance.

Non-resident companies operating in Australia through branches will be able to issue debentures, the interest on which will be exempt from withholding tax under section 128F of the ITAA 1936.

Only Australian resident companies can issue debentures under section 128F of the ITAA 1936.

Detailed explanation of new law

What is thin capitalisation?

1.16       Thin capitalisation is an investment funding issue that arises in the context of international investment. The issue is principally about the extent to which an investment is financed by way of debt funding compared to equity funding. An entity’s debt to equity funding can be expressed as a ratio. For example, a ratio of 3:1 means that for every dollar of equity the entity is funded by $3 of debt. This is also known as gearing. If an investment is funded by excess debt, it is said to be ‘thinly capitalised’ (i.e. not enough equity is used to fund that investment).

1.17       The difference in the income tax treatment of debt compared to equity funding provides an incentive to finance investments using debt rather than equity. While this is not the only consideration, multinational investors have an incentive to allocate a higher proportion of their debt to particular investments and utilise their equity to fund investments outside Australia. It is where this results in a relatively high level of debt funding of the Australian operations that the thin capitalisation regime applies.

What is the legislation about?

1.18       The thin capitalisation rules will limit the amount of debt that can be used to finance Australian operations of certain investors by reducing debt deductions where an entity’s debt to equity ratio exceeds certain limits. Those investors (companies, trusts, partnerships or individuals) that will be subject to the new regime are:

·       foreign entities that carry on business at or through Australian branches;

·       foreign entities with direct investments within Australia (e.g. land and buildings);

·       Australian entities that are foreign controlled;

·       Australian controllers of foreign entities; and

·       Australian entities that carry on business at or through overseas branches.

Some associates of these are also subject to the new regime.

1.19       Whether an entity’s debt funding is excessive or not will be determined by comparing the amount of debt, or equity in the case of ADIs, used to finance the Australian business or investment with the maximum allowable amount of debt, or minimum equity requirement, specified in the legislation.

1.20       The proportion of the entity’s debt deductions that are disallowed is the entity’s excess debt (or capital shortfall) as a proportion of its total debt. The aim of calculating the disallowed deductions in this manner is to achieve the same level of taxable income as would have been the case had the entity’s debt funding been within the prescribed limits.

Non-ADI foreign entities with Australian investments

1.21       There are several ways to determine the maximum debt level. For foreign entities investing in Australia, the maximum amount of debt will be the greater amount determined under:

·       the safe harbour debt test; or

·       the arm’s length debt test.

1.22       Under the safe harbour debt test, the amount of debt used to finance the Australian investments will be treated as being excessive when it is greater than that permitted by the safe harbour gearing limit of 3:1.

1.23       For financial entities, the safe harbour gearing ratio of 3:1 only applies to their non-lending business. An on-lending rule will operate to remove from the calculations any debt that is on-lent to third parties or that is used for similar financing activities. The application of this on-lending rule will be limited by an additional safe harbour gearing ratio of 20:1 which will apply to the financial entity’s total business. There are also special rules that result in higher allowable gearing ratios for financial entities that have assets which are allowed to be fully debt funded.

1.24       The arm’s length debt amount is determined by conducting an analysis of the entity’s activities and funding to determine a notional amount that represents what would reasonably be expected to have been the entity’s maximum debt funding of its Australian business during the period. To do that, it is assumed that the entity’s Australian operations were independent from any other operations that the entity or its associates had during the period, and that they had been financed on arm’s length terms.

Non-ADI Australian entities with foreign investments

1.25       For Australian entities investing offshore, the maximum debt amount will be the greatest amount determined under either:

·       the safe harbour debt test;

·       the arm’s length debt test; or

·       the worldwide gearing debt test.

1.26       The safe harbour limit and the arm’s length test are fundamentally the same as those described for non-ADI foreign entities with Australian investments. They take account, however, of the amount and form of investment in the Australian non-ADI’s controlled foreign investments.

1.27       The worldwide gearing debt test will allow an Australian entity with foreign investments to fund its Australian investments with gearing up to 120% of the gearing of the worldwide group that it controls. However, this test is not available if the Australian entity is itself controlled by foreign entities.

Foreign ADI entities with Australian permanent establishments

1.28       A separate regime applies to foreign ADIs that carry on business at or through Australian permanent establishments (i.e. foreign bank branches). That regime operates to ensure that these entities maintain a minimum amount of equity capital within their Australian operations. If this minimum amount is not maintained, debt deductions may be disallowed.

1.29       The minimum amount of equity capital for foreign ADIs is the lesser of:

·       the safe harbour capital amount; and

·       the arm’s length capital amount.

1.30       The safe harbour capital amount is 4% of the risk-weighted assets of the Australian banking business.

1.31       The arm’s length capital amount is determined in a similar but not identical manner to the arm’s length debt amount for non-ADIs. In this case, the analysis results in a notional amount that represents what would reasonably be expected to have been the entity’s minimum capital funding of its Australian business throughout the year.

Australian ADI entities with foreign investments

1.32       Australian ADI entities that control foreign investments are also subject to a regime that operates to ensure that these entities maintain a minimum amount of equity capital within their Australian operations. If this minimum amount is not maintained, then debt deductions may be disallowed.

1.33       The minimum amount of equity capital, for outward investing ADIs is the least of:

·       the safe harbour capital amount;

·       the arm’s length capital amount; and

·       the worldwide capital amount.

1.34       The principal component of the safe harbour capital amount is 4% of the risk-weighted assets of the Australian banking business.

1.35       The arm’s length capital amount analysis results in a notional amount that represents what would reasonably be expected to have been the bank’s minimum capital funding of its Australian business throughout the year.

1.36       The worldwide capital amount will allow an Australian ADI with foreign investments to fund its Australian investments with a minimum capital ratio equal to 80% of the Tier 1 capital ratio of its worldwide group.

1.37       Rules are not required for an Australian bank (or bank group) that does not have any foreign operations. A purely Australian group does not have the opportunity to shift debt between jurisdictions and is thereby prevented from debt loading their Australian operations. Even where the bank is foreign controlled, the prudential rules set by APRA require capital levels that are considered to be adequate for tax purposes.

What are the key elements of thin capitalisation?

1.38       There are 4 key elements that will guide an entity in determining whether the thin capitalisation rules apply and, if so, which particular rules. These elements are:

·       the de minimis rule;

·       whether the entity is an Australian or foreign multinational;

·       whether the entity is an ADI or a non-ADI; and

·       whether it is a general entity or a financial entity.

Application of the rules on a group basis is also permitted.

De minimis rule

1.39       The thin capitalisation de minimis rule is intended to remove the need for certain entities to comply the thin capitalisation regime. All entities (regardless of their nature or business) that either alone or together with associate entities, claim no more than $250,000 in debt deductions per income year, will not be subject to the new regime. [Schedule 1, item 1, section 820-35]

The entities

1.40       Subject to the de minimis exception, Australian entities that are either foreign controlled or are themselves controllers of foreign entities, their associate entities and foreign entities with operations or investments in Australia will be subject to the new thin capitalisation regime.

1.41       Entities will be classified as being either inward investing entities or outward investing entities. An inward investing entity is a foreign controlled Australian resident entity, and any foreign entity that carries on business at or through an Australian permanent establishment, or has direct investments within Australia.

1.42       An outward investing entity is an Australian resident entity that controls any foreign entity or carries on business at or through an overseas permanent establishment, and an Australian associate entity of another outward investor.

1.43       If an entity is neither an inward investing entity nor an outward investing entity, it will not be subject to the new thin capitalisation regime. If an entity is both an inward and an outward investing entity (e.g. a foreign controlled Australian resident entity that itself controls a foreign entity), the outward investing entity rules take precedence and will apply.

1.44       Comprehensive control rules, based on the control rules in the CFC provisions of the ITAA 1936, determine whether an Australian entity is an outward investor. Broadly, that will be the case where the entity is an Australian controller or an Australian associate entity of an Australian controller. The same rules will determine whether an Australian entity is foreign controlled.

ADI or non-ADI

1.45       Once it has been determined that an entity is either an inward investing entity or an outward investing entity, and therefore subject to the thin capitalisation regime, it is then necessary to know if that entity is an ADI. An ADI entity will be subject to a minimum capital requirement similar to capital requirements imposed by regulatory agencies such as APRA. If an entity is a non-ADI entity, it will be subject to a maximum amount of debt based on a safe harbour gearing ratio, an arm’s length debt amount, or in the case of outward investing entities only, a worldwide gearing debt test.

General investor or financial investor

1.46       A non-ADI entity is further classified as being either a financial entity or a general entity. A general entity is any entity that is neither a financial entity nor an ADI.

1.47       This classification is necessary because special rules apply to financial entities. These rules recognise that financial entities have different requirements for debt funding.

Grouping

1.48       Resident entities can choose to have the thin capitalisation rules apply to them as a group. The group can include, subject to certain conditions, wholly owned resident companies, certain trusts and partnerships and Australian branches of foreign banks.

1.49       Where entities choose to group, the nature of the entities in the group at the end of the income year will determine whether the inward investing entity rules or the outward investing entity rules apply to that group, and whether the group is an ADI or non-ADI.

1.50       The thin capitalisation calculations made in relation to the group are to be based on the information which would have been contained in a set of consolidated accounts prepared for that group.

1.51       If the thin capitalisation rules disallow all or part of a debt deduction of the group, the amount disallowed is apportioned to the individual entities within the group.

What are the key concepts used in the thin capitalisation rules?

What is debt capital?

1.52       The debt capital of an entity is the sum of the amounts outstanding on debt interests issued by the entity that are still on issue. [ Schedule 2, item 26, definition of ‘debt capital’ in sub section 995-1(1)]  

What is a debt interest?

1.53       The meaning of a debt interest is determined generally in accordance with the tests contained in the New Business Tax System (Debt and Equity) Bill 2001. To promote certainty and facilitate the categorisation of new types of financial instruments as debt or equity, the tests provided in that bill may be modified or supplemented by the regulations. [ Schedule 1, item 34 of the New Business Tax System (Debt and Equity) Bill 2001, sub section 974-10(5)]

1.54       Debt interests can take different forms including various types of project finance and, in certain circumstances, trade finance. Discounted securities such as bills of exchange are another form of debt interest.

1.55       A scheme or a number of integrated related schemes gives rise to a debt interest if, when it comes into existence, it satisfies the debt test . [ Schedule 1, item 34 of the New Business Tax System (Debt and Equity) Bill 2001, sub sections 974-15(1) and (2)]

What is the debt test?

1.56       The debt test provides that a debt interest arises under a scheme if:

·       the scheme is a financing arrangement or is one that constitutes a share;

·       an entity or associate receives or will receive financial benefits under the scheme;

·       the entity or a related entity has an effectively non-contingent obligation under the scheme to provide a financial benefit(s) in the future; and

·       it is substantially more likely than not that the value of the benefit to be provided will equal or exceed the value of the benefit received (depending on the term of the scheme, the relevant values may be calculated in nominal value or present value terms ) .

[ Schedule 1, item 34 of the New Business Tax System (Debt and Equity) Bill 2001, sub section 974-20(1)]

What is a debt deduction?

1.57       The thin capitalisation regime disallows all or part of the debt deductions of certain thinly capitalised entities. A debt deduction encompasses the cost incurred in connection with a debt interest that, in the absence of the thin capitalisation provisions, would be deductible. Two broad types of costs are incurred in connection with debt interests:

·       costs for the use of the financial benefit received by the entity under its debt interest arrangement; and

·       costs directly incurred in obtaining or maintaining that benefit.

[Schedule 1, item 1, section 820-40; Schedule 2, item 27, definition of ‘debt deduction’ in subsection 995-1(1)]

1.58       The cost of debt capital may not be explicit in an arrangement. For example, it may be embedded in a payment that does not differentiate between payment for acquisition of a physical asset and payment for not having to pay for that asset when it is delivered. Nevertheless, these costs are debt deductions to the extent that they are otherwise deductible.

1.59       An entity can incur costs directly in connection with debt capital other than interest or other amounts that compensate the provider of debt finance for the time the acquirer of the finance has the use of the funds. For example, there are costs of raising debt finance, such as establishment fees, fees for restructuring a transaction, stamp duty and legal costs of preparing documentation. These sorts of costs are costs of receiving the funds.

1.60       Once the funds have been raised, there may be other costs that the entity has to pay the finance provider that are directly incurred in maintaining the financial benefit received, for example, costs that are to maintain the right to draw down funds. To the extent that these costs can be deducted by the entity they are debt deductions.

1.61       The definition contains a list of costs which are debt deductions under paragraph (1)(a) of the definition. For example, amounts in substitution for interest, discounts in respect of a security and losses in respect of certain securities arrangements are costs incurred in relation to a debt interest and therefore debt deductions [ Schedule 1, item 1, subsection 820-40(2)] . An amount remains a debt deduction notwithstanding that the party to whom the amount is owed, assigns or in any other way deals with the amount [Schedule 1, item 1, paragraph 820-40(2)(f)] .

1.62       In order to avoid doubt, the definition also contains a list of amounts which are not debt deductions. Examples of these amounts include:

·       foreign currency losses associated with hedging a currency risk in respect of a debt interest;

·       foreign currency losses associated with extinguishing a debt interest where the losses are attributable to the outstanding principal; and

·       salary or wages paid to employees of an entity.

[Schedule 1, item 1, subsection 820-40(3)]

1.63       Where a borrowing expense would be fully deductible under section 25-25 of the ITAA 1997, over the term of the loan or 5 years (whichever is the shorter) and it has not been fully deducted by 1 July 2001, then a deduction would have been denied if the entity is thinly capitalised. The definition excludes these expenses to ensure that the rules will not affect the deductibility of borrowing expenses incurred prior to 1 July 2001 and not fully deducted in the year in which they were incurred. [Schedule 1, item 1, p aragraph 820-40(1)(c)]

What is equity for thin capitalisation purposes?

1.64       The term equity is not itself defined in the thin capitalisation rules. Rather, the rules contain a number of terms which define equity for different classes of entities and for different purposes. These terms are:

·       associate entity equity;

·       controlled foreign entity equity;

·       equity capital; and

·       worldwide equity.

What is equity capital and worldwide equity?

1.65       Equity capital, which is mainly relevant for inward and outward investing ADIs, is discussed in Chapters 4 and 5 [Schedule 2, item 29, definition of ‘equity capital’ in subsection 995-1(1)] . Worldwide equity is discussed in detail in the context of the worldwide gearing debt amount in Chapter 3 [Schedule 2, item 72, definition of ‘worldwide equity’ in subsection 995-1(1)] . Both of these are measures of the total equity funds of an entity (e.g. shareholders’ funds in the case of a company).

What is associate entity equity and controlled foreign entity equity?

1.66       The term associate entity equity is defined as the value of the equity interests that an entity holds in its associate entities [Schedule 2, item 11, definition of ‘associate entity equity’ in subsection 995-1(1)] . Controlled foreign entity equity means the value of the equity interests that an entity holds in its Australian controlled foreign entities [Schedule 2, item 23, definition of ‘controlled foreign entity equity’ in subsection 995-1(1)] . These terms are used mainly for inward and outward investing entities that are not ADIs. They are measures of one entity’s equity interest in another entity (e.g. shares in a company).

What are equity interests?

1.67       Broadly speaking, an equity interest is an interest which an entity has in a company, partnership or trust and which has sufficient equity-like features. For example, a share in a company and a beneficiary’s interest in a trust are equity interests. It should be noted that equity interests in a trust or partnership are only relevant for the purposes of the thin capitalisation rules and include:

·       an interest that carries a right to a variable or fixed return where the amount is contingent on the economic performance of the partnership or trust;

·       an interest that carries a right to a variable or fixed return from the trust or partnership if the right or the amount of the return is at the discretion of the entity;

·       an interest that gives its holder a right to be issued with an equity interest in the trust or partnership; and

·       an interest that will or may convert into an equity interest in the trust or partnership.

[Schedule 1, item 1, subsection 820-930(2)]

1.68       The provisions dealing with equity interests in companies are contained in the New Business Tax System (Debt and Equity) Bill 2001. The explanatory memorandum which accompanies that bill discusses equity interests in companies. Similar rules to those that apply to equity interests in a company apply to equity interests in a trust or a partnership for the purposes of the thin capitalisation rules.

1.69       An equity interest in a trust or partnership is determined by reference to Division 974 of the New Business Tax System (Debt and Equity) Bill 2001. Division 974 is modified by Division 820 to enable that definition to apply to trusts and partnerships.

1.70       The concept of equity interest in Division 974 extends the range of interests that are recognised as equity beyond the traditional share or stock. The threshold condition for equity interests other than shares or stock, is that the relevant scheme giving rise to the interest is a financing arrangement. If an interest satisfies both the debt test and the equity test, it is treated as a debt interest.

1.71       The table in subsection 820-930(1) outlines the modifications made to Division 974 to enable concepts used in the debt/equity rules to apply when determining an equity interest in a trust or a partnership being:

·       Subdivision 974-C, which provides the basic test to determine when an interest is an equity interest in a company, is modified. In particular, section 974-75 is replaced by subsections 820-930(2) to (4) to extend the test [Schedule 1, item 1, subsection 820-930(1), item 3 in the table] .

·       References to a company in Subdivisions 974-C will be taken to include a reference to a trust or a partnership. Where a reference is made to an equity interest in a company it will be taken to be an equity interest listed in the table in subsection 820-930(2). However, certain provisions which are inappropriate when applied to a trust or a partnership, such as subsection 974-95(4) and the example following section 974-80, will not apply [Schedule 1, item 1, subsection 820-930(1), items 1 to 6 in the table] .

·       In a similar fashion, Subdivision 974-D is modified to enable concepts in relation to equity interest to apply. Subdivision 974-D contains provisions common to the debt test and the equity test. The Subdivision provides guidance on, among other things, conversion of, and material changes to, debt and equity interests [Schedule 1, item 1, subsection 820-930(1), items 1 and 2 in the table] .

·       Subdivision 974-F, which defines certain concepts such as financing arrangements and non-contingent obligations, will apply in total. In addition, a reference to regulations in Subdivisions 974-C, 974-D and 974-F is taken to be a reference to the regulations made under the provisions applied by subsection 820-930(1) [Schedule 1, item 1, subsection 820-930(1), items 7 and 8 in the table] .

Assets

1.72       Assets are an important element in the application of the new regime. This is because the level of acceptable debt funding determined under the various safe harbours is calculated by reference to the amount of Australian assets. Assets are not specifically defined in the thin capitalisation regime. Rather, the term assets adopts its normal legal meaning. The value of these assets must be determined in accordance with Australian accounting standards.

Average values

1.73       The various tests in the thin capitalisation rules require measurement of amounts of what are generally balance sheet items (e.g. debt and assets). To obtain more reliable results, entities have to use average values of these items during a period (involving a minimum of 2 measurements) rather than simply using a single end of year figure. How frequently items are measured is largely, with some safeguards, left to the entity.

Inter-relationship between thin capitalisation rules and transfer pricing provisions

1.74       Some cases will attract the operation of the thin capitalisation rules and the transfer pricing rules in Division 13 of Part III of the ITAA 1936 and comparable provisions of DTAs.

1.75       A consideration of the scope and purpose of each set of provisions is relevant in determining which provisions are more appropriate to apply in the circumstances of an individual case.

1.76       The thin capitalisation rules collectively make up a comprehensive regime. They are specifically directed at debt deductions which, broadly, relate to interest and other costs of borrowing. These features of the regime show that it is intended to cover the whole subject matter to which the thin capitalisation rules apply.

1.77       The thin capitalisation rules limit the amount of debt deductions by reference to levels of debt and capital of the taxpayer. The formulations for arriving at acceptable levels of debt and capital incorporate, as part of the arm’s length amount calculations, arm’s length principles that would be applied in the application of Division 13 and comparable provisions of DTAs. Accordingly, the same result should eventuate under the different regimes in practice. In these circumstances, the arm’s length tests in the thin capitalisation rules apply. To the extent that the thin capitalisation rules apply to a specific debt deduction, it is appropriate, therefore, to determine under the thin capitalisation rules by how much, if any, the deduction for interest or other borrowing costs should be reduced.

1.78       However, the thin capitalisation rules do not have the same scope as Division 13 and comparable provisions of DTAs - the latter apply to a wider range of transactions. Further, there may be instances where the purpose of the application of the arm’s length principle under Division 13 and comparable provisions of DTAs to a particular case is not the same as for applying the arm’s length test under the thin capitalisation rules. In these cases, the arm’s length principle articulated in Division 13 and comparable provisions of DTAs should apply. For example, the application of the arm’s length principle to determine whether a rate of interest is greater than an arm’s length amount can only be done under Division 13 and comparable provisions of DTAs.

1.79       The thin capitalisation rules also interact with Division 13 and comparable provisions of DTAs may interact is in relation to the amount of a debt deduction which would otherwise be allowable. In normal circumstances, the amount otherwise allowable is that determined under section 8-1 of the ITAA 1997. However, Division 13 and comparable provisions of DTAs may also impact on the amount otherwise allowable. The thin capitalisation rules apply, therefore, to the amount of a debt deduction which is otherwise allowable having regard to any other provision in the income tax law or in the DTAs.

Further detail about the thin capitalisation regime

1.80       The key features of the new regime along with other key concepts, are discussed in detail in the following chapters.

Table 1.1:  Further details about thin capitalisation

Topic

Chapter

Inward investing entities (non-ADI)

2

Outward investing entities (non-ADI)

3

Inward investing entities (ADI)

4

Outward investing entities (ADI)

5

Resident thin capitalisation groups

6

Control of entities

7

Calculating average values

8

Financial statements for Australian permanent establishments

9

The arm’s length tests for non-ADIs and ADIs

10

Application and transitional provisions

1.81       The new thin capitalisation regime applies to an entity or a group of entities for its income year beginning on or after 1 July 2001. This will remove the need for entities with substituted accounting periods to apply the old and the new rules for parts of their 2000-2001 year of income that includes 1 July 2001. [Schedule 1, item 22, subsection 820-10(1)]  

1.82       Australian permanent establishments will be required to prepare financial statements for the income year beginning on or after 1 July 2002. [Schedule 1, item 22, subsection 820-10(2)]

1.83       The extension of the section 128F exemption to debentures issued by non-resident companies applies to debentures issued on or after 1 July 2001. [Schedule 1, item 23]

1.84       A transitional measure applies for the first year of application to all entities. While the new thin capitalisation rules will apply from the start of an entity’s first income year beginning on or after 1 July 2001, taxpayers do not have to test their compliance with the rules until the end of that year (or the first period of their application if it finishes earlier). The majority of taxpayers have at least until 30 June 2002 to comply with the new rules. [Schedule 1, item 22, section 820-25]  

1.85       All consequential amendments that depend on the commencement of the new thin capitalisation regime (see paragraphs 1.90 to 1.101) apply from the taxpayer’s income year that commences on or after 1 July 2001. [Schedule 1, items 20 to 22, sections 820-15 and 820-20 and items 24 to 26]

Transitional rules for hybrid instruments

1.86       An entity may elect to have the treatment of transactions (e.g. dividends and interest) relating to interests on issue that will be reclassified under the New Business Tax System (Debt and Equity) Bill 2001 (that takes effect on 1 July 2001) preserved for a 3 year transitional period (until 30 June 2004). Transitional provisions in the thin capitalisation rules apply for the same period to these interests to ensure the value of this concession is not reduced. [Schedule 1, item 22, section 820-35]

1.87       A debt interest is disregarded in calculating adjusted average debt and average debt where an interest that was formerly equity becomes debt and an election has been made for equity treatment of the transactions [Schedule 1, item 22, subsection 820-35(2)] . This will ensure that non-ADIs will have these amounts treated as equity for thin capitalisation purposes. In the same set of circumstances, the debt interest will be disregarded in calculating average equity capital [Schedule 1, item 22, subsection 820-35(3)] . This will ensure that ADIs (and non-ADIs applying the worldwide gearing test) will have these amounts treated as equity for thin capitalisation purposes.

1.88       Where an interest that was formerly debt has become equity and an election has been made for debt treatment of the transactions, transitional thin capitalisation provisions are not required. In the case of non-ADIs such an interest will not be included in the definition of adjusted average debt and average debt. For ADIs (and non-ADIs applying the worldwide gearing test), average equity capital will include the value of the equity interest.

Consequential amendments

1.89       As a result of the application of the new thin capitalisation regime, there will be consequential amendments to the ITAA 1936 and to the ITAA 1997.

Repeal of existing thin capitalisation and debt creation regimes

1.90       The current thin capitalisation regime and the debt creation rules which are contained in Divisions 16F and 16G of Part III of the ITAA 1936 will be repealed. [Schedule 1, item 4]

1.91       Section 12-5 of the ITAA 1997 includes a checklist that refers to provisions which contain rules about specific deductions. The repeal of Divisions 16F and 16G of Part III of the ITAA 1936 requires a consequential amendment to refer to the thin capitalisation provisions as Division 820. [Schedule 1, items 14 and 15]

Attributable income of a CFC

1.92       Section 389 will be amended to continue the exclusion of the thin capitalisation and debt creation rules from the calculation of attributable income of an eligible CFC. Therefore, the references to Divisions 16F and 16G of Part III of the ITAA 1936 will be removed and replaced with a reference to Division 820. [Schedule 1, items 12 and 13]

Record keeping

1.93       Section 262A will be amended in order to incorporate new record keeping requirements for permanent establishments operating within Australia, and for the calculation of the arm’s length amounts. These requirements are discussed further in Chapter 9. [Schedule 1, items 10 and 11]

Section 128F - definition of associate

1.94       Subsection 128F(9) currently defines the term associate by reference to its meaning in Division 16F of the ITAA 1936. Once Division 16F is repealed, the definition contained within it will no longer be available. Subsection 128F(9) will be amended to adopt the definition of associate in section 318 of the ITAA 1936.

1.95       For the purposes of section 128F, paragraphs 318 (1)(b), (2)(a), and (4)(a) will be disregarded. The effect of this modification is that a partner of the entity or a partnership in which the entity is a partner will not be associates for section 128F purposes. This is consistent with the existing definition of associate in subsection 128F(9). [Schedule 1, item 3]

Section 79D - quarantining foreign losses

1.96          Unless the exclusion for foreign investment fund deductions applies, section 79D of ITAA 1936 presently prevents a foreign loss from being deducted against domestic assessable income.

1.97       This restriction on deductions imposed by section 79D will no longer limit debt deductions, with the exception of debt deductions that are attributable to an overseas permanent establishment. Section 79D will continue to apply in these latter cases because debt deductions attributable to foreign permanent establishments are not covered by the thin capitalisation regime.

1.98          To give effect to this change, the reference in section 79D to foreign income deduction, which is defined in subsection 160AFD(9), will be amended to effectively exclude debt deductions from the operation of section 79D. [Schedule 1, item 5]

Deductions relating to foreign exempt income

1.99       Debt deductions will, in certain instances, no longer be denied to taxpayers because they were incurred in earning exempt foreign income. These debt deductions, provided they are otherwise allowable under the general deduction provisions, will come within the scope of the thin capitalisation regime when determining the amount to be allowed.

1.100     The relevant debt deductions are those incurred in earning foreign income that is exempt income under sections 23AI, 23AJ and 23AK of the ITAA 1936.

1.101     Debt deductions incurred in deriving income which is exempt under section 23AH will continue to be subject to the exempt income exception in section 8-1. [Schedule 1, item 16, section 25-90]

Consequential amendments as a result of other bills

1.102     The bill also contains 3 consequential amendments necessary as a result of 3 other bills. These are the Corporations Bill 2001, the Financial Sector (Collection of Data) Bill 2001 and the Financial Services Reform Bill 2001.

1.103     Two of the amendments will replace references to existing legislation which will be repealed. The third amendment relates to dealer’s licences granted under Part 7.3 of the Corporations Law . A single licensing regime will be introduced which will replace the licensing requirements currently applying to securities dealers, investment advisers, futures advisers and brokers, general and life insurance brokers, and foreign exchange dealers. The consequential amendments will ensure that reference is made to the appropriate licence under the new regime.

1.104     Specifically, the consequential amendments will:

·       replace the reference to Corporations Law in the definition of accounting standards with a reference to the Corporations Act 2001 ;

·       replace the reference to Financial Corporations Act 1974 in the definition of financial entity with a reference to the Financial Sector (Collection of Data) Act 2001 ; and

·       repeal paragraph (c) of the definition of ‘financial entity’ in order to substitute the type of licence an entity must hold to qualify under the definition. [Schedule 1, items 17 to 19]

1.105     Clause 2 of the bill provides that the amendment to the definition of accounting standards and the substitution of the licensing requirement will commence on the later of 1 July 2001 or at the time when the Corporations Act 2001 commences. Similarly, the remaining amendment will commence on the later of 1 July 2001 or at the time when the Financial Sector (Collection of Data) Act 2001 commences.

 



C hapter

Inward investing entities (non-ADI)

Outline of chapter

2.1         This chapter explains how the thin capitalisation rules in Subdivision 820-C will apply to a foreign investor or a foreign controlled Australian entity that is not an ADI (henceforth referred to as non-ADIs). This chapter explains how such an entity works out its maximum allowable debt, and by how much it needs to reduce its debt deductions when the thin capitalisation rules have been breached. It also explains how the rules apply to part year periods.

2.2         A threshold requirement will exclude small investors from the thin capitalisation regime. The exclusion will operate where the debt deductions of the foreign investor or the foreign controlled Australian entity, either alone or together with associate entities, are $250,000 or less.

Context of reform

2.3         A foreign entity may invest in Australia either directly (e.g. through a branch) or indirectly via an Australian entity which it controls. Such investment can be financed via debt or equity. If debt is used, the Australian investment generates interest deductions, which reduce tax in Australia. The differential tax treatment between debt and equity encourages foreign investors to allocate debt to the Australian investments. To prevent excessive interest deductions being claimed and hence loss of Australian tax revenue, the current law disallows deductions where the related party debt levels relating to the Australian investment exceed a prescribed level.

2.4         The new thin capitalisation regime is designed to prevent excessive debt deductions being claimed. However, the new rules will apply to all of the debt of the entity and not just to the debt borrowed from foreign related parties, as is the case with the existing rules. This will strengthen the integrity of the new rules.

2.5         Under the new regime the maximum debt to equity ratio allowed is 3:1, compared to 2:1 under the current provisions. However, in recognition of the fact that financial entities on-lend large amounts of their debt, such entities are allowed a debt to equity ratio of up to 20:1 under the new rules, compared to 6:1 under the current provisions. Nevertheless, in certain circumstances a ratio above 20:1 may be permitted where an entity holds a specific class of assets.

2.6         The prescribed safe harbour debt to equity ratio may be exceeded in circumstances where the funding structure could be maintained on an arm’s length basis. In such a situation, no deductions will be disallowed. This change recognises that some funding arrangements may be commercially viable notwithstanding that they exceed the prescribed limits. It also makes the rules more consistent with Australia’s DTAs.

2.7         The new rules also:

·        incorporate comprehensive concepts of debt and debt deductions that arise from debt arrangements rather than being restricted to the narrow concept of interest as in the existing rules, reflecting a move to economic substance over form;

·       apply to Australian entities with controlled foreign operations, to improve the operation of the law in relation to interest deductions in these cases (see Chapter 3); and

·       apply to groups of entities where they choose to form a group for thin capitalisation purposes (see Chapter 6).

Summary of new law

What is an inward investing entity (non-ADI)?

An inward investing entity (non-ADI) is not a bank, and is either a:

·       foreign controlled entity; or

·       a foreign entity with direct Australian investments.

What is the thin capitalisation rule applying to inward investing entities?

The rule is that debt deductions are disallowed, in whole or in part, where the entity’s average debt exceeds its maximum allowable debt.

What is the maximum allowable debt?

The maximum allowable debt is the greater of 75% of the average value of net assets (calculated differently for financial and non-financial entities) or the amount of debt that would have been provided had all the relevant parties been dealing with each other on an arm’s length basis.

How much deduction is disallowed?

The amount disallowed is in direct proportion to the amount by which actual debt exceeds maximum allowable debt.

Comparison of key features of new law and current law

New law

Current law

The thin capitalisation measures apply to foreign-controlled Australian entities and to foreign entities that have direct Australian investments, as well as to some other entities.

The thin capitalisation measures only apply to foreign controlled entities and to foreign investors deriving Australian assessable income.

The thin capitalisation measures apply to total debt of the Australian entity or total debt used to fund the Australian investment.

The thin capitalisation measures only apply to foreign related-party debt and foreign debt covered by formal guarantee.

A safe harbour gearing ratio of 3:1 will apply to general investors, with a gearing ratio of up to 20:1 applying to financial entities. There are additional special rules for certain types of securities business.

The permitted gearing ratio is 2:1 for general investors and 6:1 for financial entities.

The general safe harbour debt amount is calculated as 75% of the average value of the net assets of the business (higher for financial entities).

The permitted debt amount is calculated by multiplying actual equity amounts by 2 (6 for financial entities).

Inward investing entities also have the option of using an arm’s length rule to determine their maximum allowable debt.

There is a limited arm’s length test dealing only with guaranteed foreign debt in certain circumstances.

Detailed explanation of new law        

Overview

2.8         The thin capitalisation rules seek to limit the amount of debt that can be allocated to Australian entities which are foreign controlled and to non-residents with Australian investments. Where the prescribed gearing limits are breached, the rules operate to disallow some or all of the debt deductions attributed to the Australian operations or investments.

2.9         The inward investing rules will apply to Australian entities which are foreign controlled and to non-residents who invest in Australia directly instead of through an Australian entity, for all or part of an income year. If an Australian entity is foreign controlled but also has offshore investments (such as a foreign subsidiary), the rules for outward investing entities will take priority (see Chapter 3 for a discussion of the rules affecting Australian entities with offshore investments). [Schedule 1, item 1, subsections 820-85(2) and 820-185(1)]  

2.10       Different rules apply depending on whether the entity is classified as a general or financial entity. The rules take into account the different gearing levels required for each type of business. Generally, it is expected that financial entities require a higher level of debt funding to support their lending and securities business.

2.11       Broadly, the gearing of the Australian operations of foreign controlled Australian entities or the Australian investments of non-residents will be limited to a general safe harbour level of 3:1 debt to equity. Where these entities are foreign controlled financial entities an on-lending rule will operate to remove any debt from the thin capitalisation rules that has been on-lent to third parties either through loans or certain other arrangements. The remaining assets of the entity that are not on-lent amounts will be subject to the general safe harbour level of 3:1. In order to prevent the assets of a financial entity from being totally debt funded, an overall gearing level of 20:1 is imposed on the entity. However, where the financial entity has assets that are effectively allowed to be fully debt funded (its zero-capital amount ), higher gearing levels than the 20:1 ratio will be permitted.

2.12       Where an entity’s debt funding exceeds the safe harbour limit an adjustment to reduce the debt deductions will ordinarily occur unless the entity demonstrates that the debt funding of the Australian operations would be acceptable under arm’s length principles.

2.13       The inward investing rules will also apply to groups of entities where the groups are foreign controlled (see Chapter 6 for details).

What is an inward investing entity (non-ADI)?

2. 14       This is a term used in the legislation to encompass a number of types of foreign and Australian entities that are not banks or other ADIs. The legislation further categorises them as either an:

·       inward investment vehicle (general);

·       inward investment vehicle (financial);

·       inward investor (general); or

·       inward investor (financial).

[Schedule 1, item 1, subsection 820-185(2); Schedule 2, item 40, definition of ‘inward investing entity (non-ADI)’ in subsection 995-1(1)]

2. 15       An inward investment vehicle is a foreign controlled Australian entity and an inward investor is a foreign entity which invests directly in Australia rather than through an Australian resident vehicle. The rules further classify entities as either financial or general entities. This is done to ensure that the gearing levels permitted under the rules take into account the different debt levels required by each type of entity to undertake its business activities.

2. 16       An inward investment vehicle (general) is an Australian entity that is neither a financial entity nor an ADI at any time during the period, and is a foreign controlled Australian entity throughout the period [Schedule 1, item 1, subsection 820-185(2), item 1 in the table] . These will be referred to as general foreign controlled Australian entities throughout this chapter. The term foreign controlled Australian entity is discussed in detail in Chapter 7. However, for the purposes of this chapter it should be noted that the term includes foreign controlled Australian companies, trusts and partnerships.

2. 17       An inward investment vehicle (financial) is a financial entity and not an ADI throughout the period and is a foreign controlled Australian financial entity throughout the period [Schedule 1, item 1, subsection 820-185(2), item 2 in the table] . These will be referred to as foreign controlled Australian financial entities in this chapter.

2.18       A financial entity is an entity that is not an ADI and:

·       is a registered corporation under the Financial Corporations Act 1974 ;

·       is a securitisation vehicle; or

·       holds a dealer’s licence granted under Part 7.3 of the Corporations Law where:

-           the entity carries on a business of dealing in securities; and

-           that business is not carried on predominantly for the purpose of dealing in securities with, or on behalf of, the entity’s associates (the term associate is discussed in Chapter 7).

[Schedule 2, item 31, definition of ‘financial entity’ in subsection 995-1(1)]

2. 19       An inward investor (general) is a non-resident that is neither a financial entity nor an ADI at any time during the period and claims debt deductions against its Australian assessable income for the period. These will be referred to as foreign general investors in this chapter. [Schedule 1, item 1, subsection 820-185(2), item 3 in the table]

2. 20       Similarly, an inward investor (financial) is a non-resident financial entity that is a non-ADI which claims debt deductions against its Australian assessable income for the period. These will be referred to as foreign financial investors in this chapter. [Schedule 1, item 1, subsection 820-185(2), item 4 in the table]

What is the thin capitalisation rule for inward investing entities (non-ADI)?

Thin capitalisation rule

2. 21       The thin capitalisation rules disallow all or part of an entity’s debt deductions for the income year where the gearing of the Australian operations or investment exceeds a prescribed limit. The prescribed limit is exceeded where an entity’s adjusted average debt exceeds its maximum allowable debt . [Schedule 1, item 1, subsection 820-185(1)]  

What is an entity’s adjusted average debt?

2. 22       An entity’s adjusted average debt for an income year is:

·        the average value of its debt capital that gives rise to its debt deductions ; less

·       if the entity is a (general or financial) foreign controlled Australian entity, the average value of the entity’s associate entity debt ; or

·       if the entity is a foreign (general or financial) investor, the average value of the entity’s associate entity debt but only to the extent that debt is attributable to the entity’s permanent establishments in Australia.

[Schedule 1, item 1, subsection 820-185(3)]

2. 23       Where the entity has debt capital which does not give rise to debt deductions, that debt capital is not taken into account for thin capitalisation purposes. For example, loans on which interest or other expenses are not claimed as allowable deductions. This treatment recognises that, although these amounts are not equity, they provide capital to fund the entity’s operations for which no debt deductions are claimed. The term debt deduction is discussed in paragraphs 1.57 to 1.62.

2. 24       The characterisation of an instrument as debt or equity is determined by the New Business Tax System (Debt and Equity) Bill 2001. That bill also provides transitional treatment in relation to that characterisation for some instruments. Transitional measures are also required in the thin capitalisation measures to give effect to those debt/equity transitionals. For a detailed discussion of these characterisation issues see paragraphs 1.86 to 1.88.

2. 25       The rules also operate where the entity or Australian investment is foreign controlled for only part of the year. [Schedule 1, item 1, section 820-225]

What is the average value of an entity’s debt capital?

2. 26       The term debt capital is discussed in paragraph 1.52. The provisions that set out the methods of calculating an average value are discussed in Chapter 8. [Schedule 2, item 26, definition of ‘debt capital’ in subsection 995-1(1)]

2. 27       The thin capitalisation rules seek to limit the amount of debt used to fund the Australian operations or investment. However, at this point, it should be noted that for a foreign controlled Australian entity, whether general or financial, this debt amount is all of its debt capital. For a foreign investor, whether general or financial, it is only the debt that is attributable to its Australian investments [Schedule 1, item 1, subsections 820-185(1) and 820-185(3)] . The term Australian investments is described in paragraph 2. 97.

What is an entity’s maximum allowable debt?

2. 28       When added to an amount equal to its associate entity debt (if any), an entity’s maximum allowable debt gives the maximum amount of debt that can be used to fund its Australian assets. In other words, this total amount is the maximum amount of debt that an entity can have so as not to breach the thin capitalisation rules. To determine if a breach has occurred, the entity’s adjusted average debt is compared with the maximum allowable debt amount. [Schedule 1, item 1, section 820-185]

2. 29       Reflecting the fact that there are 2 tests, the entity’s maximum allowable debt is the greater of:

·       the safe harbour debt amount; and

·       the arm’s length debt amount.

[Schedule 1, item 1, section 820-190]

2. 30       Although entities will be required to calculate their maximum allowable debt level, they will not be required to do so under both the safe harbour and the arm’s length tests. They will have the option to choose either one of these tests. However, since the first of these is a safe harbour amount, the second will normally only be determined where the entity’s adjusted average debt is greater than the safe harbour debt amount. If the entity’s adjusted average debt capital is less than the safe harbour amount there is no need to calculate the arm’s length amount. Additionally, an entity that fails the safe harbour debt test could choose not to calculate the arm’s length debt amount and have debt deductions disallowed on the basis of the safe harbour debt amount.

2. 31       The safe harbour rule is calculated differently for each of the 4 types of entities that can be affected by the rules. However, the arm’s length debt amount is worked out in the same way for all 4 types of inward investing entities but different factors may have greater importance in the calculation for each type of entity.

What is the safe harbour rule for inward investing entities that are not ADIs?

General foreign controlled Australian entities

2. 32       In the case of a foreign controlled Australian entity that is not a financial entity, the safe harbour rule requires that its Australian assets be funded by a debt to equity ratio of not more than 3:1.

2. 33       The safe harbour debt amount is calculated by applying the following steps:

Step 1:   Work out the average value, for the income year, of all the assets of the entity.

Step 2:   Reduce the result of step 1 by the average value, for that year, of all the associate entity debt of the entity.

Step 3:   Reduce the result of step 2 by the average value, for that year, of all the associate entity equity of the entity.

Step 4:   Reduce the result of step 3 by the average value, for that year, of all the non-debt liabilities of the entity for that year.

Step 5:   Multiply the result of step 4 by three-quarters.

Step 6:   Add to the result of step 5 the average value for that year of the entity’s associate entity excess amount .

The result is the safe harbour debt amount.

[Schedule 1, item 1, section 820-195; Schedule 2, item 60, definition of ‘safe harbour debt amount’ in subsection 995-1(1)]

Why are loans provided to associates deducted from the adjusted average debt of the entity?

2. 34       Where an entity borrows funds and on-lends those funds to its associate, the same pool of debt could be tested in both entities when in economic terms there is really only one loan transaction. The associate entity debt rule eliminates the debt in the interposed lending entity so that the same pool of debt is not tested twice. For example, the associate entity debt rule would operate where 2 or more companies are involved in a joint venture and the joint venture entity is an associate entity of the companies. The entity through which the joint venture is operated may be prevented from borrowing in its own right from unassociated lenders. Where the debt is raised by the joint venturers and on-lent to the joint venture entity in these circumstances, it will be ignored for thin capitalisation purposes in the hands of the joint venturers.

2. 35       Associate entity debt is deducted in the calculation of adjusted average debt which is compared with the maximum allowable debt. It is also deducted from assets in the calculation of the safe harbour amount. The deduction from average debt and from assets is to ensure that the loan asset may be fully funded by borrowings. [Schedule 1, item 1, subsection 820-185(3) and section 820-195]

When does the associate entity debt rule apply?

2.36       To qualify for associate entity debt treatment there are a number of conditions that must be satisfied. The conditions are:

·       the associate entity is either an outward investing entity (non-ADI) or an inward investing entity (non-ADI);

·       the debt interest in relation to the loan to the associate entity remains on issue at that time;

·       payments by the associate entity for the costs of the loan must be assessable income of the lending entity. The costs of the loan may include fees or charges including application fees, lines fees, service fees, brokerage and stamp duty.  Some of these fees would ordinarily be payable to parties other than the test entity.  The fact that such amounts will not be assessable income of the lending entity will not preclude this condition from being met; and

·       the terms and condition of the loan to the associate entity are arm’s length.

2.37       These conditions seek to ensure that the associate entity debt is being tested for thin capitalisation purposes in one entity.  They also seek to ensure that the debt deductions claimed in the test entity in relation to the associate entity debt are matched with an arm’s length amount of assessable income for the test entity from the associate entity debt. [Schedule 1, item 1, section 820-910]

How is associate entity debt calculated?

2.38       The associate entity debt amount is calculated using the method statement in subsection 820-910(2). [Schedule 2, item 10, definition of ‘associate entity debt’ in subsection 995-1(1)]

Example 2. 1

Entities A Co and B Co, both inward investors, each hold 50% equity in a joint venture vehicle, C Co, which undertakes purely domestic Australian operations. A Co has provided a loan to C Co of $100 million. The terms and conditions of the loan are consistent with normal commercial arrangements and the interest is assessable income for A Co.

A Co’s loan to C Co may be treated as associate entity debt as described in section 820-910 provided C Co is an associate entity of A Co and C Co is subject to thin capitalisation rules.

To determine whether C Co is an associate entity of A Co, we look to section 318(2)(e)(i)(A) of the ITAA 1936 which provides that if A Co can sufficiently influence C Co then C Co is an associate. Sufficiently influence is further explained in subsection 318(6) of the ITAA 1936. In deciding whether a company is sufficiently influenced by another entity it is not necessary that the company is controlled by the other, only that it can be reasonably expected to act in accordance with the directions, instructions or wishes of the other. Generally speaking, C Co would be an associate of the 2 joint venturers, A Co and B Co, because it is expected each would have sufficient influence over C Co.

Having established that C Co is an associate entity of A Co and that C Co will be subject to the thin capitalisation rules, A Co is able to deduct $100 million from its average debt amount. A Co must also deduct $100 million from its assets in the calculation of its safe harbour amount (at step 2 in the method statement).

Why is equity in associates of the entity deducted from the assets of the entity?

2. 39       An entity’s associate entity equity is the total value of equity interests that an entity holds in any entities that are its associate entities. [Schedule 1, item 1, section 820-915; Schedule 2, item 11, definition of ‘associate entity equity’ in subsection 995-1(1)] . This amount is deducted from the assets of the entity as an integrity measure to prevent double counting or the cascading of equity through a chain of entities. The net effect of not deducting associate entity equity would be to permit a group of associated entities to gear up in excess of the safe harbour amount. This deduction rule will not apply where the associates and the entity form a group, therefore it only applies to equity in ungrouped associate entities. Moreover, where the associate entity does not gear up on its equity funds to the extent permitted by the thin capitalisation regime, there will be a reduction in the penalty effect of deducting associate entity equity from assets. This is done through the addition of what is called the associate entity excess amount .

2. 40       Example 2.2 illustrates the rationale behind the deduction of the equity held in associate entities.

Example 2. 2

Foreign parent invests $100 into its wholly-owned Australian holding company (AusHold). The subsidiary uses the funds to invest in Ausub1. Ausub1 then invests the funds in Ausub2.

The ownership structure is depicted in the following diagram:

 

 

 

 

 

 

 

 



Each of the Australian entities is a foreign controlled entity (see Chapter 7) and accordingly the thin capitalisation rules will apply to each entity.

By deducting the associate entity equity from the assets of each entity in the chain of companies, the measures ensure that there is no double counting of the $100 equity. In this case only $100 has been introduced as equity and not $300.

The result of deducting the associate entity equity held by each Australian entity in the chain (except Ausub2 - which does not have any associate entity equity) is that each entity is unable to increase its maximum allowable debt because its assets include the investment in its associate.

Why is the associate entity excess amount added to the safe harbour calculation?

2. 41       The deduction of associate entity equity from assets in the calculation of the safe harbour debt amount, assumes that the value of the associate entity equity is used to fully leverage debt in the associate entity. Where this is not the case, the associate entity equity rule can produce a harsh outcome. In order to address this, the rules allow excess debt capacity of an associate entity to be carried back to the entity with the equity investment (the investing entity). The carry back seeks to reduce the full impact of the associate entity equity rule by recognising the actual gearing of the associate and any premium/discount in the carrying value of the associate entity equity amount. At the extremes, (and apart from any premium or discount in the value of the associate entity) there is:

·       a full ‘carry back’ of the associate entity equity amount where the associate entity has no debt; and

·       no ‘carry back’ where the associate entity’s debt exceeds its safe harbour debt amount.  

What is the associate entity excess amount?

2. 42       The associate entity excess amount is relevant for an entity that is either an outward investing entity (non-ADI), or an inward investing entity (non-ADI). It is calculated as follows:

Step 1:   Determine the premium excess amount for the associate at the measurement date.

Step 2:  Add to step 1 the attributable safe harbour excess amount for the associate at the measurement date.

Step 3:   Aggregate the associate entity excess amounts for each associate where the associate entity excess amounts are positive.

[Schedule 1, item 1, subsection 820-920(2); Schedule 2, item 12, definition of ‘associate entity excess amount’ in subsection 995-1(1)]

2. 43       The result of step 3 is the amount of associate entity excess at the measurement date. This is done for each measurement day which the investing entity is using to calculate its average values and its safe harbour debt amount.

What is the premium excess amount?

2. 44       The premium excess amount arises where the books of account of the investing entity and those of its associate place different values on the assets of the associate. The debt capacity of any such difference is the premium excess amount. Where the amount is negative (i.e. the equity investment is valued at a discount to net assets) it is treated as a negative amount.

How is the premium excess amount calculated?

2. 45       The entity’s premium excess amount is calculated as follows:

Step 1:  Determine the associate entity equity for the associate entity.

Step 2:  Step 1 minus the equity capital of the associate entity attributable to the investing entity.  

Step 3:  Step 2 is multiplied by the fraction that is used to determine the maximum allowable debt of the investing entity (i.e. 3/4, 20/21 or the worldwide gearing amount fraction).

[Schedule 1, item 1, subsection 820-920(3)]

How is the attributable safe harbour excess amount calculated?

2. 46       The entity’s attributable safe harbour excess amount is calculated as follows:

Step 1:  Determine the safe harbour debt amount for the associate entity.

Step 2:  Step 1 minus the adjusted average debt of the associate entity.

Step 3:   Step 2 multiplied by the proportion of the associate entity’s equity capital that is attributable to the investing entity.

[Schedule 1, item 1, subsection 820-920(4)]

2. 47       The result of Step 3 is the amount of excess debt capacity in the associate entity that is transferable to the investing entity. Where the outcome is negative (i.e. the associate entity’s adjusted debt is greater than its safe harbour amount), it is treated as a nil amount.

Example 2. 3

TR Co is a general foreign controlled Australian entity.TR Co purchases 90% of equity in B Co for $3 million. (TR Co pays a premium of $1.65 million to acquire equity capital worth $1.35 million). B Co is a general foreign controlled Australian entity.All values are for a particular measurement day of TR Co.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



Premium excess

Step 1:  TR Co’s associate entity equity for B Co = $3 million.

Step 2:  Step 1 minus equity capital of B Co attributable to TR Co $1.35 million = $1.65 million.

Step 3:  Step 2 multiplied by the fraction that it is used to determine the maximum allowable debt of TR Co (3/4) = $1.2375 million.

Attributable safe harbour excess

Step 1:  B Co’s safe harbour amount ($4 million ´ 3/4) = $3 million.

Step 2:  Step 1 minus adjusted debt of B Co ($2.5 million) = $0.5 million.

Step 3:  Step 2 multiplied by the proportion of B Co equity attributable to TR Co (90%) = $0.45 million.

Associate entity equity excess

Step 1:  Attributable safe harbour excess is $0.45 million.

Step 2:  Step 1 plus premium excess of $1.2375 million gives $1.6875 million.

$1.6875 million is the associate entity excess from B Co at the measurement date.

Note that this is not the full 75% of TR Co’s associate entity equity amount of $3 million. This is because B Co has used the equity capital paid for by TR Co to increase its own debt.

Does the equity in the associate entity have to be held for the whole period?

2. 48       The associate entity excess amount is calculated at each measurement date used by the investing entity, for each associate entity. It is a point in time calculation, so that differing tax years of associates can be accommodated. The values used for this calculation are those that exist at the time of measurement and the investing entity does not have to have held the equity interest in the associate entity for the period prior to the measurement date. The calculation of the safe harbour debt amount of the associate entity and its adjusted debt are for the period of one day at the measurement date.

2. 49       Where the associate entity excess amount for a particular associate entity is negative, it is disregarded. That is, there is no further penalty for the investing entity. The associate entity excess amounts for all other associate entities are aggregated at each measurement date. The aggregate associate entity excess amount at each measurement date is averaged to determine the average associate entity excess amount for the entity for the income year or part thereof.

Example 2. 4

E Co, a general foreign controlled entity with 3 measurement dates owns J Co with an associate entity excess amount of $300 at each measurement date. E Co purchased 60% of H Co on the day before E Co’s second measurement date. The associate entity excess for H Co is nil on the first measurement date, $120 on the second measurement date and $90 on the third measurement date. The associate entity excess for the year is:

(($300  +  $0)  +  ($300  +  $120)  +  ($300  +  $90)) / 3  =  $370. E Co can add $370 to its safe harbour debt amount for the year.

Why are non-debt liabilities deducted from assets?

2. 50       The thin capitalisation safe harbour debt amounts are based on gearing ratios of 3:1 and 20:1 for general and financial businesses respectively. For general businesses, the maximum allowable debt is equal to three-quarters of the entity’s assets, after deducting non-debt liabilities (amongst certain other items). That approach recognises that if the 4 funding parts (i.e. 3 parts debt and 1 part equity) of a 3:1 gearing ratio are used to finance an entity’s assets, then neither debt nor equity funds the amount of assets above the combined debt and equity sum.

2. 51       The accounting equation recognises that the value of a firm’s assets equals the sum of its liabilities and equity. Given that debt is a subset of liabilities, it follows that the value of a firm’s assets equals the sum of its debt, non-debt liabilities and equity. Accordingly, in setting a 3:1 debt to equity safe harbour ratio based on the value of a firm’s assets, the maximum debt is equal to three-quarters of the net assets (i.e. assets minus non-debt liabilities).

2. 52       An entity’s non-debt liabilities are presently existing obligations that an entity owes to another entity. However, the following are specifically excluded:

·       its debt capital;

·       any equity interests in the entity; and

·       a provision for a distribution of profits where the entity is a corporate tax entity.

[Schedule 2, item 48, definition of ‘non-debt liabilities’ in subsection 995-1(1)]

2. 53       Non-debt liabilities must be a present obligation. An obligation will be present if the event giving rise to the obligation has already occurred. That is, the obligation cannot be contingent. An obligation that will arise in the future is therefore not present unless the actual event triggering the obligation occurs. For example, a requirement to pay long service leave does not become a present obligation until the relevant employee takes the leave accrued. Obligations under insurance policies are not present obligations until the event that gives rise to the claim has occurred.

2. 54       The exclusion of provisions for profit distributions recognises that although these provisions represent liabilities of an entity, provisions for dividends and like distributions are seen as representing part of an entity’s equity capital, rather than liabilities, for the purposes of thin capitalisation. Similarly the exclusion of equity interests in an entity recognises that the application of the debt/equity rules to a liability, within the ordinary meaning of the term, could characterise a non-debt liability as an equity interest for tax purposes. That interest should then be treated as equity for thin capitalisation purposes.

Why are the net Australian assets of the entity multiplied by three-quarters in calculating the safe harbour debt amount?

2.55       The safe harbour debt amount is determined by multiplying the average value of the net Australian assets of the entity by three-quarters [Schedule 1, item 1, section 820-195, step 5 of the method statement] . This amount represents the maximum amount of debt that the entity can use to fund its net assets (as calculated), so as to satisfy the safe harbour rule. Similarly, the remaining one quarter represents the minimum amount of equity that the entity must have to satisfy the equity requirements of the rule. This safe harbour funding mix reflects the policy of a maximum gearing ratio for debt to equity of 3:1.

Comparing average debt with the safe harbour amount

2.56       If the adjusted average debt exceeds the safe harbour debt amount then the entity has not satisfied the 3:1 debt to equity requirement. Conversely, if the adjusted average debt is less than the safe harbour debt amount the entity has satisfied the safe harbour rule. Example 2.5 illustrates the rationale behind the rule.

Example 2.5

The following average values have been extracted from Safeco’s balance sheet for the year ended 30 June 2002. The company is foreign controlled during the whole year.

Assets

Liabilities

Ratio

Current Assets

 $20

   Loan

 $75

  3 (debt)

Non-current assets

 $80

   Equity

 $25

  1 (equity)

 

$100

 

$100

 

Safeco does not have any non-debt liabilities, associate entity debt or associate entity equity.

Under the safe harbour rule Safeco’s average asset figure of $100 is multiplied by three-quarters to arrive at its safe harbour debt amount (i.e. $100  ´   ¾  =  $75). Hence, Safeco’s assets can be funded by no more than $75 of debt and at least $25 of equity (i.e. $100  ´   ¼). Given Safeco’s level of debt funding it has satisfied the 3:1 debt to equity ratio permitted under the safe harbour rule.

What if an entity’s adjusted average debt exceeds its safe harbour debt amount?

2.57       If an entity’s adjusted average debt capital exceeds its safe harbour debt amount an adjustment to disallow some or all of its debt deductions will occur unless the entity can demonstrate that the level of debt is acceptable on an arm’s length basis. The arm’s length debt amount is discussed in Chapter 10 .

Example 2.6:  General foreign controlled Australian entity

ForCo is a non-resident company that wholly owns Austco. ForCo has loaned Austco $2.5 million. Austco has also borrowed $2.5 million from an unrelated Australian financial entity.

The ownership structure and relevant transactions can be represented in the following diagram:

 

 

 

 

 

 

 

 

 

 

 

 



Austco’s average assets are $7 million and consist of the following:

Current assets                          $2 million

Non-current assets

·          buildings                            $3.5 million

·          plant and equipment          $1.5 million

Austco’s total assets have an average value of $7 million (Chapter 8 discusses the methods used to calculate average values).

Austco has non-debt liabilities of $0.5 million.

Austco’s average value of debt capital is $5 million.

Austco is a foreign controlled Australian entity and accordingly will be subject to the thin capitalisation rules. [Schedule 1, item 1, subsection 820-185(2), item 1 in the table]

Calculations - safe harbour debt amount

Austco

Step 1:   The average value of all of the assets of Austco equals $7 million.

Step 2:   The average value of Austco’s associate entity debt is zero. Therefore, the result of step 2 is $7 million.

Step 3:   The average value of Austco’s associate entity equity is zero. Therefore, the result of step 3 is $7 million.

Step 4:   The average value of Austco’s non-debt liabilities is $0.5 million. Therefore, the result of step 4 is $6.5 million.

Step 5:   Multiplying the result of step 4 by three-quarters equals $4.875 million.

Step 6:   The average value of the associate entity excess amount is zero. Therefore, the safe harbour debt amount equals $4.875 million.

The safe harbour debt amount of $4.875 million represents the maximum level of debt permitted under the general safe harbour of 3:1. That is, after taking into account non-debt liabilities, Austco’s average net Australian assets of $6.5 million could be funded by a maximum debt amount of $4.875 million and average equity amount of not less than $1.625 million. This would satisfy the maximum debt to equity gearing ratio of 3:1.

Given that Austco’s average debt capital for the period is $5 million it has not satisfied the general safe harbour rule. It has exceeded the safe harbour debt amount by $125,000.

An adjustment to its debt deductions for the period will arise if Austco is not able to demonstrate that the level of debt funding is acceptable under the arm’s length rule.

Foreign controlled Australian financial entity

2.58       In the case of foreign controlled Australian financial entities, the safe harbour rule takes into account the need for greater debt funding to support their financial intermediation activities. The on-lending rule will operate to remove certain amounts from the thin capitalisation rules where those amounts essentially represent lending to other parties, including associates. However, this does not require the entity to trace its borrowings to those amounts.

2.59       Debt which falls within the associate entity debt rule will also fall within the definition of on-lent amount . The method statements that apply to financial entities ensure that there is no double counting of these amounts. [Schedule 2, item 50, definition of ‘on-lent amount’ in subsection 995-1(1)]

2.60       The remaining part of the entity’s business that is not subject to the on-lending rule will be subject to the general safe harbour rule of 3:1. However, generally this will be subject to an overall gearing limit of 20:1. Therefore, depending on the level of lending activity (as a proportion of the total business), the entity’s maximum allowable debt will reflect a gearing level of between 3:1 and 20:1. The greater the proportion of on-lending activity the closer the overall gearing level will be to 20:1.

2.61       However, where the financial entity has assets that are zero-capital amounts , higher gearing levels than the 20:1 limit will be permitted. These amounts are effectively taken out of the safe harbour debt amount calculation and debt deductions are fully allowed in respect of these amounts. This recognises the relatively smaller gross margins at which this business falling within the zero-capital amount is conducted.

2.62       The on-lending rule does not apply to specialist in-house finance companies within non-financial groups unless those companies are registered under the Financial Corporations Act 1974 .

What is the safe harbour debt amount?

2.63       The safe harbour debt amount is the lesser of:

·       the total debt amount ; and

·       the adjusted on-lent amount .

2.64       The first of these is based on an overall 20:1 debt to equity ratio applying to the whole business with an allowance for assets falling within the zero-capital amount. The second incorporates the on-lending concession and applies the 3:1 limit to that part of the business which does not fall within that concession. The lesser amount is taken to ensure the debt to equity ratio is capped at 20:1, subject to the allowances for the zero-capital amount. [Schedule 1, item 1, subsection 820-200(1)]

What is the total debt amount?

2.65       The total debt amount is calculated by applying the following steps:

Step1:  Work out the average value, for the income year, of all the assets of the entity.

Step 2:  Reduce the result of step 1 by the average value, for that year, of all the associate entity debt of the entity.

Step 3:  Reduce the result of step 2 by the average value, for that year, of all the associate entity equity of the entity.

Step 4:  Reduce the result of step 3 by the average value, for that year, of all the non-debt liabilities of the entity.

Step 5:   Reduce the result of step 4 by the value, for that year, of the entity’s zero-capital amount .

Step 6:   Multiply the result of step 5 by 20/21.

Step 7:   Add to the result of step 6 the zero-capital amount.

Step 8:   Add to the result of step 7 the average value of the entity’s associate entity excess amount for that year.

The result of this step is the total debt amount.

[Schedule 1, item 1, subsection 820-200(2)]

What is the zero-capital amount?

2.66       The zero-capital amount provides a carve-out of certain assets from the thin capitalisation regime and as a consequence allows full debt funding for these qualifying assets. As explained in paragraph 2.61, these amounts will not be subject to the 20:1 ratio. The zero-capital amount is the sum of the following 4 amounts:

·       amounts received by the entity for the sale of securities (other than any fees associated with the sale) under the following arrangements where the securities have not been repurchased:

-           reciprocal purchase agreements;

-           sell-buyback arrangements; and

-           securities loan arrangements;

·       the total value of debt interests issued to the entity that remain on issue where:

-           the debt interests are loans of money for which no fees or charges other than interest is imposed; and

-           the long term foreign corporate credit rating of the issuer of the debt interest, at the time that it issued, was at least BBB (or equivalent) as rated by an internationally recognised credit agency. For ease of explanation these will be referred to as low margin loans;

·       the total value of the debt interests issued to the entity, that remain on issue at that time, where the debt interests have a risk-weighting of 0% or 20% under the prudential standards. For ease of explanation these will be referred to as low risk-weighted loans; and

·       the total value of an entity’s securitised assets if the entity is a securitisation vehicle.

[Schedule 1, item 1, subsection 820-942(1); Schedule 2, item 74, definition of ‘zero-capital amount’ in subsection 995-1(1)]

What are reciprocal purchase agreements, sell-buyback arrangements and securities loan arrangements?

2.67       These financial arrangements can be described as follows:

·       a REPO is a cash financing arrangement involving 2 transactions. Firstly, party A agrees to sell securities (e.g. government bonds) to party B in return for cash. Secondly, party B agrees to resell the securities to party A at a future date. The purchaser of the securities receives legal title to enable it to deal with the securities. Title returns when the securities are repurchased;

·       a sell-buyback arrangement is one where the parties enter into separate sell and buy transactions for securities. These transactions are entered into at the same time with settlement at some date in the future.The purchaser of the securities receives legal title until they are repurchased; and

·       a securities loan arrangement is an arrangement where one party lends securities to another on the payment of collateral. For example, party A agrees to lend securities (e.g. shares) to party B. In turn, party B agrees to return the securities to party A at a future date and provides collateral (e.g. cash or other securities) for the loan. Once again, the party acquiring the securities (in this case party B) obtains full title to the securities until they are repurchased by party A.

2.68       Typically, although the value of the assets which form part of these transactions is large, the gross profit margin is very small. If the thin capitalisation rules were applied to all the assets which form part of these arrangements, entities would need to hold a disproportionate amount of capital given the correspondingly small gross profit margin. In order to address this issue, the rules carve out any payments received for the sale of the securities (other than fees) under these arrangements. The effect is that entities will not be required to hold capital against assets which it holds at law and which form the basis of these arrangements.

What are low margin loans?

2.69       It is common for gross profit margins in financing arrangements to be determined by the difference between the interest rate at which the lender can itself borrow funds and the interest rate which the lender charges the borrower. These interest rates are usually determined by the credit rating of both the lender and the borrower. Generally, where the credit rating of the borrower is sufficiently high, the gross profit margin for the lender will be small.

2.70       As is the case with the securities transactions discussed in paragraph 2.67, these loans are typically large but the gross profit margin from this business is very small. As a result, lenders need to reduce the amount of capital held against these loans given the small gross profit margins, to earn a sufficient rate of return on the capital. An example of such loans are short-term bridging finance used by entities to fund corporate acquisitions. 

2.71       In order to address this issue, lenders will not be required to hold capital against the loan assets. However, to ensure that only low margin lending falls within the concession and that the credit rating has been independently determined the legislation requires that:

·       the long term foreign corporate credit rating of the issuer of the debt interest (the borrower), at the time that it is issued, was at least BBB (or equivalent); and

·       the credit rating must have been provided by an internationally recognised credit rating agency.

2.72       Further, no fees or charges other than interest can be imposed on these loans. This requirement is designed to prevent high margin business being moved to arrangements which fall within the concession by substituting fee income for interest income.

What are low risk-weighted loans?

2.73       Under the capital adequacy regime ADIs are required to risk weight assets so that appropriate amounts of capital are held against their assets. The thin capitalisation rules which apply to ADIs are based on the capital adequacy regime, including the prudential standards. Chapters 4 and 5 discuss this in detail.

2.74       The prudential standards provide that certain assets of an ADI are to be risk weighted to 0% or 20%. For example, bonds issued by the Commonwealth government have a 0% risk weighting and claims guaranteed by Australian local governments have a 20% risk weighting. Including low risk-weighted loans within the zero-capital amount will give these loans by non-ADIs roughly similar treatment to that provided to ADIs under the ADI rules.

What is securitisation?

2.75       Securitisation is the pooling of assets in a special purposes vehicle in order to move assets (e.g. mortgages and leases) from the balance sheet of the owner (the originating entity) to the special purposes vehicle. The acquisition of the assets from the originating entity is fully funded by the issue of debt securities. The effect of securitisation is to enhance the cash flow of the originating entity by transferring non-liquid assets to the special purposes vehicle in exchange for a liquid asset such as cash.

2.76       An integral feature of securisation is that the special purposes vehicle is 100% debt funded on a stand alone basis. As a consequence, these vehicles would fail the thin capitalisation requirements because they would generally be geared in excess of the 20:1 limit. In recognition of the particular structure and commercial function of securitisation, certain assets held by special purpose vehicles will be included within the zero-capital amount. However, in order to qualify for the concession the vehicle must be a securitisation vehicle and the assets must be securitised assets .

Securitisation Vehicle

2.77       An entity will be a securitisation vehicle for thin capitalisation purposes if:

·       the entity has been established for the purpose of acquiring, funding and holding securitised assets;

·       the entity has acquired the securitised assets from another entity (the originator);

·       the acquisition of the securitised assets is wholly funded by the entity issuing debt interests;

·       in issuing those debt interests the entity has not received any guarantee, security or other form of credit support from any of its associate entities, the originator or an associate entity of the originator;

·       there are no debt interests issued to the entity by any of its associate entities, the originator or an associate entity of the originator; and

·       any arrangement that the entity has with its associate entities, the originator or an associate entity of the originator, is at arm’s length.

[Schedule 1, item 1, subsection 820-942(2)]

2.78       A securitisation vehicle is a financial entity for the purposes of the thin capitalisation regime. [Schedule 2, item 31, definition of ‘financial entity’ in subsection 995-1(1)]

2.79       Note the term associate entity is explained in paragraphs 7.86 to 7.98.

Securitised Asset

2.80       An asset of an entity is a securitised asset if :

·       the entity is a securitisation vehicle;

·       the asset is either:

-           a debt interest issued by another entity other than the originating entity; or

-           a lease for the hire of goods falling within paragraph (b) of the definition of on-lent amount if the originating entity satisfies the requirements of that paragraph; and

·       the asset provides security for the issuing of a debt interest that funded the acquisition of the asset by the securitisation vehicle.

[Schedule 1, item 1, subsection 820-942(3)]

Why are the net assets of the entity multiplied by 20/21 in calculating the safe harbour debt amount?

2.81       The fraction 20/21 is best understood as arising from the 20:1 ratio in the same way as three-quarters corresponds to the 3:1 ratio. This amount represents the overall amount of debt that the entity can have to satisfy the debt to equity ratio of 20:1 applied to its net assets as calculated in the method statement.

2.82       Example 2.7 illustrates the rationale behind the total debt amount calculation:

Example 2.7

The following average values have been extracted from Safefin’s balance sheet for the year ended 30 June 2002. The company is a foreign controlled financial entity during the whole income year.

Assets

Liabilities

  Ratio

Loans provided

$90

     Loan

$95

     19 (debt)

Other assets

$ 10

     Equity

$5

     1 (equity)

 

$ 100

 

$ 100

 

Safefin does not have any non-debt liabilities, any associate entity equity nor does it undertake any transactions which would fall under the zero-capital amount.

Under the total debt amount calculation Safefin’s average assets value of $100 is multiplied by 20/21 to arrive at the total debt amount (i.e. $100 ´ 20/21 = $95.24). At $95 Safefin’s debt satisfies this requirement.

2.83       It should be noted that the total debt amount is only one part of the safe harbour test for financial entities. A discussion of how the total debt amount and the adjusted on-lent amount interact is in paragraphs 2.63 and 2.64

What is the adjusted on-lent amount?

2.84       The adjusted on-lent amount is the second calculation required to calculate the safe harbour debt amount. The adjusted on-lent amount calculation operates to remove the assets which fall within the definition of on-lent amount so as to ensure that the entity’s other assets are funded by a debt to equity ratio of not more than 3:1. The adjusted on-lent amount is calculated using the following steps:

Step 1:  Work out the average value, for the income year, of all the assets of the entity.

Step 2:  Reduce the result of step 1 by the average value, for that year, of all the associate entity equity of the entity.

Step 3:  Reduce the result of step 2 by the average value, for that year, of all the non-debt liabilities of the entity.

Step 4:  Reduce the result of step 3 by the average value, for that year, of the on-lent amount of the entity.

If the result of this step is negative, it is reset to zero.

Step 5:  Multiply the result of step 4 by three-quarters.

Step 6:  Add to the result of step 5 the average value, for that year, of the on-lent amount of the entity.

Step 7:  Reduce the result of step 6 by the average value of all the associate entity debt of the entity.

Step 8:  Add to the result of step 7 the entity’s associate entity excess amount . The result is the adjusted on-lent amount.

[Schedule 1, item 1, subsection 820-200(3)]

2.85       Any associate entity debt is deducted at step 7 simply to avoid double counting. It is deducted from debt capital in calculating adjusted average debt and so should not be added back.

What is the on-lent amount?

2.86       The on-lent amount of an entity means:

·       the value of its assets that are comprised by:

-           debt interests issued to the entity by other entities; and

-           leases for the hire of goods which are not debt interests issued by other entities where:

§    the leases are for a term of 6 months or more;

§    the leases are part of the business of hiring goods carried on by the entity; and

§    the entity’s business of hiring of goods is not carried on predominantly for the purpose of hiring goods to any of its associates (as defined in section 318 of the ITAA 1936); plus

·       the value of securities that were held by the entity that:

-           have been sold by the entity under a reciprocal purchase agreement, sell-buyback arrangement or securities loan arrangement; and

-           have not yet been repurchased by the entity under the agreement or arrangement.

[Schedule 2, item 50, definition of ‘on-lent amount’ in subsection 995-1(1)]

2.87       The treatment of the on-lent amount is an acknowledgment that financial entities are in the business of borrowing funds in order to on-lend those funds to third parties, including associates. It recognises that these entities require higher gearing ratios in order to undertake their normal commercial activities. However, the inclusion of certain leases and securities lending and repurchase arrangements recognises that there are similarities between the lending of funds and these other activities.

Why are certain leases included within the on-lent amount?

2.88       Under the current law, the majority of leases are not treated as debt for tax purposes. Consistent with the current approach, the definition of debt interest will not include leases unless they are debt for the purposes of the existing income tax law. The definition of on-lent amount will ensure that certain leases which are not debt interests will nevertheless qualify for the on-lending concession because of the equivalence of this business to that of lending.

Why are certain securities included within the on-lent amount?

2.89       Payments received for the sale of the securities (other than fees) under reciprocal purchase agreements, sell-buyback arrangements and securities loan arrangements are included within the zero-capital amount. To ensure that securities under the abovementioned arrangements receive on-lending treatment these securities are included within the on-lent amount where they have not been repurchased under the arrangement. This is notwithstanding that, as the securities have been sold, they do not legally form part of the assets of the entity. However, this treatment recognises that the acquisition of the securities may have been funded through debt which has not been extinguished because the disposal of the securities is only a temporary disposal.

2.90       It should be noted that the other assets which come within the zero-capital amount (securitised assets, low margin loans and low risk-weighted loans) also fall within the definition of on-lent amount . Specifically, these assets are assets held by the entity that are comprised by debt interests issued by other entities.

Comparing the total debt amount and the adjusted on-lent amount

2.91       If the adjusted on-lent amount is equal to or greater than the total debt amount, the safe harbour debt amount is the total debt amount. This will ensure that the gearing is capped at 20:1 (subject to the carve-out of the zero-capital amount). If the adjusted on-lent amount is less than the total debt amount it is the safe harbour amount. [Schedule 1, item 1, subsection 820-200(1)]

2.92       Generally, depending on the proportion of on-lending activity undertaken by the financial entity, the actual safe harbour gearing ratio will be somewhere between 3:1 and 20:1. However, a safe harbour in excess of 20:1 will be possible where the entity has assets which fall within the zero-capital amount.

2.93       Example 2.8 illustrates the rationale behind the adjusted on-lent amount calculation.

Example 2.8

Following on from Example 2.7 Safefin’s balance sheet for the year ended 30 June 2002 is reproduced below.

Assets

Liabilities

Loans provided

$90

     Loan

$95

Other assets

$ 10

     Equity

$5

 

$ 100

 

$ 100

Safefin does not have any non-debt liabilities, associate entity debt or associate entity equity.  It does not hold any assets which fall within the zero-capital amount.

Safefin’s adjusted on-lent amount is calculated by adding the value of the loan assets of $90 and the value of the other assets (the non-lending assets) multiplied by three-quarters. This amount equals $97.50. That is, Safefin’s non-lending assets of $10 can be funded by no more than $7.50 of debt ($10 ´ 3/4 = $7.50) whereas the on-lent amounts ($90) can be funded totally by debt. This means that under the on-lending rule Safefin could effectively have $97.50 in debt to fund its Australian operations. This would reflect an overall gearing ratio of 40:1.

However, in Safefin’s case the safe harbour debt amount limits the overall gearing of the entity to a gearing level of 20:1 because it does not have assets which fall within the zero-capital amount. The safe harbour debt amount is the lesser of the total debt amount and the adjusted on-lent amount. Therefore, as the total debt amount is $95.24 ($100 × 20/21), which is the lesser of the 2 amounts, it is the safe harbour debt amount.

Thus, Safefin is limited to a gearing ratio of 20:1.

Example 2.9:  Foreign controlled Australian financial entity

Forent (a foreign entity) owns 100% of AustFin1. AustFin1 is a financial entity that provides a range of financial services. It has provided loans to unrelated parties of $30 million. AustFin1 has invested $5 million into Assoc2 and holds a 75% interest in the company. Assoc2’s primary business activity is land development. It is not a financial entity.

AustFin1’s principle source of funds for carrying on its activities is debt financing.

The relevant transactions can be represented in the following diagram:

 

 

 

 

 

 

 



AustFin1’s average assets are as follows:

                                    Current assets                                      $2 million

                                    Investment in Assoc2                          $5 million

                                    Loans to unrelated parties                    $30 million

                                    Other non-current assets                      $4 million

AustFin1’s total assets have an average value of $41 million (Chapter 8 discusses the methods used to calculate average values).

AustFin1 has non-debt liabilities of $1 million and average debt of $35 million.

AustFin1 is a foreign controlled company. Accordingly the entity will be subject to the thin capitalisation rules as a foreign controlled Australian financial entity.

Note (a): Austfin does not have any assets that come within the zero-capital amount. Example 3.2 demonstrates how the safe harbour debt amount is calculated for a financial entity which holds these types of assets. Please note that the example deals with an outward investing Australian financial entity.

Note (b): Assoc2 is also a foreign controlled company. It will be subject to the thin capitalisation rules for general foreign controlled Australian entities. Example 2.3 demonstrates how the thin capitalisation rules affect a foreign controlled Australian company that is not a financial entity. Austfin paid a premium of $1 million for its stake in Assoc2. Assoc2 has excess debt capacity of $0.5 million.

Calculations - safe harbour debt amount

AustFin1

Total debt amount

Step 1:  The average value of all the assets of AustFin1 equals $41 million.

Step 2:  The average value of AustFin1’s associate entity debt is zero. Therefore, the result of step 2 is $41 million.

Step 3:  The average value of AustFin1’s associate entity equity is $5 million. Therefore, the result of step 3 is $36 million.

The $5 million invested in Assoc2 does not increase the maximum debt that AustFin1 may have unless there is excess debt capacity in Assoc2 or AustFin1 has paid a premium for its equity in Assoc2.

Step 4:  The average value of AustFin1’s non-debt liabilities is $1 million. Therefore, the result of step 4 is $35 million.

Step 5:   AustFin1 does not have any zero-capital amount. Therefore, the result of step 5 is $35 million.

Step 6:  Multiplying the result of step 5 by 20 / 21 equals

$33.33 million.

Step 7:  As AustFin1 does not have any zero-capital amount, the result of step 7 is $33.33 million.

Step 8:  The associate entity excess amount is $1.327 million. The total debt amount is $34.657 million. 

The premium excess amount of Assoc2 is ($1 million multiplied by 20/21) $0.952 million.  The attributable safe harbour excess amount of Assoc2 is ($0.5 million multiplied by AustFin1’s equity holding of Assoc2, 75%) $0.375 million. The associate entity excess is the total of those 2 amounts which is $1.327 million.

Adjusted on-lent amount

Step 1:  The average value of all of the assets of AustFin1 equals $41 million.

Step 2:  The average value of AustFin1’s average associate entity equity is $5 million. Therefore, the result of step 2 is $36 million.

Step 3:  The average value of AustFin1’s non-debt liabilities is $1 million. Therefore, the result of step 3 is $35 million.

Step 4:  The average value of AustFin1’s on-lent amount is $30 million. Therefore, the result of step 4 is $5 million.

Step 5:  Multiplying the result of step 4 by three-quarters equals $3.75 million.

Step 6:  Adding the average on-lent amount to the result of step 5 equals $33.75 million.

Step 7:  The value of the associate entity debt of the entity is zero. Therefore, the result of step 7 is $33.75 million.

Step 8:  The entity’s associate entity excess amount is $1.125 million. Therefore, $34.875 million is the adjusted on-lent amount. 

The premium excess amount of Assoc2 is ($1 million multiplied by 3/4) $0.75 million. The attributable safe harbour excess amount of Assoc2 is ($0.5 million multiplied by Austfin’s equity holding of Assoc 2: 75%) $0.375 million debt. The associate entity excess is the total of those 2 amounts which is $1.125 million.

As the total debt amount is less than the adjusted on-lent amount, the safe harbour debt amount is the total debt amount of $34.657 million.

The safe harbour debt amount of $34.657 million represents the maximum level of debt funding available to AustFin1 to fund its Australian operations. This amount is compared to AustFin1’s average debt amount of $35 million. Hence, AustFin1 has not satisfied the safe harbour rule for financial entities.

An adjustment to disallow some of AustFin1’s debt deduction will occur if it cannot demonstrate that its level of debt is acceptable under the arm’s length test.

Foreign general investor

2.94       The thin capitalisation rules will apply to non-residents who claim debt deductions in the course of deriving Australian assessable income. For example, the rule will apply to a non-resident company that operates in Australia through a permanent establishment (e.g. a branch) or to a non-resident partner in a partnership that derives Australian source income.

2.95       The safe harbour debt amount is calculated by applying the following method statement:

Step 1:  Work out the average value, for the income year, of all of the Australian investments of the entity.

Step 2:  Reduce the result of step 1 by the average value of all the associate entity debt of the entity from Australian investments.

Step 3:  Reduce the result of step 2 by the average value, for that year, of all the associate entity equity of the entity from Australian investments.

Step 4:  Reduce the result of step 3 by the average value of all the non-debt liabilities of the entity that have arisen because of those Australian investments. If the result is negative take it to be zero. 

Step 5:  Multiply the result of step 4 by three-quarters.

Step 6:  Add to the result of step 5 the entity’s associate entity excess amount . The result is the safe harbour debt amount. 

[Schedule 1, item 1, section 820-205]

2.96       The safe harbour rule operates in the same manner as the rule for a general foreign controlled Australian entity, (see paragraphs 2.32 to 2.57) except that it deals only with amounts (e.g. assets and debt) attributable to the foreign entity’s Australian investments .

What are Australian investments?

2.97       Australian investments are assets held by the entity that:

·       are attributable to any of its Australian permanent establishments whether the assets are located in Australia or not; or

·       are held for the purposes of producing the entity’s assessable income.

[Schedule 1, item 1, section 820-205, step 1 of the method statement]

2.98       The record keeping requirements for foreign entities carrying on business through Australian permanent establishments are contained in Subdivision 820-L and are explained in Chapter 9.

Example 2.10:  Foreign general investor

Mr Investor (a non-resident) owns several apartment blocks in Sydney and Melbourne. He derives assessable rental income from the letting of apartment units. In order to fund the acquisition of the apartment blocks he borrowed $50 million from an Australian bank and $30 million from an associate in the USA. He contributed the rest of the funds from his own savings. Mr Investor’s otherwise allowable debt deductions are $8 million per year. As this is greater than $250,000, the de minimis amount, Mr Investor is subject to Division 820.

The average value of the buildings and associated fixtures and fittings is $100 million. The assets are valued in accordance with Australian accounting standards.

Mr Investor is a foreign entity with Australian investments and hence the thin capitalisation rules apply to him. His safe harbour debt amount in respect of his Australian investment is calculated as follows:

Safe harbour debt amount

Step 1:  The average value of Mr Investor’s Australian investment is $100 million.

Step 2:  Associate entity debt is zero. The result of step 2 is $100 million.

Steps 3 and 4:  There is no associate entity equity or non-debt liabilities. Therefore, the result of step 4 is $100 million.

Step 5:  Multiplying the result of step 4 by three-quarters equals $75 million.

Step 6:  There is no associate entity excess. Therefore, $75 million is the safe harbour debt amount.

Mr Investor’s Australian investment has a safe harbour debt amount of $75 million. Thus, he has not satisfied the safe harbour rule because his total debt funding (i.e. debt capital) is $80 million which exceeds his safe harbour debt amount.

If Mr Investor is not able to demonstrate that the level of debt funding of the investment is acceptable on an arm’s length basis an adjustment to disallow part of his debt deductions against his Australian assessable income will be made for the relevant year.

Foreign financial investor

2.99       The safe harbour debt amount is the lesser of:

·       the total debt amount; and

·       the adjusted on-lent amount.

[Schedule 1, item 1, subsection 820-210(1)]

2.100     The calculation of these amounts is similar to that for a foreign controlled Australian financial entity (see paragraphs 2.58 to 2.93) but deals only with amounts attributable to its Australian investments. A total debt amount (calculated using the 20:1 ratio with an allowance for assets falling within the zero-capital amount) and an adjusted on-lent amount are calculated. In doing so, only the entity’s Australian assets (comprising its Australian investments) and its Australian non-debt liabilities are taken into account. [Schedule 1, item 1, subsections 820-210(2) and (3)]

2.101     The same record keeping requirements apply to these foreign entities as apply to foreign general investors.

Arm’s length debt amount

2.102     The arm’s length debt amount can replace the safe harbour debt amount as an entity’s maximum allowable debt for a period. An inward investing entity may choose to adopt an arm’s length debt amount as its maximum allowable debt amount where it can demonstrate that the amount satisfies the requirements set out in section 820-215.

2.103     The application of the arm’s length debt amount to inward investing entities is discussed in Chapter 10.

What is the amount of debt deduction disallowed under the thin capitalisation rules?

2.104     In circumstances where a foreign investor or foreign controlled Australian entity breaches the thin capitalisation rules an adjustment to disallow all or part of each debt deduction must be calculated [Schedule 1, item 1, subsection 820-185(1) and section 820-220] . The amount of debt deduction disallowed is calculated in the same way for all types of inward investing entities.



2.105     The amount of debt deduction disallowed is worked out using the following formula:

Where:

average debt is the entity’s average debt that gives rise to debt deductions for that year or part thereof.

debt deduction means each debt deduction for an income year, or part thereof.

excess debt equals the amount by which the adjusted average debt exceeds the maximum allowable debt.

For foreign investors, these are amounts attributable to their Australian investments.

2.106     Debt deductions are disallowed in direct proportion to the amount by which average debt exceeds the maximum allowable debt.

2.107     In effect, when applied across all deductions the formula applies an average cost of debt to the excess debt amount. The average cost is calculated from the entity’s aggregate debt and debt deduction figures without any adjustments (e.g. no amounts of debt are excluded).

2.108     The legislation provides that the amount of debt deduction disallowed must be calculated separately for each deduction [Schedule 1, item 1, subsection 820-185(1) and section 820-220] . This is done in the event that taxable profits for particular activities or certain classes of income need to be calculated (e.g. where the tax rates vary for different ‘pools’ of profits within an entity). However, in practice the entity will usually apply the formula to the total of its relevant debt deductions.

Example 2 . 11



Following on from Example 2.6 assume that Austco’s total debt deduction for the income year in respect of the loan of $5 million is $600,000. If an adjustment to Austco’s debt deduction is warranted under the thin capitalisation rules then the amount disallowed would be:

Application to part year periods for inward investing entities

2.109     In relation to inward investing entities, the thin capitalisation rules will apply where, for a part of the year the entity was an inward investing entity and its adjusted average debt for that period exceeds its maximum allowable debt. [Schedule 1, item 1, subsection 820-225(1)]

2.110     The adjusted average debt of such an entity is the average value (for the period the entity was an inward investing entity) of its debt capital that gave rise to its debt deduction expenses incurred during that period less the average value of any associate entity debt outstanding during the period. [Schedule 1, item 1, subsections 820-225(2) and (3), item 4 in the table]

2.111     When calculating the maximum allowable debt and the amount of each debt deduction to be disallowed, the average values of all the elements that are used to calculate the respective amounts for the period are calculated by reference to the period for which the entity was an inward investing entity only, and not by reference to the entire income year [Schedule 1, item 1, subsection 820-225(3), item 1 in the table] . The debt deductions included are only those which are incurred during that same period [Schedule 1, item 1, subsection 820-225(3), items 2 and 3 in the table] . Debt deductions incurred outside that period in the income year are unaffected by the result of applying the rules to its deductions during the period.

2.112     Thus, for the period that the entity is a financial entity, the rules for foreign entities apply. For any period that the entity is not a financial entity the rules for general entities apply.

Example 2.12

As at 1 July 2002, a UK trading company carries on business via a permanent establishment in Australia. On 2 February 2003 it becomes a financial entity. Its balance day is 30 June 2003.

From 1 July 2002 to 1 February 2003 the rules for foreign general investors will apply to the UK trading company. From 2 February 2003 onwards, the rules for foreign financial investor s will apply.

When calculating the average values of its assets, debt and equity the entity will separate the income year into the 2 periods, being 1 July 2002 to 1 February 2003 and 2 February 2003 to 30 June 2003, and calculate values for each period. Similarly, it will allocate its debt deductions so that only those debt deductions incurred in the first period are used for the foreign general investor calculations and only those debt deductions incurred in the second period are used for the foreign financial investor calculations.

If the entity exceeds its maximum allowable debt during the period that it was a foreign general investor, this will not affect the deductibility of its debt deductions incurred during the period it was a foreign financial investor. These latter debt deductions will only be disallowed if the maximum allowable debt applicable to foreign financial investors is exceeded for the period 2 February 2003 to 30 June 2003. Excess debt in one period cannot be reduced by not having excess debt in another period during the same or a different income year.

Yes

 

Yes

 
Diagram 2.1:  When will an adjustment be made to disallow all or part of an inward investing (non-ADI) entity’s debt deductions?

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



Application and transitional provisions

2.113     The application and transitional provisions for this measure are discussed in Chapter 1.

Consequential amendments

2.114     The consequential amendments for this measure are discussed in Chapter 1.



C hapter

Outward investing entities (non-ADI)

Outline of chapter

3.1         This chapter explains how the thin capitalisation rules in Subdivision 820-B will apply to an Australian entity that either directly or indirectly has offshore investments and is a non-ADI. It explains how such an entity works out its maximum allowable debt and by how much it needs to reduce its debt deductions where the thin capitalisation rules have been breached.

3.2         A threshold requirement will exclude small investors from the thin capitalisation regime. The exclusion will operate where the debt deductions of the entity, either alone or together with associate entities, are $250,000 or less.

Context of reform

3.3         An Australian entity may invest overseas via an investment in a foreign entity that it controls or by carrying on a business at or through an overseas branch. In a similar manner to foreign entities, an Australian entity with offshore operations in either form can allocate excessive amounts of debt to its Australian operations to maximise deductions for interest, thereby reducing tax paid in Australia. The existing thin capitalisation rules do not impose limits on the debt levels of these entities.

3.4         However, certain provisions deal with the deductibility of interest expenses for outward investors. These are contained in section 8-1 of the ITAA 1997 and sections 79D and 160AFD of the ITAA 1936. The rules in section 79D prevent a foreign loss being deducted from domestic assessable income and section 8-1 denies deductions incurred in earning exempt (foreign) income. However, because all of these rules rely on tracing the use of borrowed funds, it is relatively easy to circumvent their operation by establishing a use of funds that ensures deductibility.

3.5         Another problem with the rules is that they apply on a single entity basis, and it is therefore possible to circumvent them by using interposed entities to separate the foreign income from the expenditure.

3.6         Australia’s DTAs also require that taxpayers with foreign branches calculate the taxable (or exempt) income of those branches consistent with the business profits article of the relevant DTA. Chapter 4 outlines some of the problems with the rules for determining the appropriate capital funding of a branch in accordance with that article.

3.7         The new thin capitalisation regime will impose a limit on the extent to which the Australian operations of Australian outward investors can be funded by debt. Accordingly, the current limitations imposed by section 79D and section 8-1 (in relation to exempt income) on interest deductions will be removed in so far as they apply to debt deductions and do not relate to an entity’s overseas permanent establishment. Therefore, expenses relating to those deductions will be able to be deducted when incurred in earning exempt foreign income and will no longer be quarantined, subject to the limits imposed by the new thin capitalisation provisions.

3.8         The new thin capitalisation regime is designed to prevent excessive debt deductions being claimed. However, the new rules will apply to all of the debt of the entity and not just to the debt borrowed from foreign related parties as is the case with the existing rules. This will strengthen the integrity of the new rules.

3.9         Under the new regime the maximum debt to equity ratio allowed is 3:1, compared to 2:1 under the current provisions. However, in recognition of the fact that financial entities on-lend large amounts of their debt, such entities are allowed a debt to equity ratio of up to 20:1 under the new rules, compared to 6:1 under the current provisions. Nevertheless, in certain circumstances a ratio above 20:1 may be permitted where an entity holds a specific class of assets.

3.10       The prescribed safe harbour debt to equity ratio may be exceeded in circumstances where the funding structure could be maintained on an arm’s length basis. In such a situation, no deductions will be disallowed. This change recognises that some funding arrangements may be commercially viable notwithstanding that they exceed the prescribed limits. It also makes the rules more consistent with Australia’s DTAs.

3.11       The new rules also:

·       incorporate comprehensive concepts of debt and debt deductions that arise from debt arrangements rather than being restricted to the narrow concept of interest as in the existing rules, reflecting a move to economic form over substance; and

·       apply to groups of entities where they choose to group for thin capitalisation purposes. The application of the thin capitalisation rules to groups is discussed in detail in Chapter 6.

Summary of new law

What is an outward investing entity (non-ADI)?

An outward investing entity (non-ADI) is not a bank, and is an Australian entity that either:

·       controls (alone or with others) a foreign entity;

·       carries on business via an overseas permanent establishment; or

·       is an associate entity of either of the above entities or either of the above entities is an associate entity of the first entity.

What thin capitalisation rule applies to outward investing entities (non-ADI)?

The rule is that debt deductions are disallowed, in whole or in part, where debt used to fund the entity’s Australian operations exceeds the maximum allowable debt.

What is the maximum allowable debt?

The maximum allowable debt is the greatest of:

·       75% of the average value of net Australian assets (calculated differently for financial and non-financial entities);

·       the amount that would result in gearing equal to 120% of the gearing of the worldwide group; or

·       the amount of debt that would have been provided to fund the Australian business had all the relevant parties been dealing with each other on an arm’s length basis.

How much deduction is disallowed?

The amount disallowed is in direct proportion to the amount by which actual debt exceeds maximum allowable debt.

Comparison of key features of new law and current law

New law

Current law

Outward investing entities will have their debt deductions reduced if their debt level exceeds a maximum level.

Either a safe harbour or an arm’s length test sets the maximum debt level.

The debts of an outbound investor are traced to an end use to determine the treatment of the interest expense.

The interest expense can be denied or quarantined when it is incurred in earning foreign income.

The measures apply to Australian entities that have controlled foreign investments or permanent establishments overseas as well as to inbound investment.

The thin capitalisation measures only apply to foreign controlled Australian entities and to foreign investors deriving Australian assessable income.

The measures apply to total debt of the Australian entity.

The measures only apply to foreign related-party debt and foreign debt covered by formal guarantee.

A safe harbour gearing ratio of 3:1 will apply to general investors with a gearing ratio of up to 20:1 applying to financial entities. There are additional special rules for certain types of securities business.

The permitted gearing ratio is 2:1 for general investors and 6:1 for financial entities.

The general safe harbour debt amount is calculated as 75% of the average value of the net assets of the business (higher for financial entities).

The permitted debt amount is calculated by multiplying actual equity amounts by 2 (6 for financial entities).

Outward investing entities may also apply an arm’s length test or a worldwide gearing test (in certain circumstances) where the safe harbour gearing ratio is exceeded.

There is a limited arm’s length test dealing only with guaranteed foreign debt in certain circumstances. There is no worldwide gearing test.

Detailed explanation of new law

Overview

3.12       The outward investing rules will apply to Australian entities that either directly or indirectly have offshore operations. Such operations could include a foreign subsidiary or carrying on business at or through an overseas permanent establishment. This chapter describes only those provisions that apply to these types of entities.

3.13       The rules for outward investing entities will take precedence over the rules for inward investing entities. For example, if an Australian entity has an overseas permanent establishment but is also foreign controlled, the rules discussed in this chapter will apply. [Schedule 1, item 1, subsection 820-85(1) and paragraph 820-185(1)(a)]  

3.14       The thin capitalisation rules seek to limit the amount of debt that can be allocated to the Australian operations of entities with offshore investments. Where the prescribed gearing limits are breached the rules disallow some of the debt deductions attributed to the Australian operations. If the prescribed thin capitalisation limits are not breached, this does not mean that the entity will automatically be allowed deductions for expenses associated with its debt. The rules operate to disallow debt deductions that are otherwise allowable under the income tax law.

3.15       In determining whether an entity has breached the safe harbour or the worldwide gearing rule (where available), the gearing level of the entity’s net Australian assets will be tested. Australian assets consist of the entity’s total assets (other than assets attributable to any of its foreign permanent establishments) less its equity and debt investments in its controlled foreign entities. Certain other amounts are subtracted to arrive at the entity’s net Australian assets.

3.16       Broadly, the thin capitalisation rules applying to outward investing entities have the same rationale as, and operate in a similar manner to, the rules which apply to inward investing entities (see Chapter 2). There is an additional rule for outward investing entities which will allow, in certain circumstances, the gearing of the Australian operations to be up to 120% of the Australian entity’s worldwide gearing level.

3.17       The outward investing rules will also apply to a group of entities who have elected to group for thin capitalisation purposes if it has similar foreign operations (see Chapter 6).

What is an outward investing entity (non-ADI)?

3. 18       This is a term used in the legislation to describe Australian entities with offshore investments. Firstly, they are not banks or other ADIs. Secondly, the legislation further categorises them as either an:

·       outward investor (general); or

·       outward investor (financial).

[Schedule 1, item 1, subsection 820-85(2); Schedule 2, item 52, definition of ‘outward investing entity (non-ADI)’ in subsection 995-1(1)]

3. 19          Further, the rules classify these entities as either financial or general entities. This is done so as to ensure that the gearing levels permitted under the rules take into account the different debt levels required by each type of entity .

Outward investor (general)

3. 20       An outward investor (general) is an entity that is neither a financial entity nor an ADI at any time during the period, and is one or more of the following:

·       an Australian controller of at least one Australian controlled foreign entity (not necessarily the same Australian controlled foreign entity throughout the period) [Schedule 1, item 1, subsection 820-85(2), item 1(a) in the table] ;

·       an Australian entity that carries on a business at or through at least one overseas permanent establishment (not necessarily the same permanent establishment throughout the period) [Schedule 1, item 1, subsection 820-85(2), item 1(b) in the table] ; and/or

·       an Australian entity (referred to here as the relevant entity for ease of explanation) where:

-           the relevant entity is an associate entity of an outward investing entity (ADI) or (non-ADI); or

-           an outward investing entity (ADI) or (non-ADI) is an associate entity of the relevant entity [Schedule 1, item 1, subsection 820-85(2), item 3 in the table] .

3. 21       These types of entities will be referred to as Australian general investors throughout this chapter.  The terms Australian controller , Australian controlled foreign entity and associate entity are discussed in Chapter 7.

3. 22       An overseas permanent establishment is a permanent establishment that is located in a country other than Australia at or through which the Australian entity carries on business. [Schedule 2, item 55, definition of ‘overseas permanent establishment’ in subsection 995-1(1)]  

Outward investor (financial)

3. 23       An outward investor (financial) is defined in the same way as an outward investor (general) except that it must be a financial entity throughout the period [Schedule 1, item 1, subsection 820-85(2), item 2 in the table] . These will be referred to as Australian financial investors throughout this chapter.

3. 24       A financial entity is an entity that is not an ADI and:

·       is a registered corporation under the Financial Corporations Act 1974 ;

·       is a securitisation vehicle; or

·       holds a dealer’s licence granted under Part 7.3 of the Corporations Law where:

-           the entity carries on a business of dealing in securities; and

-           that business is not carried on predominantly for the purpose of dealing in securities with, or on behalf of, the entity’s associates (the term associate is discussed in Chapter 7).

[Schedule 2, item 31, definition of ‘financial entity’ in subsection 995-1(1)]

3. 25       This definition will be updated to take account of changes to the Financial Corporations Act 1974 and the Corporations Law .

What is the thin capitalisation rule for outward investing entities (non-ADI)?

Thin capitalisation rule

3. 26       The thin capitalisation rules will operate where the gearing of the Australian operations of outward investing entities exceeds a prescribed limit. The prescribed limit is exceeded where the entity’s adjusted average debt exceeds its maximum allowable debt . In these circumstances, the thin capitalisation rule will disallow part or all of an entity’s debt deductions for the income year. However, a debt deduction will not be disallowed under the rules (although, it could be disallowed under either section 8-1 of the ITAA 1997 or section 79D of the ITAA 1936) to the extent that it is an expense attributable to an overseas permanent establishment of the entity. [Schedule 1, item 1, subsection 820-85(1)]  

3. 27       The terms debt capital and debt deductions are explained in Chapter 1. The provisions that set out the methods of calculating an average value are discussed in Chapter 8.

3. 28       The rules also operate where the entity is an outward investing entity for part of the year. [Schedule 1, item 1, section 820-120]

What is an entity’s adjusted average debt?

3. 29       An entity’s adjusted average debt for an income year is:

·       the average value of its debt capital that gives rise to its debt deductions (other than debt capital attributable to its foreign permanent establishments); less

·       the average value of its loans to associate entities (other than any loans to its controlled foreign entities); less

·       the average value of any loans to its controlled foreign entities.

[Schedule 1, item 1, subsection 820-85(3)]

3. 30       In calculating an entity’s adjusted average debt, amounts attributable to the entity’s permanent establishments need to be disregarded. This is to ensure that only the debt of the Australian operations is tested. In certain circumstances, there is potential for double counting because amounts which need to be deducted may also be attributable to an overseas permanent establishment. For example, a loan to a controlled foreign entity raised overseas by the Australian entity’s permanent establishment may be attributable to the permanent establishment. To avoid possible double-counting, amounts attributable to any of the entity’s overseas permanent establishments should be disregarded when calculating adjusted average debt.

3. 31       By lending to its controlled foreign entities, the Australian entity effectively shifts deductions from itself to the other entity and to that extent its debt funding is not used to fund its Australian assets. For this reason, the amount of loans to controlled foreign entities is deducted from an entity’s debt before comparing it with the maximum allowable debt. As a result, the Australian entity is allowed a deduction in respect of an amount of its debt equal to the amount lent to its controlled foreign entities.

3. 32       It should be noted that loans to an Australian entity’s controlled foreign entities do not have to be traced to the entity’s borrowings or to funds raised overseas and attributed to its permanent establishments.

3. 33       The rationale for deducting associate entity debt is discussed in paragraphs 2.34 and 2.35.

3. 34       Where the entity has debt capital which does not give rise to debt deductions, that debt capital is not taken into account for thin capitalisation purposes. For example, loans on which interest or other expenses are not claimed as allowable deductions are not included. In addition, debt that does not give rise to debt deductions is also not deducted from assets in calculating the safe harbour debt amount. This treatment recognises that, although these amounts are not equity, they provide capital to fund the entity’s operations for which no debt deductions are claimed. The term debt deductions is discussed in paragraphs 1.57 to 1.62.

3. 35       Transitional measures which apply in relation to the characterisation of instruments as debt or equity are discussed in paragraphs 1.86 to 1.88.

3. 36       An entity’s adjusted average debt does not exceed its maximum allowable debt if the adjusted average debt is nil or a negative amount. This may occur where an entity borrows funds and on-lends all of these funds to its controlled foreign entities. No adjustment to the entity’s debt deductions will arise where an amount equal to or greater than the amount borrowed is on-lent by the Australian entity to its controlled foreign entity. [Schedule 1, item 1, subsection 820-85(3)]

3. 37       An entity’s adjusted average debt is calculated in the same way for both general and financial entities.

What is an entity’s maximum allowable debt?

3. 38       An entity’s maximum allowable debt is the maximum amount of debt that can be used to fund its Australian assets and thereby not breach the thin capitalisation rules [Schedule 2, item 45, definition of ‘maximum allowable debt’ in subsection 995-1(1)] . To determine if a breach has occurred the entity’s adjusted average debt is compared with the maximum allowable debt.

3. 39       The entity’s maximum allowable debt will differ depending on whether the entity is also foreign controlled. For example, an Australian entity may be an outward investing entity because it has a foreign subsidiary. However, at the same time the Australian entity may itself be foreign controlled making it an inward investment vehicle. For integrity reasons, where an entity is both an outward investor and an inward investment vehicle it will not be able to use the worldwide gearing debt test to demonstrate that its debt funding is acceptable.

3. 40       The maximum allowable debt for Australian general investors and Australian financial investors that are not foreign controlled is the greatest of:

·       the safe harbour debt amount;

·       the worldwide debt amount; or

·       the arm’s length debt amount.

[Schedule 1, item 1, subsection 820-90(1)]

3. 41       If the entity is foreign controlled the maximum allowable debt is the greater of:

·       the safe harbour debt amount; or

·       the arm’s length debt amount.

[Schedule 1, item 1, subsection 820-90(2)]

3. 42       Although entities will be required to calculate their maximum allowable debt level, they will not be required to do so under all the tests. They will have the option to choose one of these tests. However, since the first of these is a safe harbour amount, the second will normally only be determined where the entity’s adjusted average debt capital is greater than the safe harbour debt amount. If the entity’s adjusted average debt capital is less than the safe harbour amount there is no need to calculate the worldwide debt amount or arm’s length debt amount. Additionally, an entity that fails the safe harbour debt test or the worldwide debt test could choose not to calculate the arm’s length debt amount and have debt deductions disallowed on the basis of the other tests.

What is the safe harbour rule for outward investing entities that are not ADIs?

Australian general investors

3. 43       In the case of an Australian general investor, the safe harbour rule requires that its Australian assets be funded by a debt to equity ratio of not more than 3:1.

3. 44       The safe harbour debt amount is calculated by applying the following steps using average values for the income year:

Step 1:   Work out the average value of all the assets of the entity (other than assets that are attributable to any of its overseas permanent establishments).

Step 2:   Reduce the result of step 1 by the average value of all the associate entity debt of the entity (other than controlled foreign entity debt of the entity).

Step 3:   Reduce the result of step 2 by the average value of all the associate entity equity of the entity (other than controlled foreign entity equity of the entity).

Step 4:   Reduce the result of step 3 by the average value of all the controlled foreign entity debt of the entity for that year.

Step 5:   Reduce the result of step 4 by the average value of all the controlled foreign entity equity of the entity for that year.

Step 6:   Reduce the result of step 5 by the average value of all the non-debt liabilities of the entity (other than the non-debt liabilities that are attributable to any of its overseas permanent establishments).

Step 7:   Multiply the result of step 6 by three-quarters.

Step 8:   Add to the result of step 7 the entity’s associate entity excess amount.

The result is the safe harbour debt amount.

[Schedule 1, item 1, section 820-95]

3. 45       The thin capitalisation rule for outward investing entities is based on the principle that the level of debt attributable to the Australian operations is the Australian entity’s total amount of debt less any debt loaned to its controlled foreign entities. Similarly, the level of the equity attributable to the Australian operations is the total amount of equity in the Australian entity less any equity contributed to the controlled foreign entities.

3. 46       Assets attributable to overseas permanent establishments are not used in Australian operations and hence are not included in the calculation of the Australian assets of the entity. Similarly, non-debt liabilities attributable to overseas permanent establishments are excluded from the calculation. [Schedule 1, item 1, section 820-95]

What is associate entity debt, associate entity equity and an associate entity excess amount?

3. 47       The terms associate entity debt , associate entity equity and associate entity excess amount are discussed in paragraphs 2.34 to 2.49.

What is controlled foreign entity equity?

3. 48       The controlled foreign entity equity is the amount of the entity’s assets that is equity held by the entity in a controlled foreign entity of which it is an Australian controller [Schedule 2, item 23, definition of ‘controlled foreign entity equity’ in subsection 995-1(1)] . The meaning of equity in a company, trust or partnership is discussed in paragraphs 1.67 to 1.71. The controlled foreign entity equity is subtracted in the process of calculating the net Australian assets. Likewise controlled foreign entity debt which is the debt owed to the entity by its controlled foreign entities is deducted in the calculation of Australian assets [Schedule 2, item 22, definition of ‘controlled foreign entity debt’ in subsection 995-1(1)] .

What are non-debt liabilities and why are they subtracted from the entity’s assets?

3. 49       The term non-debt liabilities and their treatment is discussed in paragraphs 2.50 to 2.54.

Why are the net Australian assets of the entity multiplied by three-quarters in calculating the safe harbour debt amount?

3. 50       This issue is discussed in paragraph 2.55.

Comparing adjusted average debt with the safe harbour debt amount

3. 51       An entity’s adjusted average debt is compared with the safe harbour debt amount. If the safe harbour debt amount is nil the entity’s net Australian assets (as described earlier) will be taken to have been funded entirely by its non-debt liabilities. However, the entity’s entitlement to debt deductions in respect of debt equal to what it has lent to its controlled foreign entities or associate entities will not be reduced.

3. 52       Where the adjusted average debt exceeds the safe harbour debt amount, the entity has not satisfied the 3:1 debt to equity requirement and some debt deductions will be disallowed unless it can demonstrate that its debt funding is acceptable under either the worldwide gearing rule (where available) or on an arm’s length basis.

3. 53       However, if the adjusted average debt is less than the safe harbour debt amount the entity has satisfied the safe harbour rule and no debt deductions are denied.

Example 3.1:  Australian general investor

AustTwo borrows $3 million from an unrelated financial entity. AustTwo acquires a 75% interest in AustOne for $4.5 million. AustOne makes a loan of $2 million to its wholly-owned controlled foreign company (ForCo).

The ownership structure and relevant transactions can be represented in the following diagram:

 

 

 

 

 

 

 

 

 

 

 

AustTwo’s average assets are $9.5 million and consist of the following:

Current assets                                      $3 million

Investment in AustOne                                    $4.5 million

Buildings                                             $1 million

Plant and equipment                            $1 million

Chapter 8 discusses the methods used to calculate average values.

AustTwo has non-debt liabilities of $0.5 million.

The average value of AustTwo’s debt capital is $3 million.

AustOne’s average assets are as follows:

Current assets                                      $3 million

Loan to ForCo                                                 $2 million

Investment in ForCo                            $5 million

Other non-current assets                      $2 million

AustOne has no non-debt liabilities.

The average value of AustOne’s debt capital is $6 million.

Both Australian entities are outward investors (general) because of the control tests, which are discussed in Chapter 7. Accordingly, each entity will be subject to the thin capitalisation rules.

Calculations - safe harbour debt amount

AustTwo

Step 1:   The average value of the assets of AustTwo is $9.5 million.

Step 2:   The average value of AustTwo’s associate entity debt is zero.  The result of step 2 is $9.5 million.

Step 3:   The average value of AustTwo’s associate entity equity is $4.5 million. Therefore, the result of step 3 is $5 million.

The $4.5 million invested in AustOne does not increase the maximum debt that AustTwo may have unless there is excess debt capacity in AustOne or AustTwo has paid a premium for the purchase of AustOne.

Step 4:   The average value of AustTwo’s average controlled foreign entity debt is zero. Although AustTwo is an Australian controller of the CFC, the CFC does not owe any amount to AustTwo. Therefore, the result of step 4 is $5 million.

Step 5:   The average value of AustTwo’s controlled foreign entity equity is zero because it does not have any direct investment in ForCo. Therefore, the result of step 5 is $5 million.

Step 6:   The average value of AustTwo’s non-debt liabilities is $0.5 million. Therefore, the result of step 6 is $4.5 million.

Step 7:   Multiplying the result of step 6 by three-quarters equals $3.375 million.

Step 8:   The average value of the associate entity excess is zero. The result of this step is $3.375 million. This is the safe harbour debt amount. 

The associate entity excess amount for AustTwo is determined by adding the premium excess amount from its interest in AustOne (zero in the example) to the safe harbour excess amount of AustOne (zero, because AustOne fails the safe harbour test). There is no associate entity excess available to AustTwo. [Schedule 1, item 1, section 820-920]

The safe harbour debt amount of $3.375 million represents the maximum level of debt permitted under the general safe harbour rule of 3:1. That is, after taking into account non-debt liabilities, AustTwo’s average net Australian assets of $4.5 million could be funded by a maximum debt amount of $3.375 million and an average equity amount of not less than $1.125 million. This would satisfy the maximum debt to equity gearing ratio of 3:1.

AustTwo’s loan of $3 million is the only debt capital amount that gives rise to its debt deductions. This amount is its adjusted average debt amount and is compared with the safe harbour debt amount of $3.375 million. AustTwo has not exceeded the safe harbour debt amount and will not suffer any loss of debt deductions.

AustOne

Step 1:   The average value of the assets of AustOne is $12 million.

Step 2:   The average value of AustOne’s associate entity debt is zero (other than debt in ForCo). Therefore, the result of step 2 is $12 million.

Step 3:   The average value of AustOne’s associate entity equity is zero (other than equity in ForCo). Therefore, the result of step 3 is $12 million.

Step 4:   The average value of all of AustOne’s controlled foreign entity debt is $2 million. Therefore, the result of step 4 is $10 million.

Step 5:   The average value of AustOne’s controlled foreign entity equity is $5 million. Therefore, the result of step 5 is $5 million.

Step 6:   The average value of AustOne’s non-debt liabilities is zero. Therefore, the result of step 6 is $5 million.

Step 7:   Multiplying the result of step 6 by three-quarters equals $3.75 million.

Step 8:   The average value of the associate entity excess is zero.  (AustOne does not have any associate entity equity).  The result of this step is $3.75 million. This is the safe harbour debt amount. 

The safe harbour debt amount of $3.75 million represents the maximum level of debt permitted under the general safe harbour rule of 3:1. That is, AustOne’s average net Australian assets of $5 million could be funded by a maximum debt amount of $3.75 million and average equity amount of not less than $1.25 million. This would satisfy the maximum debt to equity gearing ratio of 3:1.

AustOne’s adjusted average debt is calculated by deducting the loan of $2 million provided to its CFC from its average debt capital. Hence, AustOne’s adjusted average debt equals $4 million. This amount is compared to AustOne’s safe harbour debt amount. Accordingly, AustOne has not satisfied the safe harbour rule. 

An adjustment to its debt deductions for the period will arise if AustOne is not able to demonstrate that the level of debt funding is acceptable under the worldwide gearing rule or under the arm’s length rule. The application of the worldwide gearing rule is discussed in paragraphs 3.61 to 3.72 and the arm’s length rule is discussed in Chapter 10 .

Australian financial investors

3. 54       In the case of Australian financial investors, the safe harbour rule reflects the greater debt funding required to support their lending and other financing activities. The on-lending rule for outward investing financial entities operates in the same manner, and for the same reasons, as the on-lending rule for foreign controlled Australian financial entities.

3. 55       The safe harbour debt amount , the total debt amount and adjusted on-lent amount are discussed in detail in paragraphs 2.63 to 2.93. However, a brief explanation of these concepts follows. [Schedule 1, item 1, section 820-100]

The total debt amount

3. 56       The total debt amount is calculated by applying the following method statement using average values for the income year.

Step 1:    Work out the average value of all the assets of the entity (other than assets that are attributable to any of its overseas permanent establishments).

Step 2:    Reduce the result of step 1 by the average value of all the associate entity debt of the entity (other than controlled foreign entity debt of the entity).

Step 3:   Reduce the result of step 2 by the average value of all the associate entity equity of the entity (other than controlled foreign entity equity of the entity).

Step 4:   Reduce the result of step 3 by the average value of all the controlled foreign entity debt of the entity.

Step 5:   Reduce the result of step 4 by the average value of all the controlled foreign entity equity of the entity.

Step 6:   Reduce the result of step 5 by the average value of all the non-debt liabilities of the entity (to the extent that they are not attributable to its overseas permanent establishments).

Step 7:   Reduce the result of step 6 by the zero-capital amount .

Step 8:   Multiply the result of step 7 by 20 / 21.

Step 9:   Add to the result of step 8 the zero-capital amount.

Step 10: Add to the result of step 9 the entity’s associate entity excess amount.

The result is the total debt amount.

[Schedule 1, item 1, subsection 820-100(2)]

What is the zero-capital amount?

3. 57       Where the financial entity has assets that are zero-capital amounts, higher gearing levels will be permitted. These amounts are effectively taken out of the thin capitalisation safe harbour test. Full debt funding is permitted for assets which fall within the zero-capital amount. This is discussed further in paragraphs 2.66 to 2.80.

The adjusted on-lent amount

3. 58       The adjusted on-lent amount is the second amount that must be calculated to determine the safe harbour debt amount. The adjusted on-lent amount calculation operates to remove assets which fall within the definition of on-lent amount so as to ensure that the entity’s other assets are funded by a debt to equity ratio of not more than 3:1. If the adjusted on-lent amount is equal to or greater than the total debt amount, the safe harbour debt amount is the total debt amount. This will ensure that the gearing of the entity is capped at 20:1 with an allowance for assets which fall within the zero-capital amount.  [Schedule 1, item 1, subsections 820-100(1) and (3)]

3. 59       The adjusted on-lent amount is calculated as follows using average values for the income year.

Step 1:   Work out the average value of all the assets of the entity (other than assets that are attributable to any of its overseas permanent establishments).

Step 2:   Reduce the result of step 1 by the average value of all the associate entity equity of the entity (other than controlled foreign entity equity of the entity).

Step 3:   Reduce the result of step 2 by the average value of all the controlled foreign entity debt of the entity.

Step 4:   Reduce the result of step 3 by the average value of all the controlled foreign entity equity of the entity.

Step 5:   Reduce the result of step 4 by the average value of all the non-debt liabilities of the entity (other than the liabilities that are attributable to its overseas permanent establishments).

Step 6:   Reduce the result of step 5 by the average value, for that year, of the entity’s on-lent amount (to the extent that it is not attributable to any of the entity’s overseas permanent establishments and is not part of the entity’s controlled foreign entity debt). This average value is the average on-lent amount .

If the result of this step is negative, it is reset to zero.

Step 7:   Multiply the result of step 6 by three-quarters.

Step 8:    Add to the result of step 7 the average on-lent amount.

Step 9:    Reduce the result of step 8 by the average value of all the associate entity debt of the entity (other than controlled foreign entity debt of the entity).

Step 10: Add to the result of step 9 the entity’s associate entity excess amount. 

The result is the adjusted on-lent amount. 

[Schedule 1, item 1, subsection 820-100(3)]

What is the on-lent amount?

3. 60       The on-lent amount is described in paragraphs 2.86 to 2.93. [Schedule 2, item 50, definition of ‘on-lent amount’ in subsection 995-1(1)] . Assets included as part of the zero-capital amount are also treated as on-lent amounts for the purpose of calculating the average on-lent amount. Because the on-lent amount is deducted at step 6, there is no separate step to deduct associate entity debt which will be part or all of the on-lent amount. This avoids double counting.

Example 3.2:  Australian financial investor

AustFin is a financial entity that provides a range of financial services. It has provided loans to unrelated parties of $30 million and to its wholly-owned controlled foreign entity amounting to $2 million. In addition, it has assets of $20 million which falls within the zero-capital amount. AustFin principally funds its activities through debt financing.

The relevant transactions can be represented in the following diagram:

 

 

 

 



AustFin’s average assets ($66.5 million) are as follows:

Current assets                                      $1 million

Loan to ForCo                                     $2 million

Investment in ForCo                            $6 million

Loans to unrelated entities                   $30 million

Assets in the zero-capital amount        $20 million

Other non-current assets                      $7.5 million

AustFin has non-debt liabilities of $0.5 million.

AustFin’s average debt is $54 million.

AustFin is an Australian financial investor. Accordingly the entity will be subject to the thin capitalisation rules.

Calculations - safe harbour debt amount

AustFin

Total debt amount

Step 1:   The average value of the assets of AustFin is $66.5 million.

Step 2:   The average value of the associate entity debt is zero. The result of step 2 is $66.5 million.

Step 3:   The average value of AustFin’s associate entity equity (other than equity in its CFC) is zero. The result of step 3 is $66.5 million.

Step 4:   The average value of AustFin’s controlled foreign entity debt is $2 million. The result of step 4 is $64.5 million.

Step 5:   The average value of AustFin’s controlled foreign entity equity is $6 million. The result of step 5 is $58.5 million.

Step 6:   The average value of AustFin’s non-debt liabilities is $0.5 million. The result of step 6 is $58 million.

Step 7:   The zero-capital amount is $20 million. The result of step 7 is $38 million.

Step 8:   Multiplying the result of step 7 by 20/21 equals $36.19 million.

Step 9:   Adding the zero-capital amount to the result of step 7 equals $56.19 million.

Step 10:   The entity’s associate equity excess amount is zero.

The total debt amount is therefore $56.19 million.

Adjusted on-lent amount

Step 1:   The average value of the assets of AustFin equals $66.5 million.

Step 2:   The average value of AustFin’s associate entity equity is zero. The result of step 2 is $66.5 million.

Step 3:   The average value of AustFin’s controlled foreign entity debt is $2 million. The result of step 3 is $64.5 million.

Step 4:   The average value of AustFin’s controlled foreign entity equity is $6 million. The result of step 3 is $58.5 million.

Step 5:   The average value of AustFin’s non-debt liabilities is $0.5 million. The result of step 5 is $58 million.

Step 6:   The average value of AustFin’s on-lent amount (that does not include controlled foreign entity debt) is $50 million. This is the average on-lent amount. The result of step 6 is $8 million.

Note:  The assets that fall within the zero-capital amount are included in the on-lent amount.

Step 7:   Multiplying the result of step 6 by three-quarters equals $6 million.

Step 8:   Adding on the average on-lent amount to the result of step 7 equals $56 million.

Step 9:   The average value of the associate entity debt is zero.  The result of this step is $56 million. 

Step 10:   The entity’s associate equity excess amount is zero .

Therefore, the adjusted on-lent amount is $56 million.

As the adjusted on-lent amount ($56 million) is less than the total debt amount ($56.19 million), the safe harbour debt amount is the adjusted on-lent amount.

The safe harbour debt amount of $56 million represents the maximum level of debt funding available to AustFin to fund its Australian operations. The amount is compared with AustFin’s adjusted average debt.

AustFin’s adjusted average debt is $52 million. This amount is calculated by deducting the $2 million loan to ForCo from its average debt capital ($54 million). This amount is compared to the safe harbour debt amount of $56 million. Hence, AustFin has satisfied the safe harbour rule for outward investing financial entities. As a result, no adjustment will be made to its debt deductions for the relevant period.

If AustFin’s debt financing had exceeded the safe harbour debt amount it would need to demonstrate that its level of gearing is acceptable under the worldwide gearing test or the arm’s length test, to avoid losing debt deductions.

What is the worldwide gearing rule for outward investing entities?

3. 61       In the event that an entity exceeds the safe harbour gearing level, the outward investing rules will allow the Australian operations, in certain circumstances, to be geared at up to 120% of the gearing of the Australian entity’s worldwide group. This recognises that Australian businesses may need to borrow funds in order to expand offshore. Where the entity is able to satisfy the worldwide gearing test its debt deductions will not be reduced.

3. 62       In the case of an entity that is also foreign controlled, the worldwide gearing test will not apply. This is because under this rule only the gearing level of the Australian entity and its controlled foreign entities is used and not the gearing of the foreign controller and other entities it controls. Therefore, the gearing level of the Australian entity’s worldwide group could be greater than the actual worldwide gearing of the group controlled by the foreign controller because it is not completely determined by the market. Excluding these entities from the test will ensure the integrity of the worldwide gearing rule. [Schedule 1, item 1, subsection 820-90(2)]

3. 63       If an entity is foreign controlled for only part of a year it will not be able to apply the worldwide gearing test for any part of the year it is not also foreign controlled. [Schedule 1, item 1, subsection 820-90(2)]

3. 64       The worldwide gearing rule will also apply to a group. If the group is also foreign controlled the group will not be able to apply the worldwide gearing test in the event that it fails the safe harbour test. The application of the thin capitalisation rules to groups is discussed further in Chapter 6.

3. 65       The method statement used to calculate the allowable debt amount under the worldwide gearing rule is essentially the same as the method statements used to calculate the safe harbour debt amount. However, under the worldwide gearing test the entity is permitted to have a gearing level as high as 120% of the gearing of the Australian entity’s worldwide group. The allowable gearing ratio is determined from the actual worldwide gearing of the Australian entity and is not predetermined. [Schedule 1, item 1, section 820-110]  

3. 66       The worldwide gearing debt amount is calculated by applying the following method statement using average values for the income year:

Step 1:   Divide the average value of all the entity’s worldwide debt for the income year by the average value of the entity’s worldwide equity.

Step 2:   Multiply the result of step 1 by 1.2.

Step 3:   Add 1 to the result of step 2.

Step 4:   Divide the result of step 2 by the result of step 3.

Step 5:   If the entity:

·       is not a financial entity, multiply the result of step 4 by the result of step 6 in the method statement for the safe harbour debt amount; or

·       is a financial entity, multiply the result of step 4 by the result of step 7 in the method statement used to calculate the total debt amount.

Step 6:   If the entity is a financial entity add to the result of step 5 the zero-capital amount.

Step 7:   Add to the result of step 6 the entity’s associate entity excess amount. 

The result is the worldwide gearing debt amount.

[Schedule 1, item 1, subsections 820-110(1) and (2)]

3. 67       The effect of step 1 and step 2 of the method statement is to apply a 20% uplift factor to the actual worldwide gearing of the entity. The worldwide gearing level is calculated by dividing the worldwide debt by the worldwide equity . This is done in order to determine what the allowable gearing ratio is for the entity’s Australian operations.

3. 68       The worldwide debt of the Australian entity consists of all of the debt owed by the entity and its controlled foreign entities (excluding any debt they owe to each other). [Schedule 2, item 71, definition of ‘worldwide debt’ in subsection 995-1(1)]

3. 69       The worldwide equity of the Australian entity consists of all of the equity capital in the entity and its controlled foreign entities (excluding equity held by each other). [Schedule 2, item 72, definition of ‘worldwide equity’ in subsection 995-1(1)]  

3. 70       Steps 3 and 4 convert the allowable gearing ratio into a debt to net assets fraction in the same way that 3:1 and 20:1 have been converted for the purposes of the other method statements.

3. 71       The net Australian assets (from method statements for the safe harbour debt amount) are then multiplied by the new debt to net assets fraction (step 5). Any associate entity excess amount or zero-capital amount (in the case of a financial entity) is then added. 

3. 72       In the case of a financial entity, the on-lending rule is ignored in working out the allowable worldwide gearing ratio. For example, if the safe harbour gearing ratio of a financial entity is effectively 12:1 (because of the on-lending rule) then the worldwide gearing ratio of the Australian entity would have to be greater than 10:1 for this method to be of benefit to the financial entity. That is, if the worldwide gearing ratio is less than 10:1 the uplift factor of 20% would not raise the allowable gearing level above the entity’s safe harbour ratio of 12:1.

Example 3.3:  Australian general investor: 120% worldwide gearing test

The following example is based on the facts of Example 3. 1. In summary, AustTwo borrows $3 million from an unrelated financial entity. It acquires a 75% interest in AustOne for $4.5 million. AustOne makes a loan of $2 million to its wholly-owned controlled foreign company (ForCo).

The ownership structure and relevant transactions can be represented in the following diagram.

 

 

 

 

 

 

 

 

 

 

 



Both Australian entities are Australian controllers of ForCo (see Chapter 7). The worldwide gearing test is available to both entities as neither is also foreign controlled. [Schedule 1, item 1, sections 820-90 and 820-110]

AustTwo

As discussed in Example 3. 1, AustTwo has satisfied the safe harbour test as its adjusted average debt amount of $3 million does not exceed its safe harbour debt amount of $3.375 million. Accordingly, there is no need to calculate its worldwide debt amount.

AustOne

As discussed in Example 3. 1, AustOne has not satisfied the safe harbour test as its adjusted average debt of $4 million exceeds its safe harbour debt amount of $3.75 million. An adjustment to its debt deductions for the period will arise if AustOne is not able to demonstrate that the level of debt funding is acceptable under the worldwide gearing rule or under the arm’s length rule.

AustOne’s balance sheet using average values for the year is as follows:

Assets

Liabilities

Current assets

$3m

   Loan

$6m

Investment in ForCo

$5m

   Non-debt liabilities

$0m

Loan to ForCo

$2m

   Equity

$6m

Other non-current assets

$2m

 

 

 

$12m

 

$12m

Relevant information concerning ForCo

ForCo has a total debt capital of $18 million of which $2 million is owed to AustOne and $16 million is owed to an unrelated foreign bank.

ForCo’s equity capital is $7 million (it has $2 million in retained earnings).

Calculation - worldwide debt amount

Step 1:   AustOne’s average worldwide debt equals $22 million. This amount consists of the $6 million owed by AustOne to the unrelated financial entity plus $16 million owed by ForCo to entities other than AustOne.

AustOne’ s average worldwide equity equals $8 million. This amount consists of AustOne’s equity of $6 million plus the $2 million retained earnings in ForCo.

The result of dividing the worldwide debt by the worldwide equity equals 2.75.

This amount is AustOne’s worldwide gearing, and can be expressed as a debt to equity ratio of 2.75:1.

Step 2:   Multiplying the result of step 1 by 1.2 equals 3.3.

This amount is AustOne’s actual worldwide gearing ratio increased by 20%, and can be expressed as a ratio of 3.3:1.

Step 3:   Adding 1 to the result of step 2 equals 4.3.

Step 4:   Dividing the result of step 2 by the result of step 3 equals 0.767.

This amount represents what the allowable gearing ratio of 3.3:1 is as a proportion of net assets of the entity.

Step 5:   Multiplying the result of step 4 by AustOne’s net assets of $5 million (AustOne’s step 6 in Example 3. 1) equals $3.837 million.

Step 6:   The entity’s associate entity excess amount is zero.

The worldwide gearing debt amount is therefore $3.837 million.

The worldwide gearing debt amount is greater than AustOne’s safe harbour debt amount of $3.75 million. The difference represents the additional debt that the entity is permitted to have in excess of the safe harbour level without breaching the thin capitalisation rules. However, as AustOne’s adjusted average debt of $4 million exceeds its worldwide gearing debt amount an adjustment to its debt deductions will be made unless it can demonstrate that its gearing is acceptable on an arm’s length basis.

Arm’s length debt amount

3. 73       Chapter 10 discusses the arm’s length debt amount.

What is the amount of debt deduction disallowed under the thin capitalisation rules?

3. 74       In circumstances where an entity breaches the thin capitalisation rule an adjustment to disallow all or part of each debt deduction must be calculated [Schedule 1, item 1, sections 820-85 and 820-115] . The amount of debt deduction disallowed is calculated in the same way for both financial and general entities.

3. 75       The formula for non-ADI outward investing entities operates in the same manner as the formula for non-ADI inward investing entities (this is explained in more detail in paragraphs 2.105 to 2.108). For outward investing entities, debt deductions will not be disallowed by this formula to the extent that it is an expense attributable to any of its overseas permanent establishments. [Schedule 1, item 1, subsection 820-85(1) and section 820-115]

Application to part year periods for outward investing entities

3. 76       The thin capitalisation rule outlined in this chapter will apply to an entity that was a non-ADI outward investing entity for part(s) of an income year. The method statements in this chapter only apply to values relating to that period. The entity’s adjusted average debt and its maximum allowable debt for part of an income year are calculated using average values of the various items during each period [Schedule 1, item 1, section 820-120] . Different thin capitalisation rules, for example the inward investing entity (non-ADI) rules, may apply during the period in which the entity was not an outward investing entity. Alternatively, if the entity was neither an inward investing entity nor an outward investing entity for a period, no thin capitalisation rules may apply.

3. 77       The method of calculating the entity’s maximum allowable debt and the amount of each deduction disallowed, for the part of a year the entity is an outward investing entity, operates in the same manner as for non-ADI inward investing entities (this is explained in paragraph 2.111). [Schedule 1, item 1, section 820-120]  



Diagram 3.1: When will an adjustment be made to disallow all or part of an outward investing (non-ADI) entity’s debt deductions?

 

 

 





Application and transitional provisions

3. 78       The application and transitional provisions for this measure are discussed in Chapter 1.

Consequential amendments

3. 79       Consequential amendments are discussed in Chapter 1. Note, in particular, the changes to section 160AFD of the ITAA 1936 and the insertion of section 25-90 in the ITAA 1997. It should be noted that neither of these amendments relates to debt deductions attributable to foreign branches of Australian entities. [Schedule 1, items 5, 16, 20 and 24]

 



C hapter

Inward investing entities (ADI)

Outline of chapter

4.1         This chapter explains how the thin capitalisation rules in Subdivision 820-E will apply to inward investing entities that are ADIs. These entities are foreign banks that operate their banking business in Australia at or through a permanent establishment. They are referred to as foreign bank branches throughout this chapter.

4.2         The thin capitalisation rules that apply to these entities ensure that they do not reduce their Australian tax liabilities by using an excessive amount of debt to finance their Australian operations. The rules do this by ensuring that the foreign bank allocates a minimum amount of equity capital to its Australian branch for the purposes of calculating its taxable income. The allocation of equity capital is an important aspect of the arm’s length attribution of profits to the branch because it bears on the amount of interest expense allocated to the branch and to other parts of the foreign bank. Where the foreign bank does not take an adequate amount of equity capital into account when calculating its Australian taxable income, its debt deductions (e.g. interest expense) will be reduced.

Context of reform

4.3         The current provisions dealing with the capitalisation of foreign bank branches are contained in Part IIIB of the ITAA 1936. Those rules impose a notional equity requirement that reduces the interest expense of a foreign bank branch by 4% (section 160ZZZB). The reduction is made to reflect that a part of the branch’s funding is in the nature of capital rather than debt. Section 160ZZZB is to be repealed as part of the measures contained in this bill (see paragraphs 4.52 to 4.54). The notional equity rule will be replaced by the rules in Subdivision 820-E.

4.4         A foreign bank that is resident in a country with which Australia has a DTA can elect that Part IIIB does not apply in the calculation of its taxable income for an income year. Where this occurs, the taxable income is calculated by having regard to the business profits article of the relevant DTA. In the past, the rules for determining the appropriate capital funding of a branch in accordance with that article have not been specific about the method for calculating the level of capital required, although the OECD has made a commitment to clarify the position by providing guidance on the application of the article.

4.5         The current notional equity provisions are problematical for several reasons including that:

·       the rules operate arbitrarily in that the 4% reduction occurs regardless of whether the foreign bank branch has equity capital in its books of account;

·       it is arguable whether the definition of interest in the withholding tax provisions, which is used as the base for the notional equity requirement, is broad enough to capture all the finance expenses that are relevant to the funding of a foreign bank branch; and

·       the mechanism for imposing the notional equity requirement may not be accepted in foreign jurisdictions as being a suitable arm’s length approach for determining the capital or debt funding of a branch, which may result in double taxation. This is important in determining whether such an approach is consistent with the business profits articles of Australia’s DTAs.

4.6         The new thin capitalisation rules will:

·       remove the uncertainty that exists in the current law;

·       set out a minimum equity capital requirement for the branch (the safe harbour capital amount);

·       provide the branch with the option to demonstrate that a lower level of equity capital is justified using arm’s length principles (the arm’s length capital amount). The arm’s length capital amount is discussed in Chapter 10;

·       treat foreign bank branches more consistently with Australian banks; and

·       will be more consistent with the business profits articles of Australia’s DTAs.

4.7         Banks internationally are subject to prudential controls (by APRA in Australia, and prudential regulation authorities in other countries) requiring them to maintain minimum levels of capital to support the risk profile of their business operations. These capital adequacy requirements are aimed at ensuring security for creditors (including depositors) of the bank and providing stability to the financial markets.

4.8         The thin capitalisation rules applying to ADIs are broadly based on the methodology of the capital adequacy requirements prescribed by prudential regulators. Under the capital adequacy regime, an ADI’s assets are risk weighted, so those assets that have higher risk (such as loans to corporate entities) require more capital than assets that have low risk (such as government bonds). Similarly, the thin capitalisation rules for ADIs will use risk-weighted asset values rather than book values of assets to calculate the safe harbour minimum capital amount.

4.9         Rules are not required for a foreign-controlled Australian bank (or bank group) that does not have any foreign operations itself, because APRA’s prudential rules set capital levels that are considered to be adequate for calculating the taxable incomes of these purely Australian operations.

4.10       The rules described in this chapter may apply to groups that include a foreign bank branch. Chapter 6 provides details about groups for thin capitalisation purposes. Non-ADI subsidiaries of foreign banks that are not grouped will be subject to the thin capitalisation rules that apply to an inward investing entity (non-ADI). These rules are explained in Chapter 2.

Summary of new law

4.11       The thin capitalisation rules that apply to foreign bank branches treat the branch, for thin capitalisation purposes, as if it were a separate entity that requires a certain minimum level of capital in order to operate a banking business in Australia. This is necessary in order to determine interest and other finance expenses of the branch when calculating the bank’s Australian taxable income.

4.12       The thin capitalisation rules for ADIs will apply from the start of an ADI’s first income year beginning on or after 1 July 2001. The rules are applied at the end of the entity’s income year using average values of the entity’s debt, equity capital and risk-adjusted assets throughout the year. However, in the first income year, special transitional rules provide that only the closing balances of those amounts need to be tested.

Comparison of key features of new law and current law

New law

Current law

Foreign bank branches have their debt deductions reduced if they do not maintain a minimum level of capital that is based on the amount of their risk-adjusted assets.

The minimum capital level is set by either a safe harbour or an arm’s length calculation.

The interest expense of a foreign bank branch is either reduced by 4% to reflect that a proportion of the branch’s funding should be capital, or an amount of capital is allocated to the branch in accordance with the business profits article of the relevant DTA.

Detailed explanation of new law

Inward investing entities (ADI)

4.13       The thin capitalisation rules for ADIs are based on a minimum equity capital level and use risk-adjusted asset values, where they are relevant, rather than the unadjusted book value of assets. The framework for these rules is provided by the capital adequacy regime that ADIs must meet as part of the licensing regime that APRA and foreign prudential regulators administer.

4.14       The alignment with the capital adequacy regime recognises that risk-adjusted assets provide a more commercially realistic and appropriate basis for setting capital requirements. This is consistent with the arm’s length principle contained within the business profits articles of Australia’s DTAs. The use of information prepared for capital adequacy purposes also recognises that regulatory reporting information provides reliable data for determining capital requirements and that a globally consistent capital adequacy regime exists for banks. This should make it easier for host and home countries to agree on the appropriate allocation of capital and thereby greatly reduce the risk of double taxation.

4.15       In the thin capitalisation rules, the requirement to maintain a minimum capital amount ensures that foreign banks do not allocate a disproportionate share of their global debt funding to their Australian operations. The rules operate to disallow some or all of the debt deductions attributed to the Australian operations of a foreign bank where it does not book sufficient equity capital in the accounts of its Australian bank branch to satisfy the minimum requirement. [Schedule 1, item 1, subsection 820-395(1)]  

What is an inward investing entity (ADI)?

4.16       The ADI rules apply to Australian and foreign entities that are ADIs for the purposes of the Banking Act 1959 . These entities include Australian banking entities and foreign bank branches.

4.17       An entity is an inward investing entity (ADI) if it is a foreign bank that carries on its banking business at or through permanent establishments in Australia. When a foreign bank has a branch in Australia, the rules for inward investing entities (ADI) apply. As mentioned in paragraph 4.3, these rules replace the notional equity requirement that is contained in section 160ZZZB of Part IIIB of the ITAA 1936. [Schedule 1, item 1, subsection 820-395(2); Schedule 2, item 39, definition of ‘inward investing entity (ADI)’ in subsection 995-1(1)]

4.18       The rules also operate where the entity is an inward investing entity (ADI) for part of the year (see paragraphs 4.42 and 4.43). [Schedule 1, item 1, section 820-420]

What are the thin capitalisation rules for inward investing entities (ADIs)?

4.19       The thin capitalisation rules will operate to deny a proportion of a foreign bank branch’s debt deductions where the equity capital of the foreign bank branch is less than the prescribed minimum. The legislation does this by requiring foreign bank branches to calculate their minimum capital amount either under a safe harbour formula or an arm’s length determination. The rules will disallow part or all of the bank’s debt deductions for the income year where the average value of the bank’s equity capital attributed to the branch is less than its minimum capital amount calculated under one of the alternatives. [Schedule 1, item 1, subsection 820-395(1)]

4.20       Although foreign bank branches will be required to calculate their minimum capital amount, they will not be required to calculate both the safe harbour and the arm’s length capital amounts. They will have the option to choose either one of these tests. However, since the first of these is a safe harbour amount, the second will normally only be determined where the bank’s average equity capital is less than the safe harbour amount. If the bank’s average equity capital is greater than the safe harbour amount there is no need to calculate the arm’s length amount.

4.21       Additionally, a foreign bank branch that has average equity capital less than the safe harbour amount could choose not to calculate the arm’s length capital amount and have debt deductions disallowed on the basis of the safe harbour capital amount.

4.22       Once a foreign bank branch’s assets, debt and equity capital have been determined, the thin capitalisation rules can be applied. The rules will disallow some of a foreign bank branch’s debt deductions where the branch’s average equity capital is less than its minimum capital amount. However, debt deductions of an OBU which relate to its offshore banking business ( allowable OB deductions ) will not be disallowed. [Schedule 1, item 1, subsection 820-395(1)]

What is a foreign bank branch’s average equity capital?

4.23       A foreign bank branch’s average equity capital is made up of 2 components:

·       the average value of the equity capital of the entity that is attributable to the branch, for Australian tax purposes, other than equity capital that has been allocated to the offshore banking activities (OB activities) of the branch; and

·       the average value of interest-free funds made available to the branch by its head office or other branches. Chapter 8 explains how to work out average values.

[Schedule 1, item 1, subsection 820-395(3); Schedule 2, item 19, definition of ‘average equity capital’ in subsection 995-1(1)]

What is equity capital?

4.24       The term equity capital is defined as the total value of the entity’s retained earnings, certain reserves and share capital (excluding any unpaid amounts and debt capital). It should be noted that the term equity capital is defined for the entity as a whole. However, the rules require an attribution in order to determine the equity capital for the branch. [Schedule 2, item 29, definition of ‘equity capital’ in subsection 995-1(1)]

Why is equity capital allocated to the OB activities of an OBU deducted from a foreign bank branch’s average equity capital?

4.25       The term offshore banking broadly refers to the intermediation by institutions operating in Australia in financial transactions between non-residents. It also includes the provision of financial services to non-residents in respect of transactions or businesses occurring outside Australia. Declaration as an OBU is confined to certain financial entities. Income derived by an OBU from OB activities is effectively taxed at a concessional rate of 10%. The meaning of an OB activity is set out in the current provisions of the ITAA 1936 dealing with OBUs. Allowable OB deductions are certain deductions which an OBU can claim, including interest expense, which relate to the OBU’s assessable OB income (income derived from OB activities).

4.26       The current provisions dealing with foreign bank branches operate so that part of the debt funding of a foreign bank branch is treated as equity funding. This provision is explained in general terms in paragraph 4.3. In relation to OBUs, section 160ZZZB provides that interest deductions which are allowable OB deductions of an OBU are excluded in the calculation of the notional equity requirement. The effect is that there is no reduction in the interest expense which can be claimed by the branch where that interest expense is an allowable OB deduction.

4.27       Under the new thin capitalisation rules, foreign bank branches will retain the concession currently provided by section 160ZZZB. F oreign bank branches will not be required to hold capital against their Australian assets which are attributable to the OB activities of the branch. This is achieved by not including the risk-weighted assets that are attributable to the OB activities of the branch in calculating the safe harbour capital amount. [Schedule 1, item 1, section 820-405, step 1 in the method statement]

4.28       However, where a foreign bank branch does allocate equity capital to its OB activities in calculating its taxable income, that equity capital will not be available to the branch in calculating its average equity capital that it is required to have to fund its other business. This ensures that equity capital which has been allocated to the OBU business cannot also be used to increase the average equity capital of the branch available for funding its other business.

4.29       Consistent with the fact that capital will not be required for OB activities, debt deductions which are allowable OB deductions will not be disallowed if the Australian branch fails the safe harbour or the arm’s length tests. [Schedule 1, item 1, subsection 820-395(1) and section 820-415]

Why are interest-free loans included in a foreign bank branch’s average equity capital?

4.30       Foreign bank branches are commonly provided with interest-free loans from other parts of the entity to use as working capital. These loans are sometimes referred to as dotation capital.

4.31       Where such loans do not give rise to debt deductions, they are included as part of the average equity capital. This recognises that although these loans are not equity in form, they provide capital to fund the branch’s operations for which no debt deductions are claimed. However, loans that give rise to a notional amount of interest under the foreign bank branch provisions of the ITAA 1936 or for which a deduction is claimed in accordance with a DTA are not interest-free loans for the purposes of Division 820. Interest paid on these loans will comprise debt deductions for the branch and therefore the loans are not debt deduction free loans.

4.32       It is possible that interest-free loans to a foreign bank branch may not involve the issue of debt interests. It may be an informal agreement between the head office (or another part of the entity) and its foreign bank branch. Provided such arrangements do not give rise to debt deductions, they can be included as average equity capital [Schedule 1, item 1, subsection 820-395(3); Schedule 2, item 19, definition of ‘average equity capital’ in subsection 995-1(1)] . Moreover, an item of dotation capital cannot also be an attributed amount in determining the equity capital amount (i.e. there should be no double counting of an amount).

What is a foreign bank branch’s minimum capital amount?

4.33       A foreign bank branch’s minimum capital amount is the lesser of its safe harbour capital amount and its arm’s length capital amount. [Schedule 1, item 1, section 820-400; Schedule 2, item 47, definition of ‘minimum capital amount’ in subsection 995-1(1)]

The safe harbour capital amount

4.34       The safe harbour test for a foreign bank branch is similar to that for an inward investing entity (non-ADI), except that it is framed in terms of capital instead of debt. Furthermore, the safe harbour capital amount is based on risk-weighted Australian assets rather than on the unadjusted value of those assets. The safe harbour capital amount is 4% of the branch’s risk-weighted assets. The safe harbour level of 4% is the level of Tier 1 capital agreed by bank regulatory authorities as the absolute minimum for capital adequacy purposes. As such, it should assist the international competitiveness of banks in Australia.

4.35       The safe harbour capital amount is determined by applying the method statement contained in section 820-405. That method statement starts with the risk-weighted assets that are attributable to the foreign bank’s Australian branch (excluding those which are attributable to the offshore banking activities of the branch). The result is multiplied by 4% to give the safe harbour capital amount. [Schedule 1, item 1, section 405; Schedule 2, item 59, definition of ‘safe harbour capital amount’ in subsection 995-1(1)]

4.36       The method statement requires an allocation or attribution of risk-weighted assets of the foreign bank to its Australian branch(es). Hence, inter-branch assets shown in the books of the branch will not automatically be taken to be part of the risk-weighted assets of the branch unless they can be shown to reflect the attribution process. Moreover, inter-branch dealings undertaken for risk management purposes will not, of themselves, increase or decrease the risk-weighted assets attributable to the Australian branch.

4.37       For the purposes of the safe harbour capital amount, the risk-weighted assets of the entity means the sum of the assessed risk exposures associated with its business. The risk-weighting calculations are:

·        carried out in accordance with the prudential standards determined by the prudential regulator in the jurisdiction of the foreign bank or by APRA; and

·       encompass both on-balance sheet and off-balance sheet business.

[Schedule 2, item 57, definition of ‘risk-weighted assets’ in subsection 995-1(1)]

4.38       The risk-weighted assets included in a report to the relevant prudential regulator will be accepted as supporting the branch’s calculation of its risk-weighted assets to the extent that the report provides information on the risk-weighted assets attributed to the branch.

The arm’s length capital amount

4.39       The calculation of the arm’s length capital amount is discussed in Chapter 10.

Amount of debt deductions disallowed

4.40       Debt deductions are denied to the extent that the amount of equity capital funding (other than any allocated to its offshore banking business) of the foreign bank branch is less than the lower of the safe harbour and arm’s length capital amounts (the capital shortfall ). [Schedule 1, item 1, section 415]

4.41       The proportion of debt deductions disallowed is worked out by dividing the amount of the capital shortfall by the average value of the branch’s debt for the period (other than debt used for offshore banking activities). [Schedule 1, item 1, section 820-415]

Example 4.1:  Working out the amount of debt deduction disallowed

The Basel Bank, a foreign bank that carries on its banking business in Australia through an Australian permanent establishment, has assets (unadjusted for risk) of $200 million attributable to its Australian branch. The bank is not an OBU. According to the prudential standards of the prudential regulator in its home jurisdiction, the bank determines that the risk-weighted assets attributable to the Australian branch are $160 million for the income year.

The branch has debt deductions of $15 million and an average debt capital of $190 million.

The equity capital attributable to the branch is made up of $3 million in dotation capital that has been supplied to it and $2 million in retained earnings. Therefore, the foreign bank branch’s average equity capital is $5 million.

Applying the method statement in section 820-405 to work out the safe harbour capital amount:

Step 1:   Determine the average value of all the risk-weighted assets that are attributable to the branch:

=   $160 million.

Step 2:   The amount calculated under step 1 is multiplied by 4%. The result is the safe harbour capital amount:

$160 million  ´   0.04  =  $6.4 million

Since this amount is more than the branch’s average equity capital, an amount of its debt deductions is disallowed, unless the branch can demonstrate that its arm’s length capital amount is equal to or less than its average equity capital.

Assuming that the bank cannot demonstrate that its arm’s length capital amount is less than its safe harbour capital amount, it has a capital shortfall of $1.4 million. That is the amount by which its average equity capital ($5 million) is less than its minimum capital amount ($6.4 million).



The amount of debt deduction that would be disallowed is determined under the formula in section 820-415:



Accordingly, the amount of debt deduction disallowed is:

Diagram 4.1:  When will an adjustment be made to disallow all or part of the debt deductions of an inward investing entity (ADI)? 

 







Application to part year periods

4.42       Where a foreign bank operates its banking business in Australia through a permanent establishment for only part of an income year, Subdivision 820-E only applies to that part year period. [Schedule 1, item 1, section 820-420]

4.43       For example, if a foreign bank is an inward investing entity for 6 months of the year, the bank’s average equity capital is the average of the equity capital attributable to the branch and any dotation capital provided to the branch for that 6 month period. Similarly, the foreign bank branch’s safe harbour capital amount and arm’s length capital amount are determined for the 6 month period. Also, the amount of each debt deduction that is disallowed is calculated by reference to the average debt, capital shortfall and debt deductions that relate to that 6 month period only.

Application and transitional provisions

4.44       The thin capitalisation rules for ADIs apply from the first income year commencing on or after 1 July 2001 [Schedule 1, item 22, section 820-10] . The existing rules will continue to apply until the beginning of that income year. This means that a foreign bank branch with a substituted accounting period is required to calculate its notional equity requirement, or the amount of equity capital attributable to the branch under the relevant DTA, up until the first income year beginning on or after 1 July 2001 [Schedule 1, item 22, section 820-15] .

4.45       The rules will normally be applied at the end of the foreign bank branch’s income year using an average of the quarterly values of its debt, capital and risk-adjusted assets throughout the year (see Chapter 8). In the first period of the rules operation, only the closing balances of those amounts at the end of the period need to be tested. [Schedule 1, item 22, section 820-25]  

Consequential amendments

Section 128F

4.46       This bill contains 2 separate amendments to section 128F of the ITAA 1936. The first amendment will replace the current definition of the term associate used in section 128F and is discussed in paragraph 1.94 and 1.95. The second will broaden the scope of the interest withholding tax exemption provided by the provision and is discussed in paragraphs 4.47 to 4.51.

What is interest withholding tax?

4.47       The taxation of Australian sourced interest paid or credited to non-residents, and residents operating through offshore permanent establishments, is subject to the provisions contained in Division 11A of Part III of the ITAA 1936. These provisions provide, in conjunction with the Income Tax Dividends, Interest and Royalties Withholding Tax Act 1974 , that the recipient of Australian sourced interest is subject to withholding tax on the gross amount paid or credited. A rate of 10% of the gross amount of the interest is imposed.

What is the section 128F interest withholding tax exemption?

4.48       Section 128F of the ITAA 1936 provides an exemption from interest withholding tax where an Australian resident company issues debentures, the company is an Australian resident when the interest is paid and the issue satisfies requirements of the public offer test contained in subsection 128F(3) or (4). The purpose of the public offer test is to ensure that lenders on capital markets are aware that an Australian company is offering debentures for issue.

Extending the scope of section 128F

4.49          Under the current law, non-resident companies cannot issue debentures that can benefit from section 128F. However, these companies can avoid this restriction by establishing an Australian resident subsidiary which raises funds under section 128F and on-lends the funds to the non-resident parent (henceforth referred to as subsidiary borrowing arrangements). For example, a non-resident company carrying on business in Australia at or through a branch can establish a subsidiary in order to raise funds for use by the branch.



Diagram 4.2:  Example of a subsidiary borrowing arrangement

4.50       Section 128F will be amended to allow non-resident companies (including foreign banks) carrying on business at or through permanent establishments in Australia to issue debentures under section 128F [Schedule 1, item 2] . However, the debentures must be issued through the Australian permanent establishment itself and not through the company’s head office or a permanent establishment in another country. This will ensure that the activities associated with issuing of debentures are undertaken in Australia. This does not mean that the debentures must be issued in Australia.

4.51       This amendment will give these non-resident companies direct access to section 128F funding and thereby reduce compliance costs. The amendment will apply in relation to debentures issued on or after 1 July 2001. [Schedule 1, item 23]

Foreign bank branches

4.52       Section 160ZZZB of the ITAA 1936 presently operates so that a proportion of the debt funding of an Australian branch of a foreign bank is treated as equity funding. The result is that the deduction for interest on the debt funding is reduced by 4%. The 4% is referred to as the notional equity requirement

4.53       The notional equity requirement is to be replaced by the provisions in the new thin capitalisation regime dealing with foreign bank branches in Australia. Hence, the notional equity requirement will be repealed. Other minor consequential amendments are made as a result of the repeal of the notional equity requirement. [Schedule 1, items 6 to 9]

4.54       These amendments apply to an amount of interest that is taken under section 160ZZZA to be paid during an income year that begins on or after 1 July 2001. If the interest is paid on or after 1 July 2001 during an income year that began before 1 July 2001, sections 160ZZZB and 160ZZZD continue to apply. [Schedule 1, item 25]

 



C hapter

Outward investing entities (ADI)

Outline of chapter

5.1         This chapter explains Subdivision 820-D that contains the thin capitalisation rules for outward investing entities that are ADIs. These entities include Australian banks, and groups that contain an Australian bank, that have foreign subsidiaries and/or branches. These entities and groups are referred to as Australian banks throughout this chapter.

5.2         The thin capitalisation rules that apply to Australian banks ensure that they do not reduce their Australian tax liabilities by using an excessive amount of debt to finance their Australian operations. The rules do this by ensuring that the bank does not allocate a disproportionate portion of its equity capital to its foreign operations and accordingly, that it maintains a minimum amount of equity capital in its Australian operations for the purposes of calculating its taxable income. Where the bank does not maintain an adequate amount of equity capital in its Australian operations, its deductions that relate to its debt finance (e.g. interest) are reduced.

Context of reform

5.3         The current provisions that deal with the deductibility of interest expenses for outward investors (including Australian banks) are contained in sections 79D and 160AFD of the ITAA 1936 and section 8-1 of the ITAA 1997.

5.4         Section 79D prevents a foreign loss being deducted from domestic assessable income and section 8-1 denies deductions incurred in earning exempt (foreign) income. However, because all of these rules rely on tracing the use of borrowed funds, it is relatively easy to circumvent their operation by establishing a use of funds that guarantees deductibility. Another problem with the rules is that they apply on a single entity basis, and it is therefore possible to circumvent them by using interposed entities to separate the foreign income derivation from the expenditure occurrence.

5.5         Australia’s DTAs also require taxpayers with foreign branches to calculate the taxable (or exempt) income of those branches consistent with the business profits article of the relevant DTA. Chapter 4 outlines some of the problems with the rules for determining the appropriate capital funding of a branch in accordance with that article.

5.6         The new thin capitalisation regime will impose a limit on the extent to which the Australian operations of Australian banks can be funded by debt. Accordingly, the current limitations on interest deductions will be removed in so far as they apply to debt deductions that are regulated by the new thin capitalisation regime. Therefore, expenses relating to those deductions will be able to be deducted when incurred in earning exempt foreign income and will no longer be quarantined, subject to the limits imposed by the new thin capitalisation provisions.

5.7         The new thin capitalisation provisions will:

·       remove the inequity and uncertainty that exists in the current law;

·       set out a minimum equity capital requirement for an Australian bank;

·       provide the bank with the option to demonstrate that a lower level of equity capital is justified using arm’s length principles (the arm’s length capital amount). The arm’s length capital amount is discussed in detail in Chapter 10; and

·       treat Australian banks more consistently with foreign bank branches while recognising the differences between them.

5.8         Banks internationally are subject to prudential controls (by APRA in Australia, and prudential regulation authorities in other countries) requiring them to maintain minimum levels of capital to support the risk profile of their business operations. These capital adequacy requirements are aimed at ensuring security for creditors (including depositors) of the bank and providing stability to the financial markets.

5.9         The thin capitalisation rules applying to ADIs are based on the methodology of the capital adequacy requirements prescribed by APRA. Under the capital adequacy regime, the ADI’s assets are risk weighted, so those assets that have higher risk (such as loans to corporate entities) require more capital than assets that have low risk (such as government bonds). APRA may also require a specific amount of capital to be held for certain assets, such as goodwill and investments in life and general insurance subsidiaries.

5.10       Similarly, the thin capitalisation rules for ADIs will use risk-adjusted assets rather than book values of assets to calculate the safe harbour minimum capital amount and the worldwide capital amount, and will require additional capital to be held against certain Australian assets.

5.11       Rules are not required for an Australian bank (or bank group) that does not have any foreign operations, because the prudential rules set capital levels that are considered to be adequate for calculating the taxable incomes of these purely Australian operations.

5.12       The rules described in this chapter will apply to bank groups. Chapter 6 provides details about groups for thin capitalisation purposes.

5.13       Non-ADI subsidiaries of an Australian bank that are not grouped with the bank will be subject to the thin capitalisation rules that apply to non-ADI entities if they directly or indirectly control foreign investments. These rules are explained in Chapter 3.

Summary of new law

5.14       The thin capitalisation rules that apply to Australian banks require a minimum capital amount to be used in calculating the taxable income of the bank’s Australian operations. The minimum capital required is determined as either a fixed safe harbour capital amount, a worldwide capital amount or an arm’s length capital amount. The safe harbour capital amount is similar to APRA’s Tier 1 capital requirement for Australian operations. 

5.15       The thin capitalisation rules for ADIs apply from the start of an ADI’s first income year beginning on or after 1 July 2001. The rules are applied at the end of the entity’s tax year using average values of the entity’s debt, equity capital and risk-adjusted assets throughout the year. However, in the first income year, special transitional rules provide that only the closing balances of those amounts need to be tested.

Comparison of key features of new law and current law

New law

Current law

Australian banks have their debt deductions reduced if they do not maintain a minimum level of capital that is based on the amount of their risk-adjusted assets and certain other assets of their Australian operations.

The minimum capital level is set by either a safe harbour, worldwide capital or an arm’s length calculation.

The thin capitalisation rules do not apply to an Australian bank unless it is foreign controlled. The debts of an Australian bank are traced to an end use to determine the treatment of the interest expense.

The interest expense can be denied or quarantined when it is incurred in earning foreign income.

Detailed explanation of new law

Outward investing entities (ADI)

5.16       The thin capitalisation rules for ADIs are based on a minimum equity capital level and use risk-adjusted asset values, where they are relevant, rather than the unadjusted book value of assets. The framework for these rules is provided by the capital adequacy regime that ADIs must meet as part of the licensing regime that APRA administers.

5.17       The rules operate to disallow some or all of the debt deductions of an Australian bank where it does not maintain sufficient equity capital in respect of its Australian operations to satisfy the minimum requirement. [Schedule 1, item 1, subsection 820-300(1)]

What is an outward investing entity (ADI)?

5.18       The ADI rules apply to Australian and foreign entities that are ADIs for the purposes of the Banking Act 1959 . These entities include Australian banking entities and foreign bank branches.

5.19       An entity is an outward investing entity (ADI) if it is an ADI that is an Australian entity and one of the following applies:

·       it carries on its business through a foreign branch;

·       it is an Australian controller of a foreign entity (e.g. it has a foreign subsidiary);

·       it has an associate entity that is an outward investing entity (ADI or non-ADI);

·       it is an associate entity of an outward investing entity (ADI or non-ADI).

[Schedule 1, item 1, subsection 820-300(2)]

5.20       Chapter 7 discusses what is meant by an Australian controller, a foreign entity and an associate entity.

5.21       The rules also operate where the entity is an outward investing entity (ADI) for part of the year (see paragraphs 5.47 to 5.50). [Schedule 1, item 1, section 820-330]

What are the thin capitalisation rules for outward investing entities (ADIs)?

5.22       The thin capitalisation rules operate where the equity capital of the Australian bank for its Australian operations is less than the prescribed minimum. The minimum capital amount is determined by calculating a safe harbour amount, a worldwide capital amount or an arm’s length amount. The rules will disallow part or all of the entity’s debt deductions for the income year, where the average value of the entity’s equity capital attributed to its Australian operations (called its adjusted average equity capital) is less than its minimum capital amount calculated under one of the tests. [Schedule 1, item 1, subsection 820-300(1)]  

5.23       Although Australian banks will be required to calculate their minimum capital amount, they will not be required to calculate the safe harbour, worldwide capital and arm’s length amounts. They will have the option to choose either of these amounts. However, the arm’s length capital amount will normally only be determined where the entity’s equity capital is less than both the safe harbour and worldwide capital amounts. If the entity’s average equity capital is greater than the safe harbour amount there is no need to calculate the arm’s length amount.

5.24       Additionally, an Australian bank that has average equity capital less than the safe harbour capital amount could choose not to calculate the arm’s length capital amount or worldwide capital amount and have debt deductions disallowed on the basis of the safe harbour capital amount.

What is the adjusted average equity capital?

5.25       The adjusted average equity capital of an Australian bank:

·       is the average value of the equity capital of the bank other than the equity capital attributed to its overseas branches; less

·       the average value of the controlled foreign entity equity other than the controlled foreign entity equity attributed to its foreign branches.

[Schedule 1, item 1, subsection 820-300(3)]

5.26       Equity capital attributable to the bank’s foreign branches will be the amount actually allocated to them (i.e. the value of capital shown in the bank’s book of accounts). However, where such an amount has been adjusted for foreign tax purposes or by the ATO for other tax purposes, the adjusted amount should be used.

5.27       The calculation of average values is explained in detail in Chapter 8 and the meaning of controlled foreign entity equity is explained in paragraphs 4.23 to 4.32. Broadly the latter is the value of its equity interests in foreign subsidiaries. To avoid double counting, any such equity held through a foreign branch and treated as an asset attributed to a foreign branch is not deducted in this calculation.

What is equity capital?

5.28       The equity capital of an Australian bank is the total value of its eligible Tier 1 capital less any instruments included in Tier 1 capital that are debt interests for tax purposes. [Schedule 2, item 29, definition of ‘equity capital’ in subsection 995-1(1)]

5.29       Eligible Tier 1 capital is defined in the APRA prudential guideline PS111 Capital Adequacy: Measurement of Capital . Eligible Tier 1 capital includes:

·       paid up ordinary shares;

·       general reserves;

·       retained earnings;

·       current year’s earnings net of expected dividends and tax expenses;

·       minority interests in subsidiaries on consolidation;

·       non-cumulative irredeemable preference shares approved by APRA; and

·       other innovative capital instruments approved by APRA.

5.30       However, an instrument is not eligible for inclusion where its inclusion will result in the aggregate amounts of the latter 2 items exceeding 25% of the sum of all other Tier 1 components.

5.31       Eligible Tier 1 capital is net of goodwill, other intangibles assets, future income tax benefits, equity and other capital investments in associated lenders mortgage insurers. These are called Tier 1 prudential capital deductions.

5.32       For the purposes of the thin capitalisation legislation, any Tier 1 capital instrument that is defined as a debt interest under sections 974-15 to 974-65 of the New Business Tax System (Debt and Equity) Bill 2001 is not included in the definition of equity capital. See paragraph 5.53 for a transitional rule to deal with debt interests subject to elective treatment as equity interests under the new debt/equity legislation. [Schedule 1, item 1, subsection 820-300(3); Schedule 2, item 29, definition of ‘equity capital’ in subsection 995-1(1)]

What is an Australian bank’s minimum capital amount?

5.33       An Australian bank’s minimum capital amount is the least of its safe harbour capital amount, its worldwide capital amount and its arm’s length capital amount. [Schedule 1, item 1, section 820-305; Schedule 2, item 47, definition of ‘minimum capital amount’ in subsection 995-1(1)]

What is the safe harbour capital amount?

5.34       The safe harbour capital amount requires an Australian bank to have equity capital of at least 4% of its risk-weighted Australian assets, plus an additional amount for certain Australian assets that APRA requires capital to be held against. The safe harbour level of 4% is the absolute minimum level of Tier 1 capital agreed by bank regulatory authorities as sufficient, in the right circumstances. It should assist the competitiveness of Australian banks. 

5.35       The safe harbour capital amount is determined by applying the method statement contained in section 820-310. That method statement starts with the risk-weighted assets of the Australian bank excluding those assets that are attributable to the bank’s foreign branches, equity interests in controlled foreign entities and prudential capital deductions. The result is multiplied by 4% and the average value of the Tier 1 prudential capital deductions is added to that amount to give the safe harbour capital amount. [Schedule 1, item 1, section 820-310; Schedule 2, item 59, definition of ‘safe harbour capital amount’ in subsection 995-1(1)]

5.36       For the purposes of the safe harbour capital amount, the risk-weighted assets of the entity means the sum of the assessed risk exposures associated with its business. The risk-weighting calculations are:

·       carried out in accordance with the prudential standards determined by APRA; and

·       encompass both on-balance sheet and off-balance sheet business.

[Schedule 2, item 57, definition of ‘risk-weighted assets’ in subsection 995-1(1)]

5.37       The risk-weighted assets included in a report to APRA will be accepted as supporting the bank’s calculation of its risk-weighted assets.

What are prudential capital deductions?

5.38       Prudential capital deductions include Tier 1 prudential capital deductions and deductions from total capital as defined in the prudential standard APS111 Capital Adequacy: Measurement of Capital . Deductions from total capital include investments in other ADIs outside the bank group, non-operating holding companies, non-consolidated subsidiaries and associates. In the calculation in the method statement, they do not include any prudential capital deductions attributable to the bank’s foreign branches because all the risk-weighted assets of those branches are already excluded. [Schedule 2, item 56, definition of ‘prudential capital deduction’ in subsection 995-1(1)]

What are Tier 1 prudential capital deductions?

5.39       Tier 1 prudential capital deductions are amounts that must be deducted in calculating the eligible Tier 1 capital as defined in the prudential standards. These deductions include goodwill, other intangibles assets, future income tax benefits, equity and other capital investments in associated lenders mortgage insurers. In the final step of the method statement, any Tier 1 prudential capital deductions attributable to foreign branches or subsidiaries are not added on because they are not a part of the bank’s Australian operations. [Schedule 2, item 67, definition of ‘Tier 1 prudential capital deduction’ in subsection 995-1(1)]

What is the worldwide capital amount for outward investing ADIs?

5.40       The outward investing entity (ADI) rules will allow the Australian operations to be capitalised at 80% of the capital ratio of the Australian entity’s worldwide group. This allows the capitalisation of the bank’s Australian operations to differ from that of its foreign operations, which can occur because of differences in regulatory regimes. Where the entity is able to satisfy the worldwide capital amount test its deductions will not be reduced. 

5.41       This is similar to the worldwide gearing debt rule provided for outward investing non-ADI entities. In the case of a bank that is foreign-owned for all or part of the year the worldwide test will not apply, for the same reasons as for non-ADIs (see Chapter 3). [Schedule 1, item 1, subsection 820-320(1)]

5.42       The worldwide capital amount is determined by applying the method statement contained in subsection 820-320(2).The method statement is similar to the safe harbour capital amount calculation but rather than multiply the adjusted risk-weighted assets of the bank by 4%, it uses 80% of the worldwide group capital ratio . [Schedule 1, item 1, subsection 820-320(2); Schedule 2, item 70, definition of ‘worldwide capital amount’ in subsection 995-1(1)]

What is the worldwide group capital ratio?

5.43       The worldwide group capital ratio is determined by applying the method statement contained in subsection 820-320(3). That method statement starts with the average value of the eligible Tier 1 capital (not including any debt interests) of the consolidated group as defined by the APRA prudential standards. This amount is divided by the risk-weighted assets (as defined by the APRA prudential standards) of the same group. [Schedule 1, item 1, subsection 820-320(3)]

The arm’s length capital amount

5.44       The calculation of the arm’s length capital amount is discussed in Chapter 10.

Amount of debt deductions disallowed

5.45       Debt deductions are denied to the extent that the amount of equity funding of an Australian bank’s Australian operations is less than the least of the safe harbour amount, the worldwide capital amount and the arm’s length amounts (the capital shortfall).

5.46       The proportion of debt deductions disallowed is worked out by dividing the amount of the capital shortfall by the average value of the Australian bank’s debt for the period. Because debt deductions of the foreign branches of the bank are not subject to these rules, they are excluded from this calculation, as is the related debt capital. [Schedule 1, item 1, section 820-325]

Example 5.1:  Working out the amount of debt deduction disallowed

Bank Oz is an Australian ADI that carries on an international banking business through Australian entities, foreign permanent establishments, and through foreign entities that it controls.

Bank Oz has total assets (unadjusted for risk) of $600 million, of which $100 million are attributable to its overseas permanent establishments and $7 million represents equity investments in controlled foreign entities.

Bank Oz has Tier 1 capital of $40 million of which $5 million are debt interests. Its total prudential capital deductions are $10 million of which $6 million is goodwill (i.e. a Tier 1 prudential capital deduction) and $4 million is an equity investment in a funds management subsidiary, which is not consolidated for capital adequacy purposes. Both assets relate to its Australian operations. It has controlled foreign entity equity of $7 million and equity attributable to its foreign branches of $4 million.

Work out the adjusted average equity capital

The calculation of average equity capital is described in subsection 820-300(3). Bank Oz has eligible Tier 1 capital of $34 million less debt interests of $5 million less controlled foreign entity equity and permanent establishment Tier 1 capital of $11 million, which results in $18 million of adjusted average equity capital.

Work out safe harbour capital amount

Work through the method statement in section 820-310 to determine the safe harbour capital amount.

Step 1:   Determine the average value of the risk-weighted assets after excluding those attributable to the foreign branches and the investment in controlled foreign entities. Assume the risk-weighted assets are $350 million.

Step 2:  Multiply the amount calculated under step 1 by 4%, which results in $14 million.

Step 3:  Add the Tier 1 prudential capital deductions of $6 million to the result of step 2, to give $20 million, which is the safe harbour capital amount.

Work out the worldwide capital amount

The calculation of the worldwide group capital ratio is described in subsection 820-320(3).

Step 1:   Determine the eligible Tier 1 capital of the consolidated group as defined by APRA prudential standards (i.e. $40 million less Tier 1 prudential capital deductions of $6 million plus $4 million of retained earnings in controlled foreign entities) less debt interests ($5 million ) is $33 million.

Step 2:   Divide step 1 by the risk-weighted assets of the group (e.g. $500 million) to give a worldwide group capital ratio of 6.6%.

The calculation of the worldwide capital amount is described in subsection 820-320(2).

Step 1:   The risk-weighted assets of Australian operations are $350 million.

Step 2:   Multiply the amount calculated under step 1 by 80% of the worldwide group capital ratio to give $18.48 million.

Step 3:   Add the Tier 1 prudential capital deductions of $6 million to the result of step 2 to give $24.48 million, which is the worldwide capital amount.

The safe harbour amount of $20 million is lower than the worldwide capital amount ($24.48 million). The safe harbour capital amount therefore becomes the minimum capital amount unless Bank Oz can demonstrate that its arm’s length capital amount is a lower amount. 

Assuming that Bank Oz cannot demonstrate that its arm’s length capital amount is less than the safe harbour capital amount, it has a capital shortfall of $2 million. That is the amount by which its adjusted average equity capital ($18 million) is less than its minimum capital amount ($20 million). Consequently, an amount of Bank Oz’s debt deductions will be disallowed.

Work out the amount of debt deduction disallowed



The amount of debt deduction that would be disallowed is determined under the formula in section 820-325. Assuming the average debt of Bank Oz’s Australian operations is $450 million (net of debt attributable to its overseas permanent establishments) which gives rise to debt deductions of $30 million, the amount of debt deduction disallowed is:



Is the ADI s adjusted average equity capital less than its safe harbour capital amount? Is the ADI s adjusted average equity capital less than its safe harbour or worldwide capital amount?

 
Diagram 5.1:  When will an adjustment be made to disallow all or part of the debt deductions of an outward investing entity (ADI)?

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



Application to part year periods

5.47       Where an entity is an outward investing entity (ADI ) for only part of an income year, section 820-330 applies Subdivision 820-D to that part year period.

5.48       Where section 820-330 applies, its effect is to convert the application of the thin capitalisation rules from full income year application, to part year period application.

5.49       For example, if an entity is an outward investing entity (ADI) for 6 months of the year, then the entity’s adjusted average equity capital is the average of the equity capital of the entity (other than that which is attributable to its overseas permanent establishments), minus the controlled foreign entity equity, for that 6 month period.

5.50       Similarly, the Australian bank’s safe harbour capital amount and arm’s length capital amounts are determined for the 6 month period only. Also, the amount of each debt deduction that is disallowed is calculated by reference to the average debt, capital shortfall and debt deductions that relate to that 6 month period only. Any identified capital shortfall for that period has no direct effect on debt deductions arising in the rest of the income year.

Application and transitional provisions

5.51       The thin capitalisation rules for ADIs apply from the ADIs first income year beginning after 30 June 2001. The existing rules will continue to apply until that income year.

5.52       The rules are applied at the end of the ADIs’s income year using an average of the quarterly values of its debt, capital and risk-weighted assets throughout the year (see Chapter 8). An average of more frequent measurements may also be used. In the first period of the rules operation, only the closing balances of those amounts at the end of that period need to be tested. [Schedule 1, item 22, section 820-25]

Transitional hybrids

5.53       Under the rules in Subdivision 820-D, debt instruments that are Tier 1 capital are not included in the average equity capital amount. However, a transitional rule applies to Tier 1 capital instruments where they would be debt interests under the debt/equity borderline from 1 July 2001 but where an election is made to have the payments made on these instruments treated as payments on an equity interest until 1 July 2004. Under the transitional rule, such instruments are included in equity capital if they are Tier 1 capital until 30 June 2004. If, in Example 5.1, the debt interest of $5 million was a transition hybrid, the $5 million would not be deducted from the eligible Tier 1 capital amount of $34 million in the calculation of the bank’s adjusted average equity capital. This would result in adjusted average capital of $23 million and therefore, no deductions would be disallowed. [Schedule 1, item 22, section 820-35]

Consequential amendments

5.54       Consequential amendments are mentioned in Chapter 1. Of particular relevance to Australian banks would be the amendments to section 160AFD of the ITAA 1936 and the insertion of section 25-90 in the ITAA 1997. It should be noted that neither of these amendments relates to debt deductions attributable to the foreign branches of an Australian bank. [Schedule 1, item 5, subsection 160AFD(9) and item 16, section 25-90]

 



C hapter

Resident thin capitalisation groups

Outline of chapter

6.1         The thin capitalisation rules apply to taxpayers on an individual basis. However, in the case of groups of taxpayers applying the rules on an individual entity basis could lead to inequitable results as well as greater compliance costs. This chapter explains the conditions that must be met to enable entities to form a group for thin capitalisation purposes (a resident TC group). It also outlines how the various thin capitalisation rules will apply to a particular resident TC group as well as to the individual entities within the group.

Context of reform

6.2         The thin capitalisation regime is designed to prevent the allocation of a disproportionate amount of debt to an entity’s Australian operations. The new regime looks at the overall debt levels of the Australian operations of an entity, unlike the existing regime which targets only foreign related party debt.

6.3         Therefore, the ability for 100% owned entities to group in determining their debt levels is seen as better reflecting group structures and the broader debt coverage of the new regime. This would have been consistent with the proposed Consolidation regime, which would treat the consolidated group as a single entity for tax purposes. Grouping or consolidation removes the possibly inequitable results that could arise with substantial amounts of intra-group debt.

6.4         With the implementation of the Consolidation regime deferred to 1 July 2002, the provision of an interim grouping rule will enable entities to determine their funding levels on a group basis until the Consolidation regime is implemented. It is contemplated that this rule will be replaced when the Consolidation regime commences.

Summary of new law

6.5         The main features outlined in this chapter are:

What are resident TC groups for thin capitalisation purposes?

Wholly-owned resident companies, being members of a group at the end of the income year, certain partnerships, trusts and Australian branches of foreign banks, that choose to form a notional group for thin capitalisation purposes, may be part of a resident TC group.

How is it determined which thin capitalisation rule applies to the resident TC group?

The nature of individual entities within the resident TC group at the end of the income year will determine which thin capitalisation rule will apply to that group. Only one set of rules applies to each group for an income year. For example, if the group is classified as an outward investing entity (ADI) at the end of the year, the outward investing entity (ADI) rules will apply to that group for that income year.

How are the thin capitalisation measures applied to the resident TC group?

The rules apply to the consolidated debt deductions of the resident TC group. All debts owed to, equity owned by, and debt payments made to, other members of the resident TC group are ignored. The value of assets and liabilities recognised in consolidated accounts will be taken into account when applying the thin capitalisation rules.

Comparison of key features of new law and current law

New law

Current law

Thin capitalisation will apply to those entities which elect to group in accordance with the grouping provisions contained in Subdivision 820-F. The resident TC group is a notional group formed for the purpose of determining the maximum allowable debt deduction of the group as if it were a single entity with the combined characteristics of its individual members.

The current thin capitalisation regime contained within Division 16F of Part III of the ITAA 1936 applies to a resident company group.

Detailed explanation of new law

6.6         The grouping provisions modify how the thin capitalisation regime will apply to entities, including Australian permanent establishment of foreign banks, that form part of the resident TC group [Schedule 1, item 1, subsection 820-460(1)] . A discussion of the meaning of resident TC groups is contained in paragraphs 6.13 to 6.29. The new thin capitalisation regime applies to those entities in the resident TC group as if the group had been one company for that income year. If the rules do apply to the resident TC group, they do not apply separately to individual members of the group [Schedule 1, item 1, subsection 820-460(3)] .

6.7         The purpose of forming the resident TC group is to determine, on a group basis, the maximum allowable debt deduction arising from debt used to finance the Australian operations. If there is any disallowed debt deduction it is apportioned to the individual entities within the resident TC group. [Schedule 1, item 1, section 820-465]  

6.8         The thin capitalisation rules that apply to the resident TC group are determined by the nature of the resident TC group, at the end of the income year, as if it were a single entity:

·       whether it is an inward or outward investing entity;

·       whether it is a non-ADI or an ADI entity; and

·       if it is a non-ADI entity, whether it is a general or a financial entity.

The grouping provisions contained in Subdivision 820-F only modify the application of the thin capitalisation rules for entities that make up the resident TC group, if the group meets the requirements of one of these classifications at the end of the income year. [Schedule 1, item 1, subsection 820-460(2)]

6.9         The end of the income year is the income year end day that is common to the eligible companies that can form the basis of a resident TC group (see paragraph 6.19).

6.10       Where these requirements are met, the resident TC group is treated as if it had incurred the debt deductions for that income year, based on the actual costs incurred by the entities that are considered for the purposes of the thin capitalisation rules to be divisions or parts of that group. [Schedule 1, item 1, subsection 820-460(5)]

6.11       The particular rules that apply to a resident TC group will depend upon the nature of the entities that are within that group at the end of the income year. Subdivision 820-F contains rules outlining the application of Subdivisions 820-B to 820-E to resident TC groups. The conditions for the application of a particular Subdivision are determined by the entities that constitute the resident TC group at the end of the relevant income year. [Schedule 1, item 1, section 820-550]

6.12       When forming a resident TC group, as the name implies it is only the resident companies of the maximum TC group (see paragraph 6.14) which are to be part of the resident TC group. For these companies which form the basis of the resident TC group there is a requirement that they be Australian entities and not prescribed dual residents. [Schedule 1, item 1, subsection 820-505(3)]

What constitutes a resident TC group?

6.13       The decision of whether or not to form a resident TC group is to be made by the top entity (see paragraph 6.16) within the maximum TC group. However, if there is more than one top entity within the maximum TC group, only one of them can make the choice. Which one makes the choice is left up to the group. [Schedule 1, item 1, subsections 820-500(1) and (2)]

What is a maximum TC group?

6.14       The maximum TC group is determined at the end of the income year. The group will consist of:

·       a company (which can be a corporate limited partnership), where that company is not a 100% subsidiary of any other company at the end of the income year; and

·       each 100% subsidiary of that company that exists at that time.

[Schedule 1, item 1, subsection 820-500(3)]

6.15       Companies which are not part of the maximum TC group at the end of year, will in all cases be ineligible to be included as part of a resident TC group even though they may meet all other necessary requirements.

What is a top entity?

6.16       A top entity of the maximum TC group is a company in the maximum TC group which is common to each 100% subsidiary company within that group that is:

·       an Australian entity; and

·       not a prescribed dual resident.

[Schedule 1, item 1, subsection 820-500(4)]

For Co 1

 

Foreign entities

 

For Co 3

 

For Co 4

 
Example 6.1

 

For Co 2

 

For Co 5

 
 

 

 

Aus Co 3

 

Aus Co 4

 
 

 

 



In this example, assuming all companies are part of the maximum TC group, both For Co 1 and 2 are common to all the Australian resident companies in the group, therefore both are considered to be top entities.

6.17       Once the maximum TC group has been determined the top entity can then make one of 3 choices [Schedule 1, item 1, subsection 820-500(1)] . The choices are to either:

·       form a single resident TC group [Schedule 1, item 1, section 820-505] ;

·       form multiple resident TC groups [Schedule 1, item 1, section 820-510] ; or

·       have no grouping apply at all [Schedule 1, item 1, section 820-520] .

Is the choice of the top entity binding?

6.18       The choice that the top entity makes in relation to forming a resident TC group, if any is to be formed, is binding on each entity within the resident TC group. It also binds companies that are part of the maximum TC group, even though they are not in the resident TC group. The decision made by the top entity for that income year cannot be revoked. [Schedule 1, item 1, section 820-525]

How is a single resident TC group formed?

6.19       The first choice, which enables the top entity to form a single resident TC group, is possible only where all companies in the maximum TC group which are:

·       Australian entities; and

·       not prescribed dual residents,

have a common end of income year. These companies are classified as being eligible companies . [Schedule 1, item 1, subsections 820-505(1) and (3)]  

6.20       The single resident TC group would then include:

·       all the eligible companies;

·       each partnership where all the interests in the income and capital of that partnership are beneficially owned by companies which are themselves part of the resident TC group [Schedule 1, item 1, paragraphs 820-505(2)(b) and 820-515(a)] ;

·       each trust where all the interests in the income and capital of that trust are beneficially owned by companies or partnerships which are themselves part of the resident TC group [Schedule 1, item 1, paragraphs 820-505(2)(b) and 820-515(b)] ; and

·       each Australian permanent establishment of a foreign bank where the foreign bank, as part of the maximum TC group, chooses to include its Australian permanent establishments in the resident TC group [Schedule 1, item 1, paragraphs 820-505(2)(c) and 820-515(c)] .

In all instances, to be part of the resident TC group each partnership, trust or Australian permanent establishment of a foreign bank must have an income year that ends on the same day as that on which the income year of the eligible companies ends [Schedule 1, item 1, subsection 820-505(2)] .

Example 6.2

 

 

 

 

 

 

 

 



Assume this is a maximum TC group.

In this example, assuming the requirements in paragraph 6.19 are met, FI as the top entity, would be able to form a single resident TC group, which would comprise all the Australian entities, that is, A1 to A8.

How are multiple resident TC groups formed?

6.21       The second choice available to the top entity is to divide the entities within the maximum TC group into one or more resident TC groups on the basis that each individual resident TC group would consist of the following:

·       a subgroup formed by:

-           a node entity (see paragraph 6.24); and

-           each 100% subsidiary of the node entity that meets the same requirements as specified for an eligible company (see paragraph 6.19) and has the same income year end as the node entity [Schedule 1, item 1, subsection 820-510(3)] ;

·       each partnership where all the interests in the income and capital of that partnership are beneficially owned by companies which are themselves part of the resident TC group [Schedule 1, item 1, paragraphs 510(1)(b) and 820-515(a)] ;

·       each trust where all the interests in the income and capital of that trust are beneficially owned by companies or partnerships which are themselves part of the resident TC group [Schedule 1, item 1, paragraphs 510(1)(b) and 820-515(b)] ; and

·       each Australian permanent establishment of a foreign bank where the foreign bank, as part of the maximum TC group, chooses to include its Australian permanent establishments in the resident TC group [Schedule 1, item 1, paragraphs 510(1)(c) and 820-515(c)] .

In all instances the relevant entities must have an income year which ends on the same day as that of the node entity [Schedule 1, item 1, subsection 820-510(1)] .

6.22       It is also possible that a resident TC group can also be formed by the combination of 2 or more of the above subgroups. For example, in Diagram 6.2 subgroups A1 and A5 would group with subgroups A2 and A6. This can occur where all the companies in those 2 or more subgroups are all 100% subsidiaries of the same foreign company, that is, the link company (Company F2 in Diagram 6.2 is a link company). In this instance, the resident TC group would include all the 100% subsidiaries of that link company which meet the requirements of an eligible company (see paragraph 6.19) and whose income year end is the same. [Schedule 1, item 1, subsection 820-510(2)]  

6.23       Therefore, each individual resident TC group must include all 100% subsidiaries of either the link company or a node entity, as the case may be, together with any relevant partnership, trust or Australian permanent establishment of a foreign bank which may be part of that resident TC group.

What is a node entity?

6.24       A node entity is a term used to describe an entity (a company or a corporate limited partnership) that is part of the maximum TC group which meets the following 2 requirements:

·       it is an Australian entity but is not a prescribed dual resident; and

·       is itself not a 100% subsidiary of another entity within the maximum TC group which also meets those same residency requirements (specified in the first dot point) at the end of that year.

[Schedule 1, item 1, paragraph 820-510(3)(a)]

Example 6.3

 

 

 

 

 

 

 

 



Assume this is a maximum TC group.

Where, instead of forming a single resident TC group, the top entity elects to form multiple resident TC groups, it has several options available to it:

·          four separate groups could be formed below the individual node entities, A1, A2, A3 and A4;

·          A1, A2, A5, and A6 could form one resident TC group with F2 being their common link company , while A3 and A4 would form individual resident TC groups with their respective subsidiaries as they would be the relevant node entities on which the resident TC groups would be based;

·          similarly, A3, A4, A7, and A8 could form one resident TC group with F3 being their common link company , while A1 and A2, together with their respective subsidiaries, would form individual resident TC groups as they would be the relevant node entities on which the groups would be based;

·          two resident TC groups, one consisting of A1, A2, A5 and A6, and the other consisting of A3, A4, A7 and A8, based on the link companies F2 and F3 respectively.

What occurs where there is no grouping within the maximum TC group?

6.25       The third choice available to the top entity of the maximum TC group is that there be no grouping of any of the entities within the maximum TC group.

6.26       Where this decision is made the thin capitalisation rules apply to each entity within the maximum TC group on an individual basis. Subdivision 820-F will have no effect on any entities in these instances. [Schedule 1, item 1, section 820-520]

What entities comprise the group during the year?

6.27       The resident TC group can only comprise entities that were part of the resident TC group at the end of the income year. If the end of the income year date is the only measurement date that is used for the first income year, then all entities within the resident TC group will comprise the group at that measurement date.

6.28       If the resident TC group chooses to use measurement dates other than just the end of the income year for the first income year, then the determination of the value of a particular matter for the resident TC group is to be based on only those entities that were a part of the resident TC group at that measurement day. That is, the entity must have been a member of the group at the end of the income year as well as at the relevant measurement date for its assets, debt, etc on that date to be counted. [Schedule 1, item 1, section 820-530]

6.29       For the first income year, being an income year which commences before 1 July 2002 and ends before 30 June 2003, special rules apply for resident TC groups to which the ADI rules apply. In these instances, where Subdivisions 820-D or 820-E are applied, the resident TC group is only permitted to use measurement days for that income year where the TC group included an ADI on that measurement day. The group may, of course, choose to use only the one measurement day, at the end of that income year. [Schedule 1, item 22, section 820-30]

How are the calculations made for a resident TC group?

What is the value of the resident TC group’s assets and liabilities?

6.30       The value of the assets and liabilities to be used by the resident TC group when determining the value of a particular matter, at a particular time, for thin capitalisation purposes is to be calculated as if the resident TC group were a single entity. This means that all intra-group transactions and balances are ignored.

6.31       The information to be used is that which would be contained in a set of consolidated accounts prepared in accordance with the accounting standards at the measurement time. [Schedule 1, item 1, paragraph 820-470(a); Schedule 2, item 2, definition of ‘accounting standards’ in subsection 995-1(1)]

6.32       The information required is only in relation to those entities that were part of the resident TC group at that measurement time. [Schedule 1, item 1, paragraph 820-470(b)]

6.33       Using consolidated accounts as the basis of determining relevant values permits recognition of items such as goodwill on consolidation for entities which are entering the resident TC group.

How is the debt deduction applied to individual entities within the resident TC group?

6.34       Where the thin capitalisation provisions would disallow all or part of a debt deduction for the resident TC group for the year, they do so on the basis that the resident TC group is a single entity. Any disallowance is only in relation to debt deductions that were external to the resident TC group. [Schedule 1, item 1, subsections 820-460(3) to (5)]

6.35       For the entities that comprise the resident TC group, this amount equates to the sum of each entity’s debt deductions (net of intra-group amounts).

6.36       On this basis, any debt deduction disallowed to the resident TC group is disallowed to the same extent to each individual entity within that group. This calculation does not affect any debt deduction claimed by the individual entities to the extent that they were incurred or owed to other entities within the resident TC group. [Schedule 1, item 1, section 820-465]

Diagram 6.4

                                                                                            resident TC group

 

 

 

 

 

 

 

Assume $10 million excess debt for the group and a consolidated group debt amount of $200 million.

If companies A, B and C comprised a resident TC group (non-ADI) for the income year then:

·          $20 million of intra-group debt deductions are ignored for thin capitalisation purposes;

·          the group’s calculation of maximum allowable debt deduction is based on $18 million of debt deduction that is external to the group; and

·          any disallowance to the individual entities is to the same extent as the disallowance to the group. For example, for Company A, the disallowed debt deduction equals

$5 million  ´   $10 million / $200 million.

When do the outward investing entity (non-ADI) rules apply to a resident TC group?

6.37       The rules for an outward investing entity (non-ADI) are in Subdivision 820-B (see Chapter 3).

6.38       A resident TC group is an outward investing entity (non-ADI) for the income year if it is either:

·       an outward investor (general) for that year; or

·       an outward investor (financial) for that year.

[Schedule 1, item 1, subsection 820-550(1); Schedule 2, item 52, definition of ‘outward investing entity (non-ADI)’ in subsection 995-1(1)]

What if the resident TC group includes an outward investor (general)?

6.39       When a resident TC group includes one or more outward investors (general) at the end of the income year but does not include a financial entity or an ADI at the end of the income year, that group will be treated as an outward investor (general). Subdivision 820-B will apply to that resident TC group, for that income year, as though it were an individual outward investor (general). This is the case even if an entity within the group is a foreign controlled Australian entity, because the thin capitalisation rules for outward investing entities take priority over the thin capitalisation rules for inward investing entities. [Schedule 1, item 1, subsection 820-550(2); Schedule 2, item 54, definition of ‘outward investor (general)’ in subsection 995-1(1)]

6.40       In applying Subdivision 820-B, it should be noted that section 820-100 does not apply to the resident TC group as that section only applies to outward investing entities that are financial entities.

What if the resident TC group includes a financial entity?

6.41       If the resident TC group at the end of the income year includes either:

·       an entity that is an outward investor (financial) but no ADI; or

·       an outward investor (general), a financial entity (whether that entity is an outward investing entity or not, and whether it is foreign controlled or not), but no ADI,

the resident TC group will be treated as an outward investor (financial) for that income year. See paragraph 2.18 for the meaning of a financial entity. Subdivision 820-B will apply to that resident TC group, for that income year, as though it were an individual outward investor (financial). [Schedule 1, item 1, subsections 820-550(3) and (4); Schedule 2, item 53, definition of ‘outward investor (financial)’ in subsection 995-1(1)]

6.42       In the application of Subdivision 820-B to the resident TC group, section 820-95 does not apply to that group. That section only applies if the group is treated as an outward investor (general).

6.43       Another modification is that, when calculating the average value of the resident TC group’s on-lent amount, only those amounts that are lent by members of the group that are financial entities throughout the income year are taken into account. Amounts lent by entities that are not financial entities throughout the income year are not included in the group’s on-lent amount. In other words, the whole group is not to be regarded as a financial entity as far as the on-lending rule is concerned. Similarly, only entities that have been financial entities throughout the income year can take into account the zero-capital amount, which is discussed in Chapter 2. [Schedule 1, item 1, section 820-560; Schedule 2, item 74, definition of ‘zero-capital amount’ in subsection 995-1(1)]

6.44       The requirement that an entity be a financial entity throughout the income year to access the on-lending and zero-capital amount concessions is not governed by the entity’s membership of the resident TC group throughout the year. That is, the entity, subject to being a member of the resident TC group at the end of the income year, must have been a financial entity for the whole of the income year that mirrors the resident TC group’s income year.

What if the resident TC group includes an ADI entity?

6.45       If a resident TC group does include an ADI entity at the end of the income year, Subdivision 820-B does not apply to that resident TC group for that income year. That group will be treated as being an outward investing entity (ADI) for that income year. See paragraphs 6.54 to 6.60 for the application of those rules to such a resident TC group.

When do the inward investing entity (non-ADI) rules apply to a resident TC group?

6.46       The rules for an inward investing entity (non-ADI) are in Subdivision 820-C (see Chapter 2).

6.47       A resident TC group is an inward investing entity (non-ADI) for the income year if it is either:

·       an inward investment vehicle (general) for that year; or

·       an inward investment vehicle (financial) for that year.

[Schedule 1, item 1, subsection 820-550(5); Schedule 2, item 40, definition of ‘inward investing entity (non-ADI)’ in subsection 995-1(1)]

What if the resident TC group includes an inward investment vehicle (general)?

6.48       Where the resident TC group includes an entity that is an inward investment vehicle at the end of the income year but does not include any financial entities, nor any ADIs or outward investing entities at the end of the income year, that group will be treated as an inward investment vehicle (general). Subdivision 820-C will apply to that resident TC group, for that income year, as though it were an individual inward investment vehicle (general). [Schedule 1, item 1, subsection 820-550(6); Schedule 2, item 42, definition of ‘inward investment vehicle (general)’ in subsection 995-1(1)]

6.49       In applying Subdivision 820-C, the first point to note is that section 820-200 does not apply to the resident TC group as that section applies only to inward investment vehicles that are financial entities. Sections 820-205 and 820-210 also do not apply as those sections apply to foreign entities only.

What if the resident TC group includes a financial entity?

6.50       If the resident TC group does include an inward investment vehicle (financial) at the end of the income year, but does not include an outward investing entity or any ADI entity, that resident TC group will be treated as an inward investment vehicle (financial) for that income year [Schedule 1, item 1, subsection 820-550(7); Schedule 2, item 41, definition of ‘inward investment vehicle (financial)’ in subsection 995-1(1)] . Subdivision 820-C will apply to that resident TC group, for that income year, as though it were an individual inward investment vehicle (financial).

6.51       In the application of Subdivision 820-C to that resident TC group, section 820-195 does not apply to that group, as that section applies only if the group is treated as an inward investment vehicle (general). Also, sections 820-205 and 820-210 do not apply to that group as those sections apply only to foreign entities.

6.52       The same limitations on treating the group as a financial entity as were discussed in paragraph 6.43 apply to groups dealt with as inward investment vehicles (financial). [Schedule 1, item 1, section 820-560]

What if the resident TC group includes an ADI entity?

6.53       If the resident TC group includes an ADI entity at the end of the income year, Subdivision 820-C does not apply to that resident TC group for that income year. Paragraphs 6.54 to 6.60 explain what thin capitalisation rules are to apply to such a group.

When do the outward investing entity (ADI) rules apply to a resident TC group?

6.54       The rules for an outward investing entity (ADI) are in Subdivision 820-D (see Chapter 5).

6.55       If, at the end of an income year, a resident TC group includes an outward investing entity (ADI), or at least one Australian controller of an Australian controlled foreign entity, that is, an outward investing entity, and another entity that is an ADI, that resident TC group will be treated as an outward investing entity (ADI) for that income year [Schedule 1, item 1, subsection 820-550(8); Schedule 2, item 51, definition of ‘outward investing entity (ADI)’ in subsection 995-1(1)] . Subdivision 820-D will apply to that resident TC group for that income year as though it were an outward investing entity (ADI).

6.56       If, however, the resident TC group is not an outward investing entity (ADI), but includes at least one foreign controlled Australian ADI and another foreign controlled Australian entity which is not a subsidiary of the ADI, Subdivision 820-D will apply to that group as if it were an outward investing entity (ADI). An example of this would be where a foreign bank has 2 wholly-owned Australian subsidiaries, one a bank and the other not a bank where the latter is not owned by the Australian bank subsidiary and so does not come under APRA supervision. [Schedule 1, item 1, paragraph 820-460(2)(c) and subsection 820-565(1)]

6.57       In the application of the outward ADI rules to such a resident TC group, the group’s average equity capital includes the consolidated eligible Tier 1 capital of the bank subgroup as determined by the APRA guidelines. These are described in paragraphs 5.29 to 5.31. It also includes the equity capital of any foreign bank branch in the group. Determining the equity capital of the foreign bank branch is discussed in Chapter 4. It will also include the consolidated equity capital of any non-bank entities that are not part of the APRA regulated subgroup. [Schedule 1, item 1, subsection 820-565(2)]

6.58       The safe harbour capital amount of the resident TC group is calculated by first determining the consolidated risk-weighted assets of the members of the resident TC group. For a foreign bank branch these are the risk-weighted assets attributable to the foreign bank branch (not including risk-weighted assets attributable to offshore banking activities) [Schedule 1, item 1, subsection 820-565(3)] . The method statement in section 820-310 is then applied to these amounts, taking into account the prudential capital deductions required by APRA.

6.59       Where an ADI subsidiary of foreign bank has issued debentures under section 128F, on-lent them to an Australian permanent establishment of the foreign bank and the 2 entities are not part of the same resident TC group, special rules apply. For the purposes of determining the safe harbour capital amount for the resident TC group which includes the ADI subsidiary, the rule reduces the risk-weighted assets of the group by not counting the section 128F funds on-lent to the permanent establishment. The rationale for the rule is to ensure that the same pool of section 128F funds is not counted twice for thin capitalisation purposes. [Schedule 1, item 1, subsection 820-570(1)]  

6.60       The rule applies for 5 years to allow time for foreign banks to refinance their section 128F programs by issuing the debentures through their Australian branches [Schedule 1, item 1, subsection 820-570(2)] . Section 128F funds are discussed in paragraphs 4.46 to 4.51.

When do the inward investing entity (ADI) rules apply to a resident TC group?

6.61       The rules for an inward investing entity (ADI) are in Subdivision 820-E (see Chapter 4).

6.62       The inward investing entity (ADI) rules apply to a foreign bank that carries on its banking business in Australia at or through an Australian permanent establishment. [Schedule 1, item 1, subsection 820-395(2); Schedule 2, item 39, definition of ‘inward investing entity (ADI)’ in subsection 995-1(1)]

6.63       However, if a resident TC group includes an Australian permanent establishment of a foreign bank (foreign bank branch) but no outward investing entity nor a foreign controlled Australian bank, a modified Subdivision 820-E will apply to that resident TC group as if it were an inward investing entity (ADI). [Schedule 1, item 1, paragraph 820-460(2)(d) and subsection 820-575(1)]

6.64       In the application of the inward ADI rules to the resident TC group, the group’s average equity capital includes the consolidated paid-up share capital (less amounts that are debt interests), retained earnings, general reserves and asset revaluation reserves of each subsidiary in the group [Schedule 1, item 1, subsection 820-575(2); Schedule 2, item 19, definition of ‘average equity capital’ in subsection 995-1(1)] . It also includes the equity capital of the foreign bank branch. Determining the equity capital of the foreign bank branch is discussed in Chapter 4.

6.65       The safe harbour capital amount of the resident TC group is calculated by determining the consolidated risk-weighted assets of the members of the resident TC group. For the foreign bank branch these are the risk-weighted assets attributable to the foreign bank branch (not including risk-weighted assets attributable to offshore banking activities) [Schedule 1, item 1, subsection 820-575(4)] . The total of the risk-weighted assets of the group is multiplied by 4% to determine the safe harbour capital amount [Schedule 1, item 1, subsection 820-575(3)] .

When are the thin capitalisation rules not applied to a resident TC group that contains an ADI?

6.66       If a resident TC group contains a foreign controlled Australian bank but does not qualify as an outward investing entity (ADI), the thin capitalisation rules may not apply to the group because the capital adequacy requirements of APRA are sufficient for tax purposes. This will be the case where the resident TC group at the end of the income year consists only of entities which are:

·       ADIs that are foreign controlled Australian entities;

·       100% subsidiaries of those ADIs in the resident TC group that are foreign controlled Australian entities; and

·       partnerships or trusts where all the interests in the income and capital of each partnership and trust are beneficially owned by either of the above.

[Schedule 1, item 1, paragraph 820-460(2)(b) and section 820-555]

Application and transitional provisions

6.67       The general application and transitional provisions apply to resident TC groups and these are discussed in Chapter 1. An additional provision dealing with the calculation of a matter for a resident TC group that includes an ADI or foreign bank branch is discussed in paragraph 6.29.

 



C hapter

Control of entities

Outline of chapter

7.1         This chapter explains which entities are either Australian controllers of foreign entities, or foreign controlled Australian entities, and therefore subject to the thin capitalisation rules. These provisions are in Subdivision 820-H and part of Subdivision 820-I.

7.2         The concept of control is a fundamental building block in the new regime as for many entities it will determine whether they fall within the new regime.

7.3         The thin capitalisation rules will apply to:

·       Australian entities that control foreign entities and their associate entities;

·       foreign controlled Australian entities; and

·       foreign entities with operations and/or investments in Australia.

Context of reform

7.4         The existing thin capitalisation legislation generally only applies where there is a foreign controller of an Australian entity. Currently, the control rules identify foreign controllers as those having a control interest of at least 15%. Control interest is measured generally by reference to shareholding, voting power or entitlement to income flows. The holdings of associates of the foreign entity are included in testing whether there is sufficient foreign control to attract the thin capitalisation rules.

7.5         The new thin capitalisation regime will be expanded to include the Australian operations of both inbound and outbound investors. To maintain broad consistency between these cases, the control rules will be changed to a unified system based on the control rules in Part X of the ITAA 1936 that deals with CFCs.

7.6         To ensure that entities cannot avoid the thin capitalisation measures by disguising control through the use of chains of interposed or associated entities, the control rules focus not only on direct control but also on control held indirectly via other entities and associate entities. Associate entities are defined in Subdivision 820-I. Subdivision 820-I narrows the application of the associates concept and will remove many unintended applications of the regime that could otherwise result.

Summary of new law

When is a foreign entity controlled by an Australian entity?

A foreign company is controlled by an Australian entity if the Australian entity:

·       holds a minimum percentage of control interests; or

·       can otherwise control the entity.

A foreign trust is controlled by an Australian entity if the Australian entity holds a minimum percentage of control interests in the trust.

An Australian entity is the controller of a foreign corporate limited partnership if it:

·       is a general partner in the partnership; or

·       holds a minimum percentage of control interests in the partnership.

 

When is an Australian entity foreign controlled?

An Australian entity is foreign controlled if foreign entities:

·       hold a certain minimum percentage of control interests; or

·       can otherwise control the entity.

A corporate limited partnership will also be foreign controlled if:

·       a foreign entity is a general partner; or

·       an Australian general partner is foreign controlled.

 

How is the level of control of a particular entity calculated?

The control interest held by any given entity is the aggregate of:

·       the direct and indirect control interests the entity holds in another entity; and

·       the direct and indirect control interests any associate entities of the entity hold in that other entity.

 

What are associate entities?

Associate entities are entities that are associates of another entity, and in addition, are influenced in decision making by that entity.

 

Comparison of key features of new law and current law

New law

Current law

Australian controllers of controlled foreign entities will be subject to the thin capitalisation rules applicable to outward investing entities.

New rules have been introduced to determine which Australian entities are controllers of Australian controlled foreign companies and trusts. These reflect the threshold requirements of the Part X rules.

New control rules for foreign corporate limited partnerships are also introduced.

There are no equivalent rules in the existing law imposing thin capitalisation requirements on Australian entities that control foreign entities.

The control rules in Part X of the ITAA 1936 are part of the provisions that attribute income of certain controlled foreign entities to residents.

Foreign controlled Australian entities will be subject to the thin capitalisation rules applicable to inward investing entities (unless they are also outward investing entities). Whether an Australian company, trust or partnership is foreign controlled, will be measured by the new control rules.

The existing thin capitalisation rules in Division 16F of the ITAA 1936 contain their own control rules. These rules apply to foreign controlled entities and contain specific definitions and thresholds for recognising control.

Detailed explanation of new law

7.7         Subdivision 820-H is concerned with the threshold issue of whether an entity is subject to the proposed thin capitalisation measures contained in Division 820. Subdivision 820-I contains definitions of associate entity and associate interests relevant to this threshold issue. Among the entities subject to the thin capitalisation requirements are Australian controllers of controlled foreign entities, Australian entities that are foreign controlled and Australian associate entities.

7.8         In considering whether a foreign company or foreign trust meets the definitions of a CFC or CFT, a comprehensive set of rules is contained in Part X at Division 3, sections 349 to 356 of the ITAA 1936. Furthermore, certain other relevant definitions are located in sections 317 and 318 of the ITAA 1936.

7.9         In Division 820, similar comprehensive rules have been provided to measure control interests held by foreign entities in Australian entities and to determine whether an Australian entity is a controller of a controlled foreign entity. These and other control interests (e.g. in corporate limited partnerships) are referred to as TC control interests. These are discussed in paragraphs 7.55 to 7.85.

7.10       It is important to note that Subdivision 820-H adapts the control tests and concepts contained in Part X to determine whether an entity is an:

·       Australian controller of an Australian controlled foreign entity; or

·       Australian entity that is foreign controlled.

Australian controller of a foreign entity

What is an Australian controlled foreign entity?

7.11       Australian controllers of Australian controlled foreign entities will be subject to the thin capitalisation measures. Therefore, it is necessary to identify all foreign entities that are Australian controlled. The rules provide for 3 categories of Australian controlled foreign entities . These are:

·       controlled foreign companies;

·       controlled foreign trusts; and

·       controlled foreign corporate limited partnerships.

[Schedule 1, item 1, section 820-745; Schedule 2, item 14, definition of ‘Australian controlled foreign entity’ in subsection 995-1(1)]

7.12       CFCs and CFTs are defined by reference to their meanings in Part X. Controlled foreign corporate limited partnerships are defined in subsection 820-760(2). [Schedule 2, items 20 and 24, definitions of ‘controlled foreign company’ and ‘controlled foreign trust’ in subsection 995-1(1)]

What is a controlled foreign company?

7.13       The term controlled foreign company takes its meaning from section 340 of the ITAA 1936. This definition contains 3 sequential control tests for testing whether the company is Australian controlled. These tests are that at a particular time:

·       a group of 5 or fewer Australian 1% entities have an aggregate associate-inclusive control interest in the foreign company of 50% or more;

·       a single Australian entity has an associate-inclusive control interest of 40% or more in the foreign company, and the foreign company is not controlled by another group of entities; or

·       a group of 5 or fewer Australian entities either alone or together with associates control the foreign company.

[Schedule 2, item 20, definition of ‘controlled foreign company’ in subsection 995-1(1)]

7.14       However, the definition of CFC has been modified for thin capitalisation purposes to exclude corporate limited partnerships [Schedule 1, item 1, section 820-745] . Special provisions have been included for corporate limited partnerships that adapt the CFC rules. These are discussed in paragraphs 7.16 and 7.17.

What is a controlled foreign trust?

7.15       The term controlled foreign trust also takes its meaning from Part X. A foreign trust is a controlled foreign trust if either:

·       a group of 5 or fewer Australian 1% entities have an aggregate associate-inclusive control interest in the foreign trust of 50% or more; or

·       there is an eligible transferor in respect of the trust (an eligible transferor is defined by reference to sections 343 to 348 of the ITAA 1936).

[Schedule 2, item 24, definition of ‘controlled foreign trust’ in subsection 995-1(1)]

What is a controlled foreign corporate limited partnership?

7.16       There are 3 requirements that a partnership must meet before it will be a controlled foreign corporate limited partnership . These are:

·       it must be a corporate limited partnership;

·       it must not be an Australian entity; and

·       either:

-           one or more general partners must be an Australian entity or an Australian controlled foreign entity; or

-           no more than 5 Australian entities (each of which holds a TC control interest of at least 1%) hold a total of TC control interests that is at least 50%.

[Schedule 1, item 1, subsection 820-760(2); Schedule 2, item 21, definition of ‘controlled foreign corporate limited partnership’ in subsection 995-1(1)]

General partner is an Australian entity or controlled foreign entity

7.17       As the general partners are the entities that control a corporate limited partnership, if a general partner is either an Australian entity or an Australian controlled foreign entity, the corporate limited partnership itself will be a controlled foreign corporate limited partnership .

Not more than 5 Australian entities hold 50% or more control interests

7.18       The other circumstance in which a corporate limited partnership will be a controlled foreign corporate limited partnership is where aggregate TC control interests of 50% or more are held by no more than 5 Australian entities (each of which holds at least 1%). Generally, an entity’s TC control interest in a corporate limited partnership is the sum of the:

·       TC direct control interests held by the entity and its associate entities (this is the greater of the percentage of assets or capital contributed or percentage of rights to distributions of capital, assets or profits); and

·       TC indirect control interests held by the entity and its associate entities (this is essentially the percentage of control arrived at by tracing interests through interposed entities).

[Schedule 1, item 1, subsection 820-760(2) and sections 820-815 and 820-865]

What is an Australian entity?

7.19       An Australian entity is a term defined in section 336 of Part X to include:

·       an Australian partnership;

·       an Australian trust; or

another entity (other than a partnership or trust) which is a Part X Australian resident within the meaning of section 317 of the ITAA 1936. [Schedule 2, item 16, definition of ‘Australian entity’ in subsection 995-1(1)]

What is an Australian controller of a controlled foreign company?

7.20       An entity will be an Australian controller of a controlled foreign company if at that time either:

·       the entity holds a TC control interest in the CFC of 10% or more; or

·       the entity is one of not more than 5 Australian entities which alone or together with associate entities control the CFC, and the entity holds a TC control interest in the CFC of at least 1%.

[Schedule 1, item 1, section 820-750; Schedule 2, item 15, definition of ‘Australian controller’ in subsection 995-1(1)]

7.21       TC control interests are discussed in paragraphs 7.55 to 7.85. Unlike the definition of associate-inclusive control interest in Part X of ITAA 1936, TC control interest does not include the interests of all possible associates but only those of a subset called associate entities . Associate entities are explained in paragraphs 7.86 to 7.98. If these requirements are satisfied, the Australian entity is an outward investing entity for the purposes of the thin capitalisation rules. [Schedule 1, item 1, subsection 820-85(2), items 1 and 2 in the table]

Example 7.1:  Australian controller of a CFC

 

 

 

 

 

 

 

 

 

 



Aust Co will be an Australian controller as it has a TC control interest in Sub2 Co of 100% by virtue of its associate entity’s (Sub Co) direct control interest of 100%. Sub Co is also an Australian controller as it has a TC control interest in Sub2 Co of 100% by virtue of its direct control interest in Sub2 Co.

What is an Australian controller of a controlled foreign trust?

7.22       An entity will be an Australian controller of a CFT if the entity is an Australian entity with a TC control interest in the trust of at least 10% [Schedule 1, item 1, section 820-755; Schedule 2, item 15, definition of ‘Australian controller’ in subsection 995-1(1)] . TC control interests are discussed in paragraphs 7.55 to 7.85. If the requirements are met, the entity is an Australian controller and an outward investing entity for the purposes of the thin capitalisation rules [Schedule 1, item 1, subsection 820-85(2), items 1 and 2 in the table] .

What is an Australian controller of a controlled foreign corporate limited partnership?

7.23       An entity will be an Australian controller of a controlled foreign corporate limited partnership if:

·       it is an Australian entity which is a general partner; or

·       it is an Australian entity that holds a TC control interest in the partnership that is 10% or more.

[Schedule 1, item 1, subsection 820-760(1); Schedule 2, item 15, definition of ‘Australian controller’ in subsection 995-1(1)]

7.24       Once again, because of the type of control a general partner exercises over a corporate limited partnership, any Australian entity which is a general partner, will be an Australian controller in relation to the limited partnership. The Australian entity will then be an outward investing entity for the purposes of the thin capitalisation rules. [Schedule 1, item 1, subsection 820-85(2), items 1 and 2 in the table]

7.25       An Australian entity will also be an Australian controller if it holds a TC control interest of at least 10%. This test mirrors one of the circumstances in which an entity will be an Australian controller of a CFC and the test for a CFT (see paragraphs 7.20 to 7.22).

7.26       In essence, every Australian controller of a CFC, CFT or controlled foreign corporate limited partnership will therefore be subject to the thin capitalisation provisions. These entities, either alone or together with others, control the foreign entity and the location of debt funding.

What is a foreign controlled Australian entity?

7.27       Paragraphs 7.11 to 7.18 deal with the provisions that identify entities controlled by Australian taxpayers. This determines whether the Australian taxpayer is an outward investor. A similar set of rules is required for determining whether an Australian entity is controlled by foreign entities in order to apply the (non-ADI) inward investing entity rules. It should be noted that the thin capitalisation rules apply to foreign controlled Australian entities and there are no direct implications for their foreign controllers.

What is a foreign entity?

7.28       A foreign entity is an entity which is not an Australian entity as defined in section 336 of Part X. [Schedule 2, item 37, definition of ‘foreign entity’ in subsection 995-1(1)]

7.29       The categories of foreign controlled Australian entities are:

·       foreign controlled Australian companies;

·       foreign controlled Australian trusts; and

·       foreign controlled Australian partnerships.

[Schedule 1, item 1, section 820-780; Schedule 2, item 34, definition of ‘foreign controlled Australian entity’ in subsection 995-1(1)]  

What is a foreign controlled Australian company?

7.30       The definition is intended to mirror the definition of a CFC in section 340 of the ITAA 1936, discussed in paragraph 7.13. It contains 3 tests, which are to be applied sequentially. If the first test applies there is no need to consider the remaining tests.

7.31       The tests that will determine whether an Australian company is a foreign controlled Australian company are:

·       no more than 5 foreign entities (each holding a TC control interest in the company of at least 1%) hold an aggregate total TC control interest of 50% or more;

·       a foreign entity holds a TC control interest of at least 40% and no other entity or entities control the company (excluding associate entities of the foreign entity); or

·       no more than 5 foreign entities (and their associate entities) control the company.

[Schedule 1, item 1, subsection 820-785(1); Schedule 2, item 33, definition of ‘foreign controlled Australian company’ in subsection 995-1(1)]

7.32       It should be noted that corporate limited partnerships are excluded from the definition of a foreign controlled Australian company because there are separate rules for them. [Schedule 1, item 1, subsection 820-785(1)]

7.33       The third test concerning control by 5 foreign entities does not require a calculation of TC control interests, but is instead directed towards an examination of facts relevant to the circumstances of each case. The term control is not defined for these purposes, but will include situations where foreign entities are capable of exercising control.

What is the exception?

7.34       An important difference from the outward investing entity rules is the exception contained in subsection 820-785(2). It applies where the Australian company is a foreign controlled company by virtue of the application of the tests in paragraphs 820-785(1)(a) or (b).

7.35       Despite the result of the tests in paragraphs 820-785(1)(a) or (b), if the total of the interests calculated using the method described in paragraph 820-785(2)(b) is less than 20%, then the company is not foreign controlled. Under section 820-875, control tracing interests are taken to be 100% in certain circumstances, for the purpose of determining whether control exists over an entity when tracing through a series of one or more interposed entities. The purpose of paragraph 820-785(2)(b) is to overcome the operation of the deeming rule in certain cases. [Schedule 1, item 1, subsection 820-785(2)]

7.36       When calculating the TC interests for the purpose of the exception, the effect of the deeming rules on the control tracing interests is disregarded and the following interests are aggregated:

·       the foreign entity’s TC direct and indirect control interests; and

·       the associate entities’ direct and indirect TC control interests other than where they have been counted in a foreign entity’s TC indirect interest.

The result should be the equivalent of the foreign entity’s indirect interest in the Australian entity without the operation of the deeming rule.

Example 7.2:  Exception provided by subsection 820-785(2)

 

 



Step 1:  Is Aust Co 3 a foreign controlled Australian company?

Foreign company is taken to have a TC control interest in Aust Co 3 of 55% via application of sections 820-815, 820-820 and 820-855, subsection 820-870(5) and section 820-875. Hence, Aust Co 3 is a foreign controlled Australian company.

Step 2:  Does the exception in paragraph 820-785(2)(b) apply?

As Foreign company does not have any TC direct control interests, it has a total TC interest of 16.6% consisting of a multiplication of its actual indirect control interests of 55%  ´  55%  ´  55% = 16.6%. Hence, Aust Co 3 will not be a foreign controlled company. As the TC control interests held by Foreign company in Aust Co 1 and Aust Co 2 according to the exception exceed 20%, even with this special rule, this exception will not apply to them.

What is a foreign controlled Australian trust?

7.37       An Australian trust will be a foreign controlled Australian trust if, when applied sequentially, any one of 4 tests is met. These tests are that:

·       no more than 5 foreign entities (each holding a TC control interest in the trust of at least 1%) hold an aggregate total TC control interest in the trust of 50% or more;

·       a foreign entity holds a TC control interest in the trust of 40% or more, and no other entity or entities (excluding the foreign entity and its associate entities) control the trust;

·       all of the following subparagraphs apply:

-           at least one of the objects or beneficiaries of the trust is a foreign entity;

-           there has been one or more distributions of income or capital of the trust made to such an object or beneficiary, whether directly or indirectly, during that income year or the preceding 2 years; and

-           the total TC control interests in the trust held by beneficiaries that are Australian entities (that are not foreign controlled) does not exceed 50%; or

·       a foreign entity is in a position to control the trust.

[Schedule 1, item 1, subsection 820-790(1); Schedule 2, item 36, definition of ‘foreign controlled Australian trust’ in subsection 995-1(1)]

What is an Australian trust?

7.38       A trust will be an Australian trust if the requirements of section 338 of the ITAA 1936 are met. These requirements are that:

·       at any time in the immediately preceding 12 months any trustee was a Part X Australian resident, or the central management and control of the trust was in Australia; or

·       the trust is a corporate unit trust or a public trading trust within the meaning of Divisions 6B and 6C of Part III of the ITAA 1936.

7.39       The first 2 tests to determine whether an Australian trust is foreign controlled are similar to the tests for foreign controlled companies. The third test in paragraph 820-790(1)(c) requires that each condition be met for the trust to be a foreign controlled Australian trust. That is, at least one of the foreign objects or beneficiaries is a foreign entity which has received a distribution in the current or either of the preceding 2 income years and Australian entities do not hold a majority of interests in the trust.

7.40       Subsection 820-790(2) sets out the circumstances for the fourth test, in which a foreign entity will be considered to be in a position to control a trust. It is only necessary for one of the circumstances to be met by a foreign entity for the foreign entity to be in a position to control the trust. The particular circumstances in which a foreign entity will be considered to be in a position to control an Australian trust are where:

·       the foreign entity or an associate entity, whether alone or together with other associate entities, has the power to obtain the beneficial use of the trust’s capital or income. This beneficial use may arise irrespective of whether or not a power of appointment or revocation is exercised, and whether or not another entity’s consent is given;

·       the foreign entity is able, directly or indirectly, to control the application of the trust’s capital or income in any manner;

·       the foreign entity is able, under a scheme, to do any of the things mentioned in the above 2 dot points;

·       a trustee of the trust is accustomed or is under an obligation (whether formal or informal) or might reasonably be expected, to act in accordance with the foreign entity’s directions, instructions or wishes; or

·       the foreign entity is able to remove or appoint a trustee of the trust.

[Schedule 1, item 1, subsection 820-790(2)]

7.41       TC control interests in relation to trusts are dealt with in sections 820-815 to 820-835, 820-860, 820-870 and 820-875. Associate entities are explained in paragraphs 7.86 to 7.98.

Exception

7.42       A similar exception applies to trusts, as is available to foreign controlled companies. The exception operates in the same manner as the exception provided for foreign controlled companies. [Schedule 1, item 1, subsection 820-790(3)]

What is a foreign controlled Australian partnership?

7.43       A foreign controlled Australian partnership is defined differently depending on whether the partnership is a corporate limited partnership or a general partnership.

Corporate limited partnership

7.44       A corporate limited partnership will be a foreign controlled Australian partnership if:

·       it is an Australian entity; and

·       either:

-           five or fewer foreign entities, each of which holds a TC control interest of at least 1%, hold between them TC control interests of 50% or more;

-           at least one general partner is a foreign entity; or

-           at least one general partner is a foreign controlled Australian entity.

[Schedule 1, item 1, subsection 820-795(1); Schedule 2, item 35, definition of ‘foreign controlled Australian partnership’ in subsection 995-1(1)]

50% TC control interest test

7.45       What constitutes a TC control interest is discussed further in paragraphs 7.55 to 7.85. A summary in relation to partnerships is provided in paragraph 7.18.

7.46       However, the partnership will not be a foreign controlled Australian partnership if the exception discussed in paragraph 7.54 applies. This exception mirrors that available to Australian companies and trusts.

General partner is a foreign entity or a foreign controlled Australian entity

7.47       As the general partners control a corporate limited partnership, if a general partner is either a foreign entity or an Australian entity which is foreign controlled, the partnership will itself be a foreign controlled Australian partnership .

Example 7.3:  Foreign controlled corporate limited partnership

 

 

 

 

 

 



Step 1:  Is the corporate limited partnership an Australian entity?

The definition of an Australian entity includes Part X Australian resident within the meaning of section 317 of the ITAA 1936 which refers to a resident within the meaning of section 6(1) of the ITAA 1936, subject to certain conditions. Assume that the corporate limited partnership satisfies section 94T of the ITAA 1936 for it to be a resident within the meaning of section 6(1) of the ITAA 1936. Therefore, the corporate limited partnership is an Australian entity.

Step 2:  Is the general partner a foreign controlled Australian entity?

Aust Co, the general partner, is not a foreign entity. Because Foreign company holds a TC control interest of 100% in Aust Co, Aust Co is a foreign controlled Australian company under paragraph 820-785(1)(a). A general partner of the partnership is therefore a foreign controlled Australian entity making the partnership itself a foreign controlled Australian partnership by virtue of subparagraph 820-795(1)(b)(ii).

Partnership

7.48       A partnership that is not a corporate limited partnership will be a foreign controlled Australian partnership if it is an Australian partnership and either:

·       five or fewer foreign entities, each of which holds a TC control interest of at least 1%, hold between them total TC control interests of 50% or more; or

·       one foreign entity holds a TC control interest of at least 40% and no other entity or group of entities (not including the foreign entity or its associate entities) controls the partnership.

[Schedule 1, item 1, subsection 820-795(2); Schedule 2, item 35, definition of ‘foreign controlled Australian partnership’ in subsection 995-1(1)]

What is an Australian partnership?

7.49       An Australian partnership has the same meaning as in section 337 of Part X. It is a partnership in which at least one of the partners is an Australian entity.

50% or more TC control interests

7.50       The first control test provides that where 5 or fewer foreign entities together hold a 50% or greater TC control interest in the partnership, the partnership will be foreign controlled. For example, where there are 4 foreign resident partners who each hold 20% of the rights to distributions of partnership income, the partnership will be a foreign controlled partnership.

40% or more TC control interests

7.51       The second test is an assumed control test. That is, where an entity has a TC control interest of at least 40%, control of the partnership is assumed unless some other entity actually controls the partnership.

7.52       For example, if a foreign entity holds a TC control interest of 45% and an Australian entity holds a TC control interest of 55%, the assumed control test is not, on an objective basis, met because the Australian entity has a greater proportion of control. However, if the partnership always deferred to the foreign entity in relation to management and control decisions, then the Australian entity does not actually control the partnership. The partnership would then be a foreign controlled Australian partnership under the assumed control test.

7.53       When determining whether there is some other entity or entities that control the partnership, the foreign entity itself and associate entities of the foreign entity are not included.

Example 7.4

A foreign entity, not being a partner, has a TC control interest of 40% in an Australian partnership (it has 2 foreign associate entities who are both partners and hold direct interests of 20% each). When looking at whether any other entities hold a controlling interest for the purposes of the 40% control test, these 2 associate entities will be disregarded.

Exception

7.54       In determining whether the requisite level of TC control interests is held by foreign entities in an Australian partnership, there is an exception to the control rules which mirrors the exception for Australian companies and trusts. [Schedule 1, item 1, subsection 820-795(3)]

Defining and measuring thin capitalisation control interests

7.55       In ascertaining whether an Australian entity is subject to the thin capitalisation rules, it is necessary to consider whether the entity falls into one of the categories of foreign controlled Australian entity or Australian controller of an Australian controlled foreign entity, as described in paragraphs 7.11 to 7.54. Rules are included in Subdivision 820-H to describe and measure control interests for these purposes. These control interests are described as TC control interests, and measure an entity’s direct and indirect control interests in the company, trust or partnership, as well as direct and indirect control interests held by the entity’s associate entities in the company, trust or partnership. The term associate entity is explained in paragraphs 7.86 to 7.98.

What is the general rule for an entity’s thin capitalisation interest in a company, trust or partnership?

7.56       In measuring whether an entity has a thin capitalisation control interest in another entity, 4 different categories of control interests are aggregated. These categories are:

·       the entity’s TC direct control interest in the company, trust or partnership;

·       the entity’s TC indirect control interest in the company, trust or partnership;

·       TC direct control interests in the company, trust or partnership held by the entity’s associate entities; and

·       TC indirect control interests in the company, trust or partnership held by the entity’s associate entities.

[Schedule 1, item 1, section 820-815; Schedule 2, item 63, definition of ‘TC control interest’ in subsection 995-1(1)]

7.57       Direct control interests and indirect control interests are defined terms discussed in paragraphs 7.58 to 7.72 and special rules to prevent double counting and to remove uncertainty are discussed in paragraphs 7.73 to 7.85. Associate entity is a defined term discussed in paragraphs 7.86 to 7.98.

What are TC direct control interests and indirect control interests?

What is a TC direct control interest in a company?

7.58       An entity’s thin capitalisation direct control interest , or TC direct control interest , in a company is determined by reference to section 350 of the ITAA 1936 and relevant definitions in Part X, subject to particular modifications necessary to enable that section to apply for the purposes of Subdivision 820-H.

7.59       Section 350 details the interests that are taken into account in calculating a direct control interest in a company. These are holdings of paid-up share capital, rights to vote or participate in decision making on specified issues, rights to distributions of capital or profits on winding-up, or otherwise than on winding-up. Subsections 350(6) and (7) are modified to apply for the purpose of calculating direct control interests over Australian companies held by foreign entities. These subsections are relevant when the test in paragraph 820-785(1)(c) has been used to establish control by 5 or fewer foreign entities (discussed in paragraph 7.33). In addition, section 350 is modified so that references to associate are changed to associate entity in order to avoid unintended applications of the provisions. [Schedule 1, item 1, section 820-855; Schedule 2, item 65, definition of ‘TC direct control interest’ in subsection 995-1(1)]

What is a TC direct control interest in a trust?

7.60       In a similar fashion, TC direct control interests in trusts held by entities are to be calculated in accordance with specified modifications to the application of section 351 of the ITAA 1936 necessary for thin capitalisation purposes. Section 351 defines the interests in income or corpus of trusts that are taken into account in determining a beneficiary’s direct control interest.

7.61       The modifications will operate to apply the section for the purposes of Subdivision 820-H and to ensure that subsections 351(3) and (4) do not apply. These subsections are concerned with eligible transferors that have transferred property or services to a trust. That concept has not been adopted for these purposes. [Schedule 1, item 1, subsections 820-860(1) and (2); Schedule 2, item 65, definition of ‘TC direct control interest’ in subsection 995-1(1)]

7.62       The rules in subsection 820-860(3) are for the purposes of determining TC indirect interests held in other entities or held by other entities through an Australian trust (see paragraphs 7.66 to 7.72). If it is established that a foreign object or beneficiary has control of the Australian trust (paragraph 820-790(1)(c)), then for the purposes of calculating the foreign entity’s indirect control interest in another Australian entity, the foreign entity will be taken to have a TC direct control interest of 100% in the trust. Similarly, where a foreign entity is in a position to control a trust covered by paragraph 820-790(1)(d), then the TC direct control interest used to calculate the foreign entity’s TC indirect control interest in an entity other than the interposed trust is 100%. [Schedule 1, item 1, subsection 820-860(3)]  

What is a TC direct control interest in a partnership?

7.63       Specific rules are also to be included to measure what will be TC direct control interests in partnerships since these are not dealt with in Part X of the ITAA 1936. In the case of a corporate limited partnership, if the entity is a general partner of the partnership it will have a TC direct control interest of 100% in that partnership. If the partnership is not a corporate limited partnership then the entity’s TC direct control interest will equal its percentage control of voting power in the partnership. [Schedule 1, item 1, paragraphs 820-865(a) and (b); Schedule 2, item 65, definition of ‘TC direct control interest’ in subsection 995-1(1)]

7.64       Alternatively, for both corporate limited partnerships and other partnerships, an entity will have a TC direct control interest equal to the following matters that the entity holds or is entitled to acquire in the partnership:

·       the total amount of assets or capital contributed to the partnership;

·       the total rights the partner has to distribution of capital, assets or profits on dissolution; or

·       the total rights the partner has to distribution of capital, assets or profits otherwise than on dissolution.

[Schedule 1, item 1, paragraph 820-865(c)]

7.65       If the percentages calculated under the alternatives listed in paragraphs 7.63 and 7.64 vary, then the greatest percentage shall be taken to be the TC direct control interest. [Schedule 1, item 1, section 820-865]

What is a TC indirect control interest in a company, trust or partnership?

7.66       A TC indirect control interest is a measure of an entity’s control over another entity determined by tracing through controlled interposed entities. For these purposes there may be an unlimited number of interposed entities. The interposed entity (or entities) must be:

·       a foreign controlled Australian entity if the purpose of the test is to determine whether another entity is a foreign controlled Australian entity; or

·       an Australian controlled foreign entity if the test is intended to determine whether an entity is another Australian controlled foreign entity or an Australian controller of such an entity.

[Schedule 1, item 1, subsection 820-870(1); Schedule 2, item 66, definition of ‘TC indirect control interest’ in subsection 995-1(1)]

What are interposed entities for this purpose?

7.67       As the name suggests, an interposed entity is an entity interposed between 2 other entities where:

·       the first entity holds a TC control tracing interest in the interposed entity; and

·       the interposed entity in turn holds a TC control tracing interest in the second entity.

[Schedule 1, item 1, subsection 820-870(2)]

7.68       The term TC control tracing interest is defined in section 820-875 and is discussed in paragraph 7.72.

What are the method statements to use for this purpose?

7.69       Three method statements are provided to determine an entity’s indirect control interest in a company, trust or partnership. The method statement to use will depend upon whether there is one, 2 or more than 2 interposed entities. [Schedule 1, item 1, subsection 820-870(3)]

Method statement for one interposed entity only

7.70       This method statement is used to determine an entity’s TC indirect control interest in another entity where there is only one interposed entity between the entity and the company, trust or partnership.

Step 1:   Calculate the TC control tracing interest that the first entity holds in the interposed entity at that time.

Step 2:   Multiply that result by the TC control tracing interest that the interposed entity holds in the company, trust or partnership at that time.

[Schedule 1, item 1, subsection 820-870(4)]

Example 7.5:  One interposed entity

 

 

 



Under step 1, Foreign Co has a TC control tracing interest in Interposed Aust Co of 100% as per subsection 820-875(1). For step 2, Interposed Aust Co has a TC control tracing interest in Aust Co of 100% as per paragraph 820-875(2)(a). Multiplying the result of step 1 by this amount gives Foreign Co a TC indirect control interest of 100% in Aust Co. That is, 100%  ´   100%  =  100%.

Method statement for 2 or more interposed entities

7.71       This process is applied in like fashion to determine an entity’s TC indirect control interest in another entity if there are 2 or more interposed entities between the entity and the company, trust or partnership. Each entity’s control tracing interest in the next entity is multiplied by the latter’s control tracing interest in the next entity, and so on, until multiplying by the final control tracing interest held in the company, trust or partnership. [Schedule 1, item 1, subsections 820-870(5) and (6)]

What is a TC control tracing interest in a company, trust or partnership?

7.72       A TC control tracing interest is a term that is relevant to the calculation of indirect control interests in companies, trusts or partnerships. In general, a TC control tracing interest held by an entity in another entity is the TC direct control interest in that other entity. However, instead of simply multiplying percentage interests where one entity controls or is taken to control an interposed entity, it will be taken to have a TC control tracing interest of 100% in that interposed entity. This occurs where:

·       the entity and its associate entities hold total TC direct control interests in the company, trust or partnership of 50% or more;

·       the entity and its associate entities hold total TC direct control interests in the company, trust or partnership (excluding corporate limited partnerships) of 40% or more, and no other entity or entities (except the entity and its associate entities) controls the company, trust or partnership; or

·       the entity, and its associate entities if applicable, controls the company, trust or partnership.

[Schedule 1, item 1, section 820-875; Schedule 2, item 64, definition of ‘TC control tracing interest’ in subsection 995-1(1)]

What are the special rules for calculation of TC control interests held by an entity?

7.73       The categories of control interests detailed in paragraph 7.56 may overlap in some cases, for example, where an entity’s indirect control interest, and an associate entity’s direct control interest, both relate to one particular shareholding in a company. This could lead to double counting of an entity’s TC control interests in that company. To alleviate this, and similar potentially inappropriate results, special rules are included [Schedule 1, item 1, section 820-820] . These rules also mirror those in Part X.

Special rules to prevent double counting

7.74       In calculating an entity’s TC control interest, the first special rule reduces the entity’s TC indirect control interest in a company, trust or partnership to the extent that it is calculated by reference to an associate entity’s TC direct or indirect control interest in that same other entity. [Schedule 1, item 1, subsection 820-820(2)]

7.75       A similar rule reduces an associate entity’s TC indirect control interest to the extent that it is determined by reference to direct or indirect control interests held by the entity or other associate entities and which are already counted. Associate entities are explained in paragraphs 7.86 to 7.98. [Schedule 1, item 1, subsection 820-820(3)]

7.76       The third special rule operates to take into account only one of:

·       a TC direct control interest held by the entity, or by another entity;

·       an entitlement to acquire that TC direct control interest,

where both would otherwise be counted in calculating an entity’s TC control interest. [Schedule 1, item 1, subsection 820-820(4)]

7.77       An entitlement to acquire is defined at section 322 of the ITAA 1936. An example of the application of this special rule would be where an entity holds shares in a company, and an associate entity holds options to purchase those shares and so would be considered to have an entitlement to acquire those shares for TC control purposes. The effect, in the absence of a special rule, would be that both the entity and the associate entity hold a TC direct control interest in respect of the same shares. As this would involve double counting of the same interest only one of the 2 interests is to be taken into account. The determination of which one of these 2 interests is to be taken into account is determined in accordance with section 820-835, discussed in paragraphs 7.83 and 7.84.

7.78       This section contains a further special rule to ensure that if the entity is included in a group of entities, then this section will not prevent section 820-825, that deals with groups of entities (discussed in the next paragraph), from operating [Schedule 1, item 1, subsection 820-820(5)] . Note that this is not referring to a group under the grouping rules in Subdivision 820-F, but rather to the 5 or fewer entities whose interests are aggregated to determine control.

Special rules for groups

7.79       In some circumstances, the total TC control interests of a number of entities may have to be aggregated to determine whether an entity is foreign or Australian controlled. Double counting of TC control interests may arise where, in determining the aggregate TC control interest of a group of entities, a particular control interest is included in the TC control interest of more than one (as an associate entity of one or more members of the group). The rule will operate to take into account the particular TC direct control interest or TC indirect control interest only once. [Schedule 1, item 1, subsection 820-825(2)]  

7.80       In addition, a rule will operate to take into account only one of a TC direct control interest held by an entity or an entitlement to acquire that TC direct control interest, where both would otherwise be counted in calculating the TC control interest held by a group of entities. The determination of which one of these 2 interests is to be taken into account is ascertained in accordance with section 820-835 as discussed in paragraphs 7.83 and 7.84. [Schedule 1, item 1, subsection 820-825(3)]

7.81       As with section 820-820, a final special rule will be included to ensure that the application of this section will not prevent section 820-820, which deals with single entities, from operating. [Schedule 1, item 1, subsection 820-825(4)]

Special rules for determining the percentage of TC control interest held

7.82       Double counting of TC control interests may also arise in considering whether an entity is controlled by another entity, or group of entities, where an entity has a TC direct control interest, or TC control tracing interest of 100%, and other entities also have a TC direct control interest or TC control tracing interest of 100% in the same company, trust or partnership. Only one entity will be taken to hold the TC direct control interest or TC control tracing interest of 100%, and the other entity or entities, will not be taken to hold the relevant control interest. [Schedule 1, item 1, section 820-830]

Example 7.6:  Application of section 820-830

 

 

 

 

 



In considering whether Sub2 Co is a foreign controlled Australian company, For Co will have a TC direct control interest of 50% in Sub Co. For tracing purposes under subsection 820-875(2), For Co will have a TC control tracing interest of 100% in Sub Co, and hence, a TC indirect control interest in Sub2 Co of 100% via application of subsections 820-870(4) and 820-875(2). For2 Co, (not an associate entity of For Co) also has a TC direct control interest of 50% in Sub Co which under subsection 820-875(2) would also equate to a TC control tracing interest of 100%. Section 820-830 operates so that only one of For Co or For2 Co will be taken to hold this TC control tracing interest of 100%. Section 820-835 operates to give the power to the Commissioner to determine which entity will be chosen for this purpose (see paragraph 7.84). Irrespective of which foreign company is taken to have an indirect interest in Sub2 Co, the Australian company is foreign controlled.

Commissioner’s power

7.83       The Commissioner will have the power to decide which control interest is to be taken into account for the purposes of calculating TC control interests so as to prevent double counting. Unless there are special circumstances relevant to the applicable case, the Commissioner’s decision would be made in a manner to achieve the result that an entity will be a foreign controlled company, trust or partnership, or an Australian controller in respect of a controlled foreign entity. [Schedule 1, item 1, paragraph 820-835(a)]

7.84       The Commissioner also will have the power to decide which entity is to be selected to hold a 100% TC direct control interest or control tracing interest in an entity for the purposes of paragraph 820-830(2)(a) (see discussion in paragraph 7.82). [Schedule 1, item 1, paragraph 820-835(b)]

7.85       As the exercise of these powers will directly affect an entity’s assessment, a person who is dissatisfied with a decision may object against the decision under Part IVC of the TAA 1953.

Associate entities

7.86       A definition of associate entity is introduced in Subdivision 820-I for the purposes of the thin capitalisation legislation. This narrows the Part X definition of associate to ensure that only those entities with a sufficient influence on another entity will be subject to the new regime. In particular, paragraph 318(2)(d) of the ITAA 1936 determines that in certain circumstances a company is an associate of its subsidiary. The effect of the narrower definition is that under the thin capitalisation rules a company will not normally be an associate entity of its subsidiary.

7.87       An associate entity of an entity can be an individual or another entity. If an entity is an Australian associate entity of another Australian entity that is itself an outward investor, the associate entity will be an outward investor [Schedule 1, item 1, subsection 820-85(2), items 3 and 4 in the table and paragraph 820-300(2)(c)] . Another effect is that an associate entity’s TC direct and indirect control interests are included in the calculation of another entity’s TC control interest in a company, trust or partnership as explained in paragraph 7.56 [Schedule 1, item 1, section 820-815] .

What is sufficient influence?

7.88       Sufficient influence is a term explained in subsection 318(6) of the ITAA 1936. It may arise in circumstances where an entity has influence or may reasonably be expected to have influence over another entity or its directors, partners, trustees or committees of management respectively, to direct the actions of the entity either directly or through interposed entities. This influence may arise formally, informally, because of obligation, custom or via membership of a corporate group.

7.89       For the purposes of thin capitalisation rules, sufficient influence is confined to influence over decisions made in relation to financial matters of the entity.

What is an associate entity?

Individuals

7.90       An individual will be an associate entity of another entity if:

·       it is an associate, as defined in section 318, of another entity; and:

·       the individual is accustomed or under an obligation (whether formal or informal) or might reasonably be expected to act in accordance with:

-           the directions, instructions or wishes of that other entity, in relation to the individual’s financial affairs; and

-           whether those directions, instructions or wishes are or may reasonably be expected to be communicated directly or through interposed entities.

[Schedule 1, item 1, subsection 820-905(2)]

Entities other than individuals

7.91       For an entity to be an associate entity it must be an associate of a second entity and either of the following conditions applies:

·       the second entity holds an associate interest of 50% or more in the entity; or

·       the entity is accustomed or under an obligation (whether formal or informal) or might reasonably be expected, to act in accordance with the directions, instructions or wishes of that second entity in relation to either:

-           the distribution or retention of its profits; or

-           the financial policies relating to its assets, debt capital or equity.

Such directions, instructions or wishes may reasonably be expected to be communicated either directly or through interposed entities.

7.92       The first entity will also be an associate entity of the second entity when, if the first entity is a company, a director of that company is influenced by the second entity. Similarly, if the first entity is a partnership, it will be an associate entity of the second entity if a partner of the partnership acts in the manner stated in the preceding paragraph. The same principle will apply with respect to trustees of trusts, and members of committees of management of unincorporated associations or bodies. [Schedule 1, item 1, subsections 820-905(1) and (3)]

What is an associate interest in a company (excluding a corporate limited partnership)?

7.93       An entity holds an associate interest in a company (excluding corporate limited partnerships) equal to the percentage of the direct control interest it holds as determined by reference to section 350 of the ITAA 1936 as modified for these purposes. The types of interests that are taken into account are holdings of paid-up share capital, rights to vote or participate in decision making on specified issues, rights to distributions of capital or profits on winding-up, or otherwise than on winding-up. [Schedule 1, item 1, subsections 820-905(4) and (5); Schedule 2, item 13, definition of ‘associate interest’ in subsection 995-1(1)]

What is an associate interest in a trust?

7.94       An associate interest in a trust held by an entity is equal to the percentage of the direct control interest it holds as determined by reference to section 351 of the ITAA 1936 as modified for these purposes. Section 351 defines the interests in income or corpus of trusts that are taken into account in determining a beneficiary’s direct control interest. [Schedule 1, item 1, subsections 820-905(6) and (7); Schedule 2, item 13, definition of ‘associate interest’ in subsection 995-1(1)]

What is an associate interest in a partnership?

7.95       An entity will also have an associate interest in a partnership in particular circumstances. In calculating the associate interest if the percentages calculated under the alternatives available vary, then the greatest percentage held will be the associate interest.

7.96       If the entity is a general partner of a corporate limited partnership it will have an associate interest of 100% in that partnership.

7.97       If the partnership is not a corporate limited partnership, then the entity will have an associate interest equal to its percentage control of voting power in the partnership at that time.

7.98       In other cases for both corporate limited partnerships and other partnerships, an entity will hold an associate interest in the partnership equal to the percentage that the entity holds, or is entitled to acquire, in any of the following:

·       the total amount of assets or capital contributed to the partnership;

·       the total rights the partner has to distribution of capital, assets or profits on dissolution; or

·       the total rights the partner has to distribution of capital, assets or profits otherwise than on dissolution.

[Schedule 1, item 1, subsection 820-905(8); Schedule 2, item 13, definition of ‘associate interest’ in subsection 995-1(1)]

Example 7.7:  Which entity is an associate entity of Australian Company C?

 

 

 

 

 

 

 

 

 



To be an associate entity of the test entity (Australian Company C), the entity must satisfy 2 conditions.

Firstly, be an associate, as defined in section 318 of the ITAA 1936.

Secondly, be an associate in which the test entity has an associate interest of at least 50%, or be an associate whose financial affairs the test entity can sufficiently influence.

All the entities are associates of Australian Company C under section 318, however, because of the second condition, probably only Foreign Company Z (by virtue of Australian Company C’s associate interest) and the partnership (as it is sufficiently influenced) will be associate entities of Australian Company C.

Application and transitional provisions

7.99       The issues discussed in this chapter are subject to the general application provisions discussed in Chapter 1.



C hapter

Calculating average values

Outline of chapter

8.1         This chapter explains how entities calculate the average values of assets, liabilities and equity. It also explains when the Commissioner may change a value calculated by an entity. The relevant rules are contained in Subdivision 820-G of this bill.

Context of reform

8.2         Entities must calculate average values for their assets, liabilities and equity in order to determine their maximum debt level (for non-ADI entities) or minimum capital level (for ADI entities). An average value is used in order to allow for the situation where debt is excessive, or equity is deficient, for only part of the period. The existing thin capitalisation provisions are very prescriptive as to frequency of measuring debt and equity even to the point of testing the greatest amount of foreign debt on a single day of the year.

8.3         Values of assets and liabilities are to be determined by reference to the relevant accounting standards. The standards also govern the manner in which amounts recorded in foreign currency are to be converted into Australian currency. The use of the accounting standards in this way allows for values other than cost to be used within the established set of rules which adds integrity to the process.

8.4         To ensure that average values are accurately reflected, the Commissioner may substitute a value if it is considered that either assets are overvalued or liabilities undervalued. This power, together with the requirement for all entities to apply the accounting standards when valuing an item, ensures integrity. 

8.5         The provisions allow entities a choice as to the frequency of valuing their assets and liabilities. Providing options allows taxpayers to utilise their accounting records for thin capitalisation purposes. This flexibility minimises compliance costs by recognising that different entities may prepare records at different intervals.

Summary of new law

How are asset values ascertained?

Values are determined according to the relevant accounting standards.



Can assets be revalued for thin capitalisation purposes?

Assets can be revalued for thin capitalisation purposes provided they are revalued by an independent expert valuer and in accordance with accounting standards.

 

What is the average value?

The average value is determined by measuring the matter on a certain number of days throughout the period and dividing the result by the number of measurement days.



How many times are non-ADIs required to value matters?

A non-ADI can choose to:

·       value all matters on a maximum of 2 days throughout the period;

·       value all matters on a maximum of 3 days throughout the period;

·       value all matters on a quarterly basis;

·       value all matters at a chosen interval between one day and 3 months; or

·       value some matters at a chosen interval and the other matters on a quarterly basis.

 

How many times are ADIs required to value matters?

An ADI can choose to:

·       value all matters on a quarterly basis;

·       value all matters at a chosen interval between one day and 3 months; or

·       value some matters at a chosen interval and the other matters on a quarterly basis.

 

Can the Commissioner change the value determined by the entity?

 

 

Do amounts recorded in foreign currency have to be converted into Australian dollars?

Yes, but only if the Commissioner considers that assets have been overvalued or liabilities have been undervalued. He must have regard to accounting standards when calculating the new value.

 

Yes, all amounts must be expressed in Australian dollars. Entities will be required to comply with the accounting standards when converting foreign currency amounts into Australian dollars.

Comparison of key features of new law and current law

New law

Current law

Valuation of assets and conversion of amounts into Australian currency are undertaken in accordance with accounting standards.

Specific rules for thin capitalisation purposes govern how assets are to be valued.

There are no specific rules for currency conversion of equivalent amounts.

Non-ADIs can choose from several methods involving different frequencies for recording values to calculate average values.

ADIs must value all matters on at least a quarterly basis and can choose to value some or all matters on a more frequent basis.

The Commissioner can substitute a value if assets were overvalued or liabilities were undervalued.

All entities can measure their debt by either taking the highest point of debt during the period or measuring debt on a daily basis and calculating an average.

Foreign equity is calculated using a combination of opening and closing balances of certain items for an income year.

Detailed explanation of new law

Calculating average values

8.6         Subdivision 820-G sets out the methods available to taxpayers for calculating average values for assets and liabilities used in the various method statements throughout Division 820. Liabilities requiring valuation under Division 820 include non-debt liabilities and debt capital. These items are referred to as matters in Subdivision 820-G and in this chapter. Non-ADIs and ADIs are treated differently in some respects.

8.7         In addition, a transitional provision is provided for calculating the average value that may be applied by an entity in relation to a period that is all or part of the first income year which commences on or after 1 July 2001. [Schedule 1, item 22, section 820-25]

Non-ADIs

8.8         A non-ADI has the choice of 3 methods for determining the average values of matters [Schedule 1, item 1, subsection 820-630(1)] . The 3 methods are:

·       the opening and closing balances method (requiring 2 valuations in the period, discussed in paragraphs 8.14 to 8.16 [Schedule 1, item 1, section 820-635] ;

·       the 3 measurement days method (requiring 3 valuations in the period, discussed in paragraphs 8.17 to 8.20) [Schedule 1, item 1, section 820-640 ] ; or

·       the frequent measurement method (requiring valuations on a quarterly basis with the option of valuing some or all matters more frequently, discussed in paragraphs 8.21 to 8.32) [Schedule 1, item 1, section 820-645] .

8.9         The different methods successively require valuations to be undertaken at more frequent intervals. A choice between methods is available to allow non-ADIs to minimise compliance costs whilst applying the method that more accurately reflects the average values of its assets and liabilities. Thus, if the values do not change significantly throughout the period, the entity may choose to use the opening and closing balances method which requires valuations at only 2 points in the income year.

8.10       A non-ADI is required to consistently apply the same method throughout the income year, or any part of that year in which it is subject to the thin capitalisation rules, for all matters [Schedule 1, item 1, subsection 820-630(2)] . However, if the entity changes status part way through the year (e.g. it was an inward investing entity and becomes an outward investing entity part way through the year), the rules apply to each period separately so that a different measurement method can be used for each period. The method that is applied can also be changed from income year to income year.

Example 8.1

Aust Corporation is a wholly-owned subsidiary of Foreign Corporation (and is therefore an inward investment vehicle). It has a standard income year. On 1 January 2004, Aust Corporation begins to carry on business outside Australia through a permanent establishment. From this point forward, Aust Corporation is treated as an outward investing entity. From 1 July 2003 to 31 December 2003, Aust Corporation used the opening and closing balances method to establish average values. From 1 January 2004 to 30 June 2004, Aust Corporation can either continue to use the opening and closing balances method or can choose another method to establish average values.

Commissioner’s power

8.11       If the entity does not apply the same method consistently throughout the relevant period to all matters, the Commissioner may recalculate all the average values for that period using the opening and closing balances method. This is irrespective of what methods the entity actually used to calculate average values for the period. [Schedule 1, item 1, subsection 820-630(3)]

8.12       As the exercise of this power may directly affect an entity’s assessment, a person who is dissatisfied with a decision to recalculate all average values may object against the decision under Part IVC of the TAA 1953 .

ADIs

8.13       ADIs can only use the frequent measurement method to calculate their average values (this method is discussed in paragraphs 8.21 to 8.32). This is consistent with reporting requirements imposed by APRA and most prudential regulators which mandate that ADIs must prepare accounts every quarter and must monitor their capital every day. Therefore, no additional compliance burden is imposed by requiring ADIs to apply the frequent measurement method because the value of matters may fluctuate throughout the income year. ADIs may find that applying the frequent measurement method will result in a more accurate valuation of their matters.

Opening and closing balances method

8.14       The opening and closing balances method requires the entity to measure the value of a matter on the first and last days of the period. The average of these amounts is then the average value for the income year or period for that matter. [Schedule 1, item 1, section 820-635]

8.15       The period involved can be part or all of an income year depending on the circumstances of the entity. For example, if the entity is an outward investing entity for the entire year, the period is the income year applying to that entity. However, if the entity changes status during an income year, for example if it commences to be an outward investing entity half way through the income year, the period is that second half of the income year.

8.16       As each period or income year will always have a first and last day, this method will be able to be used in all instances.

Example 8.2

XYZ Ltd, a non-ADI, held assets of $180 million on the first day of the income year. On the last day of the income year its assets were valued at $220 million. To calculate the average value these amounts are added together and divided by 2. The average value of its assets for the year is $200 million.

The 3 measurement days method

8.17       This method is based on an entity determining the average value of a particular matter by looking at 3 measurement days throughout a period. Again, the period can be either an income year or part of an income year, depending on the circumstances of the entity, but must be at least 6 months.

8.18       An entity can only apply the 3 measurement days method to a period that includes either the first half or the second half of its income year [Schedule 1, item 1, subsection 820-640(1)] . If the period does not include the above days then either the opening and closing balances method or the frequent measurement method must be used. The 3 measurement days method will always be available to an entity whose period is an income year as the period will include the last day of the first half of the income year and both the first and last days of that year.

Example 8.3

A non-ADI with a standard income year (e.g. 1 July 2003 to 30 June 2004) becomes an outward investing entity on 15 August 2003 and remains so for the rest of the income year. It can apply the 3 measurement days method as the last day of the first half of the income year, being 31 December 2003, and the last day of the income year, being 30 June 2004, both occur within the period. The 3 measurement days are 15 August 2003, 31 December 2003 and 30 June 2004.

However, if the entity became an outward investing entity on 15 March 2004 it could not apply this method as the last day of the first half of the income year, 31 December 2003, does not occur within the relevant period. The entity must apply either the opening and closing balances method or the frequent measurement method in these circumstances.

8.19       The average value of a matter under the 3 measurement day method is calculated as the average of the values of the matter determined on the first, second and third measurement days. [Schedule 1, item 1, subsection 820-640(2)]

8.20       The first measurement day is the first day of the period. The second measurement day is the last day of the first half of the income year (i.e. 31 December for non-ADI entities with an income year 1 July to 30 June). The third measurement day is the last day of the period. [Schedule 1, item 1, subsection 820-640(3)]

Example 8.4

International Ltd, which has a standard income year, held assets valued at $140 million on 14 August 2003, the day it became an outward investing entity (first measurement day). Assets held on 31 December 2003 were valued at $120 million (second measurement day), with $190 million being the value of assets on 30 June 2004, the last day of the income year (third measurement day). This means that the average value of assets for the period is $150 million.

International Ltd is able to use this method because the last day of the first half of the income year (31 December 2003) and the last day of the year (30 June 2004) occur within the period, therefore, paragraphs 820-640(1)(a) and (b) respectively are satisfied.

The frequent measurement method

8.21       The frequent measurement method will allow an entity to determine the average value of a particular matter using values obtained quarterly or more frequently [Schedule 1, item 1, subsection 820-645(1)] . This is the only method that ADI entities may use.

8.22       Under the frequent measurement method the average values will generally be determined using quarterly figures [Schedule 1, item 1, paragraph 820-645(1)(a)] . However, an entity can choose to use values determined on a more frequent basis for either some or all matters. If the entity measures only some matters more frequently, then any remaining matters will be measured on a quarterly basis [Schedule 1, item 1, subsection 820-645(1)] .

8.23       The frequent measurement method where values are determined quarterly will be referred to in this chapter as the quarterly option . Where an entity uses values for some or all matters determined more frequently than quarterly, this method will be referred to in this chapter as the more frequent option . [Schedule 1, item 1, subsection 820-645(1)]

The quarterly option

8.24       The quarterly option calculates the average value of a matter as the average of the values of the matter determined on each of the following measurement days.

8.25       The measurement days for the quarterly option are:

·       the first day of the period (which will be either a full income year or a part of an income year, depending on the entity’s circumstances);

·       the last day of each quarterly period that occurs in that period; and

·       the last day of that period if that day does not correspond with the last day of the final quarterly period.

[Schedule 1, item 1, subsection 820-645(2)]

8.26       The quarterly periods are the periods consisting of the first, second and third months of the income year and each successive period of 3 months thereafter [Schedule 1, item 1, subsection 820-645(3)] . Note, that these are determined by the entity’s income year not the period for which it is applying the thin capitalisation rules. For example, the quarterly periods of an entity with a standard income year (1 July to 30 June) are the September, December, March and June quarters. The end of quarter measurement days are 30 September, 31 December, 31 March and 30 June.

8.27       For entities with substituted accounting periods, the first quarterly period is the period representing the first 3 months of the entity’s income year. The following 3 month period will be the next quarter and so on. The measurement days are the last days of each of those quarters. [Schedule 1, item 1, subsection 820-645(3)]

Example 8.5

Quarter Ltd, which has a substituted accounting period ending 30 September, held assets valued at $120 million on 1 October 2003 (the first day of its income year). On the last day of each quarter for that year, the value of its assets was:

·          $110 million (31 December 2003);

·          $130 million (31 March 2004);

·          $150 million (30 June 2004); and

·          $90 million (30 September 2004).

Adding these amounts together and dividing by 5 (being the number of measurement days) gives an average value of assets for the year of $120 million.

The more frequent option

8.28       The more frequent option calculates the average value of a matter as the sum of the values of the matter as at each measurement day divided by the number of measurement days. [Schedule 1, item 1, subsection 820-645(4)]

8.29       The measurement days for this method are:

·       the first day of the period;

·       the last day of each regular interval that occurs during the period; and

·       the last day of the period if it is not the last day of the final regular interval.

[Schedule 1, item 1, subsection 820-645(4)]

8.30       This option permits matters to be calculated on a more frequent basis [Schedule 1, item 1, paragraph 820-645(1)(b)] . This recognises that values may fluctuate throughout the income year and using values obtained more frequently may result in a more accurate average value. The current thin capitalisation rules in Division 16F of the ITAA 1936 allow debt to be measured on a daily basis in recognition of the variable nature of debt levels. This option is expanded under the new regime to apply to all other matters.

8.31       Under this option, the entity is able to either:

·       measure all matters at regular intervals on a more frequent basis; or

·       select some matters to be measured on a more frequent basis and measure the remaining matters on a quarterly basis.

[Schedule 1, item 1, paragraph 820-645(1)(b)]

8.32       The regular interval may be daily, weekly, monthly, or any other fixed period of days provided the interval is not less than one day and does not exceed 3 months [Schedule 1, item 1, subsection 820-645(5)] . The entity can therefore choose to value some or all of the matters as often as it sees fit within these limits to obtain an average value. However, the first regular interval must begin on the first day of the period and the same interval must be used for all of the matters which the entity has selected to measure more frequently than quarterly [Schedule 1, item 1, subsection 820-645(6)] . For example, if an entity elected to value liabilities and equity capital on a more frequent basis, the regular interval used for both must be the same. Assets could then be measured on a quarterly basis.

Example 8.6

Foreign Owned Ltd, an inward-investing entity (non-ADI) which has a standard income year, wishes to measure its debt capital and assets more frequently than quarterly. It must choose the same regular interval for both matters. It chooses a monthly basis. The relevant values are as follows:

·          On the first day of the year (1 July 2003) it had $80 million of debt capital and $160 million of assets.

·          Its debt capital on the last day of each of the first 4 months was $90 million and the value of its assets was $170 million.

·          The value of the debt capital on the last day of each of the next 4 months was $105 million and the value of its assets was $200 million.

·          The value of its debt capital on the last day of each of the final 4 months was $110 million and the value of its assets was $240 million.

These amounts are added together and divided by 13 (being the number of measurement days) to give an average value of debt capital for that period of $100 million and an average value of assets of $200 million.

Foreign Owned Ltd will then measure all other matters (e.g. non-debt liabilities) using the quarterly method (set out in paragraphs 8.24 to 8.27).

Special rules about values and valuations

8.33       There are specific rules dealing with converting amounts into Australian currency and determining what the value of assets, liabilities or equity capital is at a particular point in time. [Schedule 1, item 1, sections 820-675 and 820-680]

Converting to Australian currency

8.34       An amount, including a value used in a calculation, must be expressed in Australian currency for the purposes of Division 820 [Schedule 1, item 1, subsection 820-675(1)] . Entities are required to comply with the accounting standards when converting an amount from foreign currency to Australian currency [Schedule 1, item 1, subsection 820-675(2); Schedule 2, item 2, definition of ‘accounting standards’ in subsection 995-1(1)] . However, the thin capitalisation provisions do not deal with the issue of whether foreign exchange gains or losses should be recognised for tax purposes.

8.35       For thin capitalisation purposes, the relevant accounting standards are those governing foreign currency translation made by the AASB. For example, AASB 1012:  Foreign Currency Translation is one accounting standard that deals with converting an amount into Australian currency. It should be noted that the AASB may issue or revise the relevant accounting standards from time to time.

8.36       The accounting standards made by the AASB may not apply to all entities that will be required to undertake calculations under the new thin capitalisation regime. Nevertheless, if the thin capitalisation rules apply to an entity, it must comply with the accounting standards when converting an amount into Australian currency for the purposes of this bill. This will allow for consistent rules to be applied to all conversions. [Schedule 1, item 1 , subsection 820-675(3)]

Valuation of assets, liabilities and equity

8.37       An entity must comply with the accounting standards in calculating the value of its assets, liabilities and equity. As with foreign currency conversions:

·       the relevant accounting standards are those made by the AASB; and

·       an entity must comply with the accounting standards whether or not it is otherwise required to do so under a particular standard.

[Schedule 1, item 1, subsection 820-680(1); Schedule 2, item 2, definition of ‘accounting standards’ in subsection 995-1(1)]

8.38       For example, AASB 1015:  Accounting for the Acquisition of Assets and AASB 1041:  Revaluation of Non-current Assets are current accounting standards which deal with the valuation of assets.

8.39       Accounting standard AASB 1001 prescribes the concepts that guide the selection, application and disclosure of accounting policies. It provides that the appropriate accounting policy is one which results in relevant and reliable financial information. For these 2 qualities to be satisfied, the information needs to be free from bias and undue error. It must also represent the substance of the transaction where substance and form differ.

8.40       Accounting standard AASB 1024 requires that parent entities must prepare consolidated accounts. Entities may also be able to group under the thin capitalisation provisions, as discussed in Chapter 6. The threshold tests for whether an entity can group under this bill and whether they are required to prepare consolidated accounts are different. The former requires 100% ownership of subsidiaries (definitions in Subdivision 975-W of the ITAA 1997) and the latter relies on the ability to “dominate the decision-making, directly or indirectly, in relation to the financial and operating policies of another” (paragraph 9 definition of control). Thus, an entity that is required to prepare consolidated accounts under AASB 1024 may not necessarily be able to group under the thin capitalisation rules. However, it is considered that entities that may group under the thin capitalisation provisions will usually also be required to prepare consolidated accounts under AASB 1024. In order to comply with the accounting standards, the group for thin capitalisation purposes will be required to base its calculations on consolidated figures for the group prepared in accordance with AASB 1024. [Schedule 1, item 1, section 820-470]

8.41       An entity must also comply with any additional requirements imposed by the regulations in relation to the valuation of debt capital. [Schedule 1, item 1, section 820-685]

Revaluations of assets for thin capitalisation purposes

8.42       An entity may use a value for an asset for thin capitalisation purposes other than the value reflected in its books of account although that would not generally be expected to be the case. The new value must be ascertained by an independent valuation and in accordance with relevant accounting standards.

8.43       An independent valuation means a valuation made by a person:

·       who is an expert in relation to valuations of that class of asset; and

·       whose pecuniary or other interests could not reasonably be regarded as being capable of affecting the person’s ability to give an unbiased opinion in relation to that valuation.

8.44       All assets in a class of assets (as per the financial statements) are to be valued on the same basis, either at cost or fair value. If all assets in a class of assets are carried at fair value the entity is required under the accounting standard AASB 1041 to make revaluations sufficiently regularly “…to ensure that the carrying amount of each asset in the class does not differ materially from its fair value at the reporting date.”.

8.45       For thin capitalisation purposes an entity is able to revalue a single asset in the class to reflect that asset’s fair value but only if it can show that the values of all other assets in the class are still at their fair values as required by AASB 1041. If an entity is recording the value of its assets at fair value it is expected that the value for thin capitalisation purposes would not be materially different from the value recorded in its accounts. If all assets in the class are valued on a cost basis, revaluation of a single asset is not permitted. However, the whole class of assets may be revalued.

Commissioner’s power

8.46       The intent of the thin capitalisation provisions could be undermined if an entity’s assets or liabilities are incorrectly valued. Incorrect valuation could affect, for example, the maximum allowable debt amount for non-ADIs or minimum capital amount for ADIs. The Commissioner therefore has a power to substitute an appropriate value for either assets or liabilities where the Commissioner considers that the entity has:

·       overvalued its assets; or

·       undervalued its liabilities.

8.47       Thus, even if the entity complied with the accounting standards, if the value arrived at is flawed in some way the Commissioner may invoke the discretion to substitute an appropriate value. For example, an asset value may have been calculated by reference to erroneous information resulting in an inappropriately high value. The Commissioner may use the discretion to substitute a more accurate value.

8.48       However, the discretion will not be employed merely because an item is off-balance sheet. It is only where the Commissioner considers that either the value of an asset is too high or the value of a liability is too low (whether the asset or liability is on- or off-balance sheet) that the discretion will be used.

8.49       In determining an appropriate value, the Commissioner must have regard to the relevant accounting standards. That is, the Commissioner will determine the value that would have been calculated had the relevant accounting standards been followed correctly and had the valuation been conducted on an independent basis using accurate and reliable information. [Schedule 1, item 1, section 820-690]

8.50       As the exercise of this power may directly affect an entity’s assessment, a person who is dissatisfied with a decision to substitute a value may object against the decision under Part IVC of the TAA 1953.

Anti-avoidance

8.51       The measurement and valuation of assets, liabilities and equity capital is a crucial component of the thin capitalisation provisions. These values directly impact on whether the prescribed debt limits or minimum capital requirements have been breached and if so the amount of debt deduction disallowed. The general anti-avoidance provisions of Part IVA of the ITAA 1936 may apply where these values are manipulated as part of a scheme entered into with the sole or dominant purpose of increasing the amount of debt deduction allowable to an entity.

Application and transitional provisions

8.52       A transitional provision provides a concession for calculating average values for the first income year beginning on or after 1 July 2001. Instead of using the rules set out in Subdivision 820-G for determining average values, entities may choose to use the values of all matters at the end of the relevant period as the average values. [Schedule 1, item 22, section 820-25]

Example 8.7

Global Co (an outward investor) has an income year beginning 1 September 2001 and ending 31 August 2002. It can choose to use the values ascertained on 31 August 2002 as the average when applying Division 820 to its 2001-2002 income year.

8.53       This measure recognises that some entities will need to re-finance in the first year of income in order to fall within the allowable limits.



C hapter

Financial statements for Australian permanent establishments

Outline of chapter

9.1         This chapter explains the requirement for some foreign entities investing in Australia to prepare financial statements that comply with the accounting standards. These requirements are contained in Subdivision 820-L.

9.2         These rules will apply to an income year that begins on or after 1 July 2002. [Schedule 1, item 22, section 820-10]

Context of reform

9.3         Special record keeping requirements will be imposed on certain non-resident entities that carry on business at or through a permanent establishment in Australia (e.g. a branch). This bill refers to these entities as inward investors. These entities will be required to keep financial statements, which have been prepared in accordance with Australian accounting standards, for their permanent establishments. The information in these statements will assist administration of the income tax laws, especially in the application of the thin capitalisation rules. Currently non-residents with Australian permanent establishments do not have to prepare such statements.

9.4         The requirement to prepare financial statements for permanent establishments is broadly consistent with Recommendation 22.11(c) contained in A Tax System Redesigned.

9.5         The separate financial statements for permanent establishments are to be prepared on the basis of the assets, liabilities, equity, revenue and expenses which are attributable to the permanent establishment. In preparing financial statements consideration should be given to the functions performed, assets used and risks borne by the permanent establishment. This would include amounts arising from notional transactions that must be recognised under the foreign bank branch provisions contained in Part IIIB of the ITAA 1936.

Summary of new law

9.6         Inward investors carrying on business in Australia at or through a permanent establishment will:

·       need to prepare separate financial statements for their permanent establishments;

·       need to prepare those statements in accordance with the accounting standards; and

·       be liable for a penalty if they fail to comply with these requirements.

Comparison of key features of new law and current law

New law

Current law

Inward investors carrying on business in Australia at or through a permanent establishment will need to prepare financial statements for their permanent establishments.

There is no equivalent rule in the existing law.

Detailed explanation of new law

Which entities are required to prepare financial statements?

9.7         The record keeping requirements will be imposed on the following entities where they carry on business at or through one or more ‘Australian permanent establishments’:

·       general inward investors;

·       financial inward investors; and

·       ADI inward investing entities.

[Schedule 1, item 1, section 820-960]

9.8         The term Australian permanent establishment is defined as a permanent establishment in Australia at or through which an entity carries on business [Schedule 2, item 17, definition of ‘Australian permanent establishment’ in subsection 995-1(1)] . An example of an Australian permanent establishment is a foreign bank branch in Sydney or Melbourne.

What financial statements need to be kept?

9.9         Entities will be required to keep:

·       a statement of financial position ; and

·       a statement of financial performance .

[Schedule 1, item 1, subsection 820-960(1)]

9.10       The terms statement of financial position and statement of financial performance have the meaning as given in the ‘accounting standards’ and include all the notes required to accompany these statements. [Schedule 1, item 1, subsection 820-960(3)]

What accounting standards are relevant?

9.11       For thin capitalisation purposes, the relevant accounting standards are those made by the AASB. [Schedule 1, item 1, section 820-960; Schedule 2, item 2, definition of ‘accounting standards’ in subsection 995-1(1)]

9.12       Currently, the AASB accounting standards define a ‘ statement of financial performance’ as the profit and loss statement required by Corporations Law . Similarly, they define a ‘statement of financial position’ as the balance sheet required by the Corporations Law . Specific requirements as to the content and form of the statements are contained in the accounting standards.

9.13       Entities will be required to comply with all the accounting standards in preparing financial statements for their Australian permanent establishments. Three accounting standards have been specifically listed in the legislation as they are of particular relevance. [Schedule 1, item 1, paragraph 820-960(2)(b)]

9.14       Two standards directly relate to the content and form of the financial statements. These are:

·       AASB 1018: Statement of Financial Performance , which prescribes the presentation and disclosure requirements for the statement of financial performance and recognised revenues, expenses and valuation adjustments; and

·       AASB 1040: Statement of Financial Position which prescribes:

-           the basis for the presentation of assets and liabilities;

-           the basis for the classification of assets, liabilities and items of equity; and

-           presentation and disclosure requirements for the statement of financial position, and recognised assets, liabilities and items of equity.

9.15       The third accounting standard, AASB 1001: Accounting Policies , prescribes the concepts that guide the selection, application and disclosure of accounting policies. The standard requires specific disclosures to be made in relation to the accounting policies adopted in the preparation and presentation of the financial report. Importantly, at paragraph 4.1.2, AASB 1001 provides guidance for selecting an appropriate accounting policy in the absence of a specific accounting standard, other authoritative pronouncements or Urgent Issues Group Consensus Views. It should be noted that the AASB may issue or revise the relevant accounting standards from time to time.

Scope of the reporting requirements

9.16       In order to define the parameters for which the entity is required to prepare financial statements, the legislation creates a notional entity which comprises the entity’s Australian permanent establishments. The statement of financial position and statement of financial performance must be prepared in accordance with the accounting standards as if:

·       the notional entity were an entity for which these statements would be required to be prepared under the accounting standards;

·       the assets, liabilities and equity that are attributable to the Australian permanent establishments were the notional entity’s assets, liabilities and equity;

·       the revenues and expenses that are attributable to the Australian permanent establishments were the notional entity’s revenues and expenses; and

·       a reference to a financial year in the accounting standards were a reference to an income year.

[Schedule 1, item 1, paragraph 820-960(2)(b)]

9.17       Therefore, it will be necessary for entities to undertake an analysis of the functions performed, the assets used and risks borne by their Australian permanent establishments in order to determine the assets, liabilities, equity, revenue and expense which should be attributed to the notional entity.

Timing

9.18       Entities will be required to prepare the financial statements before they lodge their income tax returns for a year of income beginning on or after 1 July 2002. [Schedule 1, item 1, subsection 820-960(2) and item 22, subsection 820-10(2)]

The Commissioner’s power

9.19       To ensure that inward investors are not subject to unnecessary compliance costs, the Commissioner may decide that an entity is not required to comply with an accounting standard or part of a standard. The Commissioner must be satisfied that it would be unreasonable that the entity be required to do so and the decision must be provided in writing [Schedule 1, item 1, subsections 820-960(4) and (5)] . It is envisaged that when this power is exercised the Commissioner will issue a taxation ruling advising entities accordingly.

9.20       A person who is dissatisfied with a decision by the Commissioner in exercising this power may object against the decision under Part IVC of the TAA 1953. [Schedule 1, item 1, section 820-965]

Failure to keep financial statements

9.21       The record keeping requirements imposed by Subdivision 820-L are incorporated into the general record keeping provision (section 262A) of the ITAA 1936 [Schedule 1, items 10 and 11 (consequential amendments to section 262A)] . As a consequence, failure to comply with the requirements will render a person liable to prosecution under section 262A or an administrative penalty under section 288-25 of Schedule 1 to the TAA 1953. The penalty units are 30 and 20 respectively.

9.22       The record keeping requirements in Subdivision 820-L and section 262A as well as the prosecution and offence provisions in Part III of the TAA 1953 will apply to partnerships and unincorporated companies as if these entities were persons. [Schedule 1, item 1, sections 820-990 and 820-995]

Application and transitional provisions

9.23       This measure does not commence until an income year beginning on or after 1 July 2002. [Schedule 1, item 22, subsection 820-10(2)]

Consequential amendments

9.24       A consequential amendment is made to section 262A to bring the record keeping requirements in Subdivision 820-L within that provision. [Schedule 1, items 10 and 11]

 



C hapter 10

The arm’s length tests for non-ADIs and ADIs

Outline of chapter

10.1       This chapter provides an explanation of the arm’s length tests contained in sections 820-105, 820-215, 820-315 and 820-410. The chapter discusses the calculation of the arm’s length capital amount for ADIs (which are mainly banks) separately to the calculation of the arm’s length debt amount for non-ADIs. An arm’s length test for minimum capital and maximum debt requirements is available to all taxpayers. In practice taxpayers will only choose to apply the arm’s length test where the relevant safe harbour level has been breached.

Context of reform

10.2       The new thin capitalisation rules will contain an arm’s length test. Taxpayers will be able to use this test where they fail the safe harbour test but their gearing could otherwise be justified or acceptable.

10.3       The point of the test is to examine the circumstances of the taxpayer to determine whether the Australian operations, when viewed  independently from the foreign operations could, on an arm’s length basis, have been undertaken with the actual amount of debt or equity used by the taxpayer.

10.4       The test will be of most use in those industries where it is common practice to operate with higher debt to equity ratios. The test creates the opportunity for taxpayers to claim a higher level of debt, or lower amount of equity, than would otherwise be allowable.

Summary of new law

10.5       Non-ADIs are required to compare their adjusted average debt for a year, to their maximum allowable debt for the year. The arm’s length debt amount for the year is one amount that can be used to determine the taxpayer’s maximum allowable debt. When the non-ADI’s adjusted average debt is compared with its arm’s length debt amount this is called the arm’s length test. Similarly, the arm’s length capital amount is relevant for ADIs.

10.6       The arm’s length test for non-ADIs focuses on what the business acting at arm’s length would borrow and what independent commercial lenders would lend to the business on arm’s length terms. The arm’s length debt amount that is determined may be different to the safe harbour debt amount.

10.7       Likewise, the arm’s length minimum capital amount for an ADI may be different to the minimum capital amount calculated under the safe harbour test. The arm’s length test for ADIs focuses on what would be the minimum amount of equity capital required by the bank to undertake its Australian business.

10.8       Additional documentation is required to be kept where the taxpayer relies on the arm’s length test.

Comparison of key features of new law and current law

New law

Current law

The new regime includes an arm’s length test, to be applied at the entity’s option.

There is a limited arm’s length test dealing only with guaranteed foreign debt in certain circumstances.

Detailed explanation of new law

What is the arm’s length rule for outward and inward investing entities that are not ADIs?

Arm’s length debt amount

10.9       The arm’s length debt amount can replace the safe harbour debt amount as an entity’s maximum allowable debt for a period. A non-ADI may choose to adopt an arm’s length debt amount as its maximum allowable debt amount where it can demonstrate that the amount satisfies the requirements set out in section 820-105 or 820-215.

10.10     The focus of the arm’s length debt analysis is on the Australian operations of the investing entity. The analysis looks to the assets of those operations as the source of cash flows to meet the debt repayments and the other liabilities of the operations. To sustain a high level of debt, the entity needs to consider what would have happened at arm’s length under certain assumptions, and to demonstrate that continued sound operations under those assumptions could be reasonably expected.

10.11     The arm’s length debt amount is determined by conducting an analysis of certain facts and circumstances. The analysis results in a notional amount that represents what would reasonably be expected to have been the entity’s average interest-bearing debt amount during the period, having regard to certain factual assumptions and relevant factors. Those assumptions and factors establish a scenario that would have existed if the entity’s Australian operations were independent from any other operations that the entity or its associates had during the period, and had been financed by an acceptable mix of equity and debt funding. [Schedule 2, item 8, definition of ‘arm’s length debt amount’ in subsection 995-1(1)]

10.12     An acceptable mix of debt and equity funding for the Australian operations of the entity is determined by conducting an analysis that considers the investment expectations of both the borrower (the investment entity) and the lenders (the notional lenders) as independent parties dealing at arm’s length with each other with respect to the type of Australian business operations being funded. The analysis assumes that the lenders are prudent commercial institutions (such as ADIs) and are independent of the borrower.

10.13     The analysis involves a consideration of the factors that an entity would consider when arranging the finance for its operations, and the factors that a prudent commercial lender would consider when deciding whether to provide the finance, and on what terms it would provide that finance.

10.14     The objective of the analysis will be to establish the notional amount of debt that the entity would reasonably be expected to have held throughout the period, and that independent commercial lenders would have provided on arm’s length terms and conditions [Schedule 1, item 1, subsections 820-105(1) and 820-215(1)] . Establishing this requires the consideration of whether an independent party would have borrowed the same amount and whether independent lenders would have provided the debt capital on the same, or similar, terms.

10.15     It is possible that an entity’s arm’s length debt amount can be an amount that is greater than its safe harbour debt amount, but lower than its debt capital amount. In this circumstance, the arm’s length debt amount becomes the entity’s maximum allowable debt, and the entity’s debt deductions would be reduced in proportion to the difference between that amount and its actual debt capital amount (the excess debt ).

Factual assumptions

10.16     In determining whether an independent party would have borrowed the same amount to finance its Australian operations, and an independent lender would have provided the same amount on the same terms, a comparison is required. What has to be compared are the conditions that would exist if an independent entity dealing at arm’s length with other parties had funded the Australian operations and the actual conditions that exist in the entity’s funding of the Australian operations.

10.17     In determining how an independent entity dealing at arm’s length with other parties would fund the Australian operations, the effect of any financial or credit support from its associates is ignored, as are foreign assets it may hold. The analysis is then conducted as if the taxpayer were an independent entity that finances its Australian operations without the benefit of any financial or credit support from its associates.

10.18     Subsection 820-105(2) (for outward investing entities) and subsection 820-215(2) (for inward investing entities) contains the factual assumptions that must be made to establish the circumstances in which the arm’s length debt analysis is conducted. The factualassumptions include some conditions that actually did exist during the period, and some conditions that replace what actually happened during the period.

10.19     The combination of the factual assumptions creates the basis on which the arm’s length analysis must be conducted. That scenario is that which would exist if the entity had been dealing with independent commercial lenders without the financial backing of other parties. Under that scenario, it is assumed that the entity and the notional lenders can only consider the assets and income of the entity’s Australian operations or Australian investments when conducting the required analysis.

Identifying the Australian operations

10.20     The Australian operations are in general, identified by reference to the assets that the entity uses or has available for deriving its income other than through foreign subsidiaries or branches. The principal purpose of the first assumption is to isolate the entity’s Australian operations from its foreign operations. In doing so it is necessary that the design of the assumption differs slightly between inward and outward investing entities. However, the object of focusing only on the Australian operations is the same for both. Associate entity debt is disregarded because it is deducted in the adjusted average debt calculation (in subsection 820-85(3) or 820-185(3)) with which the arm’s length amount has to be compared. [Schedule 1, item 1, paragraphs 820-105(2)(a) and 820-215(2)(a)]

10.21     The second assumption is that the Australian operations had been carried on as they actually were during the period [Schedule 1, item 1, paragraphs 820-105(2)(b) and 820-215(2)(b)] . The third assumption is that the nature of the entity’s assets and liabilities that are attributable to the Australian operations had been as they were during the period [Schedule 1, item 1, paragraphs 820-105(2)(c) and 820-215(2)(c)] . The fourth assumption is that the entity carried on business in the same circumstances as what actually happened during that year [Schedule 1, item 1, paragraphs 820-105(2)(d) and 820-215(2)(d)] .

10.22     The second, third and fourth assumptions require that the analysis assume that the entity performed the same functions (other than those disregarded by the first assumption), faced the same risks (apart from those relating to its debt and gearing), operated in the same circumstances in the industry with the same competitors, customers and suppliers, had the same income and expenses (apart from debt deductions), and had the same management.

Arm’s length financial arrangements

10.23     The fifth assumption is critical to the arm’s length analysis because it raises the possibility of an alternative scenario to that which actually occurred. It does that by specifying a fundamental condition in relation to the raising of the entity’s debt.

10.24     The fifth assumption requires that the notional amount of debt be provided to the entity in relation to the Australian business without any guarantee, security or other credit support being provided by any party other than the entity itself. This assumes that the entity was capitalised with an adequate amount of equity funding, given its Australian operations, and (after analysing the relevant factors) that the owners were concerned to receive an adequate amount of return on that equity. [Schedule 1, item 1, paragraphs 820-105(2)(e) and 820-215(2)(e)]

10.25     It is recognised that prudent commercial lenders usually look at the consolidated financial position of the group to which the borrower belongs and the resources on which it could draw within that group to fund interest charges and capital repayments. However, when applying the arm’s length test to a single entity it is necessary to limit the extent to which the wider group is taken into account by specifying that relationships with associates that are not part of the Australian operations are to be disregarded. Any credit support from the non-Australian business operations of the entity are also disregarded. Where the arm’s length test is applied to a group, the resources of the members of the group could be called upon for support but not those of associates outside the group.

Relevant factors

10.26     All of the factors set out in subsection 820-105(3) (for outward investing entities) and 820-215(3) (for inward investing entities) must be taken into account in an analysis of whether or not an amount satisfies subsection 820-105(1) or 820-215(1). It may be possible that in some circumstances factors other than those listed could also be taken into account.

10.27        The relevant factors are those that would be considered by a prudent independent party that was contemplating borrowing the notional amount on the same terms and those a prudent independent lender would consider when contemplating whether to provide the debt on the same terms. Unless the factors are taken into account, such an analysis would be incomplete and it would not be possible to conclude that an amount satisfies subsection 820-105(1) or 820-215(1).

10.28     The relevant factors must be considered in the context of the factual assumptions that are created by subsection 820-105(2) or 820-215(2). The weight given to each factor in the analysis of a particular entity may vary, depending on the facts and circumstances of the case.

10.29     In determining whether an independent commercial lender (such as a bank) would have provided the debt on the same terms, a credit analysis is usually required. A credit analysis includes consideration of the applicant’s capacity to repay (over the full term of the borrowings) and whether the applicant has sufficient security to support all its debts and other expenses.

10.30     A prudent independent commercial lender would not provide funds unless it was satisfied that the borrower met these criteria. However, it is understood that lenders revise their view of an acceptable level of gearing or income cover for particular entities or groups at different times or often reserve the capacity to do so when setting terms and conditions.

10.31     Consequently, it is possible to say that although a particular debt to equity ratio meets the arm’s length standard at a particular point in time, it may not a few years later. An arm’s length debt analysis must therefore be conducted in respect of each income year. However, where there is no change in circumstances from one year to the next, it would be reasonable to expect that the results of an arm’s length debt analysis remained relevant. Moreover, the capacity of the borrower and lenders to alter their arrangements should also be considered.

10.32     The terms of the loans actually transacted and entered into will usually be the starting point for an arm’s length debt analysis, and any adjustment or amendment to them would only be made in exceptional cases and would need to be clearly justifiable. Generally, the only justifiable circumstance would be where the arrangements made in respect of the loans differ from those that would have been adopted by the independent Australian operations behaving in a commercially rational manner.

10.33     An entity would not be able to reasonably state that simply being willing to pay a higher interest rate would give justification for a higher debt level. The starting point will always be the actual terms of its loans. Such a statement would need to be supported by an analysis of all of the factors set out in subsection 820-105(3) or 820-215(3).

10.34     The factors in subsection 820-105(3) or 820-215(3) should not be considered inisolation from each other. For example, the terms and conditions that apply to the entity’s debt capital for a period (paragraph 820-105(3)(b)) have a direct effect on the profitability of the entity (including the return on its capital) for a period (paragraph 820-105(3)(f)) and on its capacity to repay all of its liabilities that are due to be paid during the period (paragraph 820-105(3)(e)).

Functions, assets and risks

10.35     In taking into account the nature of the business that the entity conducts throughout the period, the principal functions performed by the Australian operations should be identified. It will also be relevant in identifying the functions performed, to consider the assets that were employed and the risks assumed by the entity. The functions carried out (taking into account the assets used and the risks assumed) will determine to some extent the allocation of risks between the entity and the notional lenders, and therefore the conditions each party would expect in arm’s length dealings. [Schedule 1, item 1, paragraphs 820-105(3)(a) and 820-215(3)(a)]

10.36     The analysis would also extend to the entity’s Australian equity investments, including in associates. A prudent lender would look through the equity held to the actual assets represented by the equity. It would also consider the gearing of those entities in which the equity is held. A high debt level in those entities could weaken an argument that the holding entity could have a higher gearing. This should be balanced by the need for the borrower’s debt capacity to be determined on a stand alone basis.

Terms of loans

10.37     In the open market, the assumption of increased risk by a lender will be compensated by an increase in the expected return. It is expected that this would have a direct impact on the terms (such as interest rate, repayment amount, and duration of loan) actually agreed and entered into between independent parties. Accordingly, it could be found that for the level of risks assumed by the notional lenders, they may not have provided as much debt at the entity’s actual interest rates as the entity has actually borrowed. [Schedule 1, item 1, paragraphs 820-105(3)(b) and 820-215(3)(b)]  

10.38     For example, where a lender faces unusual risks in respect of a loan provided to an entity, consideration should be given to whether any special covenants were included in the loan contracts. Covenants could include the requirement to inject equity over time, so as to improve the gearing ratio of an entity, or to require the entity to meet gearing and income cover targets at specified intervals.

10.39     An important consideration here is that the actual terms (e.g. interest rate and period of loan) that were entered into may have been struck after having regard to other than just the Australian operations. The arm’s length debt analysis isolates the Australian operations so that foreign operations cannot be used as justification for a higher debt level. It needs to be recognised that the terms of the arrangements actually entered into, particularly with the entity’s associates, may not be the same as those that would be entered into under arm’s length dealing.

Security

10.40     An appraisal of the security available (after taking into account the assumptions) to support the borrowing is always required in an arm’s length debt analysis. This includes anything pledged or deposited in support of a loan and over which the lender has taken a charge or mortgage. In commercial banking, security is usually taken for the following reasons:

·       to ensure the full commitment of the borrower to its operations;

·       to provide protection should the borrower deviate from the planned course of action outlined at the time credit is extended (or for unexpected or unforeseen reasons); and

·       to provide insurance should the borrower default.

10.41     However, it is important to note that security is not a substitute for repayment ability. When making a credit assessment, lenders first check whether there is sufficient servicing capacity and only then do they proceed to check that the borrower has sufficient security available.

10.42     Accordingly, the nature of, and title to, any assets that might provide security for the loans will be an important factor to take into account. [Schedule 1, item 1, paragraphs 820-105(3)(c) and 820-215(3)(c)]

Purpose

10.43     The purpose of entering into the loan will always be an important factor to take into account in an arm’s length debt analysis. It would be expected that an independent party would only enter into a loan arrangement if it were satisfied that it would earn enough income to repay all of its borrowings, to cover all of its other operating expenses, and to leave an adequate profit for the equity investors. It may take several years for operations to become profitable, and losses may be acceptable in the early years of start-up operations. [Schedule 1, item 1, paragraphs 820-105(3)(d) and 820-215(3)(d)]

Debt servicing capacity

10.44     Accordingly, the projected future income cover in relation to its future repayment obligations (interest and principal) and other expense obligations will usually be a critical factor to consider. In the normal case, the Australian operations would need to be earning enough income to service the repayments on the loans, to cover all other expenses related to those operations and to generate an adequate return on capital invested in those operations. Related to this will be the quality of the cash flow including historical and projected cash flows.

10.45     For example, where the future income is ensured by a contract, there is high reliability and certainty that it will eventuate. However, where it is merely a forecast, it will be less reliable unless it is supported by a comprehensive historical or comparability analysis. A better idea of the income to be generated from a new investment could be obtained from the experience of comparable independent parties that were operating under arm’s length conditions.

10.46     For a borrower to repay debt, it must have the capacity (i.e. the cash flow) to repay both the interest and principal components of the debt, in addition to all its other liabilities.

10.47     Servicing capacity does not just mean profitability (reported profits do not necessarily represent cash flows). Thus, the profit cycle of a borrower can differ from the cash flow cycle. This is especially true where a borrower’s profitability is largely comprised of unrealised capital gains.

10.48     As debts must be repaid from cash flows, it is imperative that a credit assessor establishes that the borrower has a satisfactory servicing capacity. The borrower’s income statement and forecasted cash flow statement can be used for this purpose. After-tax cash flows are used to reflect cash actually available. As this approach concentrates on the after-tax cash flows available to service both principal and interest, it is superior to the interest cover ratio in assessing repayment capacity, as that ratio merely examines the borrower’s ability to meet interest payments. [Schedule 1, item 1, paragraphs 820-105(3)(e) and (f) and 820-215(3)(e) and (f)]  

Gearing level

10.49     The gearing level of the taxpayer (its debt to equity ratio), prior to and after entering into new loan arrangements, will also be a critical factor to consider. High gearing levels are indicative that an entity has reached the limit of its borrowing capacity.

10.50     Similarly, the gearing level of the group of which the taxpayer is a part can be a critical factor in the analysis. For example, where a global group is geared at a relatively low level, it would be extremely difficult to justify that the group could, under arm’s length conditions, load debt into similar Australian operations so that they were comparatively highly geared. Of course, allowances may have to be made if the group engages in activities different to the Australian business in other locations. [Schedule 1, item 1, paragraphs 820-105(3)(g) and 820-215(3)(g)]

Commercial practice

10.51     Commercial practices in the industry in which the taxpayer operates may be an important indicator of whether an independent lender would advance funds at a particular time and for a particular purpose (independent commercial lenders may apply different lending criteria to different industries). Care should be taken to ensure that the industry practices being used as a benchmark should evidence the kind of arm’s length behaviour that is required in this analysis and take account of differences in markets. Likewise, this consideration may also play an important role in the approach that the entity takes when arranging its finances. [Schedule 1, item 1, paragraphs 820-105(3)(h) and 820-215(3)(h)]

Foreign operations

10.52     For an outward investing entity, how it finances its non-Australian business is relevant because the analysis is made in respect of the Australian operations only. The focus of an arm’s length debt analysis will be the entity’s repayment capacity and the security available in Australia to support the borrowing. The analysis looks at the Australian operations as the source of the funds for the repayments, and the way in which the foreign operations are financed will have implications for this part of the analysis.

10.53     In particular, the arm’s length debt analysis needs to consider whether the way in which the entity has financed its foreign operations can prevent it from demonstrating that its adjusted debt amount is an arm’s length debt amount. Therefore, the entity must ensure that the equity allocated to its foreign branches gives a result that is consistent with the arm’s length principle (contained in business profits article of Australia’s DTAs and Division 13, Part III of the ITAA 1936), and acknowledge that if its foreign subsidiaries are over-capitalised , that could lead to the Australian operations being under-capitalised . [Schedule 1, item 1, paragraph 820-105(3)(i)]

State of the Australian economy

10.54     The general state of the Australian economy will also have a bearing on what independent parties would do in respect of borrowing and lending arrangements. For instance, it is not considered likely that a prudent commercial lending institution would enter high-risk arrangements in times of economic downturn. [Schedule 1, item 1, paragraphs 820-105(3)(j) and 820-215(3)(i)]

Application of analysis of relevant factors in year when debt capital raised

10.55     The analysis of the relevant factors in the year the entity last raised debt capital may be the most important analysis in some circumstances. Specifically, where the entity has not raised debt capital in the intervening time and the relevant factor analysis for the year in which debt was last raised and the current year would be similar, the entity may rely on that earlier analysis.

10.56     The purpose of adopting this factor is to eliminate the compliance burden of doing a comprehensive arm’s length analysis every year when it is clear that nothing has materially changed. For example, it would be expected that the same Australian business is operating, the nature of the assets is substantially the same, its equity funding is the same and the entity still has the same or similar capacity to repay its liabilities.

10.57     Examples of where this may be useful could include situations where the only change is a decrease in the accounting value of the assets or there has been a negative movement in the exchange rates that impacts on asset or liability values. Each case would of course need to be examined on its facts. [Schedule 1, item 1, paragraphs 820-105(3)(k) and 820-215(3)(j)]  

10.58     The relevance of this factor calls for judgement and it would be expected that an entity relying on this factor would have documentation supporting the application of this factor in accordance with section 820-980.

Regulations

10.59     Other relevant factors that are required to be considered in an arm’s length debt analysis may be provided for in the regulations. [Schedule 1, item 1, paragraphs 820-105(3)(l) and 820-215(3)(k)]  

Conclusion

10.60     Consideration of these critical factors may demonstrate that the entity satisfies the arm’s length test. Alternatively, it could lead to the following conclusions:

·       that the taxpayer had borrowed more than would have been borrowed if it were an independent party dealing at arm’s length with independent commercial lending institutions; or

·       that independent parties dealing on arm’s length terms would not have entered the loan arrangements at all (the purpose of the loan may be particularly relevant here).

10.61     In either of these alternative cases, it would not be considered that the taxpayer had demonstrated that its actual adjusted average debt level was an arm’s length debt amount for its Australian business. However, it may have been demonstrated that the arm’s length debt amount was higher than the safe harbour debt amount, so that the taxpayer could justify a higher amount of debt than the safe harbour debt amount.

Commissioner’s power

10.62     The Commissioner has the power to substitute an amount worked out by the entity as its arm’s length debt amount. This would occur where the Commissioner considers an amount worked out by the entity does not appropriately take into account the factual assumptions and the relevant factors. The substituted amount must better reflect those assumptions and factors. [Schedule 1, item 1, subsections 820-105(4) and 820-215(4)]  

10.63     As the exercise of these powers will directly affect an entity’s assessment, a person who is dissatisfied with a decision may object against the decision under Part IVC of the TAA 1953.

What is the arm’s length rule for outward and inward investing entities that are ADIs?

The arms length capital amount

10.64     The arm’s length capital amount for ADIs is determined in a similar but not identical manner to the arm’s length debt amount for non-ADIs. In the case of ADIs, the analysis results in the quantification of a notional amount that represents what would reasonably be expected to have been the entity’s minimum capital amount throughout the year in relation to its Australian operations. [Schedule 2, item 7, definition of ‘arm’s length capital amount’ in subsection 995-1(1)]

10.65     The arm’s length test should determine a level of capital attributed to Australian operations that is consistent with the arm’s length, separate enterprise principle (contained in the business profits articles of Australia’s DTAs and Division 13 of Part III of the ITAA 1936). Under that principle, an enterprise could not operate without an adequate capital level. An adequate capital level is determined after taking into account the nature and extent of the business operations of the ADI, including the assets attributable to, and the risks associated with, the Australian operations.

10.66     The arm’s length capital amount for a period is determined by conducting an analysis of certain factual assumptions and relevant factors. The analysis results in the minimum amount of capital that the Australian operations would reasonably be expected to have held throughout the period. The assumptions and factors establish a scenario that would have existed if the ADI’s Australian operations were a separate entity, independent and operating at arm’s length from the other parts of the entity. [Schedule 1, item 1, subsections 820-315(1) and 820-410(1)]  

10.67     The arm’s length capital amount is required in order to achieve a level of profit expected to be found in a distinct and separate entity, undertaking the same or similar activities under the same or similar conditions.

10.68     It may be that the ADI’s arm’s length capital amount is less than its safe harbour capital amount, but more than its equity capital amount. In this circumstance, the arm’s length capital amount becomes the minimum capital amount, and the entity’s debt deductions would be reduced in proportion to the difference between that amount and its actual equity capital amount (the capital shortfall ). [Schedule 1, item 1, sections 820-325 and 820-415]

Factual assumptions

10.69     The factual assumptions that must be made in determining an arm’s length capital amount are contained in subsection 820-315(2) or 820-410(2).

10.70      The first assumption isolates the Australian operations from the rest of the ADI. It is then assumed that the Australian business was carried on as it actually was and with the same remaining assets and liabilities.

Relevant factors

10.71     As the relevant factors are almost identical for both inward and outward ADIs they are dealt with here together .

10.72     The relevant factors that must be taken into account in an analysis of the arm’s length capital amount are contained in subsection 820-315(3) or 820-410(3). These factors ensure that an arm’s length analysis is a comprehensive analysis that covers all issues that are required to be considered in order to arrive at a result consistent with the arm’s length principle.

10.73     All of the relevant factors must be taken into account in an analysis of whether or not an amount satisfies subsection 820-315(1) or 820-410(1), and of whether the equity capital of the Australian operations is an arm’s length capital amount. However, the weight given to each factor in the analysis of a particular entity may vary, depending on the facts and circumstances of the case.

10.74     The relevant factors should not be considered in isolation from each other. For example, the capital ratio of a foreign bank and its Australian branch (paragraph 820-410(3)(c)) has an effect on the credit rating of the bank and the interest rates that apply to the bank’s debt for a period (paragraph 820-410(3)(b)).

10.75     The relevant factors are those which would be considered by a prudent independent party that was evaluating the creditworthiness of an entity that was undertaking the Australian banking business, including its capacity to meet its financial obligations in a timely manner. Unless the factors are taken into account, such an analysis would be incomplete and it would not be possible to conclude that an amount satisfies section 820-315 or 820-410.

10.76     The relevant factors must be considered in the context of the arm’s length separate enterprise principle and the actual assumptions that are created. For example, the arm’s length separate enterprise principle requires that an appropriate level of equity capital of a foreign bank be allocated to the Australian branch as part of the profit attribution calculation. The assumptions contained in subsection 820-410(2) ensure that the arm’s length capital amount is determined from a consideration of the circumstances that would ordinarily occur between unrelated entities that are dealing at arm’s length.

10.77     It is possible that, although a particular level of equity capital meets the arm’s length standard at a particular point in time, it may not a few years later. An arm’s length analysis must, therefore, be conducted in respect of each income year if it is to be relied on as the minimum capital amount.

Functions, assets and risks

10.78     The amount of equity capital that is attributed to the Australian operations needs to take into account the different functions performed, assets used and risks assumed by both the bank and the Australian operations during the year. It will also be useful to take into account the credit rating of the bank throughout the year. [Schedule 1, item 1, paragraphs 820-315(3)(a) and (b) and 820-410(3)(a) and (b)]  

10.79     Risk weighting assets, in accordance with the Basel Capital Adequacy Framework, would be an appropriate way to compare the relative functions, assets and risks that a foreign bank and its Australian branch assumed throughout a year. Given the general acceptance of a fixed credit rating between different parts of a foreign bank, except for any differences in country ratings, the level of equity capital funding in each part of the bank would be expected to be broadly consistent on a risk-adjusted basis. Such an approach would take into account the different functions performed, assets used and risks assumed by each part. Other methods for comparing the relative functions, assets and risks could also be justified where the results are consistent with the arm’s length separate enterprise hypothesis.

Capital ratio

10.80     Another factor of particular importance to the analysis to determine the arm’s length capital amount for the Australian operations is the capital ratio of the bank, its Australian operations and relevant associate entities throughout the year [Schedule 1, item 1, paragraphs 820-315(3)(c) and 820-410(3)(c)] . The thin capitalisation rules are intended to ensure that taxpayers do not reduce their Australian tax liabilities by using an excessive amount of debt to finance their Australian operations. It will for example be difficult to justify, without sound commercial reasons, that the Australian branch of a foreign bank should be funded with a higher proportion of debt and a lower capital ratio than other parts of the bank’s operations.

10.81     Rules for calculating the capital ratio are contained in APRA’s Prudential Standards (APS) & Guidance Notes for Authorised Deposit Taking Institutions and in particular APS 110 and 111. The capital ratio of a foreign bank would be that calculated in accordance with the guidelines of its own regulatory authority.

Purpose

10.82     The purposes for which certain debt and equity capital arrangements were entered into by the bank may also be relevant in determining the appropriate arm’s length capital amount of its Australian operations for a period. For example, if a foreign bank raised an identifiable amount of equity capital because it planned to acquire a funds management business in another country, and it only held those funds until it carried out that transaction, then that equity capital may not be relevant to the arm’s length capital analysis of the bank’s Australian operations. This would be particularly so where the holding of that equity capital did not improve the bank’s overall credit rating or borrowing costs (because it already had a high credit rating). [Schedule 1, item 1, paragraphs 820-315(3)(d) and 820-410(3)(d)]

Profitability

10.83     The profitability of the ADI and its Australian operations throughout a period are inexorably linked to the amount of equity capital funding that is attributed to each of those enterprises. The amount of equity capital directly impacts on the profits of the Australian operations because it bears on the amount of interest expense allocated to the operation. Accordingly, it will always be necessary to consider the profitability of the Australian operations in determining whether its equity capital level is an arm’s length capital amount. [Schedule 1, item 1, paragraphs  820-315(3)(e) and 820-410(3)(e)]

Commercial practices

10.84     The commercial practices adopted by independent parties dealing at arm’s length in the banking industry in Australia (and relevant foreign countries) will also be relevant to an arm’s length capital analysis. For example, the capital ratios of comparable banks operating in those markets may be indicative of the capital ratio that could be expected in a foreign bank branch. The general state of the Australian economy during a year may have a bearing on the capital ratios which banks are prepared (or required) to operate at. [Schedule 1, item 1, paragraphs 820-315(3)(f) and (h) and 820-410(3)(f) and (g)]

Method of financing foreign operations

10.85     For outward ADIs, the arm’s length capital analysis needs to consider whether the way in which the bank has financed its foreign operations can prevent it from demonstrating that its adjusted equity capital is an arm’s length capital amount. Therefore, the bank should ensure that the equity allocated to its foreign branches gives a result that is consistent with the arm’s length separate enterprise principle (contained in the business profits article of Australia’s DTAs and Division 13 of Part III of the ITAA 1936). It also needs to be remembered that if foreign subsidiaries of the bank are over-capitalised, that could lead to the Australian operations being under-capitalised. [Schedule 1, item 1, paragraph 820-315(3)(g)]

Commissioner’s power

10.86     The Commissioner has the power to substitute an amount worked out by the entity under section 820-315 or 820-410. This would occur where the Commissioner considers an amount worked out by the entity does not appropriately take into account the factual assumptions and the relevant factors. The substituted amount must better reflect those assumptions and factors. [Schedule 1, item 1, subsections 820-315(4) and 820-410(4)]

10.87     As the exercise of these powers will directly affect an entity’s assessment, a person who is dissatisfied with a decision may object against the decision under Part IVC of the TAA 1953.

Record keeping requirements

10.88     Where an entity is relying on an arm’s length amount, records documenting the application of the factual assumptions and relevant factors must be kept by the entity. [Schedule 1, item 1, section 820-980]

10.89     Section 262A of the ITAA 1936 is being amended to include this record keeping requirement. [Schedule 1, items 10 and 11, subsections 262A(2AA) and (3)]

Application and transitional provisions

10.90     The provisions for the calculation of the arm’s length amounts are subject to the same application and transition provisions as for the rest of the thin capitalisation regime [Schedule 1, item 22, subsection 820-10(1)] . The amendments to section 262A of ITAA 1936 also apply for income years beginning on or after 1 July 2001 [Schedule 1, item 26] .

Consequential amendments

10.91     The only consequential amendments related to the subject of this chapter are in section 262A of the ITAA 1936 and are discussed in paragraphs 10.89 and 10.90.

 



C hapter 11

Regulation impact statement

Policy objective

The objectives of the New Business Tax System

11.1       The measures in this bill are part of the Government’s broad ranging reforms which will give Australia a New Business Tax System. The reforms are based on the recommendations of the Review of Business Taxation, instituted by the Government to consider reform of Australia’s business tax system.

11.2       The Government instituted the Review of Business Taxation to consult on its plan to comprehensively reform the business income tax system, as outlined in ANTS. The Review of Business Taxation’s recommendations to the Government were designed to achieve a simpler, stable and durable business tax system.

11.3       The New Business Tax System is designed to provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs and improved savings, as well as providing a sustainable revenue base so the Government can continue to deliver services to the community.

11.4       The New Business Tax System also seeks to provide a basis for more robust investment decisions. This is achieved by:

·       using consistent and clearly articulated principles;

·       improving simplicity and transparency;

·       reducing the cost of compliance through principled tax laws that are easier to understand and comply with; and

·       providing fairer, more equitable outcomes.

11.5       This bill is part of the legislative program implementing the New Business Tax System. Other bills have been introduced and passed already and are summarised in Table 11.1.

Table 11.1:  Earlier business tax legislation

Legislation

Status

New Business Tax System (Integrity and Other Measures) Act 1999

Received Royal Assent on 10 December 1999.

New Business Tax System (Capital Allowances) Act 1999

Received Royal Assent on 10 December 1999.

New Business Tax System (Income Tax Rates) Act (No. 1) 1999

Received Royal Assent on 10 December 1999.

New Business Tax System (Former Subsidiary Tax Imposition) Act 1999

Received Royal Assent on 10 December 1999.

New Business Tax System (Capital Gains Tax) Act 1999

Received Royal Assent on 10 December 1999.

New Business Tax System (Income Tax Rates) Act (No. 2) 1999

Received Royal Assent on 10 December 1999.

New Business Tax System (Venture Capital Deficit Tax) Bill 1999

Received Royal Assent on 22 June 2000.

New Business Tax System (Miscellaneous) Bill 1999

Received Royal Assent on 30 June 2000.

New Business Tax System (Miscellaneous) Bill (No. 2) 2000

Received Royal Assent on 30 June 2000.

New Business Tax System (Integrity Measures) Bill 2000

Received Royal Assent on 30 June 2000.

New Business Tax System (Alienation of Personal Services Income) Bill 2000

Received Royal Assent on 30 June 2000.

New Business Tax System (Alienated Personal Services Income) Tax Imposition Bill (No. 1) 2000

Received Royal Assent on 30 June 2000.

New Business Tax System (Alienated Personal Services Income) Tax Imposition Bill (No. 2) 2000

Received Royal Assent on 30 June 2000.

New Business Tax System (Simplified Tax System) Bill 2000

Introduced into the Parliament on 7 December 2000.

New Business Tax System (Capital Allowances) Bill 2001

Introduced into the Parliament on 24 May 2001.

New Business Tax System (Capital Allowances - Transitional and Consequential) Bill 2001

Introduced into the Parliament on 24 May 2001.

The objectives of measures in this bill

11.6       The objective of the thin capitalisation regime is to ensure that multinational entities do not allocate an excessive amount of debt to their Australian operations. This is to prevent multinational entities taking advantage of the differential tax treatment of debt and equity to minimise their Australian tax. The thin capitalisation regime, together with other parts of the New Business Tax System, will contribute to the fairness and equity of the tax system, by maintaining the integrity of the Australian tax base.

11.7          More specifically, the measures contained in this bill are outlined in Table 11.2.

Table 11.2:  Objectives of the measures in this bill

Measure

Objective

Thin capitalisation

Thin capitalisation rules will apply to foreign controlled entities and investors, as well as to Australian multinational enterprises with controlled foreign investments.

The objective of the thin capitalisation measures is to limit the proportion of debt that can be used to finance the Australian operations by disallowing deductions relating to excessive debt financing.

The new measures will apply to all debt, including related-party debt, third party debt, and both foreign and on-shore debt.

This adds integrity and fairness to the rules.

A safe harbour gearing ratio of 3:1 will apply to general investors. For financial entities, the 3:1 safe harbour gearing ratio will apply to the non-lending business, after the application of an on-lending rule. Special rules apply to low risk, low margin business. An overall safe harbour gearing ratio of 20:1 applies.

The special rules for loans and other business are provided to deal with these businesses which operate with higher gearing than general businesses.

The new measures will include an arm’s length test, to be applied at the taxpayer’s option.

To accommodate businesses operating in the market place on a stand alone basis with higher debt levels than allowed under the safe harbour rules, and to be consistent with Australia’s double tax agreements.

Thin capitalisation

The new measures will include a worldwide gearing test to be applied at the taxpayer’s option.

To allow grouping/capitalisation of the Australian part of a worldwide group to differ to some extent from the gearing/capitalisation of other parts of the group.

Treatment of branches

Branches operating in Australia will be subject to the new thin capitalisation measures. Branches (permanent establishments) of inbound investors operating in Australia will be required to prepare financial statements, comprising statement of financial position and statement of financial performance.

The preparation of financial statements for branches operating in Australia will demonstrate how those branches are financed and will enable the application of the thin capitalisation measures to those branches. The commencement of this measure has been deferred for at least 12 months and will not apply to income years starting before 1 July 2002.

The section 128F interest withholding tax exemption will be extended to eligible debenture issues by non-resident companies carrying on business at or through a branch (permanent establishment) in Australia.

Currently, non-resident companies can access the exemption by establishing an Australian resident subsidiary. The extension of the exemption provides direct access to section 128F funding thereby reducing compliance costs and providing transparency in the law.

Implementation options

11.8       The thin capitalisation measures in this bill arise directly from recommendations of the Review of Business Taxation. Those recommendations were the subject of extensive consultation. The implementation options for these measures can be found in A Platform for Consultation (APFC) and A Tax System Redesigned (ATSR). Table 11.3 shows where the measures (or the principles underlying them) are discussed in those publications.

Table 11.3:  Options for implementing measures in this bill arising directly from the recommendations

Measure

APFC

ATSR

Thin capitalisation

Chapter 33, pp. 701-704

Recommendations 22.1-22.9, pp. 659-667

Treatment of branches

Chapter 33, pp. 707-709

Recommendations 22.11(b) and (c)

Table 11.4:  Implementation options for measures not explicitly addressed in the Review of Business Taxation

Measure

Implementation options

The inclusion of a de minimis rule excluding from the regime all entities with annual debt deductions less than $250,000.

In adopting a de minimis rule, options as to the level at which the exclusion would be set were examined. The $250,000 level was adopted as it was considered that it was sufficiently high so as not to be inconsequential whilst not being so high as to exclude substantial multinational investors.

This measure was announced in Treasurer’s Press Release No. 38 of 22 May 2001.

The new thin capitalisation regime to start from the beginning of the first income year of the taxpayer commencing on or after 1 July 2001.

The alternative to an income year start date was to provide a fixed 1 July 2001 date.

This option was rejected due to the additional compliance costs for entities with substituted accounting periods who would be required to apply two thin capitalisation regimes to the one income year.

It also provides time for the restructuring of financing arrangements in order to comply with the regime.

This measure was announced in Treasurer’s Press Release No. 38 of 22 May 2001.

Providing a safe harbour test for banks based around 4% of the risk weighted assets of their Australian operations. Optional recourse for outward investing banks to a minimum capital requirement based on a capital ratio of 80% of their worldwide Tier 1 capital ratio.

The alternative option was to determine minimum capital requirements by an allocation of the bank’s actual capital levels.

This option was rejected as symmetry was sought between the treatment of non-ADI entities and ADI entities. This option would also have led to higher compliance costs.

The final details of this approach were announced in Treasurer’s Press Release No. 38 of 22 May 2001.

Modifications to some of the rules in the CFC provisions, for thin capitalisation purposes.

The alternative was to develop a new regime of control rules for thin capitalisation purposes.

Instead, the existing CFC control tests were adapted to determine whether Australian entities are foreign controlled and whether Australians control foreign entities.

Modifications were also made to prevent companies at the bottom of a long corporate chain in which there is a small indirect foreign interest being caught in the rules.

The CFC rules have also been modified to deal with some additional entities, such as corporate limited partnerships.

In response to taxpayer concerns, the breadth of ‘associates’ has been narrowed to limit associates to those who are capable of sufficiently influencing the financing decisions of an entity.

This measure was announced in Treasurer’s Press Release No. 38 of 22 May 2001.

Optional thin capitalisation notional grouping of 100% owned subsidiaries for the purposes of applying the maximum debt level and minimum capitalisation requirements to the notional group.

Partnerships and trusts wholly-owned by other members of the group be included in the grouping.

Australian branches of foreign banks be able to be grouped with wholly-owned Australian subsidiaries of the bank.

Due to the deferral of the consolidation regime until 1 July 2002, the alternative option was to provide no thin capitalisation grouping rules.

This option was not preferred due to the increased compliance costs in separately applying the regime to each entity in the group.

It was also considered that the rules may operate harshly where some members of the group individually breach the maximum debt or minimum capital requirements whilst others have surplus debt capacity.

This measure was announced in Treasurer’s Press Release No. 38 of 22 May 2001.

Bringing ungrouped associates into the regime and excluding investments in them from assets. Surplus debt capacity of an associate may be transferred to the party with the investment in the associate.

Loans to associate entities that are also subject to the thin capitalisation regime are given special treatment provided they meet certain conditions.

The approach taken in the safe harbour tests for non-banks is to deduct from assets the amount of any equity interests in unconsolidated associates and to test these associates separately.

The alternative was to include investments in associates as counting for thin capitalisation purposes. This option was excluded as it would distort the calculations of the maximum debt and allow multiple gearing on a single pool of equity funds.

Due to taxpayer concerns, this approach was further refined to allow surplus debt capacity of an associate to be carried up to the investor on a proportional basis.

The alternative to the treatment of loans to associates was to do nothing. This was rejected, to avoid double application of the rules to the one pool of debt funding of a business.

This measure was announced in Treasurer’s Press Release No. 38 of 22 May 2001.

Securities dealing and other low gross margin or low risk business (e.g. securitisation of assets and purchasing government securities) are given special treatment under the safe harbour for non-bank financial businesses.

Other options were excluding licensed Australian Stock Exchange brokers and securitisation entities altogether, or establishing another higher gearing ratio that would soften the application of the new measures.

The new capital adequacy rules for licensed brokers are inadequate for tax purposes.

By excluding assets and debts arising from these businesses before determining the safe harbour debt amount for the financial entity, a lesser amount of capital will be required.

This approach was considered preferable to devising a separate, higher gearing ratio for this business due to the degree of difficulty associated in devising a ratio which would appropriately accommodate the various levels of these businesses of various financial entities.

Transitional treatment of financial instruments that change character as a result of the debt/equity tax reform.

 

The taxpayer may elect to have the current law debt/equity characterisation applied until 30 June 2004. However, calculation of debt and debt deductions is to take account of the change in character.

The alternative was to treat an instrument, for thin capitalisation purposes, in accordance with the election of the taxpayer. This option was rejected as the transitional relief sought to be conferred by the election - retaining deductions for instruments currently treated as debt - would be significantly reduced if those instruments were to count as debt for thin capitalisation purposes.

This measure was announced in Treasurer’s Press Release No. 38 of 22 May 2001.

Amendment of the record keeping and penalty provision of section 262A of the ITAA 1936 to apply to branches of foreign entities in Australia and in relation to arm’s length amounts calculated by the entity.

 

The alternative was to create a separate penalty regime for the breach of the requirement to prepare financial statements in the stipulated circumstances. The alternative was rejected as it would represent a substantial duplication of section 262A of the ITAA 1936.

Amendments to section 262A will ensure that once implemented, the new record keeping requirements for permanent establishments (branches) are included as part of the general record keeping provisions and their penalties.

Amendment of section 128F of the ITAA 1936 so that it applies to debentures issued by permanent establishments (branches) of non-residents in Australia.

The alternative was to have ongoing special rules to avoid the double application of the thin capitalisation rules to the same pool of funds.

Amendment to section 128F will allow all non-resident companies to issue interest withholding tax-exempt debentures through a branch in Australia. They will not have to maintain Australian subsidiaries to do so and will not have unnecessary thin capitalisation problems.

Assessment of impacts

11.9       The potential compliance, administrative and economic impacts of the measures in this bill have been carefully considered, by the Government, the Review of Business Taxation and the business sector. The Review of Business Taxation focussed on the economy as a whole in assessing the impacts of its recommendations and concluded that there would be net gains to business, government and the community generally from business tax reform.

Impact group identification

11.10     The measures in this bill specifically impact on those taxpayers identified in Table 11.5.

Table 11.5:  Taxpayers affected by the measures in this bill

Measure

Affected taxpayers

Thin capitalisation

New thin capitalisation measures to apply to both foreign controlled investments in Australia, as well as Australian multinational investors with controlled foreign investments or foreign branch operations.

 

Approximately 1,300 permanent establishments operate within Australia. Approximately 7,000 companies, 30,000 superannuation funds and 22,000 trusts have foreign investments. Of these the majority are considered to be small businesses. Approximately 3,200 companies are foreign controlled. All sizes of business are affected, with application to different entity types, as well as to non-resident individuals with Australian investments.

The de minimis rule operates to exclude entities from the thin capitalisation regime with $250,000 or less annual debt deductions. This requirement excludes the majority of small taxpayers.

No data is available as to the final number of foreign controlled companies that may be subject to the measures.

Treatment of branches

Branches of foreign investors operating in Australia are required to prepare financial statements, from 1 July 2002.

Approximately 1,300 permanent establishments operating within Australia will be required to prepare financial statements and will be able to issue section 128F debentures.

Branches of foreign companies in Australia will be able to issue debentures on which interest payments to non-residents will be exempt from withholding tax, from 1 July 2001.

 

Analysis of costs/benefits

Compliance costs

11.11     The objective of the thin capitalisation regime is to ensure that multinational entities do not allocate an excessive amount of debt to their Australian operations. This is to prevent multinational entities taking advantage of the differential tax treatment of debt and equity in order to minimise their Australian tax. The most appropriate method of assessing whether in fact the Australian operations of a multinational entity are sufficiently capitalised is by the application of an arm’s length test. Such a test requires the analysis of the assets, liabilities and cash flow of the Australian operations of the entity to ascertain if the level of debt of the operation is in fact commercially justifiable for an independent entity. After significant consultation with industry representatives, it was recognised that the application of this test may be quite onerous leading to an increase in compliance costs. To reduce the compliance burden, a safe harbour approach was adopted as the rule of general application. The safe harbour allows sufficient protection of the Australian tax base to be provided whilst simultaneously minimising compliance costs.

11.12     Standard practice with new measures, requires entities affected by them to incur a cost in either familiarising themselves or having advisers familiarise themselves with the new law. The inclusion of a de minimis test ensures that the majority of entities which will fall within the thin capitalisation regime are larger more sophisticated businesses. Therefore, despite the relative complexity of this area of the law, this fact, in conjunction with the extensive consultation undertaken in relation to this measure will, to a certain extent, operate to limit that initial cost. Higher compliance costs may be incurred overall as a result of more entities being subject to the new measures. Specifically, entities with foreign investments are now subject to the thin capitalisation regime and permanent establishments are now required to prepare financial statements in accordance with accounting standards.

11.13     There will also be some additional costs for some taxpayers as they seek to restructure their financing so as to comply with the new rules from when they first apply. These may include those associated with obtaining financial advice, discharging debts and raising share capital. In this respect, transitional relief will be provided by only applying the new regime at the end of the first income year beginning after 30 June 2001. For those taxpayers that balance on a day other than 30 June this will be after 30 June 2002.

11.14     Overall, although the measures in this bill may increase compliance costs, they are part of the Government’s actions taken to improve the integrity of the business tax system as it applies to multinational businesses. However, these increases will be partially offset by some measures in this bill that are expected to reduce compliance costs. It is not possible to finally quantify the compliance costs associated with these measures as the relevant data required to extrapolate such a figure is not available.

11.15     Below are some specific examples of how the measures in this bill will impact on compliance costs.

Thin capitalisation

11.16     Currently the thin capitalisation measures apply only to foreign controlled Australian operations and non-residents deriving Australian assessable income. The current measures aim to limit excessive debt borrowed from foreign related parties and debt covered by formal guarantee. The new measures will extend the thin capitalisation provisions to Australian multinational investors with controlled foreign investments and will apply to the total debt of the Australian operations of both groups of multinationals. In this regard there will be some initial and ongoing compliance cost to Australian multinational taxpayers, which will have to determine whether their debt deductions will be affected by the application of the new measures. Compared with the current arrangements, the thin capitalisation measures will involve an increase in compliance costs, while the removal of interest expenses from the general rule of denying deductions for expenses incurred in earning exempt foreign income and from the foreign loss quarantining provisions, in most cases, will decrease compliance costs. In addition, the removal of the debt creation rules, as well as the easing of the foreign control test will result in some compliance cost savings. It is not possible to identify the net effect, however, it is unlikely to be significant.

11.17     The compliance burden - particularly on smaller entities operating in Australia - has been significantly eased by the adoption of a de minimis exemption for taxpayers with total debt deductions (combined with those of certain associates) below $250,000 in a financial year. Once a taxpayer establishes that its annual debt deductions do not exceed $250,000, it is outside the thin capitalisation regime and need go no further.

11.18     Additional compliance costs may arise as a result of the arm’s length test, as initially it may be difficult to apply until taxpayers become more familiar with it. Specifically, application of the arm’s length test requires analysis of the assets, cash flow and liabilities of the Australian operations of the multinational entity. The entity is required to keep accurate records of this analysis. Recourse to the arm’s length test is currently available in thin capitalisation cases where a double tax agreement country is involved. Therefore, the arm’s length test is not an entirely new issue, however, its application may be on a wider scale.

11.19     The Review of Business Taxation considered it appropriate to have regard to accounting principles in the development of taxation legislation. The use of Australian accounting standards in determining the value of assets for the purpose of applying the safe harbour debt test will reduce compliance costs for many taxpayers as the tax values of assets will be more closely aligned with accounting principles and practice. For some taxpayers who do not need to prepare financial reports in accordance with accounting standards there may be initial compliance costs in applying the accounting standards. However, the use of accounting standards will provide a reliable, consistent and transparent method to value assets. All of which will provide greater certainty to taxpayers in applying the new measures.

11.20     It was originally anticipated that the new measures would apply to consolidated groups where an Australian group was consolidated for tax purposes. However, with the commencement of the consolidation regime being deferred until 1 July 2002, the thin capitalisation regime will put into place an interim grouping rule. This rule will allow resident entities of the same wholly-owned group to form, subject to certain conditions, a resident thin capitalisation group. The resident thin capitalisation group would determine its maximum allowable debt or minimum capitalisation as if it were a single entity using consolidated figures. If any debt deduction is to be disallowed as a result of the group calculation, it would be done on a proportional basis in the tax return of each entity within the group. There may be minor compliance costs associated with the identification of entities which are eligible for thin capitalisation grouping as well as those associated with the collection of the appropriate data from those grouped entities. It is anticipated that these costs will be substantially offset by the benefits obtained from the one off application of the thin capitalisation requirements to the grouped entity. Further, there is no compulsion to group, allowing the taxpayers to choose to group where it will be to their benefit.

11.21     The new thin capitalisation measure both raises the control threshold to determine whether an Australian investment is foreign controlled and narrows the meaning of associates. The control test is based on the CFC control tests, which in most cases require 50% control (or 40% where there is no other person with the ability to control). The definition of associates used in applying those provisions is narrowed by the inclusion of a sufficient influence test which limits associates to those entities the funding decisions of which the taxpayer has the capacity to influence. Introducing a higher threshold for control that is consistent with the CFC control test, whilst narrowing the meaning of associates, will reduce compliance costs by excluding some entities from the rules altogether that previously would have been included. Some minor changes to the CFC control tests are also being included when using them for this purpose so as to avoid unintended application of the rules.

11.22     Others that will see a change are financial entities. For non-banks, instead of an alternative debt to equity ratio, as under the existing thin capitalisation rules, some of their business (e.g. lending, leasing and securities dealing business) will be given special treatment when applying the general rule. The result of this is that they will be able to operate with higher debt levels that are tailored to their individual businesses rather than work within a one-size-fits-all debt to equity ratio. On the whole, even though the rules for financial entities are different, once they have familiarised themselves with the rules, they will be no more difficult to apply than the rules for other taxpayers.

11.23     The thin capitalisation measures applying to licensed financial entities such as banks and foreign bank branches operating in Australia will be based on the capital adequacy requirements prescribed by APRA or other regulatory bodies in their home jurisdictions. The use of information prepared for capital adequacy purposes prescribed by regulatory bodies such as APRA will result in compliance cost savings as it alleviates the need to separately prepare information for thin capitalisation purposes only.

11.24     Where Australian taxpayers borrow for investment in controlled foreign entities, they will not have to adopt special strategies to ensure the deductibility of the interest expense. This will lessen their compliance costs. In fact, many Australian taxpayers deriving foreign income will be relieved of the need to allocate interest expense between domestic and foreign income and will not have to worry about the new rules. That is because the new rules only apply in cases where a threshold level of foreign activity has been reached (e.g. operating a foreign branch or controlling a foreign entity).

11.25     The debt creation provisions, which supplement the current thin capitalisation provisions, limit interest deductions where a foreign-controlled company sells an asset to a related foreign-controlled company. The provisions disallow interest deductions where the transfer of an asset is financed using interest-bearing debt that is introduced from outside the corporate group. Because the thin capitalisation measure will apply to the total debt of the Australian operations of a foreign-controlled group the debt creation provisions are no longer needed. Removing the rules will reduce complexity and uncertainty.

Treatment of branches

11.26     Australian permanent establishments or branches of inbound investors will be required to prepare financial statements. Commencement of this requirement is being deferred for at least 12 months to allow further time to finalise details. Once introduced, taxpayers may incur ongoing compliance costs in the preparation of this information. However, the Review of Business Taxation considered that consistent with the investment neutrality principle, taxpayers that decide to carry on a business in Australia via a subsidiary or a branch should not be treated differently under the tax system. Requiring all permanent establishments to be capitalised for tax purposes in the same proportions of debt and equity will reduce these differences.

11.27     The extension of the section 128F interest withholding tax exemption to debentures issued by Australian branches of non-residents will also reduce costs. It will no longer be necessary to maintain a subsidiary operation in Australia solely for the purpose of raising these funds. Further, the treatment of these funds under the new thin capitalisation regime will be simplified.

11.28     Further details on how the measures in this bill impact on affected taxpayers can be found in the specific chapters in this explanatory memorandum explaining each measure.

Administration costs

11.29     The thin capitalisation measures are expected to produce a slight increase in administration costs as the ATO will be managing risks associated with the new measures. As more taxpayers are affected by the new thin capitalisation measures, there will be an increase in the data to be collected, and there is expected to be an increase in the requests for advice from taxpayers. However, in relation to Australian multinationals the rules will be more certain than the existing allocation rules which should reduce ATO administration costs. Nevertheless, the costs of administering the arm’s length tests will continue.

Government revenue

11.30     The financial impact of these measures will be a gain to the revenue as outlined in the following table:

2001-2002

2002-2003

2003-2004

2004-2005

$10 million

$395 million

$350 million

$350 million

Economic benefits

11.31     The New Business Tax System will provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs and improved savings. The economic benefits of these measures are explained in more detail in the publications of the Review of Business Taxation, particularly A Platform for Consultation and A Tax System Redesigned. The measures in this bill will contribute to that by improving its integrity. It will also prevent multinational taxpayers who are able to shift debt around the world from obtaining an unfair competitive advantage.

Other issues - consultation

11.32     The consultation process began with the release of ANTS in August 1998. The Government established the Review of Business Taxation in that month. Since then, the Review of Business Taxation published 4 documents about business tax reform, in particular A Platform for Consultation and A Tax System Redesigned in which it canvassed options, discussed issues and sought public input.

11.33     Throughout that period, the Review of Business Taxation held numerous public seminars and focus group meetings with key stakeholders in the tax system. It received and analysed 376 submissions from the public about reform options. Further details are contained in paragraphs 11 to 16 of the Overview of A Tax System Redesigned . In analysing options, the published documents frequently referred to, and were guided by, views expressed during the consultation process.

11.34     Exposure draft thin capitalisation legislation was released on 21 February 2001, leading to extensive consultation following submissions by interested parties.

Conclusion and recommended option

11.35     As discussed, the thin capitalisation measures have been designed to ensure that multinational entities do not shift an excessive amount of debt to their Australian operations thereby reducing their Australian tax obligations. This objective is sought to be implemented in an effective manner whilst considering the compliance impact on taxpayers. To minimise the compliance burden on taxpayers, the measures have adopted:

·       a safe harbour approach;

·       optional application of an arm’s length test;

·       optional application of a worldwide gearing test in certain circumstances;

·       optional grouping provisions;

·       a de minimis test to exclude small business taxpayers;

·       use of accounting standards to value assets and liabilities;

·       modified application of the CFC control tests;

·       an extension of the section 128F interest withholding tax exemption; and

·       a transitional start date to accommodate taxpayers with substituted accounting periods.

The integrity of the system has been enhanced whilst balancing taxpayer concerns. Therefore, it is recommended that the measures contained in this bill should be adopted to support a more structurally sound business tax system as it applies to multinational taxpayers. They are an integral part of the New Business Tax System.

 



I ndex        

Schedule 1:  Thin capitalisation rules

Bill reference

Paragraph number

Item 1, section 405

4.35

Item 1, section 415

4.40

Item 1, section 820-35

1.39

Item 1, section 820-40

1.57

Item 1, p aragraph 820-40(1)(c)

1.63

Item 1, subsection 820-40(2)

1.61

Item 1, paragraph 820-40(2)(f)

1.61

Item 1, subsection 820-40(3)

1.62

Item 1, section 820-85

3.74

Item 1, subsection 820-85(1)

3.13, 3.26, 3.75

Item 1, subsection 820-85(2)

2.9, 3.18

Item 1, subsection 820-85(2), items 1 and 2 in the table

7.21, 7.22, 7.24

Item 1, subsection 820-85(2), items 1(a) and (b) in the table

3.20

Item 1, subsection 820-85(2), item 2 in the table

3.23

Item 1, subsection 820-85(2), item 3 in the table

3.20, 7.87

Item 1, subsection 820-85(2), item 4 in the table

7.87

Item 1, subsection 820-85(3)

3.29, 3.36

Item 1, section 820-90

Example 3.3

Item 1, subsection 820-90(1)

3.40

Item 1, subsection 820-90(2)

3.41, 3.62, 3.63

Item 1, section 820-95

3.44, 3.46

Item 1, section 820-100

3.55

Item 1, subsection 820-100(1)

3.58

Item 1, subsection 820-100(2)

3.56

Item 1, subsection 820-100(3)

3.58, 3.59

Item 1, subsection 820-105(1)

10.14

Item 1, paragraph 820-105(2)(a)

10.20

Item 1, paragraphs 820-105(2)(b) to (d)

10.21

Item 1, paragraph 820-105(2)(e)

10.24

Item 1, paragraph 820-105(3)(a)

10.35

Item 1, paragraph 820-105(3)(b)

10.37

Item 1, paragraph 820-105(3)(c)

10.42

Item 1, paragraph 820-105(3)(d)

10.43

Item 1, paragraphs 820-105(3)(e) and (f)

10.48

Item 1, paragraph 820-105(3)(g)

10.50

Item 1, paragraph 820-105(3)(h)

10.51

Item 1, paragraph 820-105(3)(i)

10.53

Item 1, paragraph 820-105(3)(j)

10.54

Item 1, paragraph 820-105(3)(k)

10.57

Item 1, paragraph 820-105(3)(l)

10.59

Item 1, subsection 820-105(4)

10.62

Item 1, section 820-110

Example 3.3, 3.65

Item 1, subsections 820-110(1) and (2)

3.66

Item 1, section 820-115

3.74, 3.75

Item 1, section 820-120

3.28, 3.76, 3.77

Item 1, section 820-185

2.28

Item 1, subsection 820-185(1)

2.9, 2.21, 2.27, 2.104, 2.108

Item 1, paragraph 820-185(1)(a)

3.13

Item 1, subsection 820-185(2)

2.14

Item 1, subsection 820-185(2), item 1 in the table

Example 2.6, 2.16

Item 1, subsection 820-185(2), item 2 in the table

2.17

Item 1, subsection 820-185(2), item 3 in the table

2.19

Item 1, subsection 820-185(2), item 4 in the table

2.20

Item 1, subsection 820-185(3)

2.22, 2.27, 2.35

Item 1, section 820-190

2.29

Item 1, section 820-195

2.33, 2.35

Item 1, section 820-195, step 5 of the method statement

2.55

Item 1, subsection 820-200(1)

2.64, 2.91

Item 1, subsection 820-200(2)

2.65

Item 1, subsection 820-200(3)

2.84

Item 1, section 820-205

2.95

Item 1, section 820-205, step 1 of the method statement

2.97

Item 1, subsection 820-210(1)

2.99

Item 1, subsection 820-210(2)

2.100

Item 1, subsection 820-210(3)

2.100

Item 1, subsection 820-215(1)

10.14

Item 1, paragraph 820-215(2)(a)

10.20

Item 1, paragraphs 820-215(2)(b) to (d)

10.21

Item 1, paragraph 820-215(2)(e)

10.24

Item 1, paragraph 820-215(3)(a)

10.35

Item 1, paragraph 820-215(3)(b)

10.37

Item 1, paragraph 820-215(3)(c)

10.42

Item 1, paragraph 820-215(3)(d)

10.43

Item 1, paragraphs 820-215(3)(e) and (f)

10.48

Item 1, paragraph 820-215(3)(g)

10.50

Item 1, paragraph 820-215(3)(h)

10.51

Item 1, paragraph 820-215(3)(i)

10.54

Item 1, paragraph 820-215(3)(j)

10.57

Item 1, subsection 820-215(4)

10.62

Item 1, paragraph 820-215(3)(k)

10.59

Item 1, section 820-220

2.104, 2.108

Item 1, section 820-225

2.25

Item 1, subsection 820-225(1)

2.109

Item 1, subsections 820-225(2) and (3), item 4 in the table

2.110

Item 1, subsection 820-225(3), items 1 to 3 in the table

2.111

Item 1, subsection 820-300(1)

5.17, 5.22

Item 1, subsection 820-300(2)

5.19

Item 1, paragraph 820-300(2)(c)

7.87

Item 1, subsection 820-300(3)

5.25, 5.32

Item 1, section 820-305

5.33

Item 1, section 820-310

5.35

Item 1, subsection 820-315(1)

10.66

Item 1, paragraphs 820-315(3)(a) and (b)

10.78

Item 1, paragraph 820-315(3)(c)

10.80

Item 1, paragraph 820-315(3)(d)

10.82

Item 1, paragraph  820-315(3)(e)

10.83

Item 1, paragraphs 820-315(3)(f) and (h)

10.84

Item 1, paragraph 820-315(3)(g)

10.85

Item 1, subsection 820-315(4)

10.86

Item 1, subsection 820-320(1)

5.41

Item 1, subsection 820-320(2)

5.42

Item 1, subsection 820-320(3)

5.43

Item 1, section 820-325

5.46, 10.68

Item 1, section 820-330

5.21

Item 1, subsection 820-395(1)

4.15, 4.19, 4.22, 4.29

Item 1, subsection 820-395(2)

4.17, 6.62

Item 1, subsection 820-395(3)

4.23, 4.32

Item 1, section 820-400

4.33

Item 1, section 820-405, step 1 in the method statement

4.27

Item 1, subsection 820-410(1)

10.66

Item 1, paragraphs 820-410(3)(a) and (b)

10.78

Item 1, paragraph 820-410(3)(c)

10.80

Item 1, paragraph 820-410(3)(d)

10.82

Item 1, paragraph 820-410(3)(e)

10.83

Item 1, paragraphs 820-410(3)(f) and (g)

10.84

Item 1, subsection 820-410(4)

10.86

Item 1, section 820-415

4.29, 4.41, 10.68

Item 1, section 820-420

4.18, 4.42

Item 1, subsection 820-460(1)

6.6

Item 1, subsection 820-460(2)

6.8

Item 1, paragraph 820-460(2)(b)

6.66

Item 1, paragraph 820-460(2)(c)

6.56

Item 1, paragraph 820-460(2)(d)

6.63

Item 1, subsection 820-460(3)

6.6, 6.34

Item 1, subsection 820-460(4)

6.34

Item 1, subsection 820-460(5)

6.10, 6.34

Item 1, section 820-465

6.7, 6.36

Item 1, section 820-470

8.40

Item 1, paragraph 820-470(a)

6.31

Item 1, paragraph 820-470(b)

6.32

Item 1, subsection 820-500(1)

6.13, 6.17

Item 1, subsection 820-500(2)

6.13

Item 1, subsection 820-500(3)

6.14

Item 1, subsection 820-500(4)

6.16

Item 1, section 820-505

6.17

Item 1, subsection 820-505(1)

6.19

Item 1, subsection 820-505(2)

6.20

Item 1, paragraphs 820-505(2)(b) and (c)

6.20

Item 1, subsection 820-505(3)

6.12, 6.19

Item 1, section 820-510

6.17

Item 1, subsection 820-510(1)

6.21

Item 1, paragraphs 510(1)(b) and (c)

6.21

Item 1, subsection 820-510(2)

6.22

Item 1, subsection 820-510(3)

6.21

Item 1, paragraph 820-510(3)(a)

6.24

Item 1, paragraphs 820-515(a) to (c)

6.20, 6.21

Item 1, section 820-520

6.17, 6.26

Item 1, section 820-525

6.18

Item 1, section 820-530

6.28

Item 1, section 820-550

6.11

Item 1, subsection 820-550(1)

6.38

Item 1, subsection 820-550(2)

6.39

Item 1, subsections 820-550(3) and (4)

6.41

Item 1, subsection 820-550(5)

6.47

Item 1, subsection 820-550(6)

6.48

Item 1, subsection 820-550(7)

6.50

Item 1, subsection 820-550(8)

6.55

Item 1, section 820-555

6.66

Item 1, section 820-560

6.43, 6.52

Item 1, subsection 820-565(1)

6.56

Item 1, subsection 820-565(2)

6.57

Item 1, subsection 820-565(3)

6.58

Item 1, subsection 820-570(1)

6.59

Item 1, subsection 820-570(2)

6.60, 6.64

Item 1, subsection 820-575(1)

6.63

Item 1, subsections 820-575(3) and (4)

6.65

Item 1, subsection 820-630(1)

8.8

Item 1, subsection 820-630(2)

8.10

Item 1, subsection 820-630(3)

8.11

Item 1, section 820-635

8.8, 8.14

Item 1, section 820-640

8.8

Item 1, subsection 820-640(1)

8.18

Item 1, subsection 820-640(2)

8.19

Item 1, subsection 820-640(3)

8.20

Item 1, section 820-645

8.8

Item 1, subsection 820-645(1)

8.21, 8.22, 8.23

Item 1, paragraph 820-645(1)(a)

8.22

Item 1, paragraph 820-645(1)(b)

8.30, 8.31

Item 1, subsection 820-645(2)

8.25

Item 1, subsection 820-645(3)

8.26, 8.27

Item 1, subsection 820-645(4)

8.28, 8.29

Item 1, subsection 820-645(5)

8.32

Item 1, subsection 820-645(6)

8.32

Item 1, section 820-675

8.33

Item 1, subsections 820-675(1) and (2)

8.34

Item 1, subsection 820-675(3)

8.36

Item 1, section 820-680

8.33

Item 1, subsection 820-680(1)

8.37

Item 1, section 820-685

8.41

Item 1, section 820-690

8.49

Item 1, section 820-745

7.11, 7.14

Item 1, section 820-750

7.20

Item 1, section 820-755

7.22

Item 1, subsection 820-760(1)

7.23

Item 1, subsection 820-760(2)

7.16, 7.18

Item 1, section 820-780

7.29

Item 1, subsection 820-785(1)

7.31, 7.32

Item 1, subsection 820-785(2)

7.35

Item 1, subsection 820-790(1)

7.37

Item 1, subsection 820-790(2)

7.40

Item 1, subsection 820-790(3)

7.42

Item 1, subsection 820-795(1)

7.44

Item 1, subsection 820-795(2)

7.48

Item 1, subsection 820-795(3)

7.54

Item 1, section 820-815

7.18, 7.56, 7.87

Item 1, section 820-820

7.73

Item 1, subsection 820-820(2)

7.74

Item 1, subsection 820-820(3)

7.75

Item 1, subsection 820-820(4)

7.76

Item 1, subsection 820-820(5)

7.78

Item 1, subsection 820-825(2)

7.79

Item 1, subsection 820-825(3)

7.80

Item 1, subsection 820-825(4)

7.81

Item 1, section 820-830

7.82

Item 1, paragraph 820-835(a)

7.83

Item 1, paragraph 820-835(b)

7.84

Item 1, section 820-855

7.59

Item 1, subsections 820-860(1) and (2)

7.61

Item 1, subsection 820-860(3)

7.62

Item 1, section 820-865

7.18, 7.65

Item 1, paragraphs 820-865(a) and (b)

7.63

Item 1, paragraph 820-865(c)

7.64

Item 1, subsection 820-870(1)

7.66

Item 1, subsection 820-870(2)

7.67

Item 1, subsection 820-870(3)

7.69

Item 1, subsection 820-870(4)

7.70

Item 1, subsections 820-870(5) and (6)

7.71

Item 1, section 820-875

7.72

Item 1, subsection 820-905(1)

7.92

Item 1, subsection 820-905(2)

7.90

Item 1, subsection 820-905(3)

7.92

Item 1, subsections 820-905(4) and (5)

7.93

Item 1, subsections 820-905(6) and (7)

7.94

Item 1, subsection 820-905(8)

7.98

Item 1, section 820-910

2.37

Item 1, section 820-915

2.39

Item 1, section 820-920

Example 3.1

Item 1, subsection 820-920(2)

2.42

Item 1, subsection 820-920(3)

2.45

Item 1, subsection 820-920(4)

2.46

Item 1, subsection 820-930(1), items 1 to 8 in the table

1.71

Item 1, subsection 820-930(2)

1.67

Item 1, subsection 820-942(1)

2.66

Item 1, subsection 820-942(2)

2.77

Item 1, subsection 820-942(3)

2.80

Item 1, section 820-960

9.7, 9.11

Item 1, subsection 820-960(1)

9.9

Item 1, subsection 820-960(2)

9.18

Item 1, paragraph 820-960(2)(b)

9.13, 9.16

Item 1, subsection 820-960(3)

9.10

Item 1, subsections 820-960(4) and (5)

9.19

Item 1, section 820-965

9.20

Item 1, section 820-980

10.88

Item 1, sections 820-990 and 820-995

9.22

Item 2

4.50

Item 3

1.95

Item 4

1.90

Item 5

1.98

Item 5, subsection 160AFD(9)

5.54

Item 5

3.79

Items 6 to 9

4.53

Items 10 and 11 (consequential amendments to section 262A)

9.21

Items 10 and 11, subsections 262A(2AA) and 262A(3)

10.89

Items 10 and 11

1.93, 9.24

Items 12 and 13

1.92

Items 14 and 15

1.91

Item 16

3.79

Item 16, section 25-90

1.101, 5.54

Items 17 to 19

1.104

Item 20

3.79

Items 20 to 22, sections 820-15 and 820-20

1.85

Item 22, section 820-10

4.44, 9.2

Item 22, subsection 820-10(1)

1.81, 10.90

Item 22, subsection 820-10(2)

1.82, 9.18, 9.23

Item 22, section 820-15

4.44

Item 22, section 820-25

1.84, 4.45, 5.52, 8.7, 8.52

Item 22, section 820-30

6.29

Item 22, section 820-35

1.86, 5.53

Item 22, subsection 820-35(2)

1.87

Item 22, subsection 820-35(3)

1.87

Item 23

1.83, 4.51

Item 24

3.79

Items 24 to 26

1.85

Item 25

4.54

Item 26

10.90

Schedule 2:  Dictionary amendments

Bill reference

Paragraph number

Item 2, definition of ‘accounting standards’ in subsection 995-1(1)

6.31, 8.34, 8.37, 9.11

Item 7, definition of ‘arm’s length capital amount’ in subsection 995-1(1)

10.64

Item 8, definition of ‘arm’s length debt amount’ in subsection 995-1(1)

10.11

Item 10, definition of ‘associate entity debt’ in subsection 995-1(1)

2.38

Item 11, definition of ‘associate entity equity’ in subsection 995-1(1)

1.66, 2.39

Item 12, definition of ‘associate entity excess amount’ in subsection 995-1(1)

2.42

Item 13, definition of ‘associate interest’ in subsection 995-1(1)

7.93, 7.94, 7.98

Item 14, definition of ‘Australian controlled foreign entity’ in subsection 995-1(1)

7.11

Item 15, definition of ‘Australian controller’ in subsection 995-1(1)

7.20, 7.22, 7.23

Item 16, definition of ‘Australian entity’ in subsection 995-1(1)

7.19

Item 17, definition of ‘Australian permanent establishment’ in subsection 995-1(1)

9.8

Item 19, definition of ‘average equity capital’ in subsection 995-1(1)

4.23, 4.32, 6.64

Item 20, definition of ‘controlled foreign company’ in subsection 995-1(1)

7.12, 7.13

Item 21, definition of ‘controlled foreign corporate limited partnership’ in subsection 995-1(1)

7.16

Item 22, definition of ‘controlled foreign entity debt’ in subsection 995-1(1)

3.48

Item 23, definition of ‘controlled foreign entity equity’ in subsection 995-1(1)

1.66, 3.48

Item 24, definition of ‘controlled foreign trust’ in subsection 995-1(1)

7.12, 7.15

Item 26, definition of ‘debt capital’ in subsection 995-1(1)

1.52, 2.26

Item 27, definition of ‘debt deduction’ in subsection 995-1(1)

1.57

Item 29, definition of ‘equity capital’ in subsection 995-1(1)

1.65, 4.24, 5.28, 5.32

Item 31, definition of ‘financial entity’ in subsection 995-1(1)

2.18, 2.78, 3.24

Item 33, definition of ‘foreign controlled Australian company’ in subsection 995-1(1)

7.31

Item 34, definition of ‘foreign controlled Australian entity’ in subsection 995-1(1)

7.29

Item 35, definition of ‘foreign controlled Australian partnership’ in subsection 995-1(1)

7.44, 7.48

Item 36, definition of ‘foreign controlled Australian trust’ in subsection 995-1(1)

7.37

Item 37, definition of ‘foreign entity’ in subsection 995-1(1)

7.28

Item 39, definition of ‘inward investing entity (ADI)’ in subsection 995-1(1)

4.17, 6.62

Item 40, definition of ‘inward investing entity (non-ADI)’ in subsection 995-1(1)

2.14, 6.47

Item 41, definition of ‘inward investment vehicle (financial)’ in subsection 995-1(1)

6.50

Item 42, definition of ‘inward investment vehicle (general)’ in subsection 995-1(1)

6.48

Item 45, definition of ‘maximum allowable debt’ in subsection 995-1(1)

3.38

Item 47, definition of ‘minimum capital amount’ in subsection 995-1(1)

4.33, 5.33

Item 48, definition of ‘non-debt liabilities’ in subsection 995-1(1)

2.52

Item 50, definition of ‘on-lent amount’ in subsection 995-1(1)

2.59, 2.86, 3.60

Item 51, definition of ‘outward investing entity (ADI)’ in subsection 995-1(1)

6.55

Item 52, definition of ‘outward investing entity (non-ADI)’ in subsection 995-1(1)

3.18, 6.38

Item 53, definition of ‘outward investor (financial)’ in subsection 995-1(1)

6.41

Item 54, definition of ‘outward investor (general)’ in subsection 995-1(1)

6.39

Item 55, definition of ‘overseas permanent establishment’ in subsection 995-1(1)

3.22

Item 56, definition of ‘prudential capital deduction’ in subsection 995-1(1)

5.38

Item 57, definition of ‘risk-weighted assets’ in subsection 995-1(1)

4.37, 5.36

Item 59, definition of ‘safe harbour capital amount’ in subsection 995-1(1)

4.35, 5.35

Item 60, definition of ‘safe harbour debt amount’ in subsection 995-1(1)

2.33

Item 63, definition of ‘TC control interest’ in subsection 995-1(1)

7.56

Item 64, definition of ‘TC control tracing interest’ in subsection 995-1(1)

7.72

Item 65, definition of ‘TC direct control interest’ in subsection 995-1(1)

7.59, 7.61, 7.63

Item 66, definition of ‘TC indirect control interest’ in subsection 995-1(1)

7.66

Item 67, definition of ‘Tier 1 prudential capital deduction’ in subsection 995-1(1)

5.39

Item 70, definition of ‘worldwide capital amount’ in subsection 995-1(1)

5.42

Item 71, definition of ‘worldwide debt’ in subsection 995-1(1)

3.68

Item 72, definition of ‘worldwide equity’ in subsection 995-1(1)

1.65, 3.69

Item 74, definition of ‘zero-capital amount’ in subsection 995-1(1)

2.66, 6.43