Guide A: Guide to thin capitalisation
Guide A: Guide to thin capitalisation
Do you need to read this publication?
Australia's thin capitalisation rules apply to:
- Australian entities investing overseas and their associate entities
- foreign entities investing in Australia.
If you answer 'yes' to any of the questions below, or there is a possibility the rules could apply, read this publication to work out whether you or your client is affected by the thin capitalisation rules.
- Do you carry on business outside of Australia?
- Do you control a foreign entity by having at least a 10% interest in a foreign entity (this includes direct and indirect interests and interests held by associate entities) or otherwise have substantive control of a foreign entity?
- Are you associated with anyone who does carry on a business outside of Australia or has at least a 10% interest in a foreign entity?
- Is your Australian entity controlled by foreign entities, either directly or indirectly?
- Are you a foreign entity that has investments in Australia?
Thin capitalisation schedule
If you must complete a Thin capitalisation schedule at the time of preparing your tax return, use this guide, and the other guides in the series, to help you complete that schedule. The schedule should be lodged at the same time as your tax return, though you must send it to a different address.
This guide contains links to help you move quickly to the various instructions that will help you complete the schedule - there are only three in this guide, the remainder are in the relevant guides to the thin capitalisation calculations.
The schedule should be sent to:
Australian Taxation Office
PO Box 1365
ALBURY NSW 2640
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Some technical terms used in this guide may be new to you. They are explained in the glossary and also in section 2 of this guide.
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All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.
01 Thin capitalisation
This section:
- provides a broad overview of the thin capitalisation rules
- explains who is affected by the rules
- briefly describes the grouping rules and the methods for establishing average values.
Thinly capitalised entities
A thinly capitalised entity is one whose assets are funded by a high level of debt and relatively little equity. An entity's debt-to-equity funding is sometimes expressed as a ratio. For example, a ratio of 3:1 means that for every $3 of debt, the entity is funded by $1 of equity. This is also known as 'gearing'. An entity that is highly geared has funded its assets with more debt than equity.
The thin capitalisation rules can apply to Australian entities investing overseas, their associate entities, foreign controlled Australian entities and foreign entities investing directly into Australia. Under the thin capitalisation rules, the amount of debt used to fund those Australian operations or investments is limited. They disallow the debt deductions an entity can claim against Australian assessable income when the entity's debt used to fund Australian assets exceeds certain limits.
A debt deduction is an expense an entity incurs in connection with a debt interest, such as an interest payment or a loan fee that the entity would otherwise be able to claim a deduction for in Australia. Certain expenses are excluded from being debt deductions under tax law, including rental expenses on certain leases and some foreign currency losses. A debt interest is an interest classified as debt under the debt/equity rules in Division 974. Examples of debt interests include loans, bills of exchange or promissory notes.
From when do the thin capitalisation rules apply?
The thin capitalisation rules apply from an entity's first income year, starting on or after 1 July 2001.
Entities that are affected by the rules
The thin capitalisation rules affect:
- Australian entities with certain overseas operations, and their associate entities (outward investors)
- Australian entities that are foreign controlled (inward investors)
- foreign entities with operations or investments in Australia that are claiming debt deductions (inward investors).
The thin capitalisation rules can apply to companies, trusts, partnerships, unincorporated bodies and individuals.
An outward investor is an Australian entity that is any of the following:
- an Australian controller of an Australian controlled foreign entity
- an entity that carries on business through an overseas permanent establishment, such as a branch
- an associate entity of either of the above.
An Australian controller is an entity that either has at least a 10% thin capitalisation control interest in an Australian controlled foreign entity or otherwise has substantive control of an Australian controlled foreign entity. An example of an outward-investing entity is an Australian company that has a 51% shareholding in a New Zealand company. Section 3 of this guide contains more information about the concept of 'control'.
An inward investing entity is either of the following:
- an Australian entity controlled by a foreign entity; that is, a foreign controlled Australian entity
- a foreign entity (although all foreign entities are inward investing entities, the thin capitalisation rules only affect those with Australian income-producing assets).
An example of the first type of inward investing entity is an Australian company that is a subsidiary of a United States company. An example of the second type of inward investing entity is a foreign entity that owns a rental property located in Australia or a foreign entity that has a permanent establishment in Australia.
Associate entities
The thin capitalisation rules also affect associate entities of outward investors. An associate entity is an entity (entity A) that is an associate of another entity (entity B) under section 318 of the Income Tax Assessment Act 1936 (ITAA 1936), and at least one of the following apply:
- entity B holds an interest of 50% or more in entity A
- entity A (either directly or indirectly) is accustomed, under an obligation, or reasonably expected to act in accordance with the directions, instructions or wishes of entity B in relation to whether entity A retains or distributes its profits or its financial policies.
If entity A is an associate entity of entity B, entity B is automatically an associate entity of entity A. Also, if two separate entities are both associate entities of the same entity, they are also associate entities of each other. An example of this is two companies that are subsidiaries of the same parent company. As they are both associate entities of the parent company, they are also associate entities of each other.
There are additional special rules to deal with financing arrangements between associate entities that are not grouped.
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See section 2 for more information about associate entities.
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Entities that are not affected by the rules
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An asset that is used (or is held for use) wholly or principally for private or domestic purposes is not subject to the thin capitalisation rules - see section 820-32.
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For any given income year, the following entities are not affected by the thin capitalisation rules:
- an entity that does not incur debt deductions for the income year
- an entity whose debt deductions, together with those of any associate entities, are $250,000 or less for the income year - see section 820-35
- an Australian resident entity that is neither an inward investing entity nor an outward investor
- a foreign entity that has no investment or presence in Australia
an outward investor that is not also foreign controlled and meets the assets threshold test. This is explained further in section 820-37.
Certain special purpose entities are also excluded where all of the following apply:
- the entity is established for the purposes of managing some or all of the economic risk associated with assets, liabilities or investments
- at least 50% of its assets are funded by debt interests
- the entity is an insolvency remote special purpose entity according to the criteria of an internationally recognised rating agency that are applicable to the entity's circumstances. That entity does not have to have been rated by a rating agency.
Where several large entities are taken to be a single, notional entity, any one of those entities can still meet this exception provided that all the entities taken together would meet the above conditions.
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The entity will only be exempted from the thin capitalisation rules for the period that it meets all of the above conditions.
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The assets threshold test
An outward investor that is not also foreign controlled is excluded from the thin capitalisation regime where the sum of its average Australian assets and the average Australian assets of its associates (as defined in section 318 of the ITAA 1936) represents 90% or more of the sum of its average total assets and the average total assets of its associates. The terms 'average Australian assets' and 'average total assets' are specifically defined for the purposes of this test.
The average Australian assets of an Australian entity means all the Australian entity's assets other than:
- assets attributable to any of the Australian entity's overseas permanent establishments
- any asset to the extent it is either controlled foreign entity debt or controlled foreign entity equity
- any asset that is a debt interest or equity interest held in the Australian entity's associates.
The average Australian assets of a foreign entity for the purposes of the assets threshold test means the foreign entity's assets that are:
- located in Australia
- attributable to any of the foreign entity's Australian permanent establishments
- debt interests and equity interests to the extent they are held in Australian entities that are not attributable to those Australian entities' foreign permanent establishments.
This definition does not include debt interests and equity interests held in any of the foreign entity's associates.
The average total assets for both Australian entities and foreign entities means all assets other than debt interests and equity interests held in the entity's associates.
The following diagram summarises who is affected by the thin capitalisation rules. However, an entity that is not affected in one income year may be affected in later years.
The thin capitalisation rules apply differently depending on whether an entity is:
- an inward investing entity or an outward investor
- a general entity or a financial entity
- an authorised deposit-taking Institution (ADI).
These categories determine how to calculate the maximum allowable debt or, in the case of an ADI entity, the minimum capital amount.
Special rules apply to entities that are ADIs under the Banking Act 1959. Entities covered by these rules include Australian banks and foreign banks that carry on business in Australia through a permanent establishment - for example, a foreign bank branch.
Financial entities that meet certain conditions can also choose to apply the ADI rules - see section 7 for more information.
Provided certain conditions are satisfied, including where all the ADIs in the group are specialist credit card institutions, the head company of a consolidated or multiple entry consolidated group (MEC group) containing one or more ADIs is allowed to apply the thin capitalisation rules as if the group was a financial entity - see section 8 for more information.
Under the thin capitalisation rules, a non-ADI entity must calculate its adjusted average debt and compare it to the maximum allowable debt prescribed under the rules. Debt deductions are disallowed to the extent that the amount of adjusted average debt used to fund an entity's Australian operations exceeds the prescribed maximum allowable debt. If the entity's adjusted average debt does not exceed its maximum allowable debt, no debt deductions are disallowed under the thin capitalisation rules.
For an outward investing entity that is neither an ADI nor a financial entity, the maximum allowable debt is the greatest of:
- the safe harbour debt amount, which is 3/4 of the average value of the entity's Australian assets, with some adjustments. This is based on the safe harbour ratio of 3:1.
- the arm's length debt amount, which is the amount of debt that could have been borrowed by an independent party carrying on the entity's Australian operations
- the worldwide gearing debt amount, which in certain circumstances can allow the Australian operations to be geared at up to 120% of the gearing of the Australian entity's worldwide group.
The relevant guide to thin capitalisation calculations contains further information about how to calculate these three amounts.
For an inward investing entity that is a non-ADI, the maximum allowable debt is the greater of the following:
- the safe harbour debt amount
- the arm's length debt amount.
Entities do not necessarily need to calculate their maximum allowable debt under all the methods. Generally the safe harbour debt amount would be calculated first and then the other amounts are calculated only if the entity's adjusted average debt is greater than the safe harbour debt amount.
If an entity is both an inward investing and an outward investing entity, the rules for outward investing entities apply to it but the entity cannot apply the worldwide gearing debt test.
A financial entity is an entity other than an ADI that is one of the following:
- registered under the Financial Sector (Collection of Data) Act 2001
- a financial services licensee under the Corporations Act 2001 and meets certain conditions
- exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 and meets certain other conditions
- a securitisation vehicle.
Examples of financial entities include finance companies and securities dealers.
The rules for non-ADI entities are modified for financial entities in recognition that such entities are primarily engaged in lending businesses and have different requirements for debt funding. For example, for financial entities, the 3:1 safe harbour ratio applies to their non-lending business while their lending and certain other financial business is allowed much higher debt levels.
Certain financial entities can elect to apply the ADI rules. For more information on this election, see section 7 of this guide.
What happens to the disallowed debt deductions?
If an entity breaches the thin capitalisation rules in an income year, it cannot deduct a proportion of its debt deductions in that year. Also, the disallowed amounts cannot be carried forward to future income years.
Disallowing a deduction from an amount does not affect whether the recipient is subject to Australian tax on that amount, including withholding tax. Also, disallowed debt deductions are not included as part of the CGT cost base when calculating the net gain made in respect of a CGT event. See section 110-54 for more information.
Thin capitalisation and consolidations
If entities choose to consolidate, the thin capitalisation rules apply to the head company of the consolidated group or MEC group.
Once consolidated, the thin capitalisation rules then apply to the group as though it were a single company for the income year. Subject to certain conditions, the group can include wholly-owned resident companies, trusts and partnerships, and Australian bank branches of foreign banks.
There are additional special rules to deal with financing arrangements between associate entities that are not grouped.
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For more information about grouping, see section 5 of this guide.
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What are average values?
Entities must calculate the average values of items such as their assets, non-debt liabilities, debt capital and equity capital in order to apply the thin capitalisation rules. The rules provide three methods for working out average values:
- the opening and closing balances method - an average of the opening and closing values for the period
- the three measurement days method - an average based on three specified days during the period
- the frequent measurement method - an average using quarterly measurement days. This method also allows for more frequent measurement days to be used, such as daily, weekly or monthly measurement days.
Assets and liabilities must be valued in accordance with the accounting standards, which incorporate the international financial reporting standards. These values should be recorded in the entity's books of account. However, it is permissible to revalue assets for thin capitalisation purposes and not for accounting purposes.
The values of assets and liabilities used by a group when calculating its thin capitalisation position are based on information that would be contained in a set of consolidated accounts prepared in accordance with the accounting standards.
Because the consolidation rules only allow 100% owned entities to consolidate, the consolidated accounts prepared for accounting purposes may not be able to be used, without modification, for thin capitalisation purposes. The accounts are to take into account only those entities that can be grouped under the consolidation rules.
For income years commencing on or after 1 January 2009, calculations made for thin capitalisation purposes, in relation to identifying and valuing an entity's assets, liabilities and equity capital, must be made using the Australian equivalents to International Financial Reporting Standards (AIFRS) with modifications for non-ADI entities as set-out in sections 820-682, 820-683 and 820-684. The modifications applicable to ADI's are set out in sections 820-300 and 820-310.
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For more information about average values and valuation methods, see section 6 of this guide.
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02 Thin capitalisation concepts
This section explains some of the more complex concepts that you may need to understand to apply the thin capitalisation rules. Other concepts are explained in the glossary.
ADI equity capital
ADI equity capital is used to determine:
- adjusted average equity capital for ADI entities that are outward investing entities
- average equity capital for ADI entities that are inward investing entities
- consolidated groups classified as an ADI.
The ADI equity capital of an entity at a particular time is the sum of:
- the entity's equity capital
- the total value of debt interests issued by the entity that
- are on issue and have been on issue for 90 days or more at that time
- do not give rise to any costs covered by paragraph 820-40(1)(a).
If a debt interest is on issue for a total of 90 days or more, it will be treated as having been on issue for 90 days or more for all relevant measurement days. For example, an ADI with a standard income year that uses monthly measurement days, issues a debt interest that does not give rise to any costs covered by paragraph 820-40(1)(a) on 2 July 2008. On the second and third measurement days - 31 July and 31 August 2008 - the debt interest has been on issue for less than 90 days and would not be included in ADI equity capital. On the third measurement day - 30 September 2008 - the debt interest is still on issue and has been on issue for more than 90 days. The debt interest will therefore be included in the ADI's equity capital on this measurement day and will be treated as having been included in ADI equity on the two preceding measurement days.
Associate entities
An associate entity is used to determine whether an entity is subject to the thin capitalisation rules when:
- working out whether an entity is a controlling entity or is controlled by an entity
- calculating maximum allowable debt.
The concept of an associate entity is narrower than the concept of associate in section 318 of the ITAA 1936. Broadly, one entity will be an associate entity of another if either of those entities has a sufficient influence over the other.
There are a number of situations in which an entity will be an associate entity. Under the most common situation, contained within subsection 820-905(1), an entity that is not an individual (entity B) will be an associate entity of another entity (entity A) if both of the following apply:
- entity B is an associate of entity A under section 318 of the ITAA 1936
- either
- entity A holds an associate interest of 50% or more in entity B, or
- entity B (or a director, partner, general partner, trustee or member of entity B's committee of management, as relevant) is accustomed, under an obligation, or is reasonably expected to act in accordance with the directions, instructions or wishes of entity A in relation to the distribution or retention of entity B's profits or its financial policies relating to its assets, debt capital or equity capital.
This is illustrated in the following diagram:
An individual can also be an associate entity of another entity under subsection 820-905(2). An individual is an associate entity of another entity if both of the following apply:
- the individual is an associate of the other entity under section 318 of the ITAA 1936
- the individual is accustomed, under an obligation, or is reasonably expected to act in accordance with the directions, instructions or wishes of that other entity in relation to the individual's financial affairs.
There are two additional rules, they are:
- If an entity (the first entity) is an associate entity of another entity then that other entity is also an associate entity of that first entity - see subsection 820-905(3B). In the above diagram, as entity B is an associate of entity A, entity A is automatically an associate of entity B.
- If an entity (entity B in the below example) is an associate of another entity (entity A) and a third entity (entity C) is also an associate of entity A, then entity B is also an associate entity of the entity C - see subsection 820-905(3A). This is illustrated in the example below.
Example
As both entity B and entity C are 100% controlled, they are both associates of entity A. They are also both associates of each other.
There are some special rules that apply if the entity is a responsible entity of a registered scheme. These rules are described in subsection 820-905(2A).
A registered scheme is a management investment scheme that is registered under section 601EB of the Corporations Act 2001. The responsible entity will only be an associate entity, in its capacity as responsible entity, of another entity if both of the following apply:
- the entity, in its capacity as responsible entity, is an associate of that other entity under section 318
- either
- that other entity holds an associate interest of 50% or more in the registered scheme, or
- that other entity holds an associate interest of 20% or more in the registered scheme and the responsible entity (or director, general partner, trustee or member of the responsible entity's committee or management, as relevant) is accustomed, under an obligation, or is reasonably expected to act in accordance with the directions, instructions or wishes of that other entity in relation to the distribution or retention of the schemes profits or the financial policies relating to the scheme's assets, debt capital or equity capital.
These rules only apply to make the responsible entity (in its capacity as responsible entity) and another entity become associate entities where that other entity can sufficiently influence the responsible entity in carrying out its duties.
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For a more detailed definition of 'associate entity', refer to section 820-905.
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Associate entity debt
The concept of associate entity debt is relevant to calculating a non-ADI entity's adjusted average debt and maximum allowable debt. Associate entity debt is an amount calculated by the lending entity in respect of each of its associate entities.
Certain conditions must be satisfied for an amount to be treated as associate entity debt during a period. Firstly, the lender (or debt interest holder) must be either a non-ADI outward investor or a non-ADI inward investing entity throughout the period. Secondly, the associate entity must be one of the following throughout the period:
- a non-ADI outward investor
- a non-ADI inward investment vehicle
- a non-ADI inward investor that either or both
- carries on business in Australia at or through one or more of its Australian permanent establishments
- holds assets that are attributable to its Australian permanent establishments or other assets that are held for the purposes of producing its Australian assessable income.
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For the purposes of determining an entity's associate entity debt, an associate entity that has elected to be treated as an ADI under Subdivision 820-EA, is still treated as a non-ADI. Refer to subsection 820-430(4) for more information.
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The associate entity must also not be either of the following:
- an exempt entity in the period
- excepted from the thin capitalisation rules by either the debt deduction threshold or the asset threshold rules in the period.
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The asset threshold only applies to entities that are outward investing entities - non-ADI or ADI. For example, they are not also inward investing entities - non-ADI or ADI.
Also, the associate entity must not be exempt from the thin capitalisation rules under section 820-39 for all or some of the period. Certain special purpose vehicles are exempted under this section.
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These requirements ensure that the associate entity receiving the debt funding is itself subject to the thin capitalisation rules so that the debt is tested in at least one entity.
The lender's associate entity debt is the value of the debt interests it holds that satisfy all the following requirements:
- the debt interests were issued by an associate entity that meets all the above conditions, whether the debt interest was originally issued to the investing entity or another entity, and remain on issue
- the debt interests give rise to costs that are debt deductions for that associate entity
- the amount of the debt deductions incurred is included in the lender's assessable income - this requirement does not apply to amounts mentioned in paragraph 820-40(2)(c) as these costs are ordinarily payable to an entity other than the lender
- the terms and conditions of the debt interest are arm's length.
If the associate entity is a foreign entity, debt interests issued by it are only included in the lender's associate entity debt to the extent they are attributable to either of the following:
- assets attributable to the foreign entity's Australian permanent establishments
- assets held by the foreign entity for the purposes of producing its Australian assessable income.
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For a more detailed definition of 'associate entity debt', refer to section 820-910.
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Associate entity equity
Associate entity equity is an amount calculated by a non-ADI outward investor or a non-ADI inward investing entity (an investing entity) in respect of each of its associate entities.
An investing entity can only have associate entity equity in a foreign associate entity if the foreign entity has either of the following:
- assets that are attributable to the foreign entity's Australian permanent establishments
- other assets that are held for the purposes of producing the foreign entity's Australian assessable income.
The investing entity's associate entity equity is the sum of all of the following:
- the value of equity interests the investing entity holds in its associate entities
- the value of debt interests held by the investing entity that were issued by each associate entity, whether to the investing entity or someone else, which remain on issue, and
- of which no part is cost-free debt capital, and
- which do not give rise to any costs covered by paragraph 820-40(1)(a) at any time
- the value of the debt interests held by the investing entity that were issued by associate entities, whether to the investing entity or someone else, which remain on issue, and give rise to costs that are
- covered by paragraph 820-40(1)(a)
- not deductible from the associate entity's assessable income in any income year.
If the equity interests or debt interests were issued by a foreign associate entity, the interest is only included in the lender's associate entity equity to the extent it is attributable to either of the following:
- assets attributable to the foreign entity's Australian permanent establishments
- other assets held for the purposes of producing the foreign entity's Australian assessable income.
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For a more detailed definition of 'associate entity equity', refer to section 820-915.
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Associate interests
To apply the associate entity rules to entities other than individuals, it is necessary to consider the concept of associate interest. This concept differs depending on whether you are dealing with a company, trust or partnership.
Associate interest in a company
An associate interest in a company (except a corporate limited partnership) is the direct control interest measured under subsections 350(1) to 350(5) of the ITAA 1936. Broadly, an entity holds an associate interest in a company equal to the greatest of the percentages that the entity holds, or is entitled to acquire, of the following:
- total paid-up share capital in the company
- total rights to vote or to participate in any decision making in relation to
- the distribution of capital or profits
- the changing of constituent documents
- the varying of share capital of the company
- total rights to distributions or capital or profits of the company on winding-up
- total rights to distributions of capital or profits of the company other than on winding up.
For these purposes, eligible finance shares (defined in section 327 of the ITAA 1936) held in the company are not counted.
For example, if you hold a 50% voting interest and a 75% income interest in a company, your associate interest in the company is 75%.
Associate interest in a trust
An associate interest in a trust is the direct control interest measured under subsections 351(1) and 351(2) of the ITAA 1936. Broadly, an entity holds an associate interest in a trust equal to the greatest of the percentages that the entity holds or is entitled to acquire to either of the following:
- the share of the trust's income
- the share of the trust's capital.
For example, if an entity is entitled to 50% of the capital and 75% of the income of the trust, the associate interest in the trust is 75%.
Associate interest in a partnership
An associate interest in a partnership is measured under subsection 820-905(8). An entity holds an associate interest in a partnership equal to the greatest of the following percentages:
- in the case of corporate limited partnership - 100% if the entity is a general partner of the partnership
- in the case of a partnership that is not a corporate limited partnership - the percentage of the control of voting power in the partnership that the entity holds at that time
- in any other case - the greatest percentage the entity holds or is entitled to acquire at that time of any of the following
- the total amount of assets or capital contributed to the partnership
- the total rights of partners to distributions of capital, assets or profits on the dissolution of the partnership
- the total rights of partners to distributions of capital, assets or profits otherwise than on the dissolution of the partnership.
Borrowed securities amount
A borrowed securities amount is relevant to calculating adjusted average debt and non-debt liabilities for financial entities.
An entity's borrowed securities amount at a point in time is the total of its liabilities that meet the following conditions:
- the value of the liabilities is calculated by reference to the value, at that time, of the securities the entity has short sold
- at that time, the entity has settled the sale using securities it acquired under one of the following arrangements
- a reciprocal purchase agreement
- a sell-buyback arrangement
- a securities loan arrangement.
Controlled foreign entity debt
Controlled foreign entity debt is relevant to calculating a non-ADI outward investor's maximum allowable debt and adjusted average debt amounts.
An entity can have an amount of controlled foreign entity debt if it is a non-ADI outward investing entity and either of the following apply:
- it is an Australian controller of a controlled foreign entity
- its associate entity is an Australian controller of a controlled foreign entity.
The controlled foreign entity debt is then the sum of the debt interests held by such an entity that:
- are on issue
- were issued by the controlled foreign entity - whether or not to the current holder
- give rise to a cost covered by paragraph 820-40(1)(a), which is listed in point 1 of the definition of 'debt deduction' in this section.
Controlled foreign entity debt does not include a debt interest to the extent it is attributable to any assets:
- attributable to the controlled foreign entity's Australian permanent establishments
- held by the controlled foreign entity for the purposes of producing the controlled foreign entity's assessable income. The value of these debt interests will be included in associate entity debt.
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For a more detailed definition of 'controlled foreign entity debt', refer to section 820-885.
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Controlled foreign entity equity
Controlled foreign entity equity is relevant to calculating both of the following:
- a non-ADI outward investor's maximum allowable debt
- an ADI outward investing entity's minimum capital and adjusted average equity capital amounts.
An entity can have an amount of controlled foreign entity equity if it is an outward investing entity - non-ADI or ADI - and either of the following apply
- it is an Australian controller of a controlled foreign entity
- its associate entity is an Australian controller of a controlled foreign entity.
The controlled foreign entity equity is the sum of all of the following:
- the equity interests held by the Australian controller or associate entity in the controlled foreign entity
- the debt interests held by such an entity that
- are on issue
- were issued by the controlled foreign entity, whether or not to the current holder, and
- do not give rise to a cost covered by paragraph 820-40(1)(a). This is listed in point 1 of the definition of debt deduction in this section.
The controlled foreign entity equity does not include equity interests and debt interests to the extent they are attributable to any assets:
- attributable to the controlled foreign entity's Australian permanent establishments
- held by the controlled foreign entity for the purposes of producing the controlled foreign entity's assessable income.
- The value of these interests will be included in associate entity equity.
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For a more detailed definition of 'controlled foreign entity equity', refer to section 820-890.
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Cost-free debt capital
Debt interests issued by an entity that do not give rise to any debt deductions are generally treated as neither debt nor non-debt liabilities. This means that such debt interests are generally not included in adjusted average debt and do not reduce assets when calculating the safe harbour debt amount. However, as an integrity measure, these debt interests may be included in a non-ADI's adjusted average debt where the arrangement contains features that make it possible to manipulate the debt and asset levels to the advantage of either or both of the lender and borrower. To this end, debt interests will be included in adjusted average debt if they are 'cost-free debt capital'.
An entity (the borrower) can have a cost-free debt capital amount if both of the following apply:
- it is a
- non-ADI outward investor
- non-ADI inward investment vehicle, or
- non-ADI inward investor that holds assets attributable to its Australian permanent establishment or other assets held for the purposes of producing its Australian assessable income
- it is not
- an exempt entity, and
- excepted from the thin capitalisation rules by either the debt deduction threshold or asset threshold rules, or because of section 820-39, which exempts certain special purpose vehicles.
The asset threshold only applies to entities that are outward investing entities (non-ADI or ADI) not inward investing entities (non-ADI or ADI).
The borrower's cost-free debt capital is then the total value of all the debt interests issued by it that:
- remain on issue, and
- do not give rise to a cost covered by paragraph 820-40(1)(a) and
- if the lender (or holder of the debt interest) meets the same conditions as the borrower (see above), the measurement days used by the borrower to measure its adjusted average debt are different to the measurements days used by the lender to measure its assets; that is, either the method used to calculate average values is different or the actual measurement days are different or both are different, or
- if the lender does not meet the same conditions as the borrower; that is, the lender is not required to apply the thin capitalisation rules, the debt interest has been on issue for less than 180 days at the measurement day.
If the total period for which the interest is on issue is ultimately 180 days or more, the debt interest is not taken to be cost-free debt capital. For example, an entity with a standard income year issues a debt interest that does not give rise to any debt deductions on 1 June 2008. The holder of that interest is not subject to the thin capitalisation rules. As at 30 June 2008 the debt interest is classified as debt-free capital. On 28 December 2008, the debt interest is still on issue. As it has been on issue for more than 180 days, it will be taken not to have been cost-free debt capital on 30 June 2008.
If the borrower is a foreign entity, debt interests can only form part of its cost-free debt capital to the extent they are attributable to assets attributable to the foreign entity's Australian permanent establishments or to other assets held for the purposes of producing the foreign entity's Australian assessable income.
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For a more detailed definition of cost-free debt capital, refer to section 820-946.
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Debt deductions
The term debt deduction is defined in section 820-40. Broadly, a debt deduction is the costs incurred in connection with a debt interest that are deductible (in Australia) subject to the thin capitalisation rules.
Specifically, a debt deduction is a cost incurred by an entity in relation to a debt interest issued by the entity, to the extent to which:
- the cost is
- interest, an amount in the nature of interest, or any other amount that is calculated by reference to the time value of money
- the difference between the financial benefits received, or to be received by the entity under the scheme giving rise to the debt interest and the financial benefits provided, or to be provided under that scheme, excluding foreign exchange losses, or
- any amount directly incurred in obtaining or maintaining the financial benefits received or to be received by the entity under the scheme giving rise to the debt interest, and
- the entity can, apart from the thin capitalisation rules, deduct the cost from its assessable income for that year.
In this context, a financial benefit means anything of economic value and includes property and services. A benefit is still a financial benefit even if the transaction that confers it on the entity also imposes an obligation on the entity. Refer to section 974-160 for more information.
Regulations can be made to further specify what both a debt deduction and financial benefit is.
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For a more detailed definition of 'debt deduction', refer to section 820-40.
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Debt interest
The tax law contains rules for determining whether something is debt or equity. The rules are contained in Division 974.
As a broad guide, if the following five elements are present, the interest is a debt interest:
- there is a scheme
- the scheme is a financing arrangement
- a financial benefit is received by the issuing entity
- the issuing entity has an effectively non-contingent obligation to provide a future financial benefit
- it is substantially more likely than not that the value of the financial benefit to be provided will be at least equal to or exceed the financial benefit received.
Equity capital
Equity capital is relevant to calculating the:
- associate entity excess amount - used to calculate the maximum allowable debt for non-ADI's
- worldwide equity amount - used to calculate the worldwide gearing debt amount for non-ADI outward investors
- ADI equity capital - used to calculate the average equity capital for ADI's.
The equity capital of an entity at a particular time means:
- the total of the following
- the issue price of each equity interest on issue, reduced by any unpaid portion of the issue price
- the entity's general reserves and asset revaluation reserves
- the entity's retained earnings
- the entity's net earnings for the current year, reduced by the amount of tax the entity expects to pay on those earnings, as well as any distributions made or declared to the entity's members that are attributable to the entity's earnings for the current year
- if the entity is a corporate tax entity, any provisions for distributions of profit
- if the entity is not a corporate tax entity, any provisions for distributions to the entity's members
- reduced by the total of the following
- the entity's negative retained earnings
- the entity's net loss for the current income year.
Equity interest
Division 974 contains rules for determining whether something is debt or equity. While this division is relevant only to companies, the thin capitalisation rules extend it to trusts and partnerships with certain modifications for the purposes of applying the thin capitalisation rules only.
Broadly, an equity interest has been issued if the interest is not a debt interest and it is any of the following:
- a share in a company, an interest as a beneficiary of a trust or an interest as a partner in a partnership
- an interest providing returns that depend on the issuer's economic performance
- an interest providing returns at the discretion of the issuer
- an interest that may or will convert into such an interest or share.
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For more information about equity interests, refer to:
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Excluded equity interest
Under the debt/equity rules, some types of financial instruments that are commonly regarded as debt are now classified as equity interests. These types of interests have features that make it possible to manipulate the debt and asset levels to the advantage of either or both of the holder and issuer. To prevent entities issuing equity interests immediately before a valuation day and cancelling the interests immediately after, certain short term equity interests called 'excluded equity interests' are deducted from assets in the method statements for determining the safe harbour debt of the issuer. This reduces the maximum allowable debt of the entity.
An entity (the issuer) can have an excluded equity interest if both of the following apply:
- it is a
- non-ADI outward investor,
- non-ADI inward investment vehicle, or
- non-ADI inward investor that holds assets attributable to its Australian permanent establishment or other assets held for the purposes of producing its Australian assessable income
- the issuer is not an exempt entity and is not exempted from the thin capitalisation rules by either the debt deduction threshold or asset threshold rules or because of section 820-39, which exempts certain special purpose vehicles.
The issuer's excluded equity interest is then the total value of all the equity interests issued by it that:
- if the holder is an associate, meet the same conditions as the issuer (see above) and the measurement days used by the issuer to measure its adjusted average debt are different to the measurements days used by the holder to measure its assets, the equity interests where the interest has been on issue for a period of less than 180 days, or
- if the holder is an associate, does not meet the same conditions as the issuer; that is, the holder is not required to apply the thin capitalisation rules, the equity interest that has been on issue for less than 180 days at the measurement day.
However, if the total period for which the equity interest is on issue is ultimately 180 days or more, the equity interest is not taken to be an excluded equity interest. For example an entity with a standard income year that uses quarterly measurement dates issues an equity interest on 30 September 2008. The holder of that interest is not subject to the thin capitalisation rules. As at 31 December 2008 the equity interest is classified as an excluded equity interest. On 31 March 2009, the equity interest has been on issue for more than 180 days so it will be taken not to have been an excluded equity interest on 31 December 2008.
If the issuer is a foreign entity, equity interests can only form part of its excluded equity interests to the extent they are attributable to assets attributable to the foreign entity's Australian permanent establishments or to other assets held for the purposes of producing the foreign entity's Australian assessable income.
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For a more detailed definition of 'excluded equity interest', refer to section 820-946.
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Non-debt liabilities
Non-debt liabilities are relevant to calculating the safe harbour debt amount for non-ADI entities. An entity's non-debt liabilities are liabilities at that time other than:
- the entity's debt capital
- equity interests held in the entity
- a provision for a distribution of profit - this is relevant only if the entity is a company, corporate limited partnership, corporate unit trust or a public trading trust
- a provision for a distribution to the entity's members - this is relevant only if the entity is not a company, corporate limited partnership, corporate unit trust or a public trading trust
- liabilities under a securities loan arrangement if, at the relevant time, the entity has received amounts for the sale of securities (other than any fees associated with that sale) but has not yet repurchased the securities
- liabilities that meet the conditions for being included in the entity's borrowed securities amount.
Non-debt liabilities that are wholly or principally of a private or domestic nature are also excluded - see section 820-32. Whether something is a liability is determined by reference to the accounting standards. See subsection 820-680(1A) and taxation ruling TR 2002/20.
On-lent amount
An on-lent amount is relevant to calculating a financial entity's safe harbour debt amount. Generally, on-lent amounts represent the financial entity's on-lending business, which is subject to a concessionary on-lending rule.
A financial entity's on-lent amount is the sum of the following assets:
- the value of debt interests issued to the financial entity by other entities
- the value of leases for the hire of goods that are not debt interests issued by other entities where
- the leases are for six months or more
- the leases are part of the business of hiring goods carried on by the financial entity, and
- the financial entity's business of hiring goods is not carried on predominantly for the purpose of hiring goods to any of its associates
- the value of securities held by the financial 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
- if the entity carries on a business of dealing in securities but not predominately for the purposes of dealing in securities with, or on behalf of, the entity's associates, all the shares that
- the entity holds
- are listed for quotation in the official list of an approved stock exchange, and
- are not shares in any of the entity's associate entities.
Zero-capital amount
A zero-capital amount is relevant to calculating a financial entity's safe harbour debt amount. The zero-capital amount represents the value of the financial entity's assets that are low-margin, low-risk transactions.
A financial entity's zero capital amount is the sum of all of the following:
- the total value of all the entity's assets that represent debt interests that
- are of a kind commonly dealt in by entities that carry on a business of dealing in securities
- that the entity has sold under a reciprocal purchase agreement, sell buy-back arrangement or securities loan arrangement, and
- the entity has not yet repurchased under the agreement or arrangement
- the total value of debt interests issued to the financial entity that remain on issue where
- the debt interests are loans of money for which no fees or charges or other consideration for the purpose of enhancing the credit rating of the issuer of the interest have been paid or are payable to the entity, any of the entity's associates or a foreign entity, and
- the long-term foreign corporate credit rating of each entity that has issued the debt interests, at the time of issue or at any time within six months immediately preceding or immediately after issue, was rated at least BBB or equivalent by an internationally recognised credit agency. However, if the debt interest is a subordinated debt interest (see below), the long-term foreign currency corporate credit rating must be at least A or equivalent at the time of issue or at any time within the six months immediately preceding or immediately after issue
- the total value of the debt interests that are assets of the financial entity (whether or not the debt interests were issued to the financial entity) that remain on issue at that time, where the debt interests have risk-weighting of 0% or 20% under the prudential standards and do not satisfy all the conditions in the second dot point
- the total value of all the entity's assets to the extent that they are rights to the return of assets that
- the entity provided as security for the performance of its obligations in relation to securities it acquired under a reciprocal purchase agreement, sell-buyback arrangement or securities loan arrangement
- do not consist of shares, and
- are not covered by one of the amounts listed in the above dot points
- the total value of the entity's securitised assets if the entity is a securitisation vehicle.
A subordinated debt interest is a debt interest issued to either of the following:
- an unsecured creditor
- a secured creditor who, in the event of a liquidation of the issuer, can make a claim on that interest only after the claims of other secured creditors regarding their debt interests issued by the issuer have been met.
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For a more detailed definition of 'zero-capital amount', refer to section 820-942.
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03 Control of entities
This section explains how to determine whether an Australian entity is:
- an Australian controller; that is, an outward investor
- foreign controlled; that is, an inward investment vehicle.
The control rules draw heavily on the controlled foreign company rules in Part X of the ITAA 1936.
What is an Australian controller?
An Australian entity will be an Australian controller if both of the following apply:
- there is an Australian controlled foreign entity
- there is an Australian controller of the foreign entity.
What is an Australian controlled foreign entity?
Whether a foreign entity is Australian controlled is largely determined by the control rules contained in Part X of ITAA 1936. An Australian controlled foreign entity is any of the following:
- a controlled foreign company (except a corporate limited partnership) - that is, a non-resident company that satisfies one of the three control tests in section 340 of the ITAA 1936
- a controlled foreign trust - that is, a non-resident trust that satisfies either one or both of two tests in section 342 of the ITAA 1936
a controlled foreign corporate limited partnership. The test for a controlled foreign corporate limited partnership is contained in section 820-760. A controlled foreign corporate limited partnership is a foreign corporate limited partnership in which
- either one or more of the general partners is an Australian entity or an Australian controlled foreign entity, or
- there are no more than five Australian entities (each of which holds a 'TC control interest' of at least 1%) which, together with associate entities, hold a total of TC control interests of at least 50% in the controlled foreign entity. See section 820-760(2).
TC control interest is discussed below. It includes interests held by associate entities.
Once you have established that there is an Australian controlled foreign entity, you then need to determine which Australian entities are Australian controllers of those foreign entities. Australian controllers are subject to the thin capitalisation rules.
Who is an Australian controller of a controlled foreign company?
An Australian controller of a controlled foreign company is an Australian entity that is either of the following:
- a holder of a TC control interest of 10% or more in the controlled foreign company
- an entity to which all of the following apply
- the company is a controlled foreign company because of the application of the test in paragraph 340(c) of the ITAA 1936
- the Australian entity has a TC control interest of at least 1% in the controlled foreign company
- that entity is one of a group of 5 or fewer Australian entities that, alone or with associate entities, controls the controlled foreign company.
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For a more detailed definition of an 'Australian controller of a controlled foreign company', refer to section 820-750.
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Who is an Australian controller of a controlled foreign trust?
An Australian controller of a controlled foreign trust is an Australian entity that holds a TC control interest of 10% or more in the trust.
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For a more detailed definition of an 'Australian controller of a controlled foreign trust', refer to section 820-755.
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An Australian controller of a controlled foreign corporate limited partnership is an Australian entity that is either of the following:
- a general partner of the partnership
- a holder of a TC control interest of 10% or more in the partnership.
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For a more detailed definition of an 'Australian controller of a controlled foreign corporate limited partnership', refer to subsection 820-760(1).
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If the entity is an Australian controller of an Australian controlled foreign entity, it is subject to the thin capitalisation rules. How the thin capitalisation rules actually apply to an Australian controller is determined according to which category the entity is in. This is explained in section 4, which also directs you to the relevant guide to the thin capitalisation calculations.
What is a foreign controlled Australian entity?
The thin capitalisation rules also apply to foreign controlled Australian entities. A foreign controlled Australian entity is an Australian entity that is any of the following:
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For a more detailed definition of a 'foreign controlled Australian entity', refer to section 820-780.
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What is a foreign controlled Australian company?
An Australian resident company (except a corporate limited partnership) is a foreign controlled Australian company if any of the following apply:
- a group of five or fewer foreign entities (each of which holds a TC control interest of at least 1% in the Australian company) holds a TC control interest of at least 50% in the Australian company. For example, if three foreign residents hold interests of 20% each in an Australian company, totalling 60%, that Australian company is foreign controlled
- a single foreign entity holds a TC control interest of at least 40% in the Australian company and no other entity (except for an associate entity) controls that Australian company. For example, if a foreign resident holds an interest of 45% in the Australian company and 11 Australian residents that are unrelated to the foreign resident and each other hold 5% each, the Australian company is foreign controlled. However, this test is not satisfied if, for example, the foreign company holds 45% and a single, unrelated Australian entity holds 55%
- a group of five or fewer foreign entities, either alone or with associate entities, control the company.
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For a more detailed definition of a 'foreign controlled Australian company', refer to section 820-785.
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What is a foreign controlled Australian trust?
An Australian trust is a foreign controlled Australian trust if one of the following four tests applies:
- A group of five or fewer foreign entities (each of which holds a TC control interest of at least 1% in the Australian trust) holds a TC control interest of at least 50% in the Australian trust. For example, if three foreign residents are entitled to 30%, 10% and 10% respectively of an Australian trust's income, the trust is foreign controlled.
- A single foreign entity holds a TC control interest of at least 40% in the Australian trust, and no other entity (except for an associate entity) controls the trust.
- All of the following apply
- at least one of the objects or beneficiaries of the Australian trust is a foreign entity
- the trust has made at least one distribution of income or capital to that foreign entity (directly or indirectly) during the current income year or during the preceding two income years.
- Australian entities hold TC control interests of 50% or less in the trust
- A foreign entity is in a position to control the trust.
Broadly, a foreign entity is in a position to control the Australian trust if any of the following apply:
- the foreign entity, or an associate entity of the foreign entity, can obtain the beneficial enjoyment of the trust's income or capital
- the foreign entity, or an associate entity of the foreign entity, can control the application of the trust's income or capital
- a trustee might reasonably be expected to act in accordance with directions of the foreign entity or an associate entity of the foreign entity
- the foreign entity, or an associate entity of the foreign entity, can remove or appoint a trustee.
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For a more detailed description of a 'foreign controlled Australian trust', refer to section 820-790.
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What is a foreign controlled Australian partnership?
A partnership that is not a corporate limited partnership
An Australian partnership, other than a corporate limited partnership, is a foreign controlled Australian partnership if at least one of the partners is an Australian entity and one of the following applies:
- a group of five or fewer foreign entities (each of which holds a TC control interest of at least 1% in the Australian partnership) hold a TC control interest of at least 50% in the Australian partnership. For example, if three foreign residents are entitled to 20% each of an Australian partnership's income
- a single foreign entity holds a TC control interest of at least 40% in the Australian partnership, and no other entity (except for an associate entity) controls the partnership.
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For a more detailed definition of a 'foreign controlled Australian partnership', refer to subsection 820-795(2).
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A corporate limited partnership
An Australian corporate limited partnership is a foreign controlled Australian partnership if either of the following apply:
- a group of five or fewer foreign entities (each of which holds a TC control interest of at least 1% in the Australian partnership) holds a TC control interest of at least 50% in the Australian partnership
- at least one of the general partners is either a foreign entity or a foreign controlled Australian entity.
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For a more detailed definition of a 'foreign controlled Australian corporate limited partnership', refer to subsection 820-795(1).
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In certain circumstances, an Australian entity may not be a foreign controlled Australian entity even though the above tests are met. This will be the case where, ignoring certain deeming rules, the actual control interest is less than 20%. This exception is in subsection 820-785(2) for companies, subsection 820-790(3) for trusts and subsection 820-795(3) for partnerships and corporate limited partnerships.
If the entity is a foreign controlled Australian entity, it is subject to the thin capitalisation rules. How the thin capitalisation rules apply to the entity depends on which category the entity is in. This is explained in section 4 which also directs you to the relevant guide to thin capitalisation calculations.
What are thin capitalisation control interests in a company, trust or partnership?
Thin capitalisation (TC) control interests are used to determine whether an entity is an Australian controller of an Australian controlled foreign entity and also when an Australian entity is foreign controlled. They are also used to determine whether a foreign corporate limited partnership is Australian controlled.
The concept of TC control interest is not used to establish whether a foreign company or trust is Australian controlled. The terms controlled foreign company and controlled foreign trust are contained in Part X of the ITAA 1936 and the concept of control used in those definitions is also wholly contained in Part X - refer to sections 349-355 of the ITAA 1936 for more information.
An entity's TC control interest is the total of all of the following at that time:
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For a more detailed definition of 'TC control interests', refer to section 820-815.
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TC direct control interests
In the case of a company TC direct control interests include the interests an entity directly holds, or is entitled to acquire (for example, through the exercise of options), in the company including at that time:
- the total paid-up share capital of the company
- the total rights of shareholders to vote or participate in decision-making about making distributions of capital or profits, or changes to the constituent documents of the company, or variations to share capital
- the total rights to distributions of capital or income upon winding-up of the company
- the total rights to distributions of capital or income upon events other than winding-up of the company.
There are some further rules dealing with determining the percentage of rights to distributions and direct control interests. Refer to section 820-855 of the ITAA 1997 and section 350 of the ITAA 1936 for more information.
Example: Direct control interests in a company
An Australian entity holds 75% of the issued share capital of a foreign entity.
The TC direct control interest of the Australian entity would be 75%.
In the case of a trust, the TC direct control interests are those interests in the income or corpus of trusts held by beneficiaries. Specifically, a TC direct control interest in a trust is the percentage of interest an entity holds, or is entitled to acquire, in the income or corpus of the trust, whichever is the greater. There are some further rules dealing with determining the percentage of rights to income and capital. Refer to section 820-860 of the ITAA 1997 and section 351 of the ITAA 1936 for more information.
In a corporate limited partnership, a general partner always has a TC direct control interest of 100% in that partnership. If the partnership is not a corporate limited partnership, the TC direct control interest equals the percentage control of voting power in the partnership.
As an alternative for both corporate limited partnerships and other partnerships, the TC direct control interest of a partner is equal to the percentage the partner holds, or is entitled to acquire, of any of the following:
- the total amount of assets or capital contributed to the partnership
- the total rights to distribution of capital, assets, or profits on dissolution
- the total rights to distribution of capital, assets, or profits otherwise than on dissolution.
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For a more detailed definition of a 'TC direct control interest in a partnership', refer to section 820-865.
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If an entity holds more than one type of TC direct control interest (for example, the entity holds both the right to income and the right to capital), the greatest percentage is taken to be the TC direct control interest. For example, if the entity holds 50% of the voting rights and a right to 25% of the capital of an entity, the TC direct control interest in the entity is 50%.
TC indirect control interests
An entity can have a TC control interest in another entity, even though it does not hold any direct interest in that other entity. As outlined above, a TC control interest includes any TC indirect control interests held in another entity. Such TC indirect control interests are those interests an entity holds in another entity via direct interests held in an interposed entity.
Example
Entity A holds a 100% TC direct interest in entity B. Entity B holds a TC direct control interest in entity C of 75%. Entity A has an indirect control interest in entity C of 75%, measured by tracing through the interest held through B.
If the TC control interest is being measured to determine whether an Australian entity is foreign controlled, an interest can be traced through an interposed entity only if the interposed entity is itself a foreign controlled Australian entity.
If the TC control interest is being measured to determine whether a foreign entity is Australian controlled or whether an Australian entity is an Australian controller of an Australian controlled foreign entity, an interest can be traced through an interposed entity only if the interposed entity is itself an Australian controlled foreign entity.
In certain circumstances, the direct interest the entity holds in the interposed entity is taken to be 100% for the purpose of measuring indirect control.
TC direct and indirect interests of associate entities
The total TC control interests of an entity also include any TC direct or indirect interests that are held by an entity's associate entities, subject to the two exceptions mentioned below. The effect of this is that an Australian entity can still be an Australian controller even though that Australian entity may not hold any TC direct or TC indirect control interests of its own.
However, in two circumstances, the total TC control interests of an entity will not include the TC control interests of the entity's associate entities.
- If the associate entity is only an associate entity because of the rule contained in subsection 820-905(3B) the associate entity's TC control interests are not included. For example, company A owns 100% of company B. Company B is an associate entity of company A under subsection 820-905(1). Company A is then an associate entity of company B under subsection 820-905(3B)
When measuring company B's TC control interest, any TC control interests held by company A are ignored.
If the associate entity is a foreign entity and is only an associate entity because of the rule contained in subsection 820-905(3A) the associate entity's TC control interest is also not included. For example, a foreign company (For Co) has a 100% Australian subsidiary (Aust Co) and a 100% foreign subsidiary (FE Co). FE Co has several wholly owned foreign subsidiaries. Aust Co and FE Co are associate entities of each other under subsection 820-905(3A). When Aust Co calculates its TC control interests in any foreign entities, it does not include any TC control interests held by FE Co in FE Co's foreign subsidiaries. Also, Aust Co would also not include any TC control interests held by its parent entity, For Co, because of the first rule outlined above.
04 Entity categories
The legislation separates entities into categories because the rules for calculating the maximum debt levels or minimum capital levels are different depending on the type of entity involved. This section tells you how to categorise the entity and where to find the thin capitalisation rules that apply to that entity - see table 1 at the end of this section.
How to categorise a resident thin capitalisation group is explained in section 5.
There are eight entity categories, namely:
Non-ADI entities
- an outward investor that is a general entity
- an outward investor that is a financial entity
- an inward investment vehicle that is a general entity
- an inward investment vehicle that is a financial entity
- an inward investor that is a general entity
- an inward investor that is a financial entity.
Authorised deposit taking institutions - ADI entities
- an outward investing entity that is an ADI
- an inward investing entity that is an ADI.
Once you have worked out what type of entity you are dealing with, use table 1 at the end of this section to find out which guide explains how the thin capitalisation rules apply to that entity.
Outward investors
An entity is an outward investor if it is any of the following:
- an Australian controller of an Australian controlled foreign entity
- an Australian entity that carries on business through an overseas permanent establishment
- an Australian entity that is an associate entity of either of the above two entities.
An outward investor can be a general, financial or ADI entity.
Inward investing entities
An entity is an inward investing entity if it is either of the following:
- an inward investment vehicle; that is, an Australian entity that is controlled by a foreign entity or foreign entities, or
- an inward investor; that is, a foreign entity. Although all foreign entities are inward investors, the thin capitalisation rules only affect foreign entities
- with an Australian permanent establishment or other Australian income producing assets
- that are claiming debt deductions.
Inward investment vehicles can be either general or financial. An inward investor can be a general, financial or ADI entity.
General entities, financial entities and ADI entities
A general entity is an entity that is neither a financial entity nor an ADI entity.
A financial entity is an entity, other than an ADI, that is any of the following:
- a registered corporation under the Financial Sector (Collection of Data) Act 2001
- a securitisation vehicle
- an entity that
- is a financial services licensee, within the meaning of the Corporations Act 2001, whose licence covers dealings in at least one of the financial products mentioned in paragraphs 764A(1)(a), (b) and (j) of that Act or dealings in derivatives, or
- under paragraph 911A(2)(h) or (l) of the Corporations Act 2001, is exempt from the requirement to hold an Australian financial services licence for dealings in at least one of those financial products or dealings in such derivatives, and
- carries on a business of dealings in securities or such derivatives, but not predominantly for the purposes of dealing in securities or such derivatives with, or on behalf of, the entity's associates.
Certain financial entities can elect to be treated as an ADI under the thin capitalisation rules. The conditions for making this election are explained in section 7 of this guide.
An ADI entity is a body corporate that is an authorised deposit taking institution for the purposes of the Banking Act 1959.
An entity is a securitisation vehicle if all of the following apply:
- it is established for the purposes of acquiring, funding and holding securitised assets
- it acquired the securitised assets from another entity and funded that acquisition wholly by debt
- it does not receive any guarantee, security or other form of credit support from any of its associate entities or from the entity it acquired the securitised assets from, or that entity's associate entities
- it has issued debt interests; that is, borrowed money, for the sole purpose of acquiring the securitised assets
- it has not been issued with any debt interests by any of its associate entities, by the entity it acquired the securitised assets from or by that entity's associate entities
- any arrangements between the entity and its associate entities, the entity it acquired the securitised assets from and that entity's associate entities are reasonably expected to be on arm's length terms.
Entities that are both outward and inward investing entities
If an entity is both an outward investing entity and an inward investing entity, the rules for outward investing entities apply. For example, if an Australian resident entity is foreign controlled and also carries on business through an overseas permanent establishment, the rules for outward investing entities apply. However, the entity is neither able to apply the worldwide gearing test nor the assets threshold test.
The following tables summarise the rules explained in this section. They also tell you which guide explains how to apply the thin capitalisation rules to the type of entity you are dealing with.
Table 1: How to categorise the entity and where to find the rules for different entity types
Table 2: How to categorise a financial entity that has elected to apply the ADI rules and where to find the rule
05 Applying the thin capitalisation rules to consolidated groups or MEC groups
What rules apply?
The head company of a consolidated group or MEC group can be classified as any of the following:
- an outward investing entity (non-ADI)
- an inward investing entity (non-ADI)
- an outward investing entity (ADI)
- an inward investing entity (ADI).
However, the thin capitalisation rules will not apply where the consolidated group or MEC group passes either the debt deduction test - see section 820-35 - or the assets threshold test - see section 820-37. There is a further exemption relating to a head company that is either a foreign controlled ADI or a foreign controlled Australian company that wholly owns a foreign controlled Australian ADI. This is discussed in more detail under the heading Exemptions for certain foreign controlled consolidated groups.
How the head company is classified is determined by the nature of the entities making up the consolidated group or MEC group. Section 4 explains how individual entities are classified. If the consolidated group or MEC group contains a special purpose entity that is exempt from thin capitalisation under section 820-39, it is treated as not being part of that group for thin capitalisation purposes only - refer to section 820-584 for more information.
Non-ADI grouping provisions
Table 3: When do the outward investing entity (non-ADI) rules apply to the group?
Group composition
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Classification
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The head company is a non-ADI general outward investor and no member of the group is a financial entity or an ADI.
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Non-ADI outward investor general and Subdivision 820-B applies.
The head company will be an outward investor if one of its associate entities is an outward investor. This means that if at least one of the head company's subsidiary members is an outward investor, the head company will be an outward investor. Even if the head company or any other company in the group is foreign owned, it will still be classified as an outward investor if it or one of the group's subsidiary members is an outward investor as the outward investor rules take priority over those applying to inward investing entities.
Refer to subsection 820-583(2) for more information.
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The head company is a non-ADI outward investor and at least one member of the group (this can be the head company or any other group member) is a financial entity but no member of the group is an ADI.
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Non-ADI financial outward investor and Subdivision 820-B applies.
The head company will be an outward investor if one of its associate entities is an outward investor. This means that if at least one of the head company's subsidiary members is an outward investor, the head company will be an outward investor. Even if the head company or any other company in the group is foreign owned, it will still be classified as an outward investor if it, or one of the group's subsidiary members is an outward investor as the outward investor rules take priority over those applying to inward investing entities.
The special rules about on-lent amounts and zero-capital amounts apply to all of the group's assets that satisfy the definitions, whether those assets are held by the actual financial entities in the group or by other entities in the group.
Refer to subsection 820-583(3) for more information.
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Table 4: When do the inward investing entity (non-ADI) rules apply to the group?
Group composition
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Classification
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The head company is a foreign controlled Australian entity and is not also an outward investor, and no member of the group is a financial entity or an ADI.
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Non-ADI general inward investment vehicle and the rules in Subdivision 820-C apply.
Refer to subsection 820-583(5) for more information.
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The head company is a foreign controlled Australian entity and not also an outward investor, and at least one member of the group, which can be the head company, is a financial entity and no member is an ADI.
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Non-ADI financial inward investment vehicle and the rules in Subdivision 820-C apply.
The special rules about on-lent amounts and zero-capital amounts apply to all of the group's assets that satisfy the definitions, whether those assets are held by the actual financial entities in the group or by other entities in the group.
Refer to subsection 820-583(6) for more information.
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Grouping branches of foreign banks and financial entities
On or after 1 July 2002 and for thin capitalisation purposes only, a head company of a consolidated group, or a single resident company, can choose to treat an Australian branch of an establishment entity as part of itself where the head company or single company are part of the same wholly owned group as the establishment entity. This choice can be made each income year.
An establishment entity is a reference to either of the following:
- a foreign bank that carries on its banking business in Australia through at least one Australian permanent establishment
- a foreign entity that is a financial entity and has at least one Australian permanent establishment.
The head company can make a choice to include the Australian branch of the establishment entity during the grouping period, which can be all or part of the income year during which the group existed. The grouping period is the period during which the following conditions are satisfied within the head company's income year:
- the Australian branch of the establishment entity and the head company are members of the same wholly-owned group, and
- the establishment entity carries on a banking business in Australia through at least one Australian permanent establishment, or
- the establishment entity is a financial entity and has at least one Australian permanent establishment.
If a choice is made, the Australian branch of the establishment entity is included in the consolidated group or MEC group for the entire grouping period. The head company cannot choose to include the Australian branch of the establishment entity for part of the grouping period only. Once made, the choice is binding on both the head company and the establishment entity and is binding for the entire grouping period in the head company's income year. A new choice may be made each income year.
Where the head company and the establishment entity have different income years, the thin capitalisation position must be worked out for each period that relates to the different income years. This is because both the head company and the establishment entity need to calculate the extent to which debt deductions are denied, if any.
Example 1
The head company has an income year ending 30 June 2006. The establishment entity has a substituted accounting period ending 31 December 2005. The head company chooses to include the Australian branch of the establishment entity in its consolidated group. The grouping period spans the head company's entire income year and so the head company must treat the Australian branch as part of itself for its entire income year.
A thin capitalisation calculation must be done for three separate periods being:
- the period 1 July to 31 December 2005
- the period 1 January to 30 June 2006
- the following period of 1 July to 31 December 2006.
The combined calculations for the first and second periods determine any disallowed debt deductions for the head company and the combined calculations for the second and third test periods determine any disallowed deductions for the establishment entity.
The rules also allow a single Australian resident company to treat an Australian branch of an establishment entity as part of itself for thin capitalisation purposes only.
The company can make a choice to include the Australian branch of an establishment entity during the grouping period. The grouping period, which can be all or part of an income year, is the period during which the following conditions are satisfied within the single company's income year:
- the single company was an Australian entity and was not a prescribed dual resident
- the single entity was not a member of a consolidatable group, nor a member of a consolidated group or a member of a MEC group
- the establishment entity and the single company are members of the same wholly-owned group, and either of the following applies
- the establishment entity carries on a banking business in Australia through at least one Australian permanent establishment
- the establishment entity is a financial entity and has at least one Australian permanent establishment.
If a choice is made, the Australian branch of the establishment entity is treated as being part of the single company for the entire grouping period. The company cannot choose to include the Australian branch of the establishment entity for part of the grouping period only. Once made, the choice made by the single resident company is binding on it and the establishment entity and is binding for the entire grouping period in the single company's income year. A new choice may be made each income year.
As with a head company, where the single company and the establishment entity have different income years, the thin capitalisation position must be worked out for each period that relates to the different income years. This is because both the single company and the establishment entity need to calculate the extent to which debt deductions are denied, if any. See example 1 - Substituting references to a head company with a reference to a single company.
When a head company or single company chooses to include an Australian branch of an establishment entity then, during the grouping period, the branch is not considered to be part of the establishment entity for thin capitalisation purposes. During this period any debt deductions incurred by the establishment entity and attributable to the Australian branch of the establishment entity are treated as being debt deductions of the head company or single company for thin capitalisation purposes. Similarly, each asset and liability attributable to the Australian branch of the establishment entity is treated as being as asset and liability of the head company or single company for thin capitalisation purposes and are included for those purposes in the head company or single company's calculations.
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Legislative reference: section 820-603.
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Even though the Australian branch of the establishment entity is not treated as being a part of the establishment entity for the purposes of determining the thin capitalisation position of the head company or single company, the establishment entity is still subject to the requirement in Subdivision 820-L to keep certain records in relation to its Australian branches.
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How is a group that contains an ADI classified?
The following tables set out what rules will apply to a consolidated group or MEC group that includes an ADI or single company that treats an Australian branch of an establishment entity as part of itself.
Table 5: Classification if no choice is made to include an Australian branch of an establishment entity
Group composition
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Classification
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At least one member of the group would be an outward investing ADI - ignoring the application of the consolidation provisions; that is, classify the member as if it were a separate entity.
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Outward investing ADI and the rules in Subdivision 820-D apply.
Refer to paragraph 820-583(7)(a) for more information.
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At least one member of the group is a non-ADI outward investing entity and at least one other member is an ADI.
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Outward investing ADI and the rules in Subdivision 820-D apply.
Refer to paragraph 820-583(7)(b) for more information.
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The head company of a MEC group is not an outward investing ADI and the group includes at least one foreign controlled Australian ADI and another entity that is an eligible tier-1 company of the top company for the group:
- is not an ADI, and
- does not have a wholly owned subsidiary that is an ADI.
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Treated as if an outward investing ADI and the rules in Subdivision 820-D apply.
Refer to section 820-587 for more information.
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The head company has made a choice to apply the ADI rules under Subdivision 820-EA and the head company would otherwise be classified as an outward investor - financial.
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Outward investing ADI and the rules in Subdivision 820-D apply.
Refer to section 820-430(1) for more information.
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The head company has made a choice to apply the ADI rules under Subdivision 820-EA and the head company would otherwise be classified as an inward investment vehicle - financial.
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Outward investing ADI and the rules in Subdivision 820-D apply.
Refer to section 820-430(1) for more information.
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Table 6: Classification if a choice has been made to include an Australian branch of an establishment entity
Group composition
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Classification
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The head company or single company is an outward investing entity (ADI) and elects to group with a branch of an establishment entity that is a foreign bank.
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Outward investing ADI and the rules in Subdivision 820-D apply.
Refer to paragraph 820-609(1)(b) for more information.
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The head company or single company would otherwise be an outward investing entity (non ADI) and an outward investor (financial or general) and elects to group with a branch of an establishment entity that is a foreign bank.
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Outward investing ADI and the rules in Subdivision 820-D apply.
Refer to paragraph 820-609(1)(b) for more information.
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The head company has chosen to treat an Australian branch of an establishment entity as part of itself under section 820-597 and, had that choice not been made, would be exempt from the thin capitalisation rules under section 820-585.
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Outward investing ADI and the rules in Subdivision 820-D apply.
Refer to:
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The head company has chosen to treat an Australian branch of an establishment entity as part of itself under section 820-597 and, had that choice not been made, would have been treated as an outward investing ADI under section 820-587.
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Outward investing ADI and the rules in Subdivision 820-D apply.
Refer to:
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The head company or single company would, had the choice to include an Australian branch of an establishment entity not been made, be classified as an inward investment vehicle - general or financial.
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Inward investing ADI and the rules in Subdivision 820-E apply.
Refer to:
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The thin capitalisation rules will apply even if the thin capitalisation rules would otherwise not apply to the head company or single company had the choice to include the Australian branch not been made. That is, if the group would otherwise have been exempt from thin capitalisation because of section 820-585, it will be subject to thin capitalisation once the choice is made.
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A debt deduction is not disallowed under the thin capitalisation rules where, throughout an income year, either of the following apply:
- the head company is both a foreign controlled Australian company and an ADI (ignoring the application of the consolidation rules; that is, classify the ADI as if it were a separate entity) and has not made a choice to treat an Australian branch as part of itself for thin capitalisation purposes
- the head company is a foreign controlled Australian company that
- beneficially owns all the membership interest in a member of the group that is both a foreign controlled Australian entity and an ADI throughout that period, and
- would (ignoring the application of the consolidation rules) have no other assets and no debt capital.
However, if at least one other member of the group is an outward investing entity (ADI or non-ADI) throughout the year (classifying the member as if it were a separate entity), the exemption does not apply.
A debt deduction is further not disallowed if the above conditions are satisfied for part of an income year only and the debt deduction is incurred by the head company during that period.
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This exemption does not apply where all the ADI's that are members of the group are specialist credit card institutions.
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Legislative reference: sections 820-585 and 820-597.
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Where the head company or single company is classified as an outward investing ADI, Subdivision 820-D applies to determine its thin capitalisation position. The calculations in Subdivision 820-D are based on the APRA rules. However, as the group may contain entities that are not supervised by APRA, the rules for calculating adjusted average equity capital and the safe harbour capital amount in Subdivision 820-D are modified. These modifications relate to:
- how adjusted average equity capital is calculated
- how the safe harbour capital amount is calculated.
Calculating adjusted average equity capital
In the case of a head company of a MEC group, the head company's ADI equity capital is worked out using all of the following points:
- by taking into account the equity interests or debt interests held in the head company by entities outside the group
- on the basis that an equity interest or debt interest in an eligible tier 1 company (other than the head company) that is a member of the group at that time is treated as an equity interest or debt interest (as appropriate) in the head company, but only if it is held at that time by an entity that is not a member of the group
- on the basis of the information that would be contained in a set of consolidated accounts
- prepared, in accordance with the accounting standard on consolidated accounts, as at that time, and
- covering the members of the group as at that time.
Where the head company or single company includes an Australian branch of an establishment entity as part of itself for thin capitalisation purposes, the head company or single company's adjusted average equity capital is increased by the average value of both of the following:
- so much of the establishment entity's ADI equity capital that is attributable to its Australian branch that has not been allocated to the offshore banking activities of the entity
- any loans that the establishment entity has provided to its Australian branch that do not give rise to debt deductions in that income year or any other income year.
Calculating the safe harbour capital amount
The second modification relates to the calculation of the safe harbour capital amount where an Australian branch of an establishment entity is included in a group or is treated as a part of a single company. When calculating the safe harbour capital amount, the head company or single company includes in its risk-weighted assets so much of the establishment entity's risk-weighted assets that are both of the following:
- attributable to the Australian branch included in the group
- not attributable to the off-shore banking activities of the establishment entity.
Where the head company or single company is classified as an inward investing ADI, Subdivision 820-E applies to determine its thin capitalisation position. The calculations in Subdivision 820-E are based on the APRA rules. However, as the group may contain entities that are not supervised by APRA, the rules in Subdivision 820-E are modified in relation to:
- how average equity capital is calculated
- how the safe harbour capital amount is calculated.
Calculating average equity capital
Where a head company or single company is classified as an inward investing ADI, the average equity capital for the test period is the sum of the following:
- the average value, for the period, of all the ADI equity capital of the company
- the average value for that period, of so much of the establishment entity's ADI equity capital that is attributable to each of its Australian branches, which has not been allocated to offshore banking activities
- any loans that the establishment entity has provided to its Australian branches that do not give rise to debt deductions for the income year or any other income year.
Calculating the safe harbour capital amount
The second modification relates to the calculation of the safe harbour capital amount where an Australian branch of an establishment entity is included in the group. When calculating the safe harbour capital amount, the head company or single company includes in its risk-weighted assets so much of the establishment entity's risk-weighted assets that:
- are attributable to the Australian branch included in the group
- are not attributable to the off-shore banking activities of the establishment entity.
The values of the assets and liabilities and other matters are worked out, as far as practicable, on the basis of information that would be contained in a set of consolidated accounts prepared in accordance with accounting standards on each measurement date covering each entity in the group and including each Australian branch.
Because the consolidation rules only allow 100% owned entities to consolidate, the consolidated accounts prepared for accounting purposes may not be able to be used without modification for thin capitalisation purposes. The accounts are to take into account only those entities that can be grouped under the consolidation rules.
What if a consolidated group or MEC group is formed or ceases to exist part way through the year or an entity joins part way through the income year?
Where a consolidated group or MEC group is formed part way through an income year, the thin capitalisation rules will apply to the entities on a separate basis for the period they were not part of a consolidated group or MEC group. Alternatively, if a consolidated group or MEC group ceases to exist, the thin capitalisation rules will apply on a separate basis to each entity that was in the group from that point forward.
The part of the income year the consolidated group or MEC group exists and the part of the income year during which it did not are treated as part year periods and the thin capitalisation calculations are worked out for each period separately. A Thin capitalisation schedule is only required for the latest application of the thin capitalisation rules.
What if a consolidated group or MEC group changes classification part way through an income year?
If the head company of a consolidated group or MEC group changes classification part way through an income year, the relevant thin capitalisation rules apply separately to each part of the income year on a part year basis.
For example, a head company of a consolidated group with a standard income year changes from a non-ADI inward investing entity to a non-ADI outward investing entity on 1 January. From 1 July to 31 December, the non-ADI inward investing entity rules apply. From 1 January to 30 June, the non-ADI outward investing entity rules apply. A Thin capitalisation schedule needs to be prepared for the latest application of the thin capitalisation only.
How do the thin capitalisation rules apply to a consolidated group or MEC group?
The thin capitalisation rules apply to the head company of a consolidated group or MEC group. For the purposes of determining the group's income tax liability, all intra-group transactions, debt and shareholdings are not recognised. Each debt deduction external to the group is treated as if it were incurred by the head company and, if the thin capitalisation rules are breached, a proportion of debt deductions is disallowed to the head company.
All assets and liabilities of the subsidiary members are treated as if they were assets and liabilities the head company. For the purposes of the thin capitalisation calculations, the values of the head company's assets and liabilities are based on information that would be contained in a set of consolidated accounts prepared in accordance with the accounting standards.
Because the consolidation rules only allow 100% owned entities to consolidate, the consolidated accounts prepared for accounting purposes may not be able to be used, without modification, for thin capitalisation purposes. The accounts are to take into account only those entities that can be grouped under the consolidation rules.
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Legislative reference: Subdivision 820-FA.
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If the consolidated group or MEC group contains a special purpose entity that is exempt under section 820-39, the entity is treated as not being part of that group for thin capitalisation purposes. This means that its assets and liabilities will not be treated as assets or liabilities of the head company.
Thin capitalisation schedule
Only the head company of a consolidated group or MEC group needs to complete the Thin capitalisation schedule and instructions 2009. The schedule is prepared at the same time as the tax return. The completed schedule is sent to:
Australian Taxation Office
PO Box 1365
Albury NSW 2640
06 Determining average values
You must calculate average values for particular matters (for example, assets, liabilities, debt and equity capital) in order to determine maximum debt level - for non-ADI entities - or minimum capital level - for ADI entities. This section explains how to establish a 'value' and an 'average value' for a matter.
Values of assets, debt, other liabilities, equity and other matters
The value of assets, debt capital, other liabilities, equity capital and other matters requiring a value is calculated by applying the relevant accounting standards. These standards also govern how amounts recorded in foreign currency are converted into Australian currency. The relevant accounting standards are the Australian equivalents to International Financial Reporting Standard (AIFRS) as adopted by the government on 1 January 2005. An entity must comply with the accounting standards when valuing a matter for thin capitalisation purposes, regardless of whether or not they are otherwise required to apply the standards.
It is to be noted that certain modifications to the application of the accounting standards apply for non-ADI entities and ADI entites for the purposes of making calculations under the thin capitalisation regime.
These modifications are set-out in sections 820-682, 820-683 and 820-684 (for non-ADI's) and sections 820-300 and 820-310 (for ADI's).
The value the entity uses in its books of account for accounting purposes and the value it uses for thin capitalisation purposes do not necessarily need to be the same, provided that the value used for thin capitalisation purposes is established by complying with the accounting standards.
Assets can be revalued for thin capitalisation purposes, provided the revaluation is done in accordance with accounting standards, even if they are not also revalued for accounting purposes.
Once an asset is revalued, the asset must continue to be revalued in accordance with the frequency set out in the accounting standards. If the entity does not continue to revalue in accordance with the accounting standards, then it cannot use the original revaluation for the period that it fails to comply with the accounting standards in this regard. It must use the value specified in its financial statements.
If the revaluation is done for the purposes of calculating the entity's thin capitalisation position and is reflected in its financial statements that it is required by Australian law to prepare, the revaluation does not need to be done by either an external expert or an internal expert. However, if either the entity is not required to prepare financial statements or it is required to but the revaluation is not reflected in those statements, the revaluation must be done by either an external expert or by an internal expert.
External expert
An independent expert is a person:
- who is an expert in relation to valuations of that class of assets, and
- whose pecuniary or other interests could not reasonably be regarded as being capable of affecting that person's ability to give an unbiased opinion in relation to that valuation.
Internal expert
An internal expert must be a person who is an expert in valuing such assets, and
- whose pecuniary or other interests could reasonably be regarded as affecting the person's ability to give an unbiased opinion but only because the person would be one of the following:
- performing duties as an employee of the entity
- providing services to the entity under an arrangement with the entity that is substantially similar to a contract of employment.
To be an acceptable value, the internal expert must make the revaluation in accordance with a methodology that has been reviewed and accepted as suitable by an external expert - see criteria above. The review of the methodology by the external expert must include the validity of any assumptions made, and the accuracy and reliability of the data and other information to be used.
Revaluing an asset in a class of assets
The values used for thin capitalisation purposes are the values calculated under the accounting standards. If the accounting standards require an asset to be revalued at certain intervals, the entity must comply with this for thin capitalisation purposes as well.
A strict adherence to this would require that once an asset in a class is revalued, all the assets in that class must be revalued. The thin capitalisation rules will allow an entity to revalue one or more assets in the class only, provided that no asset in the class of assets has fallen in value.
For example, two assets in the same class - asset A and B - have a carrying value of $1,000 and $2,000 respectively. The entity wants to revalue asset A but not asset B. In the relevant income year, asset A has increased in value to $1,200 and the value of asset B has remained the same. Because, as a class, no asset has fallen in value, asset A can be revalued without having to also revalue asset B. However, if the value of asset B had fallen to $800, asset A could not be revalued without asset B also being revalued.
Revaluation records
An entity must keep records in relation to the revaluation containing details about all of the following:
- the methodology used in making the revaluation, including any assumptions that may have been made
- how the methodology was applied, including information used
- who made the revaluation, their qualifications and their experience as an expert in valuing assets of the relevant kind
- the remuneration and expenses paid to that person.
Where the revaluation was made by the internal expert, the records must also include the following details:
- who the external expert was that reviewed the methodology for the valuation
- the external expert's qualifications and experience as an expert in valuing assets of the relevant kind
- the remuneration and expenses paid to the external expert
- the external expert's review of the methodology and their agreement that the methodology is suitable.
All records must be prepared by the time the entity must lodge its tax return for the income year for which the revaluation is made.
However records need not be kept where the asset was revalued subject to subsection 820-680(2A).
To adjust for certain impacts of the 2005 adoption of Australian equivalents to International Financial Reporting Standards, the thin capitalisation regime was modified in relation to the use of accounting standards for identifying and valuing an entity's assets, liabilities and equity capital. It does this by providing for the accounting standard treatment of specified assets and liabilities to be disregarded in certain circumstances. These modifications only apply to non-ADI entities.
Circumstances in which certain assets and liabilities are not permitted to be recognised by particular entities for thin capitalisation purposes relate to deferred tax assets and liabilities within the scope of AASB 112 Income taxes, and assets and liabilities arising from defined benefit plans within the scope of AASB 119 Employment Benefits.
In addition, particular entities may choose to recognise or revalue certain intangible assets, contrary to the relevant accounting standard. This primarily relates to intangible assets within the scope of AASB 138 Intangible Assets.
These modifications are applicable to an entity from its first income year starting on or after 9 December 2008.
To ensure the integrity of the values used, we have the discretion to substitute an appropriate value where we consider that the entity has either overvalued its assets or undervalued its liabilities.
As the exercise of this power may directly affect an entity's assessment, an entity that is dissatisfied with our decision to substitute a value may object to the decision under Part IVC of the Taxation Administration Act 1953.
Average values
The value of a matter is measured at several points during either the income year or the income period if the thin capitalisation rules applied for only part of the year or if different thin capitalisation rules applied to different parts of the year. The value is then averaged over that year or period.
A non-ADI entity can calculate the average by applying one of the following three methods:
- the opening and closing balances method
- the three measurement days method
- the frequent measurement method - this method contains two sub-options: a quarterly option and a more frequent option.
One method must be used to calculate the average value of all matters and must be consistently applied during the period. However, an entity can change the method used from one income year to the next. Also, if an entity changes categories part-way through the year, it can use different methods. For example, if an entity was an inward investment vehicle and then becomes an outward investor (for example, by acquiring a foreign subsidiary), it can use different methods for each part year period. Refer to 'Application to part-year periods' in the relevant guide to thin capitalisation calculations for more information.
An ADI must always use the frequent measurement method.
The different methods are explained in the following table.
Instruction
If you are subject to the thin capitalisation rules, you will be required to complete a Thin capitalisation schedule. The schedule requires a code at item 3a indicating the type of method you used to calculate an average value. The relevant code is indicated in the left hand column of this table.
Table 7: Methods for valuing matters
Method
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Days on which value is measured - measurement days
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How to calculate the average value
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Special conditions
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Opening and closing balances
Code 1
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- The first day of the period, and
- The last day of the period
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Add the values together and divide by two.
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Cannot be used by an ADI entity.
Refer to section 820-635 for more information.
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Three measurement days
Code 2
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- The first day of the period
- The last day of the first half of the income year, and
- The last day of the period
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Add the values together and divide by three.
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Cannot be used by an ADI entity.
The period must include at least either the first day of the income year or the last day of the income year and be at least six months long.
Refer to section 820-640 for more information.
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Frequent measurement method (quarterly basis)
Code 3
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- The first day of the period
- The last day of each quarter in that period, and
- The last day of the period, unless the last day was already included in the second dot point
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Add the values together and divide by the number of measurement days.
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One of the methods that must be used by an ADI entity
Refer to section 820-645 for more information.
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Frequent measurement method (more frequent basis)
Code 4
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The measurement days are the days occurring at a regular interval chosen by the entity - for example, monthly, weekly, daily.
- The first day of the measurement period
- The last day of each regular interval for the measurement period
- The last day of the measurement period unless the last day was already included in the second dot point.
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Add the values together and divide by the number of measurement days.
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One of the methods that must be used by an ADI entity
The regular interval selected cannot be less than one day or more than three months.
An entity can choose to measure some matters on a more frequent basis under this method and measure the remainder on a quarterly basis - for example, measure assets and debt daily and non-debt liabilities and equity quarterly. However, in respect of the matters that the entity has selected to measure more frequently, it must use the same regular interval - for example, the entity cannot measure assets daily, debt weekly and non-debt liabilities monthly.
Refer to section 820-645 for more information.
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Three measurement days
ABC Co uses a standard income year - 1 July to 30 June. It becomes subject to the thin capitalisation rules on 1 November 2002 and remains subject to the rules until the end of the financial year. The company can apply the three measurement days method because the period is at least six months and includes the last day of its income year. The three measurement days are 1 November 2002, 31 December 2002 and 30 June 2003.
If ABC Co has assets of $62 million, $65 million and $53 million on 1 November 2002, 31 December 2002 and 30 June 2003 respectively, the average value of assets for the period is $60 million.
Frequent measurement method - quarterly basis
XYZ Co has a substituted accounting period running from 1 January to 31 December 2004 and chooses to measure all its matters quarterly in its 2004 income year. On the first day of the measurement period, the value of its assets is $52 million. On the last day of each quarter in its income year, the value of its assets is as follows:
- $61 million - 31 March 2004
- $65 million - 30 June 2004
- $63 million - 30 September 2004
- $64 million - 31 December 2004.
These values are added together and divided by five. The average value of assets for the year is $61 million.
Frequent measurement method - more frequent basis
LCD Co uses a standard income year (1 July to 30 June) and chooses to measure its debt capital on a monthly basis. The relevant values are as follows:
- on the first day of the year (1 July 2002), its debt capital is $60 million
- on the last day of July, August and September, its debt capital is $65 million
- on the last day of October, November and December, its debt capital is $70 million
- on the last day of January, February and March, its debt capital is $75 million
- on the last day of April, May and June, its debt capital is $80 million.
Adding the amounts together and dividing by 13 (being the number of measurement days) gives an average value of debt capital for that period of $71.54 million. LCD Co then measures its remaining matters (debt, non-debt liabilities etc) on a quarterly basis.
07 Election to use the ADI rules
This section explains when a financial entity can elect to apply the ADI thin capitalisation rules.
Overview
Some financial entities may undertake similar activities to banks - ADIs. For this reason, and in certain circumstances, a financial entity can elect to use the thin capitalisation rules that apply to ADI entities. The rules for making this election are contained in Subdivision 820-EA.
To be entitled to make this election, the financial entity must meet either of the two conditions set out below. The entity must test itself for these conditions every three years. This means if the entity doesn't satisfy these conditions, the choice to apply the ADI rules is not automatically revoked. It is only if the entity does not meet these conditions at the end of the third income year after the choice is made (or after the last time the entity was required to test), that the choice is revoked.
Condition 1
The average value of the financial entity's on-lent amount in an income year must be equal to or more than 80% of the average value of its assets in that same income year.
Condition 2
The entity must, for the first part of the income year, satisfy either of the following conditions:
- It is a financial entity because it is a financial services licensee within the meaning of the Corporations Act 2001 whose licence covers dealings in derivatives or is exempt from holding such a licence because of paragraph 911A(2)(h) or (l) of the Corporations Act 2001, or
- It is a head company of a consolidated group of MEC group and at least one member of the group is a financial entity because it is a financial services licensee within the meaning of the Corporations Act 2001 whose licence covers dealings in derivatives or is exempt from holding such a licence because of paragraph 911A(2)(h) or (l) of the Corporations Act 2001.
Regardless of which of the above points the entity satisfies, the sum of the entity's average on-lent amount and average net unrealised gains on derivatives must be greater than or equal to 80% of the entity's average total assets, net of unrealised losses on derivatives.
It should also be noted that the on-lent amount of the entity will also include the average value for the year of any precious metal assets that the entity holds for that income year.
Table 8 - Condition 2 valuation
Steps
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Comments
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Calculate the average value, for the income year, of the entity's on-lent amount and the average value of its assets that are precious metals.
Insert this amount at label A of worksheet 1.
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The term on-lent amount is explained in section 2. Average values are discussed in section 6.
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Step 1.2: Calculate the average value, for the income year, of the entity's unrealised gains on trading derivatives.
Insert this amount at label B of worksheet 1.
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The term 'trading derivatives' has the meaning it has in the Corporations Act 2001.
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Step 1.3: Calculate the average value, for the income year, of the entities unrealised losses on derivatives. This amount is the lesser of:
- the entity's unrealised losses on trading derivatives
- the entity's unrealised gains on trading derivatives
Insert this amount at label C of worksheet 1.
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Step 1.4: Take the amount at C from the amount at B.
Insert the result at label D in worksheet 1.
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This figure can never be less than zero.
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Step 1.5: Add the amounts at A and D together.
Insert the result at label E in worksheet 1.
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Step 1.6: Calculate the average value, for the income year, of the entity's total assets.
Insert this amount at label F in worksheet 1.
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Step 1.7: Take the amount at C from the amount at F.
Insert the result at label G in worksheet 1.
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Step: 1.8 Divide the amount at E by the amount at G.
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If this is equal to or greater than 0.8, the entity has satisfied the condition.
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Worksheet 1
Steps
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$
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Step 1.1: Average on-lent amount
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(A) _____________
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Step 1.2: Average unrealised gains on trading derivatives
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(B) _____________
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Step 1.3: Average unrealised losses on trading derivatives
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(C) _____________
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Step 1.4: B − C
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(D) _____________
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Step 1.5: A + D
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(E) _____________
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Step 1.6: Average total assets
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(F) _____________
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Step 1.7: F − C
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(G) _____________
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Step 1.8: E ÷ G
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______________
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How is the election made?
The entity does not have to tell us about their choice. Their choice is effective from the period that started on or after a day specified in the choice. If the entity has not specified a day, their choice is effective from the day they made it.
What ADI rules apply?
The following table tells you how a financial entity that has elected to apply the ADI rules is classified and which ADI rules apply.
Table 9
Type of financial entity
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Classification and rules
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Outward Investor - financial
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Outward investing ADI. The rules in Subdivision 820-D apply.
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Inward Investment vehicle - financial
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Outward investing ADI. The rules in Subdivision 820-D apply.
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Inward investor - financial
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Inward investing ADI. The rules in Subdivision 820-E apply.
When applying Subdivision 820-E, all of the entity's business is considered to be its banking business.
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Outward investor - financial and inward investment vehicle - financial
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Outward investing ADI. The rules in Subdivision 820-D apply.
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Interaction with associate entity debt and associate entity equity rules
For a holder of a debt interest to hold associate entity debt, the issuer must be a non-ADI entity - see section 2 and explanation of 'associate entity debt'. For the purposes of determining whether a debt interest is associate entity debt, the choice made by the borrowing financial entity is disregarded. That is, the debt interest will still be treated as associate entity debt even though the borrowing financial entity has elected to apply the ADI rules to itself.
Similarly, an equity investment in a financial entity electing to apply the ADI rules that is an associate entity of a non-ADI investing entity, will still be associate entity equity providing it meets the relevant conditions - see section 2 and the explanation of associate entity equity. However, because the financial entity has elected to apply the ADI rules, the investing entity will not be able to utilise the associate entity excess provisions to increase its safe harbour debt amount or worldwide gearing debt amount.
Interaction with rule about consolidated groups and MEC groups
If the financial entity is a subsidiary member of a consolidated group or MEC group, its choice to apply the ADI rules to itself will have no effect. This is because the classification of the group depends on the choice made by the head company. A head company of a consolidated group or MEC group that is (ignoring the choice to apply the ADI rules) classified as an outward investor financial or an inward investment vehicle financial can make a choice to apply the ADI rules provided it meets one of the conditions as a group.
When can an entity that has made a choice use the non-ADI rules?
Once an election has been made, the only circumstances in which the entity can revert back to using the non-ADI rules are where either of the following applies:
- it no longer meets one of the conditions when tested at the end of the third year
- we approve a revocation of the choice.
The entity must test itself that it satisfies one of the conditions explained above every three years. However, if the entity doesn't satisfy these conditions, the choice to apply the ADI rules is not automatically revoked during the intervening three years. It is only if the entity does not meet these conditions at the end of the third income year after the choice is made (or after the last time the entity was required to test) that the choice is revoked - for example, the entity only reverts back to using the non-ADI rules for the next financial year.
The only other situation in which the choice can be revoked is with written approval from us. We can only approve a revocation if we are satisfied that the entity's circumstances have changed significantly since the entity made the choice. If we approve a revocation, the choice no longer applies from the date on which the revocation is approved or, if we specify an earlier date, from that earlier date.
If the choice is revoked, either because the entity fails the conditions at the end of the third year or we approve a revocation, the entity can never again choose to apply the ADI rules.
08 Choice to treat specialist credit card institutions as financial entities and not ADIs
This section explains the choice available to treat ADI's that are specialist credit card institutions as financial entities rather than ADIs for thin capitalisation purposes.
Overview
In 2003, as part of reforms made to the credit card market, a new class of ADIs was established by APRA. This new class of ADIs, known as 'specialist credit card institutions', are authorised to conduct limited banking business and are supervised differently by APRA compared to other ADIs.
Unlike other ADIs, the capital adequacy of specialist credit card institutions is not determined on a consolidated group basis where a specialist credit card institution is part of a group that does not contain any other types of ADI. In this case, the capital adequacy requirements apply to a specialist credit card institution and its subsidiaries (if any) on a consolidated basis but not the wider corporate group.
The advent of ADIs whose capital adequacy is not determined on a consolidated group basis for prudential purposes was not originally considered when the thin capitalisation rules were first introduced. As such, the thin capitalisation rules in their original form require all consolidated or MEC groups containing ADIs to determine their capital adequacy by taking into account risk-weighted assets on a group-wide basis.
It is considered that this requirement places unnecessary compliance costs on groups containing ADIs that are only specialist credit card institutions.
Therefore, provided certain conditions are satisfied, the head company of a consolidated or MEC group containing one or more ADIs is allowed to apply the thin capitalisation rules as if the group did not contain an ADI, where all the ADIs in the group are specialist credit card institutions. Each specialist credit card institution will instead be treated as if it was a financial entity.
What is a specialist credit card institution?
A specialist credit card institution is defined as an ADI, authorised under the Banking Act 1959, to conduct banking business that is confined to credit card acquiring and/or credit card issuing and involves participation in a payment system that is a credit card scheme, where that payment system is designated under section 11 of the Payment Systems (Regulation) Act 1998.
Conditions
The three conditions that must be met in order for a choice to be made to treat a specialist credit card institution as a non-ADI for thin capitalisation purposes are:
- at all times in a period, at least one member of the consolidated group or MEC group is an ADI
- each ADI that is a member of the group at any time in the period is a specialist credit card institution at that time
- the head company of the group for the period chooses, before lodging its income tax return for the income year, to apply the thin capitalisation rules as if the group did not contain any ADIs during the period.
Result of choice
If a choice is made, each specialist credit card institution in the group will be treated for thin capitalisation purposes as a financial entity during the relevant periods.
The head company of the group will be classified as either an 'outward investing entity - non-ADI' and an 'outward investor - financial', or an 'inward investing entity - non-ADI' and an 'inward investment vehicle - financial' as the case may be; that is, depending on what the usual thin capitalisation classification of the head company would be without the ADI rules applying.
This means, Subdivision 820-B or 820-C will apply to the head company instead of Subdivision 820-D.
Which guide to read next
The remaining guides in this series explain how to apply the thin capitalisation rules to the type of entity you are dealing with. The following table tells you which guide you need to read.
Table 10: Where to find the rules for different entity types
If you are not sure what type of entity you are dealing with, read section 4
Last Modified: Tuesday, 8 May 2012
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