• Worked example of calculations for a non-ADI general outward investor

Calculating if you meet the thin capitalisation rules

The steps a non-ADI general outward investor takes to calculate if they have met the thin capitalisation rules are:

• Step 1: Calculate the adjusted average debt
• Step 2: Calculate the safe harbour debt amount
• Step 2A: Calculate the average associate entity excess amount for the safe harbour debt amount (if they have more than one associate entity)
• Step 3: Calculate the worldwide gearing debt amount
• Step 4: Calculate the arm's length debt amount
• Step 5: Calculate debt deductions disallowed.

This worked example goes through each of these steps.

Worked example

Aust Co is a general entity. It has a wholly-owned foreign subsidiary (For Sub) and a wholly-owned Australian subsidiary (Ozzie Co) that is also a general entity. Aust Co has borrowed \$12 million from an unrelated financial institution and has \$0.5 million of non-debt liabilities. It has invested \$2 million as equity in For Sub and lent \$3 million to For Sub. It has invested \$1 million as equity in Ozzie Co. This represents what Aust Co paid a third party for 100% of the equity in Ozzie Co. For Sub has borrowed \$5 million from an unrelated financial institution and has \$7 million in retained earnings.

Neither Aust Co nor Ozzie Co has any overseas permanent establishments and they have not formed a consolidated group for tax purposes. All loans are at commercial interest rates. For the purposes of this example, Aust Co is the only entity being tested under the thin capitalisation rules. The test year is the 2014–15 income year.

Diagram: financial information for Aust Co and Ozzie Co

Aust Co's assets and liabilities for the year ending 30 June 2015 – average values using opening and closing balances method

Assets

\$m

Liabilities

\$m

Loan to For Sub

3

Debt

12

Equity in For Sub

2

Non-debt liabilities

0.5

Equity in Ozzie Co*

1

Share capital

3.5

Building & plant

10

16

16

* Assume the equity investment in Ozzie Co remains valued at \$1 million at all times throughout the income year.

Aust Co and its associate entities have debt deductions totalling \$2,100,000 in the 2014–15 income year and fail the debt deduction de-minimus test. Assume Aust Co does not meet the asset de-minimus test nor the exemption in section 820-39.

Ozzie Co's assets and liabilities at 1 July 2014

Assets

\$m

Liabilities

\$m

Non-current assets

0.9

Share capital

0.85

Retained earnings

0.05

0.9

0.9

Ozzie Co's assets and liabilities at 30 June 2015

Assets

\$m

Liabilities

\$m

Non-current assets

0.95

Share capital

0.85

Retained earnings

0.1

0.95

0.95

Step 1: Calculate Aust Co's adjusted average debt

Worksheet 1: Aust Co's step 1

 Steps Worksheet 1 \$m Step 1.1: The average value of all Aust Co's debt capital that gives rise to debt deductions is \$12m Average debt capital (A) 12 Step 1.2: Aust Co does not have any associate entity debt. The loan to For Sub is not included because it is not attributable to For Sub's Australian permanent establishments or other assets held by For Sub for the purpose of producing Australian assessable income Average associate entity debt (B) 0 Step 1.3: Aust Co's controlled foreign entity debt is the \$3m loan to For Sub Average controlled foreign entity debt (C) 3 Step 1.4: All of Aust Co's debt capital gives rise to debt deductions Average cost-free debt capital (D) 0 Step 1.5: Aust Co's adjusted average debt is \$9m Adjusted average debt(A – B – C + D) = 9

Aust Co's adjusted average debt is \$9 million. This is now compared to Aust Co's maximum allowable debt, which is the greatest of its:

• safe harbour debt amount
• worldwide gearing debt amount
• arm's length debt amount.

Aust Co can calculate these amounts in any order it chooses and does not necessarily have to calculate all three amounts.

Step 2: Calculate Aust Co's safe harbour debt amount

Worksheet 2: Aust Co's step 2

 Steps Worksheet 2 \$m Step 2.1: The average value of Aust Co's assets is \$16m Average assets (E) 16 Step 2.2: None of the equity interests issued by Aust Co are excluded equity interests Average excluded equity interests (QQ) 0 Step 2.3: Aust Co does not have any associate entity debt – see step 1.2 Average associate entity debt from B on worksheet 1 (B) 0 Step 2.4: The average value of Aust Co's associate entity equity is \$1m. Equity invested in For Sub is not included in associate entity equity because it is not attributable to For Sub's Australian permanent establishments or other assets held by For Sub for the purpose of producing Australian assessable income Average associate entity equity (F) 1 Step 2.5: The average value of Aust Co's controlled foreign entity debt is the \$3m owed to Aust Co by For Sub Average controlled foreign entity debt from C on worksheet 1 (C) 3 Step 2.6: The average value of Aust Co's controlled foreign entity equity is the \$2m invested in For Sub Average controlled foreign entity equity (G) 2 Step 2.7: The average value of Aust Co's non-debt liabilities is \$0.5m Average non-debt liabilities (H) 0.5 Step 2.8: Reduce Aust Co's average assets by the amounts at QQ, B, F, C, G & H E − QQ – B – F – C – G – H (J) 9.5 Step 2.9: Multiply the result at J by 3/5 J x 3/5 (K) 5.7 Step 2.10: The average value of Aust Co's associate entity excess is \$600,000 – see worksheet 2A Average associate entity excess amount from L on worksheet 2A (L) 0.6 Step 2.11: Aust Co's safe harbour debt amount is calculated by adding the amounts at K and L Safe harbour debt amount (K + L) = 6.3

Step 2A: Calculate Aust Co's average associate entity excess amount for the safe harbour debt amount

Aust Co's associate entity excess amount is calculated on each of its measurement days. Aust Co uses the opening and closing balances method so its measurement days are 1 July 2014 (the first day of the period) and 30 June 2015 (the last day of the period).

Worksheet 2A: Aust Co's step 2A

 Steps Worksheet 2A 1 July 2014 \$m 30 June 2015 \$m Step 2A.1: The value of Aust Co's associate entity equity on both measurements days is the \$1m invested in Ozzie Co Aust Co's associate entity equity on a measurement day (M) 1 1 Step 2A.2: The value of Ozzie Co's equity capital attributable to Aust Co's equity interests in Ozzie Co is \$900,000 on 1 July and \$950,000 on 30 June Ozzie Co's equity capital attributable to Aust Co's equity interests on a measurement day (N) 0.9 0.95 Step 2A.3: Aust Co's premium excess amount is calculated by deducted N from M and multiplying the result by 3/5 (M – N)   3/5 (P) 0.06 0.03 Step 2A.4: Ozzie Co's safe harbour debt amount on a measurement day is its assets multiplied by 3/5 Ozzie Co's safe harbour debt amount on a measurement day (Q) 0.54 0.57 Step 2A.5: Ozzie Co does not have any debt capital so its adjusted average debt on both days is \$0 Ozzie Co's adjusted average debt on a measurement day (R) 0 0 Step 2A.6: Ozzie Co's excess borrowing capacity is calculated by reducing its safe harbour debt amount by its adjusted average debt Q – R (S) 0.54 0.57 Step 2A.7: The value of Ozzie Co's equity capital attributable to Aust Co is the same as N Value of Ozzie Co's equity capital and debt deduction free debt attributable to Aust Co on a measurement day (T) 0.9 0.95 Step 2A.8: Ozzie Co's total equity capital is the same as T because Aust Co owns 100% of Ozzie Co Ozzie Co's total equity capital and debt deduction free debt on a measurement day (U) 0.9 0.95 Step 2A.9: The proportion of Ozzie Co's equity capital held by Aust Co is 100% on both days T   U (V) 1 1 Step 2A.10: The attributable safe harbour excess amount is the proportion of equity capital held by Aust Co (100%) multiplied by Ozzie Co's excess borrowing capacity S   V (W) 0.54 0.57 Step 2A.11: The associate entity excess amount on a measurement day is the sum of the premium excess amount and the attributable safe harbour excess amount P + W (X) 0.6 0.6 Step 2A.12: Aust Co has only one associate entity so Y is the same as X Transfer from X (Y) 0.6 0.6 Step 2A.13: Y is calculated for the other measurement day (this has been done in the far right column) Step 2A.14: The average associate entity excess amount is calculated by adding the results at Y (\$600,000 and \$600,000) and dividing by two – the number of measurement days (\$600,000 + \$600,000)/2 (L) 0.6Transfer to L on worksheet 2

Aust Co's safe harbour debt amount is \$6,300,000, which is less than its adjusted average debt. Aust Co can calculate an alternative amount under either the worldwide gearing debt amount test or the arm's length debt amount test, though neither amount may be higher than the safe harbour debt amount. Alternatively, it can choose to use the safe harbour debt amount as its maximum allowable debt.

Step 3: Calculate Aust Co's worldwide gearing debt amount

Aust Co is not foreign controlled so it uses the method statement in section 820-110 to calculate its worldwide gearing debt amount.

Worksheet 3: Aust Co's step 3

 Steps Worksheet 3 Step 3.1: Aust Co's worldwide debt is \$17m. \$12m is owed by Aust Co to a third party and \$5m owed by For Sub to a third party The \$3m loan from Aust Co to For Sub is not included because worldwide debt does not include debt lent from an entity within the worldwide group Worldwide debt (Z) \$17m Step 3.2: Aust Co's worldwide equity is \$10.5m; that is. \$3.5m equity interests held in Aust Co and the \$7m retained earnings in For Sub The \$2m equity invested in For Sub by Aust Co is not included because worldwide equity does not include equity invested from an entity within the worldwide group Worldwide equity (AA) \$10.5m Step 3.3: Aust Co's worldwide gearing ratio is calculated by dividing its worldwide debt by its worldwide equity Z   AA (BB) 1.619047 Step 3.4: Insert the amount of BB at CC BB (CC) 1.619047 Step 3.5: Add 1 (one) to the amount at CC CC + 1 (DD) 2.619047 Step 3.6: Divide the amount at CC by the amount at DD CC   DD (EE) 0.618182 Step 3.7: The gearing ratio is applied to Aust Co's net assets as calculated at J on worksheet 2 EE   \$9.5m (FF) \$5,872,729 Step 3.8: The average value of Aust Co's associate entity excess amount is \$601,364 Average associate entity excess amount from GG on worksheet 3A (GG) \$601,364 Step 3.9: Aust Co's worldwide gearing debt amount is calculated by adding the amounts at FF and GG Worldwide gearing debt amountFF + GG \$6,474,093

Step 3A: Calculate Aust Co's average associate entity excess amount for the worldwide gearing debt amount

Worksheet 3A: Aust Co's step 3A

 Steps Worksheet 3A 1 July 2007 \$m 30 June 2008 \$m Step 3A.1: The value of Aust Co's associate entity equity on both measurement days is the \$1m invested in Ozzie Co Aust Co's associate entity equity on a measurement day (M) 1 1 Step 3A.2: The value of Ozzie Co's equity capital attributable to Aust Co's equity interests in Ozzie Co is \$900,000 on 1 July and \$950,000 on 30 June Ozzie Co's equity capital attributable to Aust Co's equity interests on a measurement day (N) 0.9 0.95 Step 3A.3: Aust Co's premium excess amount is calculated by deducting N from M and multiplying the result by the worldwide gearing ratio calculated at EE on worksheet 3 (M – N)   EE (HH) 0.0618182 0.0309091 Step 3A.4: The attributable safe harbour excess amount has been calculated at W on worksheet 2A Attributable safe harbour excess amount (from W on worksheet 2A) (W) 0.54 0.57 Step 3A.5: The associate entity excess amount is the sum of the premium excess amount and the attributable safe harbour excess amount HH + W (JJ) 0.601818 0.600909 Step 3A.6: Aust Co has only one associate entity so KK is the same as JJ Transfer from JJ (KK) 0.601818 0.600909 Step 3A.7: KK is calculated for the other measurement day. This has been done in the far right column Step 3A.8: The average associate entity excess amount is calculated by adding the results at KK (\$601,818 and \$600,909 and dividing by 2, which is the number of measurement days (\$601,818 + \$600,909) / 2 (GG) \$601,364 (transfer to GG on worksheet 3)

Aust Co's worldwide gearing debt amount is \$6,474,093. This is more than its safe harbour debt amount. Aust Co can calculate an alternative amount under the arm's length debt test. Aust Co could also choose to not calculate an arm's length debt amount (as this may be less than worldwide gearing debt amount as well) and use the worldwide gearing debt amount as its maximum allowable debt to calculate the proportion of debt deductions that is disallowed.

Step 4: Calculate Aust Co's arm's length debt amount

For the purposes of this exercise, assume Aust Co chooses not to calculate an arm's length debt amount.

Step 5: Calculate Aust Co's debt deductions disallowed

Aust Co's maximum allowable debt is \$6,474,093 – the worldwide gearing debt amount, being the greatest of the three amounts. As Aust Co's adjusted average debt (\$9 million) is more than its maximum allowable debt, a proportion of its debt deductions will be disallowed under the thin capitalisation rules.

Aust Co's debt deductions are \$2,100,000.

Worksheet 5: Aust Co's step 5

 Steps Step 5.1: Aust Co's adjusted average debt is \$9m and its maximum allowable debt is \$6,474,090 Excess debt (\$9m − \$\$6.474m) (LL) \$2.526m Step 5.2: Aust Co's average debt is \$12m Average debt (MM) \$12m Step 5.3: Divide the amount at LL by the amount at MM to calculate the proportion to be applied to Aust Co's debt deductions LL   MM (\$2.526m   \$12m) (NN) 0.2105 Step 5.4: Aust Co's debt deductions for the income year are \$2,100,000 Debt deductions for the year (PP) \$2,100,000 Step 5.5: The amount of debt deductions disallowed is calculated by multiplying the amount at NN by the amount at PP NN   PP= 0.2105   \$2,100,000 \$442,050

Aust Co cannot deduct \$442,050 of its debt deductions.