Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 8 - Calculating average values
Outline of chapter
8.1 This chapter explains how entities calculate the average values of assets, liabilities and equity. It also explains when the Commissioner may change a value calculated by an entity. The relevant rules are contained in Subdivision 820-G of this bill.
Context of reform
8.2 Entities must calculate average values for their assets, liabilities and equity in order to determine their maximum debt level (for non-ADI entities) or minimum capital level (for ADI entities). An average value is used in order to allow for the situation where debt is excessive, or equity is deficient, for only part of the period. The existing thin capitalisation provisions are very prescriptive as to frequency of measuring debt and equity even to the point of testing the greatest amount of foreign debt on a single day of the year.
8.3 Values of assets and liabilities are to be determined by reference to the relevant accounting standards. The standards also govern the manner in which amounts recorded in foreign currency are to be converted into Australian currency. The use of the accounting standards in this way allows for values other than cost to be used within the established set of rules which adds integrity to the process.
8.4 To ensure that average values are accurately reflected, the Commissioner may substitute a value if it is considered that either assets are overvalued or liabilities undervalued. This power, together with the requirement for all entities to apply the accounting standards when valuing an item, ensures integrity.
8.5 The provisions allow entities a choice as to the frequency of valuing their assets and liabilities. Providing options allows taxpayers to utilise their accounting records for thin capitalisation purposes. This flexibility minimises compliance costs by recognising that different entities may prepare records at different intervals.
Summary of new law
| How are asset values ascertained? | Values are determined according to the relevant accounting standards. | |
| Can assets be revalued for thin capitalisation purposes? | Assets can be revalued for thin capitalisation purposes provided they are revalued by an independent expert valuer and in accordance with accounting standards. | |
| What is the average value? | The average value is determined by measuring the matter on a certain number of days throughout the period and dividing the result by the number of measurement days. | |
| How many times are non-ADIs required to value matters? |
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| How many times are ADIs required to value matters? |
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| Can the Commissioner change the value determined by the entity? | Yes, but only if the Commissioner considers that assets have been overvalued or liabilities have been undervalued. He must have regard to accounting standards when calculating the new value. | |
| Do amounts recorded in foreign currency have to be converted into Australian dollars? | Yes, all amounts must be expressed in Australian dollars. Entities will be required to comply with the accounting standards when converting foreign currency amounts into Australian dollars. |
| New law | Current law |
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| Valuation of assets and conversion of amounts into Australian currency are undertaken in accordance with accounting standards. |
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Detailed explanation of new law
8.6 Subdivision 820-G sets out the methods available to taxpayers for calculating average values for assets and liabilities used in the various method statements throughout Division 820. Liabilities requiring valuation under Division 820 include non-debt liabilities and debt capital. These items are referred to as matters in Subdivision 820-G and in this chapter. Non-ADIs and ADIs are treated differently in some respects.
8.7 In addition, a transitional provision is provided for calculating the average value that may be applied by an entity in relation to a period that is all or part of the first income year which commences on or after 1 July 2001. [Schedule 1, item 22, section 820-25]
8.8 A non-ADI has the choice of 3 methods for determining the average values of matters [Schedule 1, item 1, subsection 820-630(1)] . The 3 methods are:
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- the opening and closing balances method (requiring 2 valuations in the period, discussed in paragraphs 8.14 to 8.16 [Schedule 1, item 1, section 820-635] ;
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- the 3 measurement days method (requiring 3 valuations in the period, discussed in paragraphs 8.17 to 8.20) [Schedule 1, item 1, section 820-640] ; or
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- the frequent measurement method (requiring valuations on a quarterly basis with the option of valuing some or all matters more frequently, discussed in paragraphs 8.21 to 8.32) [Schedule 1, item 1, section 820-645] .
8.9 The different methods successively require valuations to be undertaken at more frequent intervals. A choice between methods is available to allow non-ADIs to minimise compliance costs whilst applying the method that more accurately reflects the average values of its assets and liabilities. Thus, if the values do not change significantly throughout the period, the entity may choose to use the opening and closing balances method which requires valuations at only 2 points in the income year.
8.10 A non-ADI is required to consistently apply the same method throughout the income year, or any part of that year in which it is subject to the thin capitalisation rules, for all matters [Schedule 1, item 1, subsection 820-630(2)] . However, if the entity changes status part way through the year (e.g. it was an inward investing entity and becomes an outward investing entity part way through the year), the rules apply to each period separately so that a different measurement method can be used for each period. The method that is applied can also be changed from income year to income year.
Example 8.1
Aust Corporation is a wholly-owned subsidiary of Foreign Corporation (and is therefore an inward investment vehicle). It has a standard income year. On 1 January 2004, Aust Corporation begins to carry on business outside Australia through a permanent establishment. From this point forward, Aust Corporation is treated as an outward investing entity. From 1 July 2003 to 31 December 2003, Aust Corporation used the opening and closing balances method to establish average values. From 1 January 2004 to 30 June 2004, Aust Corporation can either continue to use the opening and closing balances method or can choose another method to establish average values.
8.11 If the entity does not apply the same method consistently throughout the relevant period to all matters, the Commissioner may recalculate all the average values for that period using the opening and closing balances method. This is irrespective of what methods the entity actually used to calculate average values for the period. [Schedule 1, item 1, subsection 820-630(3)]
8.12 As the exercise of this power may directly affect an entitys assessment, a person who is dissatisfied with a decision to recalculate all average values may object against the decision under Part IVC of the TAA 1953 .
8.13 ADIs can only use the frequent measurement method to calculate their average values (this method is discussed in paragraphs 8.21 to 8.32). This is consistent with reporting requirements imposed by APRA and most prudential regulators which mandate that ADIs must prepare accounts every quarter and must monitor their capital every day. Therefore, no additional compliance burden is imposed by requiring ADIs to apply the frequent measurement method because the value of matters may fluctuate throughout the income year. ADIs may find that applying the frequent measurement method will result in a more accurate valuation of their matters.
Opening and closing balances method
8.14 The opening and closing balances method requires the entity to measure the value of a matter on the first and last days of the period. The average of these amounts is then the average value for the income year or period for that matter. [Schedule 1, item 1, section 820-635]
8.15 The period involved can be part or all of an income year depending on the circumstances of the entity. For example, if the entity is an outward investing entity for the entire year, the period is the income year applying to that entity. However, if the entity changes status during an income year, for example if it commences to be an outward investing entity half way through the income year, the period is that second half of the income year.
8.16 As each period or income year will always have a first and last day, this method will be able to be used in all instances.
Example 8.2
XYZ Ltd, a non-ADI, held assets of $180 million on the first day of the income year. On the last day of the income year its assets were valued at $220 million. To calculate the average value these amounts are added together and divided by 2. The average value of its assets for the year is $200 million.
8.17 This method is based on an entity determining the average value of a particular matter by looking at 3 measurement days throughout a period. Again, the period can be either an income year or part of an income year, depending on the circumstances of the entity, but must be at least 6 months.
8.18 An entity can only apply the 3 measurement days method to a period that includes either the first half or the second half of its income year [Schedule 1, item 1, subsection 820-640(1)] . If the period does not include the above days then either the opening and closing balances method or the frequent measurement method must be used. The 3 measurement days method will always be available to an entity whose period is an income year as the period will include the last day of the first half of the income year and both the first and last days of that year.
Example 8.3
A non-ADI with a standard income year (e.g. 1 July 2003 to 30 June 2004) becomes an outward investing entity on 15 August 2003 and remains so for the rest of the income year. It can apply the 3 measurement days method as the last day of the first half of the income year, being 31 December 2003, and the last day of the income year, being 30 June 2004, both occur within the period. The 3 measurement days are 15 August 2003, 31 December 2003 and 30 June 2004.
However, if the entity became an outward investing entity on 15 March 2004 it could not apply this method as the last day of the first half of the income year, 31 December 2003, does not occur within the relevant period. The entity must apply either the opening and closing balances method or the frequent measurement method in these circumstances.
8.19 The average value of a matter under the 3 measurement day method is calculated as the average of the values of the matter determined on the first, second and third measurement days. [Schedule 1, item 1, subsection 820-640(2)]
8.20 The first measurement day is the first day of the period. The second measurement day is the last day of the first half of the income year (i.e. 31 December for non-ADI entities with an income year 1 July to 30 June). The third measurement day is the last day of the period. [Schedule 1, item 1, subsection 820-640(3)]
Example 8.4
International Ltd, which has a standard income year, held assets valued at $140 million on 14 August 2003, the day it became an outward investing entity (first measurement day). Assets held on 31 December 2003 were valued at $120 million (second measurement day), with $190 million being the value of assets on 30 June 2004, the last day of the income year (third measurement day). This means that the average value of assets for the period is $150 million.
International Ltd is able to use this method because the last day of the first half of the income year (31 December 2003) and the last day of the year (30 June 2004) occur within the period, therefore, paragraphs 820-640(1)(a) and (b) respectively are satisfied.
The frequent measurement method
8.21 The frequent measurement method will allow an entity to determine the average value of a particular matter using values obtained quarterly or more frequently [Schedule 1, item 1, subsection 820-645(1)] . This is the only method that ADI entities may use.
8.22 Under the frequent measurement method the average values will generally be determined using quarterly figures [Schedule 1, item 1, paragraph 820-645(1)(a)] . However, an entity can choose to use values determined on a more frequent basis for either some or all matters. If the entity measures only some matters more frequently, then any remaining matters will be measured on a quarterly basis [Schedule 1, item 1, subsection 820-645(1)] .
8.23 The frequent measurement method where values are determined quarterly will be referred to in this chapter as the quarterly option . Where an entity uses values for some or all matters determined more frequently than quarterly, this method will be referred to in this chapter as the more frequent option . [Schedule 1, item 1, subsection 820-645(1)]
8.24 The quarterly option calculates the average value of a matter as the average of the values of the matter determined on each of the following measurement days.
8.25 The measurement days for the quarterly option are:
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- the first day of the period (which will be either a full income year or a part of an income year, depending on the entitys circumstances);
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- the last day of each quarterly period that occurs in that period; and
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- the last day of that period if that day does not correspond with the last day of the final quarterly period.
[Schedule 1, item 1, subsection 820-645(2)]
8.26 The quarterly periods are the periods consisting of the first, second and third months of the income year and each successive period of 3 months thereafter [Schedule 1, item 1, subsection 820-645(3)] . Note, that these are determined by the entitys income year not the period for which it is applying the thin capitalisation rules. For example, the quarterly periods of an entity with a standard income year (1 July to 30 June) are the September, December, March and June quarters. The end of quarter measurement days are 30 September, 31 December, 31 March and 30 June.
8.27 For entities with substituted accounting periods, the first quarterly period is the period representing the first 3 months of the entitys income year. The following 3 month period will be the next quarter and so on. The measurement days are the last days of each of those quarters. [Schedule 1, item 1, subsection 820-645(3)]
Example 8.5
Quarter Ltd, which has a substituted accounting period ending 30 September, held assets valued at $120 million on 1 October 2003 (the first day of its income year). On the last day of each quarter for that year, the value of its assets was:
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- $110 million (31 December 2003);
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- $130 million (31 March 2004);
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- $150 million (30 June 2004); and
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- $90 million (30 September 2004).
Adding these amounts together and dividing by 5 (being the number of measurement days) gives an average value of assets for the year of $120 million.
8.28 The more frequent option calculates the average value of a matter as the sum of the values of the matter as at each measurement day divided by the number of measurement days. [Schedule 1, item 1, subsection 820-645(4)]
8.29 The measurement days for this method are:
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- the first day of the period;
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- the last day of each regular interval that occurs during the period; and
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- the last day of the period if it is not the last day of the final regular interval.
[Schedule 1, item 1, subsection 820-645(4)]
8.30 This option permits matters to be calculated on a more frequent basis [Schedule 1, item 1, paragraph 820-645(1)(b)] . This recognises that values may fluctuate throughout the income year and using values obtained more frequently may result in a more accurate average value. The current thin capitalisation rules in Division 16F of the ITAA 1936 allow debt to be measured on a daily basis in recognition of the variable nature of debt levels. This option is expanded under the new regime to apply to all other matters.
8.31 Under this option, the entity is able to either:
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- measure all matters at regular intervals on a more frequent basis; or
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- select some matters to be measured on a more frequent basis and measure the remaining matters on a quarterly basis.
[Schedule 1, item 1, paragraph 820-645(1)(b)]
8.32 The regular interval may be daily, weekly, monthly, or any other fixed period of days provided the interval is not less than one day and does not exceed 3 months [Schedule 1, item 1, subsection 820-645(5)] . The entity can therefore choose to value some or all of the matters as often as it sees fit within these limits to obtain an average value. However, the first regular interval must begin on the first day of the period and the same interval must be used for all of the matters which the entity has selected to measure more frequently than quarterly [Schedule 1, item 1, subsection 820-645(6)] . For example, if an entity elected to value liabilities and equity capital on a more frequent basis, the regular interval used for both must be the same. Assets could then be measured on a quarterly basis.
Example 8.6
Foreign Owned Ltd, an inward-investing entity (non-ADI) which has a standard income year, wishes to measure its debt capital and assets more frequently than quarterly. It must choose the same regular interval for both matters. It chooses a monthly basis. The relevant values are as follows:
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- On the first day of the year (1 July 2003) it had $80 million of debt capital and $160 million of assets.
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- Its debt capital on the last day of each of the first 4 months was $90 million and the value of its assets was $170 million.
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- The value of the debt capital on the last day of each of the next 4 months was $105 million and the value of its assets was $200 million.
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- The value of its debt capital on the last day of each of the final 4 months was $110 million and the value of its assets was $240 million.
These amounts are added together and divided by 13 (being the number of measurement days) to give an average value of debt capital for that period of $100 million and an average value of assets of $200 million.
Foreign Owned Ltd will then measure all other matters (e.g. non-debt liabilities) using the quarterly method (set out in paragraphs 8.24 to 8.27).
Special rules about values and valuations
8.33 There are specific rules dealing with converting amounts into Australian currency and determining what the value of assets, liabilities or equity capital is at a particular point in time. [Schedule 1, item 1, sections 820-675 and 820-680]
Converting to Australian currency
8.34 An amount, including a value used in a calculation, must be expressed in Australian currency for the purposes of Division 820 [Schedule 1, item 1, subsection 820-675(1)] . Entities are required to comply with the accounting standards when converting an amount from foreign currency to Australian currency [Schedule 1, item 1, subsection 820-675(2); Schedule 2, item 2, definition of accounting standards in subsection 995-1(1)] . However, the thin capitalisation provisions do not deal with the issue of whether foreign exchange gains or losses should be recognised for tax purposes.
8.35 For thin capitalisation purposes, the relevant accounting standards are those governing foreign currency translation made by the AASB. For example, AASB 1012: Foreign Currency Translation is one accounting standard that deals with converting an amount into Australian currency. It should be noted that the AASB may issue or revise the relevant accounting standards from time to time.
8.36 The accounting standards made by the AASB may not apply to all entities that will be required to undertake calculations under the new thin capitalisation regime. Nevertheless, if the thin capitalisation rules apply to an entity, it must comply with the accounting standards when converting an amount into Australian currency for the purposes of this bill. This will allow for consistent rules to be applied to all conversions. [Schedule 1, item 1, subsection 820-675(3)]
Valuation of assets, liabilities and equity
8.37 An entity must comply with the accounting standards in calculating the value of its assets, liabilities and equity. As with foreign currency conversions:
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- the relevant accounting standards are those made by the AASB; and
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- an entity must comply with the accounting standards whether or not it is otherwise required to do so under a particular standard.
[Schedule 1, item 1, subsection 820-680(1); Schedule 2, item 2, definition of accounting standards in subsection 995-1(1)]
8.38 For example, AASB 1015: Accounting for the Acquisition of Assets and AASB 1041: Revaluation of Non-current Assets are current accounting standards which deal with the valuation of assets.
8.39 Accounting standard AASB 1001 prescribes the concepts that guide the selection, application and disclosure of accounting policies. It provides that the appropriate accounting policy is one which results in relevant and reliable financial information. For these 2 qualities to be satisfied, the information needs to be free from bias and undue error. It must also represent the substance of the transaction where substance and form differ.
8.40 Accounting standard AASB 1024 requires that parent entities must prepare consolidated accounts. Entities may also be able to group under the thin capitalisation provisions, as discussed in Chapter 6. The threshold tests for whether an entity can group under this bill and whether they are required to prepare consolidated accounts are different. The former requires 100% ownership of subsidiaries (definitions in Subdivision 975-W of the ITAA 1997) and the latter relies on the ability to dominate the decision-making, directly or indirectly, in relation to the financial and operating policies of another (paragraph 9 definition of control). Thus, an entity that is required to prepare consolidated accounts under AASB 1024 may not necessarily be able to group under the thin capitalisation rules. However, it is considered that entities that may group under the thin capitalisation provisions will usually also be required to prepare consolidated accounts under AASB 1024. In order to comply with the accounting standards, the group for thin capitalisation purposes will be required to base its calculations on consolidated figures for the group prepared in accordance with AASB 1024. [Schedule 1, item 1, section 820-470]
8.41 An entity must also comply with any additional requirements imposed by the regulations in relation to the valuation of debt capital. [Schedule 1, item 1, section 820-685]
Revaluations of assets for thin capitalisation purposes
8.42 An entity may use a value for an asset for thin capitalisation purposes other than the value reflected in its books of account although that would not generally be expected to be the case. The new value must be ascertained by an independent valuation and in accordance with relevant accounting standards.
8.43 An independent valuation means a valuation made by a person:
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- who is an expert in relation to valuations of that class of asset; and
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- whose pecuniary or other interests could not reasonably be regarded as being capable of affecting the persons ability to give an unbiased opinion in relation to that valuation.
8.44 All assets in a class of assets (as per the financial statements) are to be valued on the same basis, either at cost or fair value. If all assets in a class of assets are carried at fair value the entity is required under the accounting standard AASB 1041 to make revaluations sufficiently regularly to ensure that the carrying amount of each asset in the class does not differ materially from its fair value at the reporting date.
8.45 For thin capitalisation purposes an entity is able to revalue a single asset in the class to reflect that assets fair value but only if it can show that the values of all other assets in the class are still at their fair values as required by AASB 1041. If an entity is recording the value of its assets at fair value it is expected that the value for thin capitalisation purposes would not be materially different from the value recorded in its accounts. If all assets in the class are valued on a cost basis, revaluation of a single asset is not permitted. However, the whole class of assets may be revalued.
8.46 The intent of the thin capitalisation provisions could be undermined if an entitys assets or liabilities are incorrectly valued. Incorrect valuation could affect, for example, the maximum allowable debt amount for non-ADIs or minimum capital amount for ADIs. The Commissioner therefore has a power to substitute an appropriate value for either assets or liabilities where the Commissioner considers that the entity has:
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- overvalued its assets; or
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- undervalued its liabilities.
8.47 Thus, even if the entity complied with the accounting standards, if the value arrived at is flawed in some way the Commissioner may invoke the discretion to substitute an appropriate value. For example, an asset value may have been calculated by reference to erroneous information resulting in an inappropriately high value. The Commissioner may use the discretion to substitute a more accurate value.
8.48 However, the discretion will not be employed merely because an item is off-balance sheet. It is only where the Commissioner considers that either the value of an asset is too high or the value of a liability is too low (whether the asset or liability is on- or off-balance sheet) that the discretion will be used.
8.49 In determining an appropriate value, the Commissioner must have regard to the relevant accounting standards. That is, the Commissioner will determine the value that would have been calculated had the relevant accounting standards been followed correctly and had the valuation been conducted on an independent basis using accurate and reliable information. [Schedule 1, item 1, section 820-690]
8.50 As the exercise of this power may directly affect an entitys assessment, a person who is dissatisfied with a decision to substitute a value may object against the decision under Part IVC of the TAA 1953.
8.51 The measurement and valuation of assets, liabilities and equity capital is a crucial component of the thin capitalisation provisions. These values directly impact on whether the prescribed debt limits or minimum capital requirements have been breached and if so the amount of debt deduction disallowed. The general anti-avoidance provisions of Part IVA of the ITAA 1936 may apply where these values are manipulated as part of a scheme entered into with the sole or dominant purpose of increasing the amount of debt deduction allowable to an entity.
Application and transitional provisions
8.52 A transitional provision provides a concession for calculating average values for the first income year beginning on or after 1 July 2001. Instead of using the rules set out in Subdivision 820-G for determining average values, entities may choose to use the values of all matters at the end of the relevant period as the average values. [Schedule 1, item 22, section 820-25]
Example 8.7
Global Co (an outward investor) has an income year beginning 1 September 2001 and ending 31 August 2002. It can choose to use the values ascertained on 31 August 2002 as the average when applying Division 820 to its 2001-2002 income year.
8.53 This measure recognises that some entities will need to re-finance in the first year of income in order to fall within the allowable limits.