House of Representatives

Taxation Laws Amendment Bill (No. 4) 2002

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 1 - Thin capitalisation

Outline of chapter

1.1 This chapter explains amendments to the thin capitalisation provisions contained in Division 820 of the ITAA 1997 and amendments to the ITAA 1936. Legislative references are to the ITAA 1997 unless otherwise stated. The amendments ensure that the thin capitalisation regime operates as intended, will improve the integrity of the regime and clarify the operation of the law.

Context of amendments

1.2 Division 820 introduced a new thin capitalisation regime consistent with recommendations of A Tax System Redesigned . The objective of the regime is to ensure that multinational entities do not allocate an excessive amount of debt to their Australian operations. Following implementation of the new rules, a number of amendments are required largely to ensure that the rules operate as intended.

Summary of new law

1.3 This bill will amend the ITAA 1997 and the ITAA 1936 to:

·
exclude assets that are used principally for private or domestic purposes and exclude non-debt liabilities that are principally of a private or domestic nature;
·
ensure that the Australian assets threshold rule operates as intended;
·
ensure consistent treatment of interest-free loans and prevent manipulation of the thin capitalisation calculations through the use of these loans;
·
clarify the record keeping requirements in relation to the arms length debt amount and arms length capital amount;
·
remove the unintended consequences of the associate entity provisions on the control rules;
·
ensure that associate entity equity, associate entity debt, controlled foreign entity equity and controlled foreign entity debt have their intended meanings; and
·
clarify the operation of the law.

Comparison of key features of new law and current law
New law Current law
Assets that are used or held for use wholly or principally for private or domestic purposes and non-debt liabilities that are wholly or principally of a private or domestic nature are excluded from the thin capitalisation calculations. These assets and non-debt liabilities are included in thin capitalisation calculations.
In calculating the asset threshold, assets held by associate entities are not double counted. Additionally, assets not used in an entitys Australian operations are excluded from the definition of average Australian assets. In calculating the asset threshold, assets held by associate entities are double counted. The current definition of average Australian asset is so broad as to include many assets not used in Australian operations (e.g. most assets of foreign associates).
An entity relying on an arms length amount will be required to prepare records before it lodges its tax return for the particular income year. An entity must keep records on the arms length debt amount or arms length capital amount that it worked out for the purposes of the thin capitalisation regime. However, the thin capitalisation provisions do not currently specify when these records must be prepared.
Debt interests that do not give rise to debt deductions because the costs associated with the debt are not allowable deductions will be treated as quasi-equity. The thin capitalisation provisions treat some loans as debt where they have interest expenses or other similar types of costs associated with them but which are not deductible because of the operation of section 8-1.
Interest free debt that is included in adjusted average debt is now called cost-free debt capital and will apply to all lenders that could potentially provide interest free loans. Where the lender is not subject to thin capitalisation calculations there is an exemption for long-term interest-free debt. An integrity measure includes some interest free loans in adjusted average debt where the lender and the borrower have different valuation days.
Interest free loans are included in the calculation of the disallowed deductions where those loans are included in an entitys adjusted average debt. The calculation for determining the amount of deduction disallowed uses the definition of average debt. This definition does not include interest free loans.
Interest free loans that are included in the calculation of adjusted average debt for the borrower will not be included in the associate entity equity of the lender. Additionally, they will not be included in the associate entity debt of the lender. However, they will remain associate entity equity if the loan is made to an exempt entity or an entity that is not subject to the thin capitalisation calculations. Interest free loans are always treated as associate entity equityfor the lender.
Interest free loans will be included in CFE equity and excluded from CFE debt. Interest free debt is included in controlled foreign entity debt and excluded from controlled foreign entity equity.

An interest in a foreign entity only qualifies as associate entity equity or associate entity debt to the extent that it is attributable to Australian operations.

An interest in a foreign entity only qualifies as CFE equity or CFE debt to the extent that it is not attributable to Australian operations.

An equity or debt interest that meets the definition of associate entity equity (or associate entity debt) and CFE equity or CFE debt may be deducted twice from assets in calculating the safeharbour amounts.
In calculating the safeharbour excess amount, cost-free debt capital is not included in determining an investing entitys equity in an associate entity. In calculating the proportion of equity held in the associate entity all interest free debt is included.
In calculating the premium excess amount, negative amounts of equity capital are taken to be nil. Where the associate entitys equity capital is less than zero, the premium excess amount can be inflated because a negative amount can be deducted in calculating the premium excess amount.
In calculating a premium excess amount, interest free loans are excluded. Interest free loans which qualify as associate entity equity are included in calculating the premium excess amount.

Associate entity debt treatment will not be available where:

·
the loan costs are not deductible; or
·
the borrower is an exempt entity or is otherwise not subject to thin capitalisation rules.

Associate entity debt treatment is provided where:

·
the loan costs are not deductible; or
·
the borrower is an exempt entity or is otherwise not subject to thin capitalisation rules.

Detailed explanation of new law

Private use assets and non-debt liabilities of a private or domestic nature

1.4 Assets are an important element in the application of the thin capitalisation regime because the level of acceptable debt funding is calculated by reference to the amount of Australian assets. Assets are also important in the context of the assets threshold rule in section 820-37 as entities which satisfy the rule do not need to comply with the thin capitalisation rules. The value of an entitys non-debt liabilities is also a relevant factor in calculating its acceptable level of debt.

1.5 The existing thin capitalisation provisions do not make a distinction between business and private use assets. Consequently, private use assets are included in undertaking calculations under the regime. Although the term non-debt liabilities is a defined term, the definition does not make a distinction between non-debt liabilities that are of a business nature and those that are of a private or domestic nature.

1.6 The requirement to include private use assets in undertaking the thin capitalisation calculations increases compliance costs especially in the case of individuals. For example, in certain situations the legislation could require an individual to value private use assets such as household items.

1.7 In order to reduce compliance costs the Government has decided to exclude from the application of Division 820 assets that are used wholly or principally for private or domestic purposes. Assets that are held for use wholly or principally for private or domestic purposes are also excluded. This will ensure that assets that are not actually used by an entity but which are held for private or domestic purposes fall within the exclusion. [Schedule 1, item 3, section 820-32]

1.8 Non-debt liabilities that are wholly or principally of a private or domestic nature will also be excluded to ensure consistency between the treatment of assets and the treatment of non-debt liabilities. [Schedule 1, item 3, section 820-32]

1.9 It should be noted that debt capital of a private or domestic nature does not give rise to similar problems because of the definition of adjusted average debt. Adjusted average debt generally only includes debt capital that gives rise to debt deductions. Debt capital of a private or domestic nature is excluded from the regime because it does not give rise to debt deductions under section 8-1.

The assets threshold rule

1.10 The assets threshold test contained in section 820-37 excludes from the thin capitalisation regime Australian entities, which are not foreign controlled, with relatively small overseas investments. The exclusion applies where the foreign assets of an entity and its associates represent 10% or less of the combined total assets. Two issues have been identified which require amendments in order to ensure that the rule operates as intended.

1.11 Firstly, the calculation of an entitys average Australian assets and average total assets can be distorted because of double counting of some assets. Where one entity (A) holds equity in, or lends funds to, an associate (B) there is potential for essentially the same assets to be counted in both entities. For example, the equity interest held by A in B will be counted in calculating As assets. The assets held by B which are funded by As equity interest in B will be counted in calculating Bs assets. This bill amends the definition of average Australian assets and average total assets to prevent such double counting. This is achieved by excluding assets comprised by the equity interests an entity holds in associates and the debt interests it holds which have been issued by associates. [Schedule 1, items 4 and 5, section 820-37]

1.12 The second issue relates to the category of asset which is included in the calculation of average Australian assets for foreign associates of the entity. Under the existing definition all assets of a foreign associate are included in calculating average Australian assets. This distorts the calculation because non-Australian assets are also included. To remove this distortion the term average Australian assets for foreign entities will be defined to mean:

·
assets located in Australia;
·
assets attributable to the entitys Australian PEs; or
·
equity interests or debt interests issued by Australian entities to the extent that those interests are not attributable to the issuers foreign PEs.

[Schedule 1, items 4 and 6, section 820-37]

Foreign tax credits

1.13 The New Business Tax System (Thin Capitalisation) Act 2001 amended subsection 160AF(8) of the ITAA 1936 to ensure that in determining the amount of allowable foreign tax credits, debt deductions, to the extent that they are not attributable to a taxpayers overseas PE, do not reduce net foreign income. A technical amendment to subsection 160AF(8) is required to ensure that the measure has its intended effect. [Schedule 1, item 43, subsection 160AF(8) of the ITAA 1936]

Arms length debt amount and arms length capital amount

1.14 Section 820-980 provides that an entity must keep records on the arms length debt amount or arms length capital amount that it worked out for the purposes of the thin capitalisation regime. Those records must contain particulars about the factual assumptions and relevant factors that are taken into account. However, the thin capitalisation provisions do not currently specify when these records must be prepared.

1.15 Section 820-980 will be amended in order to clarify the law. An entity relying on an arms length amount will be required to prepare these records before it lodges its tax return for the particular income year [Schedule 1, item 38, subsection 820-980(3)] . Failure to comply with this requirement will render a person liable to prosecution or an administrative penalty [Schedule 1, item 44, paragraph 262A(3)(d) of the ITAA 1936] .

Definition of financial entity

1.16 The thin capitalisation provisions contain special rules for financial entities. In order to apply those rules a definition of the term financial entity is contained in subsection 995-1(1). Paragraph (c) of that definition includes an entity that:

·
is a financial services licensee within the meaning of the Corporations Act 2001 whose licence covers dealings in financial products mentioned in paragraphs 764(1)(a), (b) and (j) of that Act;
·
carries on a business of dealing in securities; and
·
does not carry on that business predominantly for the purposes of dealing in securities with, or on behalf of, the entitys associates.

1.17 The existing definition requires that an entity holds a licence which covers all 3 of the financial products mentioned. However, under the new financial products regime in the Corporations Act 2001 entities may apply for a licence that covers only one financial product. The bill amends the definition so that entities will only need to hold a licence that covers at least one of the financial products referred to in the current definition rather than a licence which includes all of those products. [Schedule 1, item 42, definition of financial entity in subsection 995-1(1)]

The control rules and the associate entity definition

1.18 Division 820 has comprehensive rules which measure control interests held by foreign entities in Australian entities and to determine whether an Australian entity is a controller of a controlled foreign entity. These control interests are referred to as TC control interests. TC control interests measure both direct and indirect interests in an entity as well as direct and indirect interests in an entity held by associate entities. It is the latter situation which is the subject of this amendment.

1.19 The term associate entity is defined in section 820-905. Subsection 820-905(3A) makes 2 entities (e.g. B and C) associate entities of each other if both B and C are associate entities of a third entity (A). The extension of associate entity definition in this way has had unintended consequences for the TC control interest rules.

Example 1.1 A (a foreign company) has a 100% Australian subsidiary (B) and a 100% foreign subsidiary (C). Under the associate entity rules both B and C are associate entities of A and vice-versa. Additionally, subsection 820-905(3A) deems B and C to be associate entities of each other. The thin capitalisation rules classify B as an inward investor. Under this scenario, the section 820-905(3A) relationship does not impact on the outcome.

1.20 If, in Example 1.1, the foreign subsidiary (C) controls another foreign entity, the Australian subsidiary becomes an outward investor because of the impact of subsection 820-905(3A) on the TC control interest rules. However, the appropriate outcome is for the Australian subsidiary to be an inward investor in both cases. One implication of the current law is that if an Australian authorised deposit-taking institution is classified as an outward investor it will be subject to the thin capitalisation rules. If it is an inward investor it could rely only on the capital adequacy rules issued by the Australian Prudential Regulation Authority and not be subject to the thin capitalisation rules.

1.21 In order to address this issue the bill amends sections 820-815, 820-820 and 820-825 so that the TC control rules do not apply where the:

·
entity is an associate entity because of section 820-905(3A); and
·
the associate entity is not an Australian entity.

[Schedule 1, items 23 to 27, subsections 820-815(2), 820-820(3) and 820-825(2)]

1.22 To avoid unintended consequences for controlled foreign entity equity and debt from these amendments (and those made earlier because of subsection 820-905(3B)), the definitions of these terms will be amended. They will extend to controlled foreign entities of which an associate entity of the tested entity is an Australian controller. [Schedule 1, item 28, paragraph 820-881(b)]

Transitional rule for hybrid instruments

1.23 Consistent with the general transitional measures in the New Business Tax System (Debt and Equity) Act 2001 , the Income Tax (Transitional Provisions) Act 1997 contains thin capitalisation transitional measures in sections 820-35 and 820-40. These measures ensure that the issuer of an interest that changes character from 1 July 2001 as a result of applying the debt/equity rules to the interest is not disadvantaged for a transitional period of up to 4 years. The thin capitalisation transitional rules also ensure that the holder of the interest is not affected for a 4 year transitional period.

1.24 Specific transitional measures are provided in the debt/equity rules at subsection 974-75(4) for at call loans. At call loans issued between 21 February 2001 and 31 December 2002 will be debt interests until 1 January 2003.

1.25 The interaction of the general thin capitalisation transitional measures and the specific transitional measure for at call loans in the debt/equity rules means that at call loans issued on or after 21 February 2001 and before 1 July 2001 are subject to 2 transitional regimes:

·
the debt/equity rules at subsection 974-75(4) until 31 December 2002; and
·
the thin capitalisation rules from 1 January 2003 until 30 June 2004.

1.26 Industry has requested that only one set of transitional rules apply to at call loans to simplify the law and minimise the compliance burden. Consequently, the Government is amending the law to ensure that the general thin capitalisation transitional rules do not apply to at call loans. This amendment will not affect issuers as the interest would be treated as equity for thin capitalisation purposes from 1 January 2003 under either of the transitional rules.

1.27 However, holders of the interest may be affected as what would have been a debt interest from 1 January 2003 to 30 June 2004 under the thin capitalisation transitional measure will now be an equity interest. This is consistent with the intention of the at call loan transitional provision that such loans would only be treated as debt until 31 December 2002. [Schedule 1, item 45, subsection 820-40(1) of the Income Tax (Transitional Provisions) Act 1997]

Interest free debt

1.28 The term debt deduction is defined in section 820-40. Broadly speaking, a debt deduction is the cost incurred in connection with a debt interest that is deductible, subject to the thin capitalisation rules. These costs include but are not limited to interest payments. Where a debt interest does not give rise to a debt deduction it may be referred to as debt deduction free debt. However, in this chapter for ease of explanation, debt deduction free debt is referred to as an interest free loan. Similarly, the issuer and the holder of a debt interest are referred to as the borrower and the lender, respectively.

1.29 Where an entity has been provided with an interest free loan, that loan is treated as quasi-equity and is generally not included in the calculation of adjusted average debt of that entity for thin capitalisation purposes. This recognises that although the funds are not equity they provide capital to fund the entitys operations for which no debt deductions are claimed.

1.30 The legislation includes a number of integrity measures with respect to interest free loans to ensure that they are not used to manipulate the thin capitalisation rules. For example:

·
these loans cannot give rise to debt deductions in any year of income;
·
these loans are treated as associate entity equity for the lender; and
·
the lender and the borrower must use the same measurement days when calculating average values under the regime (if not the loan is counted as debt for the borrower).

1.31 A number of issues have been identified with respect to interest free loans that produce inappropriate outcomes. These include:

·
the inclusion of loans that are interest free because the costs associated with them do not give rise to debt deductions. These loans are not the type of loan that is really interest free and their inclusion distorts a number of calculations;
·
the lender of an interest free loan may have to include the loan as associate entity equity although the borrower must treat the loan as debt;
·
an interest free loan is always denied quasi-equity treatment where it has been provided by an entity that does not have to undertake thin capitalisation calculations;
·
the calculation of the amount of debt deductions to be disallowed does not include an interest free loan as debt where it has been denied quasi-equity treatment;
·
inconsistent treatment of interest free loans in the calculation of the premium excess amount; and
·
loans that have been denied quasi-equity treatment are included as quasi-equity in calculating the attributable safeharbour excess amount.

1.32 Consequently, a number of amendments are made by this bill to address these problems.

Loans that have costs but the costs are not deductible

1.33 The thin capitalisation provisions treat some types of loans as interest free although they may have interest expenses or other similar types of costs associated with them but these costs do not give rise to debt deductions. This is true, for example, for debt interests of capital nature, or where the costs have been incurred in deriving exempt income. These types of loans will not ordinarily enter the thin capitalisation calculations and their inclusion and treatment as interest free loans distort the calculation of a number of important items such as adjusted average debt.

1.34 Consequently, debt interests that do not give rise to debt deductions because the costs associated with the debt are not allowable deductions will be treated as quasi-equity. These are not the types of loans that would be made to intentionally subvert the operation of the thin capitalisation rules. That is, only certain truly interest free debt will be counted as debt in the calculations.

1.35 Specifically, loans that give rise to costs which are not deductible will not be included in the borrowers adjusted average debt. In addition, these loans will be included in the calculation of the lenders associate entity equity. [Schedule 1, item 8, subsection 820-85(3), item 17, subsection 820-120(2), item 19, subsection 820-185(3), item 21, subsection 820-225(2), item 30, paragraph 820-915(3)(c) and item 37, section 820-946]

Cost-free debt capital

1.36 Broadly, interest free loans that do not have any costs associated with them will be included in adjusted average debt but only where:

·
the lender and the borrower use different valuation days or a different number of valuation days; or
·
the loan is for less than 180 days.

1.37 The effect of treating interest free loans as quasi-equity is that the borrowers assets (other funding remaining unchanged) increase without any corresponding increase to its adjusted average debt. This creates the opportunity for the safeharbour debt amount calculations to be manipulated by providing an interest free loan and then repaying it shortly after the borrowing entitys valuation day.

1.38 An integrity measure operates within the definition of adjusted average debt so that an interest free loan is included as adjusted average debt where the borrower and the lender do not use the same valuation days for thin capitalisation purposes. A valuation day is a day on which an entity measures the value of its assets, liabilities and debt.

1.39 The integrity measure is deficient as it:

·
does not capture all lenders that could possibly provide interest free loans;
·
denies quasi-equity treatment where an interest free loan has been provided by a lender that does not have valuation days; and
·
does not recognise that the costs associated with the loan may not give rise to debt deductions.

1.40 To address this, the integrity measure will now apply to all lenders that could potentially provide interest free loans and introduces the 180 day rule. It is based on the new concept of cost-free debt capital. Where an interest free loan meets the definition of cost-free debt capital it will not be treated as quasi-equity but as adjusted average debt. [Schedule 1, item 8, subsection 820-85(3), item 17, subsection 820-120(2), item 19, subsection 820-185(3), item 21, subsection 820-225(2) and item 41, definition of cost-free debt capital in subsection 995-1(1)]

1.41 Cost-free debt capital is defined in new Subdivision 820-KA [Schedule 1, item 37, section 820-946] . The definition has 3 components. Firstly, it identifies to which borrowers the provision applies. Secondly, it identifies the relevant debt interests of those borrowers. Thirdly, it provides certain conditions that must be met by the borrower and lender or the loan.

The borrower

1.42 Whether cost-free debt capital applies to a borrower depends on the classification of the borrower. Cost-free debt capital may arise for a borrower where:

·
the borrower is an outward investing or inward investing entity (non-ADI);
·
if the borrower is a foreign entity, it holds assets that are attributable to an Australian PE or other assets held to produce its assessable income;
·
the borrower is not an exempt entity; and
·
neither of the threshold tests in sections 820-35 and 820-37 operates to prevent the borrowers debt deductions being disallowed.

[Schedule 1, item 37, subsection 820-946(1)]

Qualifying interest free loans

1.43 Cost-free debt capital comprises the total value of loans that:

·
do not give rise to costs covered by paragraph 820-40(1)(a); when
·
at least one of 3 conditions is satisfied.

[Schedule 1, item 37, subsection 820-946(2)]

1.44 Only loans which are free of costs can qualify as cost-free debt capital. Although these are described as interest free loans in this chapter, the costs covered by the provision are broader than interest. Paragraph 820-40(1)(a) forms part of the definition of debt deduction. Broadly, it covers costs for the use of financial benefits received by the entity under the debt interest arrangement and costs directly incurred in obtaining or maintaining those benefits. It should be noted, however, that paragraph 820-40(1)(a) must be read in conjunction with subsections 820-40(2) and (3) which specify costs that are expressly included and others that are excluded.

1.45 In relation to borrowers that are foreign entities, interest free loans to them are taken into account for the purposes of cost-free debt capital only to the extent that the loans relate to their Australian investments. That is, they must be partly or wholly attributable to assets that are attributable to an Australian PE or other assets held to produce assessable income. This means that part of a debt of a foreign entity may qualify as cost-free debt capital. [Schedule 1, item 37, subsection 820-946(5)]

1.46 The conditions to be met by the borrower and lender, or by the loan, depend on whether subsection 820-946(1) also applies to the lender. That is:

·
the lender is an outward investing or inward investing entity (non-ADI);
·
if the lender is a foreign entity, it holds assets that are attributable to an Australian PE or other assets held to produce its assessable income;
·
the lender is not an exempt entity; and
·
neither of the threshold tests in sections 820-35 and 820-37 operates to prevent the lenders debt deductions being disallowed.

[Schedule 1, item 37, subsections 820-946(3) and (4)]

1.47 Where the lender satisfies these requirements, a loan will be cost-free debt capital only if either of the following is satisfied:

·
the valuation days used to calculate the average value of the lenders assets are different from the valuation days used to calculate the borrowers adjusted average debt; or
·
the number of valuation days used to calculate the average value of the lenders assets is different from the number of valuation days used to calculate the borrowers adjusted average debt.

[Schedule 1, item 37, subsection 820-946(3)]

1.48 In all other cases, a loan will be cost-free debt capital only if the loan has been on issue for less than 180 days. [Schedule 1, item 37, subsection 820-946(4)]

1.49 The following flowchart provides a graphical representation of how cost-free debt capital is determined.

Further amendments resulting from the changes to interest free loans

1.50 These changes to the treatment of interest free loans will have a number of implications. These are discussed in paragraphs 1.51 to 1.58.

Amount of debt deduction disallowed

1.51 Currently, the calculation for determining the amount of deduction disallowed under the thin capitalisation regime does not include interest free loans on the basis that they receive quasi-equity treatment. However, where the interest free loan has been denied quasi-equity treatment (because it is cost-free debt capital and is treated as debt) the exclusion of this debt results in an incorrect outcome. Consequently, the definition of average debt will be amended so that it includes interest free loans where those loans are included in an entitys adjusted average debt. [Schedule 1, item 15, section 820-115, item 18, subsection 820-120(4), item 20, section 820-220 and item 22, subsection 820-225(3)]

Associate entity equity

1.52 In general, interest free loans are treated as associate entity equityfor the lender. This provides for consistency of treatment between the lender and the borrower and prevents the cascading of equity through the use of interest free loans.

1.53 However, where the interest free loan has been denied quasi-equity treatment in the borrowing entity (because it is cost-free debt capital and is treated as debt) there is an inconsistency in treatment between the lender and the borrower. The definition of associate entity equity will be amended so that an interest free loan (or any portion of it) that is cost-free debt capital for the borrower will not be included in the associate entity equity of the lender. [Schedule 1, item 30, subsection 820-915(3)]

Associate entity equity, associate entity debt, controlled foreign entity debt and controlled foreign entity equity

1.54 Under the existing law interest free debt is included in CFE debt and is excluded from CFE equity. This treatment does not recognise that interest free debt is generally treated as quasi-equity and is thus included in associate entity equity. This inconsistency creates a number of anomalies in the application of the thin capitalisation rules. In particular, in calculating the safeharbour debt amount for non-ADIs, interest free loans provided to a CFE are deducted twice from the assets of the taxpayer. Firstly, as associate entity equity and secondly as CFE debt. To ensure consistent treatment, interest free loans will only be included in CFE equity and will be excluded from CFE debt. [Schedule 1, item 28, subsections 820-885(1) and 820-890(1)]

1.55 However, the more substantive issue is to ensure that any equity or debt interest that meets the definition of associate entity equity (or associate entity debt) and CFE equity or CFE debt is not deducted twice from assets in calculating the safeharbour amounts. There are a number of specific provisions in the method statements that seek to ensure that double counting does not take place. However, this may not cover all possible situations as the example in paragraph 1.54 demonstrates. Consequently, to remove any possible overlap:

·
an interest in a foreign entity only qualifies as associate entity equity or associate entity debt to the extent that it is attributable to Australian operations [Schedule 1, item 29, subsection 820-910(4) and item 30, subsection 820-915(4)] ;and
·
an interest in a foreign entity only qualifies as CFE equity or CFE debt to the extent that it is not attributable to Australian operations [Schedule 1, item 28, subsections 820-885(2) and 820-890(2), item 39, definition of controlled foreign entity debt in subsection 995-1(1) and item 40, definition of controlled foreign entity equity in subsection 995-1(1)] .

1.56 This means that an interest free loan to a CFC that operates a PE in Australia (but has no other Australian investments) will be associate entity equity to the extent that the loan is used to fund operations of the PE and CFE equity to the extent that it funds the non-PE operations. For example, a $100 interest free loan to the CFC could be $20 associate entity equity and $80 CFE equity.

1.57 It also means that an entity cannot have associate entity equity in a foreign entity that has no Australian operations. [Schedule 1, item 30, paragraph 820-915(2)(b)]

1.58 As a consequence of this amendment, the specific steps in the method statements that seek to avoid the double counting will be removed. [Schedule 1, item 7, subsection 820-85(3), item 9, section 820-95, item 10, section 820-95, item 11, subsection 820-100(2), item 12, subsection 820-100(2), item 13, subsection 820-100(3), item 14, subsection 820-100(3) and item 16, subsection 820-120(2)]

Other amendments

Associate entity excess amount

1.59 Associate entity equity is deducted from an entitys assets as an integrity measure to prevent over-gearing from the cascading of equity through chains of entities. The associate entity equity rule can produce harsh outcomes where the value of the associate entity equity is not used to fully leverage debt in the associate. In order to address this, the associate entity excess amount allows excess debt capacity of an associate entity to be carried back to the entity with the equity investment. An amendment will be made to clarify the operation of the associate entity excess amount and recognise that both equity and debt interests can be associate entity equity. [Schedule 1, item 31, subsection 820-920(1), item 32, subsection 820-920(2) and item 33, subsection 820-920(2)]

1.60 The associate entity excess amount is made up of 2 components: the attributable safeharbour excess amount and the premium excess amount.

Premium excess amount

1.61 A premium excess amount arises where the books of account of the investing entity and those of the associate place different values on the assets of the associate. The debt capacity attributable to any such difference is the premium excess amount.

Negative equity

1.62 Where the associate entitys equity capital is less than zero, the premium excess amount can be inflated because a negative amount is deducted in the method statement in subsection 820-920(3). This has the effect of producing a premium excess amount which is greater than the amount deducted for associate entity equity. In order to correct this anomaly, negative amounts of equity capital will be taken to be nil. [Schedule 1, item 34, subsection 820-920(3)]

Interest free loans

1.63 Step 1 of the method statement in subsection 820-920(3) inadvertently includes interest free loans held by the investing entity through the use of the term associate entity equity. This distorts the calculation of the premium excess amount because these loans are not included in the equity capital of the associate entity at step 2. To remove the distortion, step 1 of the method statement will be amended to exclude any debt interests that are included in the calculation of associate entity equity. [Schedule 1, item 34, subsection 820-920(3)]

Equity capital of the associate entity

1.64 In the current legislation, step 1 of the premium excess amount removes CFE equity from the associate entity equity in the calculation of the premium excess amount. As associate entity equity and CFE equity are now mutually exclusive as outlined in paragraph 1.55, the removal of CFE equity is unnecessary in step 1. Consequently the reference to CFE equity will be removed from step 1. [Schedule 1, item 34, subsection 820-920(3)]

1.65 Another consequence of applying the new definition of associate entity equity at step 1 of the method statement is that there will be a mismatch of concepts in step 2 that could lead to erroneous results. The problem is that associate entity equity for a foreign entity is determined on the basis of Australian operations whereas there is no such apportionment for equity capital in step 2. An amendment will be made to step 2 to ensure that equity capital will only relate to Australian operations. This is achieved by ensuring that equity capital in step 2 does not include an amount that is CFE equity for the test entity. [Schedule 1, item 34, subsection 820-920(3)]

Safeharbour excess amount

1.66 As discussed in paragraph 1.60, the associate entity excess amount is comprised of the premium excess amount and the attributable safeharbour excess amount. The attributable safeharbour excess amount allows the carry back of excess debt capacity from an associate entity to an investing entity on the basis of the proportion of total equity the investing entity holds in the associate. In calculating the proportion of equity held in the associate entity, steps 3 and 4 in subsection 820-920(4) include amounts of interest free debt provided on the basis that it will be treated as quasi-equity. However, where an interest free loan meets the definition of cost-free debt capital it should not be included in the calculation as it has lost its quasi-equity status. Consequently, steps 3 and 4 will be amended to ensure that any cost-free debt capital is not included in determining an investing entitys equity in an associate entity. [Schedule 1, item 35, subsection 820-920(4) and item 36, subsections 820-920(5) and (6)]

Associate entity debt

1.67 Where an entity borrows funds and on-lends those funds to an associate entity, the same pool of funds could be tested in both entities when in economic terms there is only one loan transaction. The associate entity debt rule eliminates the debt in the interposed lending entity so that the same pool of funds is not tested twice. A requirement of this rule is that it is only provided to an entity where the debt is tested in another entity.

1.68 However, the current legislation is deficient in a number of respects as it provides associate entity debt treatment where:

·
the loan is interest free and is treated as quasi-equity for the borrower in applying the thin capitalisation rules;
·
the borrower is an exempt entity and the thin capitalisation rules do not apply; and
·
thin capitalisation calculations do not apply because the borrower satisfies the requirements for exemption in sections 820-35 and 820-37.

1.69 In each of these cases the associate entity debt rule provides an unintended advantage to the lender by reducing its tested debt. This outcome can be exploited by tailoring loans to meet the above criteria thus subverting the thin capitalisation rules.

1.70 Consequently, the associate entity debt definition will be amended to ensure that associate entity debt can exist only:

·
where the loan gives rise to debt deductions for the associate entity (i.e. an interest free loan will not be associate entity debt); and
·
the associate entity is not freed from the thin capitalisation rules because of the threshold rules in section 820-35 or section 820-37 or because it is a tax exempt entity.

[Schedule 1, item 29, subsections 920-910(2) and (3)]

1.71 The definition of associate entity debt will also be amended to make it clear that, where a foreign entity is the issuer of the debt interest, the interest is only included to the extent that it is attributable to Australian operations (see paragraph 1.55 for explanation of this amendment). [Schedule 1, item 29, subsection 820-910(4)]

Interests acquired in an associate or controlled foreign entity

1.72 The current definitions of associate entity equity, associate entity debt and controlled foreign entity debt only include some interests if they have been directly issued to the tested entity by its associate entity or the controlled entity. This could have unintended consequences, either advantageous or disadvantageous for taxpayers, if interests have been acquired via another party or on the secondary market. To correct this anomaly, the definitions will be amended to ensure that they apply to interests held by the entity irrespective of how they have been acquired. [Schedule 1, item 28, section 820-885, item 29, section 820-910 and item 30, section 820-915]

Application and transitional provisions

1.73 The amendments made by Schedule 1 will apply from the start of a taxpayers first income year beginning on or after 1 July 2001 when Division 820 began to apply. [Schedule 1, items 46 to 48]


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