Senate

Revised Explanatory Memorandum

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

Chapter 3 - Thin capitalisation - application to groups containing certain authorised deposit-taking institutions

Outline of chapter

3.1 Schedule 3 to this Bill introduces a choice mechanism under which a particular type of authorised deposit-taking institution (ADI) - known as a specialist credit card institution - may, in certain circumstances, be treated for thin capitalisation purposes as if it was not an ADI but rather as if it was a financial entity.

3.2 Unless otherwise stated, all legislative references are to the Income Tax Assessment Act 1997 .

Context of amendments

3.3 The thin capitalisation rules in Division 820 are designed to ensure both Australian and foreign-owned multinational entities do not allocate an excessive amount of debt to their Australian operations. The rules operate to disallow a proportion of otherwise deductible finance expenses (eg, interest) where the debt used to fund the Australian operations exceeds certain thresholds.

3.4 Entities may determine their thin capitalisation position using various tests - the 'safe harbour' test, the 'arm's length' test and the 'worldwide gearing' test. The tests require the calculation of an entity's debt, assets and/or equity.

3.5 The calculation methods depend on whether the entity is an ADI (as defined in the Banking Act 1959 ), a financial entity that is not an ADI, or a general entity (neither an ADI nor a financial entity).

3.6 Entities are also classified on the basis of whether they are outward investing or foreign-controlled, and calculation methods differ to a degree depending on this classification.

3.7 In relation to consolidated or multiple entry consolidated groups (MEC groups), the thin capitalisation rules applied to the head company of the group depend on the composition of the group (eg, whether it contains ADIs or non-ADIs; inward or outward-investors).

3.8 If the consolidated or MEC group contains an entity that is an 'outward investing entity (ADI)', the thin capitalisation rules are applied to the head company as if it was such an entity (subsection 820-583(7)). Thus, the head company is required to adopt the calculations applying to outward investing ADIs in Subdivision 820-D.

3.9 If the head company uses the safe harbour test in Subdivision 820-D, it must calculate the 'safe harbour capital amount', which requires determination of the risk-weighted assets of entities within the group in accordance with prudential standards (section 820-310). Risk-weighted assets also form part of the calculation of the 'worldwide capital amount' for the purposes of the worldwide gearing test (section 820-320).

3.10 At the time the current thin capitalisation rules commenced in 2001, all ADIs were prudentially supervised (including the setting of capital adequacy requirements) on both a stand-alone and a consolidated group basis. This meant the requirement to risk-weight assets was applied to the ADI as an individual entity, and to other financial entities in the same group as the ADI (with some exceptions).

3.11 In view of this, it was seen as appropriate that the thin capitalisation rules provide for groups containing ADIs to adopt calculations similar to those required for prudential purposes, in order to minimise compliance costs.

3.12 In 2003, as part of reforms to the credit card market, a new class of ADI, known as specialist credit card institutions, was established by the Australian Prudential Regulation Authority (APRA). Specialist credit card institutions are authorised to conduct only limited banking business and, consequently, APRA supervises them differently to other ADIs.

3.13 In particular, 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 to the wider corporate group.

3.14 The advent of ADIs whose capital adequacy is not determined on a consolidated group basis for prudential purposes was not foreseeable when the thin capitalisation rules were introduced. Hence, the rules require all consolidated or MEC groups containing ADIs to determine capital adequacy taking into account risk-weighted assets on a group-wide basis. In the case of groups containing only specialist credit card institutions, this would unnecessarily increase compliance costs.

Summary of new law

3.15 These amendments will allow the head company of a consolidated or MEC group containing one or more ADIs 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.

3.16 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 .

3.17 These amendments will also allow:

•

the head company of a consolidated or MEC group; or

•

a single Australian resident company that cannot consolidate,

that chooses to treat as part of itself the Australian permanent establishments of a foreign bank (the 'establishment entity'), to apply the thin capitalisation rules as if the head company or single company was an outward investing entity (non-ADI) or inward investing entity (non-ADI), as the case may be, where, if any of the head company, single company or establishment entity is an ADI, they are also a specialist credit card institution.

3.18 The exemption from the thin capitalisation rules for the head company of a consolidated group under section 820-585 will not apply where all of the ADIs in the group are specialist credit card institutions.

Comparison of key features of new law and current law

Detailed explanation of new law

Choice to treat specialist credit card institutions as financial entities

3.19 Subsection 820-583(7) sets out the circumstances in which the head company of a consolidated or MEC group will be treated as an outward investing entity (ADI). These conditions are (disregarding the consolidation provisions) that:

•

at least one member of the group is an outward investing entity (ADI); or

•

at least one member of the group is an outward investing entity (non-ADI) and at least one other member of the group is an ADI.

3.20 Where, during a period that is all or part of an income year, a consolidated or MEC group contains one or more ADIs and all of those ADIs are specialist credit card institutions, the head company may choose to apply the thin capitalisation rules as if the group did not contain any ADIs during that period. If there is more than one period in an income year where all of the ADIs in the group are specialist credit card institutions, and the head company makes the choice mentioned above, that choice applies in respect of all of those periods within that income year. [Schedule 3, item 2, subsections 820-588(1) and (2)]

3.21 If the choice is made, each specialist credit card institution in the group will be treated, for the purposes of Division 820, as if it was a financial entity during the relevant period(s). The result is that the head company of the group will no longer be classified under section 820-583 as an outward investing entity (ADI) during the period(s), but rather 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. Hence, Subdivision 820-B or 820-C will apply to the head company instead of Subdivision 820-D. [Schedule 3, item 2, subsection 820-588(1) , notes 1 and 2]

3.22 A specialist credit card institution is defined as an ADI authorised to carry on banking business (as defined in the Banking Act 1959 ) consisting only of credit card acquiring and/or issuing (as defined under the banking regulations) 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 . [Schedule 3, item 2, subsection 820-588(3)]

3.23 Once the choice to apply the thin capitalisation rules as if the group did not contain any ADIs has been made in respect of a particular income year, it may not be revoked. [Schedule 3, item 2, subsection 820-588(4)]

3.24 However, the choice is available in respect of each income year and a head company may, for example, exercise the choice in one income year and not in the next.

Example 3.1

Forco wholly-owns all of the shares in Austco 1 and Austco 2. Austco 1 and Austco 2 formed a MEC group on 1 July 2003, with Austco 1 as the provisional head company. Austco 1 owns all of the shares of Austco 3.

On 1 August 2004 Austco 3 is authorised by APRA as a specialist credit card institution. None of the other members of the MEC group are ADIs or financial entities during the income year, which begins on 1 January.

Austco 1 as the head company of the MEC group makes a choice under section 820-588 in respect of Austco 3 for the period commencing 1 August 2004 to 31 December 2004. Consequently, for the purposes of Division 820, the head company of the MEC group applies the thin capitalisation provisions as if it were an inward investment vehicle (financial) for the period 1 August 2004 to 31 December 2004.

Example 3.2

Assume the same facts as for Example 3.1, except that Austco 2 is a financial entity for the whole of the income year ended 31 December 2004.

For the purposes of Division 820, the head company of the MEC group applies the thin capitalisation provisions as if it were an inward investment vehicle (financial) for the whole of the income year ended 31 December 2004. It is not necessary to break the year into part-year periods because a choice has been made under section 820-588 to treat Austco 3 as a financial entity from the time of its authorisation by APRA as a specialist credit card institution.

Interaction of the choice mechanism with section 820-587

3.25 Section 820-587 applies the rules in Subdivision 820-D for outward investing entities (ADI) to MEC groups to which they would not otherwise apply.

3.26 An example of the intended application of section 820-587 was provided in paragraph 6.27 of the explanatory memorandum to the New Business Tax System (Consolidation and Other Measures) Bill (No. 1) 2002 , which inserted the section. The example indicated that the section would apply to a MEC group where a foreign bank has two wholly-owned Australian subsidiaries, one being a bank and the other not a bank, where the latter is not owned by the Australian bank and so does not come under APRA supervision.

3.27 If the choice under proposed section 820-588 is made by the head company of a MEC group, section 820-587 will not apply. This is because the effect of making the choice under section 820-588 is that none of the members of the group is an ADI. Therefore, the requirement in paragraph 820-587(b) that at least one member of the group is both a foreign controlled Australian entity and an ADI will not be satisfied.

Section 820-585 is not to apply where the group contains only specialist credit card institutions

3.28 Section 820-585 essentially provides that a consolidated group will not have any debt deductions denied under the thin capitalisation rules where the head company of the group, in its own right, is either a foreign-controlled Australian ADI that does not qualify as an outward investing entity (ADI), or a foreign-controlled Australian company that is a pure ADI holding company.

3.29 This provision was inserted into the law because the capital adequacy requirements of APRA were considered sufficient in relation to such head companies and it was, therefore, unnecessary to also apply thin capitalisation rules.

3.30 However, this view was formed on the basis that all ADIs were, at the time, supervised by APRA on a consolidated group basis for prudential purposes. Because groups containing specialist credit card institutions but no other type of ADI are not prudentially supervised on a consolidated group basis, the application of section 820-585 is inappropriate.

3.31 These amendments, therefore, specify that section 820-585 does not apply to the head company of a consolidated group containing one or more ADIs if, at that time, all ADIs that are members of the group are specialist credit card institutions. It should be noted that section 820-585 will not apply to such a head company regardless of whether it makes the choice under proposed section 820-588. [Schedule 3, item 1, subsection 820-585(3)]

Subdivision 820-FB

3.32 Subdivision 820-FB allows:

•

the head company of a consolidated or MEC group; or

•

a single Australian resident company that cannot consolidate,

to treat as part of itself the Australian branch of a foreign bank or foreign financial entity. The Australian branch is referred to in the Subdivision as the 'Australian permanent establishment', and the foreign bank or foreign financial entity is the 'establishment entity'.

3.33 APRA's guidelines on the establishment of specialist credit card institutions allow for the possibility that a foreign credit card bank might establish a branch in Australia that is authorised as a specialist credit card institution.

3.34 A similar choice mechanism will, therefore, apply in situations to which Subdivision 820-FB applies.

3.35 This means that:

•

the head company of a consolidated or MEC group; or

•

a single Australian resident company,

that treats as part of itself the Australian permanent establishments of an establishment entity, may choose to apply the thin capitalisation rules as if the head company or single company was an outward investing entity (non-ADI) or an inward investing entity (non-ADI), as the case requires if, where any of the head company, single company or establishment entity are ADIs, they are also specialist credit card institutions. [Schedule 3, item 5, section 820-610]

3.36 This choice has effect despite sections 820-85 and 820-185 (which define 'outward investing entity (non-ADI)' and 'inward investing entity (non-ADI)' respectively), and section 820-609 (which deals with the classification of a head company or single company that chooses to treat as part of itself the Australian permanent establishments of an establishment entity). [Schedule 3, item 5, subsection 820-610(4)]

3.37 To make clear that section 820-609 is subject to the choice mechanism in section 820-610, subsection 820-609(7) is amended to specifically refer to section 820-610. This amendment is required because subsection 820-609(7) currently provides that section 820-609 applies despite any other provision of Division 820, other than Subdivision 820-EA. [Schedule 3, item 4]

3.38 A consequential amendment is made to paragraph 820-609(2)(a). This amendment does not change the effect of the paragraph, but ensures it operates appropriately given the amendment to section 820-585 in item 1 of the Schedule. [Schedule 3, item 3]

3.39 Consequential amendments are also made to various definitions in subsection 995-1(1) as a result of the insertion of proposed sections 820-588 and 820-610. [Schedule 3, items 6 to 10]

Application and transitional provisions

3.40 These amendments will apply to income years beginning on or after 1 January 2004. This is because the ADIs that the amendments are relevant to (ie, specialist credit card institutions) were first authorised as ADIs by APRA in 2004. This retrospective application of the amendments will benefit taxpayers. [Schedule 3, item 11]