House of Representatives

Tax Laws Amendment (2008 Measures No. 5) Bill 2008

Explanatory Memorandum

Circulated By the Authority of the Treasurer, the Hon Wayne Swan Mp

Chapter 2

Thin capitalisation - modification of the rules in relation to application of accounting standards

Outline of chapter

2.1 Schedule 2 to this Bill modifies the thin capitalisation regime contained within Division 820 of the Income Tax Assessment Act 1997 (ITAA 1997) in relation to the use of accounting standards for identifying and valuing an entity's assets, liabilities and equity capital.

2.2 This measure aims to adjust for certain impacts of the 2005 adoption of the Australian equivalents to International Financial Reporting Standards (AIFRS) on an entity's thin capitalisation position. It does this by providing for the accounting standard treatment of specified assets and liabilities to be disregarded in certain circumstances.

2.3 This chapter outlines the circumstances in which certain assets and liabilities are not permitted to be recognised by particular entities for thin capitalisation purposes. This relates to deferred tax assets and liabilities, within the scope of Australian accounting standard AASB 112 Income Taxes , and assets and liabilities arising from defined benefit plans, within the scope of Australian accounting standard AASB 119 Employment Benefits .

2.4 It also outlines those circumstances in which particular entities may choose to recognise or revalue certain intangible assets, contrary to the relevant accounting standard. This primarily relates to intangible assets within the scope of Australian accounting standard AASB 138 Intangible Assets .

2.5 This chapter identifies that those entities using the authorised deposit-taking institutions' (ADIs) thin capitalisation rules are excluded from the scope of this measure.

2.6 All references to legislative provisions in this chapter are references to the ITAA 1997 unless otherwise stated.

Context of amendments

2.7 The thin capitalisation regime in Division 820 of the ITAA 1997 is designed to ensure that Australian and foreign-owned multinational entities do not allocate an excessive amount of debt to their Australian operations. It does this by disallowing a proportion of otherwise deductible finance expenses (eg, interest) where the debt used to fund the Australian operations exceeds certain limits.

2.8 Accounting standards are required to be used as the basis for the identification and valuation (including revaluation) of assets, liabilities and equity capital for thin capitalisation purposes.

2.9 This measure implements the joint announcement of the Treasurer and the Assistant Treasurer and Minister for Competition Policy and Consumer Affairs in Media Release No. 053 of 13 May 2008 that the Government will amend the thin capitalisation regime to accommodate certain impacts arising from the 1 January 2005 adoption of new accounting standards known as AIFRS.

2.10 These standards replaced the previous Australian Generally Accepted Accounting Principles . The adoption of AIFRS is regarded as aligning Australia more closely with international accounting practice. These standards generally take a more conservative approach to the recognition and valuation of assets and liabilities.

2.11 The Government announced amendments to allow entities subject to the thin capitalisation regime to depart from current accounting treatment in relation to certain intangible assets and exclude deferred tax assets and liabilities and surpluses and deficits in defined benefit superannuation funds in undertaking necessary calculations.

2.12 These amendments adjust for certain differences in treatment from the previous accounting standards, where the treatment under the new standards disregards the economic value attached to certain assets or would introduce volatility to thin capitalisation calculations. They are intended to provide a sounder economic base from which to undertake thin capitalisation calculations, rather than introduce more concessionary arrangements.

2.13 Prior to the new accounting standards, defined benefit plan assets and liabilities were not required to be recognised on balance sheets. These items are potentially volatile, consequent on changes in underlying actuarial assumptions. Further, it has been put forward that the new accounting requirements for income taxes has introduced volatility into the year-to-year thin capitalisation positions of entities. This means future investment planning is conducted in a less certain environment. It was concluded that exclusion was the best means of neutralising this volatility, without establishing an environment whereby taxpayers include such items only when it is favourable to do so. This latter position would be inconsistent with the tax system integrity role performed by the thin capitalisation regime.

2.14 It is also accepted that certain intangible assets may have an economic value greater than that permitted to be recognised by the new accounting standards. For example, monopoly distribution rights, despite the absence of an active market for such rights, could reasonably be expected to have a value over time that differs from the historic acquisition cost. The approach adopted in the accounting standards recognises uncertainty exists as to what that value may be. These amendments provide a framework to ensure a considered and fair value is recognised, which is as consistent as possible with the requirements embedded in the accounting standards.

2.15 This measure does not reflect an intention to neutralise all differences in outcome between the previous and current accounting standards, reflecting the obvious realignment of Australian financial reporting requirements with international practice and the key integrity role played by the thin capitalisation regime. It is not intended to provide entities with scope to artificially inflate their asset base to support higher gearing levels inconsistent with the broader intent of this regime.

2.16 These amendments effectively establish the framework to apply on expiration of the current transitional arrangements. The transitional arrangements enable entities to elect to apply the accounting standards as they existed at 31 December 2004 (rather than the current accounting standards) for a period of four income years commencing on or after 1 January 2005. These arrangements are set out in section 820-45 of the Income Tax (Transitional Provisions) Act 1997 .

Summary of new law

2.17 For income years commencing on or after the date this Bill receives Royal Assent, entities will be able to deviate from the accounting standard treatment of certain assets and liabilities.

2.18 Entities will not be permitted to recognise deferred tax assets or liabilities, or amounts arising from defined benefit plans that are required to be recognised as assets or liabilities.

2.19 Entities will be able to choose to recognise an intangible asset as an internally generated intangible asset, where recognition is currently prohibited under accounting standard AASB 138 Intangible Assets on the basis the asset cannot be reliably costed, provided other recognition requirements within the standard can be met. This relates primarily to internally generated brands, mastheads, publishing titles, customer lists and items similar in substance. Accounting standard requirements must then be complied with to the maximum extent possible (as if recognition were permitted). A choice may be revoked prospectively.

2.20 Entities will also be able to choose to revalue an intangible asset that is subject to the measurement requirements in AASB 138 Intangible Assets but is unable to use the revaluation method under that standard due to the absence of an active market. The revalued amount must be determined in accordance with the established rules, which include a requirement for the amount to be determined in compliance with the relevant accounting standards and for the valuation to be undertaken by an independent valuer or by an internal expert, using a valuation methodology endorsed by an external expert. A choice may be revoked prospectively.

2.21 These amendments will apply for all purposes under Division 820, other than for entities using the ADI inward and outward investing entities thin capitalisation rules or for the purposes of section 820-960, which establishes record-keeping obligations for Australian permanent establishments.

Comparison of key features of new law and current law

New law Current law
Certain entities must not recognise for thin capitalisation purposes assets or liabilities arising from defined benefit plans. Entities must recognise for thin capitalisation purposes assets and liabilities as required by the accounting standards.
Certain entities must not recognise for thin capitalisation purposes deferred tax assets or deferred tax liabilities. Entities must recognise for thin capitalisation purposes assets and liabilities as required by the accounting standards.
New law Current law
Certain entities may choose, in writing, to recognise for thin capitalisation purposes one or more internally generated intangible assets that are determined not to meet the recognition criteria under accounting standard AASB 138 Intangible Assets as they cannot be reliably costed, where they satisfy the other recognition requirements. Entities must recognise for thin capitalisation purposes assets and liabilities as required by the accounting standards.
Certain entities may choose, in writing, to revalue for thin capitalisation purposes one or more intangible assets that are unable to be revalued under accounting standard AASB 138 Intangible Assets due to the absence of an active market. Entities must recognise for thin capitalisation purposes assets and liabilities as required by the accounting standards.
Such revaluations must be undertaken in compliance with existing subsections 820-680(2) and (2A). No equivalent.
Recognition and revaluation under the above provisions must, to the maximum extent possible, comply with the accounting standards as if recognition or revaluation were permitted under the standard. No equivalent.
The above amendments do not apply for the purposes of the Australian permanent establishment record-keeping requirements identified in section 820-960. No equivalent.
The above amendments do not apply to entities subject to or electing to use the ADI inward or outward investing entities rules. No equivalent.

Detailed explanation of new law

2.22 Subsection 820-680(1) establishes that an entity must comply with the accounting standards in determining what are its assets and liabilities and in calculating the value of its assets, liabilities and equity capital when undertaking its thin capitalisation calculations. Subsection 820-680(1A) further states that an entity has an asset or liability at a particular time only if the accounting standard provides that the asset or liability can or must be recognised at that time. Accounting standards has the same meaning as in the Corporations Act 2001 .

Certain assets and liabilities not to be recognised for most thin capitalisation purposes

2.23 The amendments provide that certain assets and liabilities that would be required to be recognised for thin capitalisation purposes under the above provisions must not be recognised.

Deferred tax liabilities and assets not to be recognised

2.24 An entity must not recognise deferred tax liabilities or deferred tax assets for thin capitalisation purposes [Schedule 2, item 5, subsection 820-682(1)] . Recognition would, otherwise, be required as a consequence of Australian accounting standard AASB 112 Income Taxes .

2.25 This exclusion has application for all purposes under Division 820, other than:

·
in relation to entities using the thin capitalisation rules for ADI inward or outward investing entities

-
Subdivisions 820-D and 820-E [Schedule 2, item 5, subsection 820-682(3)] ; and

·
the record-keeping requirements applying to Australian permanent establishments in section 820-960 [Schedule 2, item 5, subsection 820-682(4)] .

2.26 The basis for the carve-out for entities using the ADI rules identified above reflects the different basis on which thin capitalisation calculations are undertaken for such entities, and the uncertain and potentially adverse impact these amendments may have for their thin capitalisation positions. This carve-out would apply to entities that elect to use the ADI rules under Subdivision 820-EA, but not to those entities that elect out of these rules under section 820-588.

2.27 The section 820-960 carve-out from the exclusion reflects the wider role performed by this record-keeping requirement, which makes it inappropriate for these records to reflect adjustments specific to thin capitalisation calculations. For example, these records are used for the purposes of Part IIIB of the Income Tax Assessment Act 1936 relating to Australian branches of foreign banks and other financial entities.

Defined benefit plan liabilities and assets not to be recognised

2.28 An entity must not recognise an amount arising from a defined benefit plan as an asset or liability for thin capitalisation purposes [Schedule 2, item 5, subsection 820-682(2)] . This would, otherwise, be required as a consequence of Australian accounting standard AASB 119 Employee Benefits .

2.29 This exclusion is intended to cover those circumstances in which an entity is required to recognise as assets or liabilities amounts arising from defined benefit plans provided as a direct consequence of its role as an employer providing post-employment benefits to employees or where such liabilities or assets are recognised by an entity on behalf of another member of a group.

2.30 This exclusion has application for all relevant purposes under Division 820, other than:

·
in relation to entities using the thin capitalisation rules for ADI inward or outward investing entities

-
Subdivisions 820-D and 820-E [Schedule 2, item 5, subsection 820-682(3)] ; and

·
the record-keeping requirements applying to Australian permanent establishments in section 820-960 [Schedule 2, item 5, subsection 820-682(4)] .

2.31 The basis for these carve-outs from the general exclusion is discussed in paragraphs 2.26 and 2.27.

An entity may choose to recognise certain internally generated intangible assets

2.32 Certain assets within the scope of Australian accounting standard AASB 138 Intangible Assets are prohibited from recognition as internally generated intangible assets under that standard. The basis for this exclusion is the determination within the standard that the expenditure on these items cannot be distinguished from the cost of developing the business as a whole (implying they cannot be reliably costed).

2.33 This relates to internally generated brands, mastheads, publishing titles, customer lists and items similar in substance (see paragraph 63 of AASB 138 Intangible Assets (compiled 25 October 2007)).

2.34 These amendments provide that an entity may choose to recognise, for a period relevant for thin capitalisation purposes, assets specified in this standard that are deemed to fail to meet the requirements to be recognised as internally generated intangible assets on the basis they cannot be reliably costed (as described in paragraphs 2.32 and 2.33), provided these assets meet the remaining recognition requirements in the standard [Schedule 2, item 5, subsections 820-683(1) and (2)] . For example, the prohibition within the standard on recognising expense incurred in the research phase would be applicable.

2.35 The relevant period would be all or part of an income year relevant for thin capitalisation purposes. This enables recognition of assets at all valuation points within that period, as identified in the average value methods identified in Subdivision 820-G.

2.36 Items recognised under these amendments must not amount to internally generated goodwill [Schedule 2, item 5, subsection 820-683(1)] . The distinction between internally generated goodwill and internally generated assets for accounting purposes is evident from paragraph 49 of AASB 138 Intangible Assets (compiled 25 October 2007), which provides that goodwill is not an identifiable resource. That is, it is neither separable (able to be sold, transferred, licensed etc) nor does it arise from contractual or other legal rights. Therefore, for an asset to be recognised (or revalued as described in paragraphs 2.43 to 2.55) under these provisions it must meet the identifiability criteria outlined in paragraph 12 of AASB 138 Intangible Assets .

2.37 A choice must be made, in writing, prior to the due date for lodging an entity's income tax return for the income year that contains the relevant period for thin capitalisation purposes. A choice may relate to one or more assets. The choice covers both the initial and future periods. However, once a choice has been made, it is irrevocable for periods for which the relevant income tax return lodgment due date has passed, for so long as the entity recognises that asset as an asset of the entity. [Schedule 2, item 5, subsection 820-683(3)]

2.38 A choice may be revoked in relation to future periods, provided this occurs, in writing, before the due date for lodging an entity's income tax return for the income year of the relevant next period for thin capitalisation purposes [Schedule 2, item 5, subsection 820-683(4)] . A decision to revoke a choice in relation to an asset does not mean that choice cannot be made again.

2.39 Once a choice has been made in relation to an asset, the requirements of the relevant accounting standards apply as if the asset had been able to be recognised under AASB 138 Intangible Assets [Schedule 2, item 5, subsection 820-683(5)] . For example, the measurement requirements applying at and following recognition will apply in determining the appropriate carrying amount to be used for thin capitalisation purposes. Similarly, the impairment testing requirements established within that standard would need to be satisfied.

2.40 As a natural outcome of this approach, where an asset is unable to be revalued under the above accounting standard due to the absence of an active market, the revaluation mechanism (see paragraphs 2.43 to 2.55) will be available to the entity in relation to that asset. [Schedule 2, item 5, subsection 820-683(5)]

Example 2.1 : Interaction of the recognition and revaluation provisions Maher Co manufactures an extremely popular range of branded products. It has developed its brand internally over an extended period.While identifiable as an intangible asset under AASB 138 Intangible Assets , the brand is not able to be recognised as an asset in the company's financial reports. Maher Co has, consequently, expensed the costs associated with its development.However, Maher Co is satisfied the brand is an intangible asset, there is an identifiable stream of expected future economic benefit that will flow to the company that is attributable to the asset and associated expenses do not relate to a research phase.As a result, Maher Co chooses, in writing, to recognise the brand as an asset for thin capitalisation calculation purposes.Maher Co then looks to the measurement and related requirements of AASB 138 and other relevant accounting standards as if the asset had been recognisable under that standard.Maher Co determines this asset would not be able to use the revaluation model within AASB 138, due to the absence of an active market. It then chooses, in writing, to use the revaluation provisions within the thin capitalisation rules.Maher Co has the masthead revalued by an independent expert. Having had regard, as far as practical, to the valuation requirements of the relevant accounting standards, the expert values the brand at $100.

2.41 The choice detailed above has application for all relevant purposes under Division 820 other than:

·
in relation to entities using the thin capitalisation rules for ADI inward or outward investing entities

-
Subdivisions 820-D and 820-E [Schedule 2, item 5, subsection 820-683(6)] ; and

·
the record-keeping requirements applying to Australian permanent establishments in section 820-960 [Schedule 2, item 5, subsection 820-683(2)] .

2.42 The basis for these carve-outs from the general exclusion is discussed in paragraphs 2.26 and 2.27.

An entity may elect to revalue certain intangible assets

2.43 In complying with Australian accounting standard AASB 138 Intangible Assets , intangible assets are unable to use the revaluation model within that standard where there is no active market. An active market is defined within the standard as a market in which all of the following conditions exist:

·
the items traded in the market are homogeneous;
·
willing buyers and sellers can normally be found at any time; and
·
prices are available to the public.

(The existence of an active market is the most reliable way of determining the fair value of an asset. However, the fair value of an asset is more broadly defined in the accounting standards to be the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction.)

2.44 In the above circumstance, an entity will be able to choose to revalue, consistent with the requirements established by these amendments, one or more of these assets for the relevant period (being all or part of an income year) [Schedule 2, item 5, subsections 820-684(1) and (2)] . This covers all relevant valuation points within that period, as identified in the average value methods in Subdivision 820-G. For example, where an entity has decided to use the opening and closing balances method for a period (see section 820-635), a revalued amount could be determined as the value for the first day of the period and for the last day of the period.

2.45 A choice to revalue an intangible asset under these provisions may be made in relation to any intangible asset required to comply with AASB 138 Intangible Assets in relation to measurement at, or following, recognition of that asset.

2.46 A choice must be made in writing, and may cover one or more assets, including assets recognised under new section 820-683 [Schedule 2, item 5, paragraph 820-684(3)(a)] . This choice must be made prior to an entity's due date for lodgment of its income tax return for a particular income year, and has effect for future periods [Schedule 2, item 5, paragraphs 820-684(3)(b) and (c)] . Once a choice is made in relation to an asset, it is irrevocable for periods for which the relevant income tax return lodgment date has passed. A decision to revoke the choice must be made, in writing, prior to the lodgment date for the entity's income tax return for a relevant period [Schedule 2, item 5, subsection 820-684(4)] . This does not imply the revaluation amount cannot be amended.

2.47 A decision to revoke a choice in relation to an asset does not mean that a choice cannot be made again.

2.48 Revaluations are required to be undertaken in a manner consistent with existing subsections 820-680(2) and (2B) [Schedule 2, item 5, subsection 820-684(5)] . These subsections, in essence, establish that revaluations must be undertaken either by an independent expert or by an internal expert, consistent with a valuation methodology that has been endorsed by an external expert. The carve-out from the requirement to satisfy subsection 820-680(2) embodied in subsection 820-680(2A) would be expected to have no practical application in these circumstances.

2.49 The revalued amount arising from this process must comply to the maximum extent possible with the requirements of the relevant accounting standards. That is, the carrying amount recognised for thin capitalisation purposes must reflect the accounting standard requirements that would have applied were revaluation permitted under accounting standard AASB 138 Intangible Assets . This includes incorporating impairment and amortisation adjustments, where applicable. [Schedule 2, item 5, subsection 820-684(6)]

2.50 The frequency of revaluation of an asset would be determined by reference to the general requirements of the accounting standards in relation to the revalued intangible asset. For example, AASB 138 Intangible Assets requires revaluations to be made with such regularity that at the reporting date the carrying amount of the asset does not differ materially from its fair value. For the purposes of these provisions, fair value would have its broader meaning (ie, without the requirement for it to be referenced to an active market). The impairment testing requirements and outcomes in Australian accounting standard AASB 136 Impairment of Assets apply.

2.51 The decision to permit a revaluation choice under these provisions to be revoked will allow entities to avoid unnecessary compliance costs associated with revaluation obligations, should these prove unwarranted in the future. The likelihood entities would switch between these provisions and accounting standard treatment to avoid the requirement to reflect a significantly reduced revalued amount, which is not the intent of these amendments, is minimised by Australian accounting standard AASB 136 Impairment of Assets . This standard requires, for example, the annual impairment testing of intangible assets with indefinite useful lives (to compare the carrying amount of the asset with its recoverable amount). This implies significant downward adjustments of a revalued amount are likely to be mimicked by a requirement to reduce the carrying amount under a cost model.

2.52 This approach seeks to ensure consistency with the valuation requirements applying to other assets and to minimise the scope for arbitrary outcomes that do not reflect valuation norms reflected in international accounting practice.

2.53 Existing record-keeping requirements in relation to revaluations and the independence of the valuer will apply to revaluations undertaken which are consistent with subsection 820-684(2). These record-keeping requirements are currently contained in section 820-985. [Schedule 2, items 7 and 8, subsections 820-985(1) and (3)]

2.54 The choice detailed above has application for all relevant purposes under Division 820, other than:

·
in relation to entities using the thin capitalisation rules for ADI inward or outward investing entities

-
Subdivisions 820-D and 820-E [Schedule 2, item 5, subsection 820-684(7)] ; and

·
the record-keeping requirements applying to Australian permanent establishments in section 820-960 [Schedule 2, item 5, subsection 820-684(2)] .

2.55 The basis for these carve-outs from the general exclusion is discussed in paragraphs 2.26 and 2.27.

Commissioner of Taxation's power to substitute a value

2.56 The Commissioner of Taxation's (Commissioner) power to substitute one value for another in certain circumstances will include values included in an entity's thin capitalisation schedule in relation to assets recognised or revalued under these amendments. [Schedule 2, item 6, section 820-960]

2.57 This power is modified to reflect the choices to recognise or revalue assets provided for under these amendments. The intention is that the Commissioner would not be able to substitute a value simply as a result of the exercise of such a choice, on the basis the outcome is inconsistent with the accounting standards. However, the Commissioner would be able to have regard to general valuation concepts within those standards in considering an appropriate carrying amount.

Application and transitional provisions

2.58 These amendments will apply to assessments for each income year commencing on or after the date this Bill receives Royal Assent. There may be a period of overlap for certain entities between the date of effect of these amendments and the application of the existing transitional provisions (see section 820-45 of the Income Tax (Transitional Provisions) Act 1997 ). In these circumstances, an entity that chooses not to use the transitional provisions will have immediate access to these provisions. An entity that has chosen to use the transitional provisions for one last year would theoretically have access to these provisions, but there is not expected to be any practical effect due to the differences between the old and new accounting standards in these areas. [Schedule 2, item 9]

Consequential amendments

2.59 Consequential amendments are made to insert notes advising modifications have been made to the general applicability of accounting standards for the identification and valuation of assets and liabilities for thin capitalisation purposes and in relation to the application of the existing independent valuation requirements. [Schedule 2, items 1 to 4, subsections 820-680(1), (1A), (2) and (2B)]


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