House of Representatives

Tax and Superannuation Laws Amendment (2014 Measures No. 4) Bill 2014

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon J. B. Hockey MP)

Chapter 1 - Thin capitalisation

Outline of chapter

1.1 Schedule 1 to this Bill tightens the statutory limit settings in the thin capitalisation rules to ensure that multinationals do not allocate a disproportionate amount of debt to their Australian operations. Schedule 1 also increases the de minimis threshold to minimise compliance costs for small businesses, and introduces a new worldwide gearing debt test for inbound investors.

Context of amendments

1.2 The current thin capitalisation rules were introduced in 2001 following the Review of Business Taxation. It was intended to prevent multinationals from profit shifting by allocating a disproportionate amount of debt in their Australian operations, and claiming excessive debt deductions in Australia, thereby reducing their Australian taxable income. If the Australian operations are funded by excessive debt, they are said to be 'thinly capitalised'.

1.3 Multinationals have the commercial flexibility to determine where international financing can occur and how debt will be allocated within the group, through intra-group funding arrangements. This provides them with the opportunity to effectively choose the jurisdiction that deductions for interest are claimed in. For example, multinationals can allocate a greater proportion of debt to higher taxing jurisdictions where debt deductions are often more valuable. This behaviour can effectively reduce or negate Australian income tax while increasing after tax profits for the multinational group.

1.4 The thin capitalisation rules operate by disallowing a proportion of otherwise deductible debt related expenses where the debt allocated to a multinational's Australian operations exceeds certain limits (or where there is a capital shortfall in the case of authorised deposit-taking institutions (ADIs)). These limits are determined by reference to the greater of a 'safe harbour' debt amount, an 'arm's length' debt amount and, currently for certain outbound investors, the 'worldwide gearing' debt amount. This does not prevent the Australian operations from assuming higher levels of debt; however, the debt deductions will be denied where the relevant statutory debt limits are exceeded. For ADIs (principally banks), the tests are framed as a minimum requirement for equity capital based on prudential regulatory requirements.

1.5 Setting these statutory debt limits involve balancing a number of factors, including minimising unnecessary compliance costs for multinationals, ensuring that the debt limits do not impede the efficient allocation of capital, and maintaining the integrity of the revenue base.

1.6 When first introduced, the statutory debt limits were intended to provide broad coverage to accommodate commercial gearing levels across a range of industries. While gearing practices vary, recent data suggests these limits are now higher than the normal gearing levels of most corporates with independent financing arrangements, which is often less than 1:1 on a debt-to-equity basis.

1.7 The gap between the statutory debt limits and the actual gearing levels of most companies can have a distorting effect on debt allocation decisions for the Australian operations of domestic and foreign multinationals. It may encourage multinationals to allocate excessive debt to Australia for tax purposes, rather than for commercial reasons.

1.8 To address this, the Government announced on 6 November 2013 that it would proceed with reforms to tighten the thin capitalisation limits. It also announced that it would increase the de minimis threshold to minimise compliance costs for small businesses, and introduce a new worldwide gearing debt test for inbound investors.

Summary of new law

1.9 The thin capitalisation rules will be tightened to prevent erosion of the Australian tax base by:

reducing the maximum statutory debt limit from 3:1 to 1.5:1 (on a debt-to-equity basis) for general entities and from 20:1 to 15:1 (on a debt-to-equity basis) for non-bank financial entities;
reducing the 'outbound' worldwide gearing ratio from 120 per cent to 100 per cent with an equivalent adjustment to the worldwide capital ratio for ADIs; and
increasing the safe harbour capital limit for ADIs from 4 per cent to 6 per cent of their risk weighted Australian assets.

1.10 To minimise compliance costs for small businesses, the de minimis threshold for the thin capitalisation limits will be increased from $250,000 to $2 million of debt deductions.

1.11 To provide greater flexibility for inward investing entities, a new 'inbound' worldwide gearing debt test will be introduced. This test imports the commercial limits of the financial markets to gearing, and mirrors market outcomes for businesses that, as a whole, have naturally higher gearing levels. This will provide a further option to inward investing entities, where they do not fall within the safe harbour limit, and do not meet the arm's length debt test. To minimise compliance costs, this test will utilise the audited consolidated financial statements that are already required to be prepared by the worldwide parent entity.

Comparison of key features of new law and current law

New law Current law
The safe harbour debt limit for general entities (not an authorised deposit-taking institution (non-ADI)) is 1.5:1 on a debt-to-equity basis. The safe harbour debt limit for general entities (non-ADI) is 3:1 on a debt-to-equity basis.
The safe harbour debt limit for financial entities (non-ADI) is 15:1 on a debt-to-equity basis. The safe harbour debt limit for financial entities (non-ADI) is 20:1 on a debt-to-equity basis.
The safe harbour capital limit for an ADI is 6 per cent of its risk weighted Australian assets. The safe harbour capital limit for an ADI is 4 per cent of its risk weighted Australian assets.
The worldwide debt limit for outward investing entities (non-ADI) allows the Australian operations, in certain circumstances, to be geared at up to 100 per cent of the gearing of the entity's worldwide group. The worldwide debt limit for outward investing entities (non-ADI) allows the Australian operations, in certain circumstances, to be geared at up to 120 per cent of the gearing of the entity's worldwide group.
The worldwide capital amount for ADIs allows the entity's Australian operations to be capitalised at 100 per cent of the capital ratio of the Australian entity's worldwide group. The worldwide capital amount for ADIs allows the entity's Australian operations to be capitalised at 80 per cent of the capital ratio of the Australian entity's worldwide group.
The de minimis threshold is debt deductions of $2 million or less. The de minimis threshold is debt deductions of $250,000 or less.
A new worldwide gearing debt limit will be available to inward investing entities (and inward investment vehicles that are also outward investing), to be applied if the entity chooses, subject to an assets threshold. There is currently no equivalent test.

Key concepts and summary of current framework

1.12 There are a number of statutory debt limits (or in the case of ADIs a capital limit) currently set out in Division 820 of the Income Tax Assessment Act 1997 (ITAA 1997) (all section references are to the ITAA 1997 unless otherwise specified). These statutory limits vary depending on whether the entity is inward investing or outward investing, and the type of entity - general, financial or ADI.

Outward and inward investing entities

1.13 Different statutory debt limit tests apply depending on whether an entity is an inward investing entity or an outward investing entity.

1.14 An inward investing entity is a foreign controlled Australian resident entity, and any foreign entity that carries on business at or through an Australian permanent establishment, or has direct investments within Australia.

1.15 An outward investing entity is an Australian resident entity that controls any foreign entity or carries on business at or through an overseas permanent establishment, and an Australian associate entity of another outward investor.

ADI or non-ADI (general and financial)

1.16 An ADI is an authorised deposit-taking institution for the purposes of the Banking Act 1959.

1.17 In the case of non-ADIs, debt deductions will be disallowed where the maximum allowable debt is exceeded. In the case of ADIs, debt deductions will be disallowed where the minimum capital requirement is not met.

1.18 A non-ADI entity is further classified as being either a financial entity or a general entity. A financial entity is defined in section 995-1. A general entity is any entity that is neither a financial entity nor an ADI.

Summary of current debt limits

Maximum allowable debt (non-ADI)

1.19 A taxpayer's maximum allowable debt for both inward investing entities (non-ADI) and outward investing entities (non-ADI) is the greater of the following amounts:

the safe harbour debt limit: different limits apply depending on whether the entity is a general entity or a financial entity; or
the arm's length debt limit: this limit seeks to benchmark commercial or independent debt outcomes.

1.20 Outward investing entities (non-ADI) may also elect to apply the worldwide gearing debt limit, which allows gearing of the Australian operations based on the debt-to-equity ratio of the worldwide group.

Minimum capital amount (ADIs)

1.21 An ADI's minimum capital amount for both inward and outward investing entities is the lesser of the following amounts:

the safe harbour capital amount: this limit is based on the entity's risk-weighted Australian assets; or
the arm's length capital amount: this limit seeks to benchmark what would be the minimum amount of equity capital required by the bank to undertake its Australian business.

1.22 Outward investing entities (ADI) may also elect to apply the worldwide capital amount.

Detailed explanation of new law

Safe harbour debt limit (non-ADI)

1.23 The thin capitalisation rules, when first introduced, were intended to provide broad coverage to accommodate commercial gearing levels across a range of industries.

1.24 However, the gearing ratio allowed in the safe harbour debt limits is now much higher than the normal gearing levels of most corporates with independent arrangements.

1.25 To address this, the safe harbour debt limit for:

outward investors (general);
inward investors (general); and
inward investment vehicles (general),

are reduced from 3:1 to 1.5:1 on a debt-to-equity basis.

[Schedule 1, Part 1, items 1, 3 and 5, method statements in sections 820-95, 820-195, and 820-205]

1.26 The safe harbour debt limit for:

outward investors (financial);
inward investors (financial); and
inward investment vehicles (financial),

are reduced from 20:1 to 15:1 on a debt-to-equity basis.

[Schedule 1, Part 1, items 2, 4 and 6, method statements in subsections 820-100(2), 820-200(2), 820-210(2)]

1.27 The new safe harbour debt limit more closely aligns with commercial debt levels, and for financial entities the new safe harbour debt limit brings debt levels more closely into line with prudential standards as amended under Basel III.

Safe harbour capital amount (ADIs)

1.28 In contrast to non-ADIs, the safe harbour capital test for ADIs is determined by reference to a minimum capital amount (rather than a maximum allowable debt). Debt deductions claimed by the ADI may be disallowed if the minimum capital requirement is not met.

1.29 Under the current law, an inward investing ADI is required to have capital equal to 4 per cent of its Australian risk-weighted assets. An outward investing ADI is subject to the same minimum requirement, but must also have capital to match certain other Australian assets.

1.30 Under the new law, the safe harbour capital limit for inward and outward investing ADIs will be increased from 4 per cent to 6 per cent of their risk-weighted Australian assets. [Schedule 1, Part 4, items 15 to 17, method statement in subsections 820-310(1) and 820-615(3), and section 820-405]

1.31 The 'risk-weighted assets' of the entity means the sum of the assessed risk exposures of assets as calculated in accordance with the prudential standards determined by the prudential regulator in the jurisdiction of the foreign bank or by the Australian Prudential Regulation Authority.

Worldwide gearing debt limit for outward investing entities (non-ADI)

1.32 Currently, an outward investing entity (non-ADI) which is not also an inward investment vehicle may exceed the safe harbour debt amount without having debt deductions denied if it does not exceed the worldwide gearing debt amount.

1.33 The effect of the worldwide gearing rule is to allow the Australian operations, in certain circumstances, to be geared at up to the level of the gearing of the Australian entity's worldwide group.

1.34 The worldwide gearing ratio applying to general and financial outward investors, will be reduced from 120 per cent of the gearing of the entity's worldwide group to 100 per cent of the gearing of the entity's worldwide group. [Schedule 1, Part 2, items 11 and 12, method statements in section 820-110]

1.35 For the purposes of this test, the gearing of the entity's worldwide group is determined by reference to method statements contained in section 820-110.

1.36 A new worldwide gearing debt test will also be introduced for inward investing entities (non-ADI). The new test is explained below.

New worldwide gearing debt limit for inward investing entities (non-ADI)

1.37 The worldwide gearing debt test, currently only available to outward investing entities that are also not foreign controlled, will be extended to inward investing entities that are not an ADI [Schedule 1, Part 6]. The new test will also be available to an entity that is both an inward investment vehicle (non-ADI) and also an outward investing entity (non-ADI) [Schedule 1, Part 2, item 9, paragraph 820-90(2)(c)].

1.38 This will provide further flexibility to inward investing entities (non-ADI) that do not meet the safe harbour test or the arm's length debt test.

1.39 Allowing a worldwide gearing debt test to be available to inward investing entities (non-ADI) also, in the typical case, better reflects the policy intent of the thin capitalisation rules to prevent the disproportionate allocation of debt to Australia for income tax purposes. This is achieved by allowing the Australian operations to claim deductions on their debt where they are geared to the same level as the global group.

1.40 As a result, the new worldwide gearing debt test for inward investing entities (non-ADI) will provide greater flexibility by effectively importing the commercial considerations of financial markets to limit gearing in cases where the statutory safe harbour limits are exceeded.

1.41 Under the new law, the maximum allowable debt for an inward investing entity (non-ADI) in an income year will be the greatest of the following amounts:

the safe harbour debt amount;
the arm's length debt amount; or
the worldwide gearing debt amount unless:

-
the entity's statement worldwide equity, or statement worldwide assets is nil or negative;
-
audited consolidated financial statements do not exist; or
-
an assets threshold is satisfied.

[Schedule 1, Part 6, item 19, section 820-190]

Which types of entities can choose to apply the new test?

1.42 The new worldwide gearing debt test will be available to inward investing entities (non-ADI). That is, any of the following entities can choose to apply the new test, provided that certain requirements are met:

inward investment vehicles (general);
inward investment vehicles (financial);
inward investors (general); and
inward investors (financial).

[Schedule 1, Part 6, item 20, sections 820-216 to 820-219]

1.43 If an inward investment vehicle (non-ADI) is also an outward investing entity (non-ADI), then it can also choose to apply the new worldwide gearing debt test, provided that certain requirements are met. That is, the new worldwide gearing debt test will apply to:

an entity that is an inward investing entity (non-ADI); and
an entity that is both an inward investment vehicle (non-ADI) and also an outward investing entity (non-ADI) (unless it is the head of a consolidated group or multiple-entry consolidated (MEC) group, in which case, the worldwide gearing debt test in section 820-110 for outward investing entities would apply).

[Schedule 1, Parts 2 and 6, items 9 and 19 respectively, paragraphs 820-90(2)(c) and 820-190(1)(c)]

1.44 This ensures that an entity that is both an inward investment vehicle and an outward investing entity has access to the new inbound worldwide gearing debt test, as they cannot use the existing outbound worldwide gearing debt test under subsection 820-90(2) (other than the head of a consolidated or MEC group).

1.45 An entity cannot use the new worldwide gearing debt test unless it satisfies an assets threshold. Broadly, this threshold requires that the entity's Australian assets represent no more than 50 per cent of the consolidated group's worldwide assets.

1.46 That is, if the result of the following formula is greater than 0.5, the entity is not eligible to apply the new worldwide gearing debt test:

Average Australian assets fot eh entity / Statement worldwide assets of the entity for the income year

1.47 The intention of this asset threshold is to ensure that the thin capitalisation rules remain effective. Where the entity's Australian assets are greater than 50 per cent of the consolidated group's worldwide assets, the Australian operations can drive the worldwide gearing levels of the worldwide group. For this reason, a maximum threshold level of 50 per cent of Australian assets is considered appropriate to access the new worldwide gearing debt test.

1.48 The assets threshold test removes access to the worldwide gearing debt test for high gearing structures, such as private equity investment schemes, where a foreign entity with high levels of related party debt (often provided by shareholders) acquires an Australian target company, being the worldwide group's main asset.

1.49 The numerator ('average Australian assets' of the entity) is calculated as follows:

For inward investment vehicles that are also outward investing entities, the average Australian assets of the entity is the average value of all the assets of the entity, other than:

-
any assets attributable to the entity's overseas permanent establishments;
-
any debt interests held by the entity, to the extent to which any value of the interests is all or a part of the controlled foreign entity debt of the entity; or
-
any equity interests or debt interests held by the entity, to the extent to which any value of the interests is all or a part of the controlled foreign entity equity of the entity.

[Schedule 1, Part 2, item 9, subsection 820-90(3)]

For inward investment vehicles that are not also outward investing entities, the average Australian assets of the entity is the average value of all the assets of the entity, other than:

-
any debt interests held by the entity, to the extent to which any value of the interests is all or a part of the controlled foreign entity debt of the entity; or
-
any equity interests or debt interests held by the entity, to the extent to which any value of the interests is all or part of the controlled foreign entity equity of the entity.

[Schedule 1, Part 6, item 19, section 820-190, paragraph (a) of the definition of average Australian assets]

For inward investors, the average Australian assets of the entity is the average value of all the assets of the entity that are:

-
located in Australia;
-
attributable to the entity's Australian permanent establishments;
-
debt interests held by the entity, that were issued by an Australian entity and are on issue; and
-
equity interests held by the entity, in an Australian entity.

[Schedule 1, Part 6, item 19, paragraph 820-190(2)(c), paragraph (b) of the definition of average Australian assets]

1.50 The denominator ('statement worldwide assets') is the amount of assets shown in the audited consolidated financial statements referred to in section 820-935. These financial statements must, among other things, be the consolidated financial statements of the worldwide parent entity, comply with specified accounting standards, and be audited (see paragraphs 1.69 to 1.88 below for a further explanation about these requirements).

1.51 It is relevant to note that the numerator is calculated using Australian tax concepts (based on the definition of average Australian assets currently contained in section 820-37, with modifications) and the denominator is calculated using audited consolidated financial statements prepared in accordance with accounting concepts (which are relied upon further for the purposes of the applying the new worldwide gearing debt test - see below). These amounts have been chosen to provide an indicative assessment of the relative Australian to global assets of the group whilst minimising the compliance costs of applying the asset threshold test for the worldwide gearing debt test.

1.52 Pragmatically, it will be necessary to identify the period that the audited consolidated financial statements relate to and then calculate the average Australian assets for that same period, to ensure that both the numerator and denominator apply in relation to the same period [Schedule 1, items 9 and 19, subsections 820-90(4) and 820-190(3)]. Further, both the numerator and denominator must be expressed in Australian dollars.

Example 1.1 JMP is an overseas hedge fund which has investments in several countries, including Australia. JMP's average Australian assets (which are calculated using Australian tax law) are $3 billion, and its statement worldwide assets (which are calculated using the specified audited consolidated financial statements) are $10 billion. As JMP's asset threshold ratio is 0.30, it is eligible to use the new worldwide gearing debt test for inward investing entities (provided that its statement worldwide equity is a positive amount).

Example 1.2 MRP is an overseas private equity fund that has investments in several countries, including Australia. MRP's average Australian assets (which are calculated using Australian tax law) are $3 billion, and its statement worldwide assets (which are calculated using the specified audited consolidated financial statements) are $4 billion. As MRP's asset threshold ratio is greater than 0.50, it is not eligible to use the new worldwide gearing debt test for inward investing entities. MRP will need to apply either the 'safe harbour' debt test or the 'arm's length' debt test, to determine whether any debt deductions will be denied.

1.53 The asset threshold test is supported by an integrity rule that is intended to ensure that the asset threshold test is not circumvented. The purpose of the rule is to prevent scenarios where an entity might acquire, hold or otherwise deal with its statement worldwide assets in a way that increases the amount of its worldwide assets for the purpose of circumventing the asset threshold test. The rule ensures that such actions or arrangements undertaken with a purpose, other than an incidental purpose, of inflating the amount of an asset included in the statement worldwide assets will result in that inflated amount being disregarded.

1.54 This means that the amount of the statement worldwide assets of the entity for the income year is reduced by the inflated amount where the asset was held, acquired or otherwise dealt with for a purpose, other than an incidental purpose, of avoiding the application of the asset threshold test.

Is the new test mandatory to apply?

1.55 An inward investing entity does not need to apply the new test. For example, if an inward investing entity applies the relevant safe harbour debt limit and determines that it has not exceeded its maximum allowable debt, then it does not need to also apply the new worldwide gearing debt test.

How does the new test work?

1.56 The calculation of the worldwide gearing debt amount differs depending on the type of entity:

For an inward investor (general), the worldwide gearing debt amount is calculated using the steps outlined in paragraph 1.57 (also see section 820-218).
For an inward investor (financial), the worldwide gearing debt amount is calculated using the steps outlined in paragraph 1.58 (also see section 820-219).
For an inward investment vehicle (general) that is not also an outward investing entity, the worldwide gearing debt amount is calculated using the steps outlined in paragraph 1.59 (also see section 820-216).
For an inward investment vehicle (financial), that is not also an outward investing entity, the worldwide gearing debt amount is calculated using the steps outlined in paragraph 1.60 (also see section 820-217).
For an inward investment vehicle (general) that is also an outward investing entity (general), the worldwide gearing debt amount is calculated using the steps outlined in paragraph 1.62 (also see subsection 820-211(1)).
For an inward investment vehicle (financial) that is also an outward investing entity (financial), the worldwide gearing debt amount is calculated using the steps outlined in paragraph 1.64 (also see subsection 820-211(2)).
For an outward investing entity (non-ADI), that is also not an inward investment vehicle (general or financial), the worldwide gearing debt amount continues to be calculated under section 820-110.

1.57 For an entity that is an inward investor (general), the worldwide gearing debt amount is calculated as follows:

Step 1: Divide the entity's statement worldwide debt for the income year by the entity's statement worldwide equity for that year (see further below for an explanation of statement worldwide debt and statement worldwide equity).
Step 2: Add 1 to the result of step 1.
Step 3: Divide the result of step 1 by the result of step 2.
Step 4: Multiply the result of step 3 above by the result of step 4 in the method statement in section 820-205.
Step 5: Add to the result of step 4 the average value, for that year, of the entity's associate entity excess amount. The result of this step is the worldwide gearing debt amount.

[Schedule 1, Part 6, item 20, section 820-218]

1.58 For an entity that is an inward investor (financial), the worldwide gearing debt amount is calculated as follows:

Step 1: Divide the entity's statement worldwide debt for the income year by the entity's statement worldwide equity for that year (see further below for an explanation of statement worldwide debt and statement worldwide equity).
Step 2: Add 1 to the result of step 1.
Step 3: Divide the result of step 1 by the result of step 2.
Step 4: Multiply the result of step 3 above by the result of step 5 in the method statement in section 820-210(2).
Step 5: Add to the result of step 4 the average value, for that year, of the entity's zero capital amount (that has arisen because of the Australian investments mentioned in step 1 of the method statement in subsection 820-210(2)).
Step 6: Add to the result of step 5 the average value, for that year, of the entity's associate entity excess amount. The result of this step is the worldwide gearing debt amount.

[Schedule 1, Part 6, item 20, section 820-219]

1.59 For an entity that is an inward investment vehicle (general) that is not also an outward investor (general), the worldwide gearing debt amount is calculated as follows:

Step 1: Divide the entity's statement worldwide debt for the income year by the entity's statement worldwide equity for that year (see further below for an explanation of statement worldwide debt and statement worldwide equity).
Step 2: Add 1 to the result of step 1.
Step 3: Divide the result of step 1 by the result of step 2.
Step 4: Multiply the result of step 3 above by the result of step 4 in the method statement in section 820-195.
Step 5: Add to the result of step 4 the average value, for that year, of the entity's associate entity excess amount. The result of this step is the worldwide gearing debt amount.

[Schedule 1, Part 6, item 20, section 820-216]

1.60 For an entity that is an inward investment vehicle (financial) that is not also an outward investor (financial), the worldwide gearing debt amount is calculated as follows:

Step 1: Divide the entity's statement worldwide debt for the income year by the entity's statement worldwide equity for that year (see further below for an explanation of statement worldwide debt and statement worldwide equity).
Step 2: Add 1 to the result of step 1.
Step 3: Divide the result of step 1 by the result of step 2.
Step 4: Multiply the result of step 3 above by the result of step 5 in method statement in subsection 820-200(2).
Step 5: Add to the result of step 4 the average value, for that year, of the entity's zero-capital amount.
Step 6: Add to the result of step 5 the average value, for that year, of the entity's associate entity excess amount. The result of this step is the worldwide gearing debt amount.

[Schedule 1, Part 6, item 20, section 820-217]

1.61 For the purposes of the calculations in sections 820-216 to 820-219, references to an income year are taken to be a reference to a part year period (if applicable), as these calculations are contained in method statements that are covered by table item 1 in subsection 820-225(3).

1.62 For an entity that is an inward investment vehicle (general) that is also an outward investor (general), the worldwide gearing debt amount is calculated as follows:

Step 1: Divide the entity's statement worldwide debt for the income year by the entity's statement worldwide equity for that year (see further below for an explanation of statement worldwide debt and statement worldwide equity).
Step 2: Add 1 to the result of step 1.
Step 3: Divide the result of step 1 by the result of step 2.
Step 4: Multiply the result of step 3 above by the result of step 6 in the method statement in section 820-95.
Step 5: Add to the result of step 4 the average value, for that year, of the entity's associate entity excess amount. The result of this step is the worldwide gearing debt amount.

[Schedule 1, Part 2, item 13, section 820-111]

1.63 For the purposes of this calculation, references to an income year are taken to be a reference to a part year period (if applicable), as this calculation is contained in a method statement that is covered by table item 1 in subsection 820-120(4).

1.64 For an entity that is an inward investment vehicle (financial) that is also an outward investor (financial), the worldwide gearing debt amount is calculated as follows:

Step 1: Divide the entity's statement worldwide debt for the income year by the entity's statement worldwide equity for that year (see further below for an explanation of statement worldwide debt and statement worldwide equity).
Step 2: Add 1 to the result of step 1.
Step 3: Divide the result of step 1 by the result of step 2.
Step 4: Multiply the result of step 3 above by the result of step 7 in method statement in subsection 820-100(2).
Step 5: Add to the result of step 4 the average value, for that year, of the entity's zero-capital amount (other than any zero-capital amount that is attributable to the entity's overseas permanent establishments).
Step 6: Add to the result of step 5 the average value, for that year, of the entity's associate entity excess amount. The result of this step is the worldwide gearing debt amount.

[Schedule 1, Part 2, item 13, section 820-111]

For the purposes of this calculation, references to an income year are taken to be a reference to a part year period (if applicable), as this calculation is contained in a method statement that is covered by table item 1 in subsection 820-120(4).

Further explanation of the steps in the method statements

1.65 Steps 1 to 3 under each of the calculations set out above is intended to obtain a gearing ratio for the entity (further explanation of step 1 is below).

1.66 Step 4 is intended to apply that gearing ratio to the amount of the entity's Australian adjusted assets, as determined by reference to entity's equivalent safe harbour gearing amount.

1.67 For financial entities, an additional step has been included to add the entity's zero capital amount to permit higher levels of gearing where the financial entity has assets that are effectively allowed to be fully debt funded.

1.68 For both general and financial entities, the associate excess amount is added to determine the worldwide gearing debt amount. Associate entity equity is deducted from an entity's 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.

'Statement worldwide debt' and 'statement worldwide equity' under step 1

1.69 For step 1 (under the worldwide debt limit calculations set out above), the 'statement worldwide debt' and 'statement worldwide equity' will, for the purposes of the new test, be determined by reference to amounts shown in the audited consolidated financial statements that are prepared in relation to the 'worldwide parent entity', provided the statements satisfy specified requirements. [Schedule 1, Part 6, item 21, section 820-933]

1.70 That is, for the purposes of the new test for inward investing entities (non-ADI), accounting concepts are used to determine:

the amount of the 'statement worldwide debt';
the amount of the 'statement worldwide equity';
the amount of the 'statement worldwide assets' for the purpose of determining whether the assets threshold (explained above) is satisfied; and
the entities that are to be included in the consolidated group, as the inclusion of entities in the audited consolidated financial statements are based on the accounting concept of control.

1.71 The reliance on accounting concepts is intended to minimise compliance costs, as the calculation of the maximum allowable debt will be based on figures that are already required to be calculated as part of the worldwide parent's consolidated financial reports.

1.72 The consolidated financial statements must be prepared in accordance with any of the following standards:

international financial reporting standards (IFRS) that are made or adopted by the International Accounting Standards Board; or
the accounting standards that are made or adopted in any of the following jurisdictions:

-
the European Union;
-
the United States of America;
-
Canada;
-
Japan;
-
New Zealand; or
-
any other jurisdiction that the Minister specifies by legislative instrument.

[Schedule 1, Part 6, item 21, subsection 820-935(3)]

1.73 These jurisdictions are broadly based on those that are currently accepted for the separate existing requirement for inward investing entities to prepare financial statements for their permanent establishments (see subsections 820-960(1C) and (1D)). However, allowance has been made to permit other jurisdictions to be included where the Minister specifies.

1.74 This requirement does not mean that the worldwide parent entity needs to be resident in a listed jurisdiction. Rather, the entity's foreign parent must have complied with all applicable accounting standards that are required or permitted in a listed jurisdiction in preparing its audited consolidated financial statements.

1.75 The audited consolidated financial statements must have been prepared in relation to the 'worldwide parent entity'. A 'worldwide parent entity' is an entity that is not controlled by another entity according to the standards that were used to prepare the statements.

Example 1.3 Austco is an Australian entity with a parent in Singapore, Singco. Singco is itself controlled by another entity in Japan, Japco. Japco is not controlled by another entity according to the accounting standards that it uses to prepare its audited consolidated financial statements.For the purposes the new worldwide gearing debt test, Japco is the worldwide parent entity. Austco cannot use Singco's audited consolidated financial statements (if any). Austco can use Japco's audited consolidated financial statements for determining the statement worldwide debt and statement worldwide equity amounts.

1.76 If more than one set of financial statements satisfy the requirements relating to the audited consolidated financial statements, then the entity can choose the financial statements it would like to use for the purpose of the new worldwide gearing debt test [Schedule 1, Part 6, item 21, paragraph 820-935(1)(b)]. However, if an entity chooses to use a particular set of audited consolidated financial statements, those same statements must be used for the purpose of calculating the following amounts for a particular period:

the 'statement worldwide debt';
the 'statement worldwide equity';
the 'statement worldwide assets' for purpose of determining whether the assets threshold (explained above) is satisfied; and
control for the purpose of determining the 'worldwide parent entity'.

1.77 For example, an entity could not use one set of statements prepared using US GAAP for the purpose of determining it's statement worldwide equity, and use another set of statements prepared using IFRS for the purpose of determining its statement worldwide debt, for a particular period.

1.78 The audited consolidated financial statements must also show certain amounts that are relevant to the calculation of the new test. These amounts include the following (however described):

liabilities;
provisions;
liabilities in relation to distributions to equity participants;
trade payables;
deferred tax liabilities;
liabilities relating to employee benefits;
current tax liabilities;
deferred revenue;
liabilities relating to insurance;
net assets;
assets; and
any other amount specified by legislative instrument.

[Schedule 1, Part 6, item 21, paragraph 820-935(2)(c)]

1.79 It is not necessary for these amounts to be separately presented in the statements if this type of presentation is not required by the relevant accounting standards. For example, it would not be necessary to separately disclose liabilities relating to employee benefits as a separate line item on the statement of financial position, if a relevant accounting standard allowed this amount to be presented as part of a more general category of liabilities. However, it is necessary for these amounts to be calculated in accordance with the relevant accounting standards on a consolidated basis, and for these amounts to be reflected in the financial statements in a way those standards permit (albeit aggregated with other amounts).

1.80 To calculate the amount of statement worldwide debt under step 1 of the method statements mentioned above, the entity must start with the total amount of liabilities for the period, and deduct the following amounts:

provisions;
liabilities in relation to distributions to equity participants;
trade payables;
deferred tax liabilities;
liabilities relating to employee benefits;
current tax liabilities;
deferred revenue;
liabilities relating to insurance; and
any other amount specified by legislative instrument.

The result of this calculation is the statement worldwide debt for the period.

[Schedule 1, Part 6, item 21, subsection 820-933(1)]

1.81 This calculation is intended to better reflect the amount of 'debt' for the consolidated group. As accounting standards generally use the concept of liability, which is broader than the concept of debt, various adjustments are made to the consolidated liabilities to deduct certain amounts of liabilities that are non-debt in nature. For example, liabilities relating to employee benefits (including retirement benefit obligations) and those that relate to provisions, trade payables and current and deferred tax liabilities. This requirement is intended to provide a closer 'proxy' for debt, although it does not seek to deduct all types of liabilities that are non-debt in nature, in recognition that this would impose undue compliance burden on entities.

1.82 For a relevant period, the audited consolidated financial statements that are to be relied upon for the purposes of the test must be the statements for the most recent period ending:

no later than the end of the relevant period; and
no earlier than 12 months before the start of the relevant period.

[Schedule 1, Part 6, item 21, paragraph 820-935(2)(e)]

1.83 The relevant period is the income year for an entity (or a part year period, if applicable).

1.84 The consolidated financial statements need not relate to an annual period - part year financial statements could be used if they satisfy the other relevant requirements. Similarly, an entity would not necessarily be precluded from using the new worldwide gearing debt test if it has a newly incorporated worldwide parent entity whose first set of financial statements cover a period of more than 12 months (provided the other relevant requirements are satisfied).

1.85 This would allow the new test to be calculated for a relevant period using the audited consolidated financial statements prepared by the entity's worldwide parent entity for the most recent accounting period.

1.86 This requirement is intended to balance the need to ensure that the most recent financial statements are used (to increase the relevance and reliability of the amounts used in the test) whilst recognising that the audited consolidated financial statements are prepared on a historical basis and may lag the income year in which the new test is being applied.

Example 1.4 ABC Limited is an Australian entity, with an income year of 1 July 2014 to 30 June 2015. ABC Limited has a worldwide parent entity, XYZ Limited, in the United States. XYZ Limited has a balance date of 31 December, and prepares an audited consolidated financial statement using US GAAP.In applying the worldwide gearing debt test, ABC Limited must determine the 'statement worldwide debt' and 'statement worldwide equity' by reference to the XYZ Limited's financial statements for the period commencing 1 January 2014 to 31 December 2014.

Example 1.5 ABC Limited is an Australian entity, with an income year of 1 July 2014 to 30 June 2015. ABC Limited has a worldwide parent entity, STE Limited, in the UK. STE Limited has a balance date of 31 March, and prepares an audited consolidated financial statement using IFRS.In applying the worldwide gearing debt test, ABC Limited must determine the 'statement worldwide debt' and 'statement worldwide equity' by reference to the STE Limited's financial statements for the period commencing 1 April 2014 to 31 March 2015.

Example 1.6 ABC Limited is an Australian entity, with an income year of 1 July 2014 to 30 June 2015. ABC Limited has a worldwide parent entity, POW Limited, in New Zealand. POW Limited has a balance date of 30 June, and prepares an audited consolidated financial statement using IFRS.In applying the worldwide gearing debt test, ABC Limited must determine the 'statement worldwide debt' and 'statement worldwide equity' by reference to the POW Limited's financial statements for the period commencing 1 July 2014 to 30 June 2015.

1.87 To ensure the integrity of the new worldwide gearing debt test, the consolidated financial report will need to be audited in accordance with a law of a jurisdiction mentioned in subsection 820-935(3), or another jurisdiction that has adopted IFRS. [Schedule 1, Part 6, item 21, paragraph 820-935(2)(d)]

1.88 The auditor's report must also be unqualified [Schedule 1, Part 6, item 21, paragraph 820-935(2)(d)]. This is intended to enhance the reliability and integrity of the financial information being relied upon for the purposes of the new test.

Worldwide capital amount for outward investing entities (ADIs)

1.89 Outward investing entities that are ADIs can currently use the worldwide capital amount test in section 820-320, if they are also not a foreign controlled Australian entity throughout the income year.

1.90 Currently, the worldwide capital amount allows an Australian ADI with foreign investments to fund its Australian investments with a minimum capital ratio equal to 80 per cent of the Tier 1 capital ratio of its worldwide group.

1.91 Under the new law, the worldwide capital amount will require an Australian ADI with foreign investments to fund its Australian investments with a minimum capital ratio equal to 100 per cent of the Tier 1 capital ratio of its worldwide group. [Schedule 1, Part 3, item 14, method statement in subsection 820-320(2)]

1.92 For the purposes of this test, the Tier 1 capital ratio (and more broadly, the worldwide capital amount) is determined by reference to the method statements contained in section 820-320.

De minimis threshold

1.93 Currently, the thin capitalisation rules do not disallow any debt deductions of an entity, if the entity and all its associate entities have debt deductions of $250,000 or less (the de minimis threshold).

1.94 To reduce compliance costs and ensure that small businesses are protected from the effects of the thin capitalisation debt tests, the current de minimis threshold will be increased from debt deductions of $250,000 or less, to $2 million or less. [Schedule 1, Part 5, item 18, section 820-35]

1.95 For the purpose of paragraph 815-140(1)(a), an entity under the de minimis threshold is still considered to be applying Division 820. An entity can only qualify under the de minimis threshold if it has applied Subdivision 820-A and determined that its debt deductions fall under the threshold under section 820-35.

Consequential amendments

1.96 As a result of the changes to the thin capitalisation debt limits, several consequential amendments have been made to update figures and calculations contained in various examples throughout Division 820. [Schedule 1, Part 7, items 24 to 25, 27, 30, 33, 35 to 36, 38 to 40, 42, 44 to 45 and 47].

1.97 Consequential amendments have also been made to update cross-references to the revised debt limits, in various method statements throughout Division 820. [Schedule 1, Part 7, items 26, 37, 41, 49 and 50 ]

1.98 As the de minimis threshold has increased from $250,000 of debt deductions to $2 million of debt deductions, various cross-references to the threshold amount have been updated to reflect the new threshold amount. [Schedule 1, Part 7, items 23, 34, 43, 46, 48 and 51]

Application provision

1.99 These amendments apply for income years starting on or after 1 July 2014 [Schedule 1, Part 8, item 56]. The amendments were announced by the Government on 6 November 2013, and taxpayers will be required to apply them to assessments completed after the end of that income year. Consequently, no taxpayer will be required to calculate their tax liabilities for the 2014-15 income year until after the Bill receives Royal Assent.

STATEMENT OF COMPATIBILITY WITH HUMAN RIGHTS

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Tax and Superannuation Laws Amendment (2014 Measures No. 4) Bill 2014 - Thin capitalisation

1.100 This Bill is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011.

Overview

1.101 The Bill:

tightens the debt limit settings in the thin capitalisation rules to ensure that multinationals do not allocate a disproportionate amount of debt to their Australian operations;
increases the de minimis threshold to minimise compliance costs for small businesses; and
introduces a new worldwide gearing debt test for inbound investors.

Human rights implications

1.102 This Bill does not engage any of the applicable rights or freedoms.

Conclusion

1.103 This Bill is compatible with human rights as it does not raise any human rights issues.


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