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Senate

New Business Tax System (Thin Capitalisation) Bill 2001

Supplementary Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
Requests for amendments and amendments to be moved on behalf of the Government

Glossary

The following abbreviations and acronyms are used throughout this supplementary explanatory memorandum.

Abbreviation Definition
ADI authorised deposit-taking institution
APRA Australian Prudential Regulation Authority
CFE controlled foreign entity
Debt and Equity Bill New Business Tax System (Debt and Equity) Bill 2001
ITAA 1936 Income Tax Assessment Act 1936
ITAA 1997 Income Tax Assessment Act 1997
non-ADI not an authorised deposit-taking institution
TC thin capitalisation
Thin Capitalisation Bill New Business Tax System (Thin Capitalisation) Bill 2001

General outline and financial impact

Amendments to the New Business Tax System (Thin Capitalisation) Bill 2001

The amendments to the Thin Capitalisation Bill will ensure that the new thin capitalisation regime will operate as intended. There are a number of amendments as a result of the consideration of submissions made after the Thin Capitalisation Bill was introduced on 28 June 2001. Other amendments will ensure the integrity of the new regime. The amendments also make a number of changes which are of a technical and clarifying nature.

There are also a number of corrections to the explanatory memorandum that clarify the operation of the Thin Capitalisation Bill.

Date of effect: 1 July 2001.

Proposal announced: Not previously announced.

Financial impact: The proposed changes will have a marginal but unquantifiable revenue cost.

Compliance cost impact: Overall, the amendments will involve a net reduction in compliance costs as compared with the operation of the Thin Capitalisation Bill.

Chapter 1 - Amendments to the New Business Tax System (Thin Capitalisation) Bill 2001

Outline of chapter

1.1 The amendments to the Thin Capitalisation Bill will ensure that the bill operates as intended. There are a number of amendments as a result of the consideration of submissions made after the Thin Capitalisation Bill was introduced on 28 June 2001. Other amendments will ensure the integrity of the new regime. The amendments also make a number of changes which are of a technical and clarifying nature. There are also a number of corrections to the explanatory memorandum that clarify the operation of the Thin Capitalisation Bill.

Explanation of requests for amendments

Amendments 6 and 22

1.2 The amendments to the definition of outward investing entity (non-ADI) and outward investing entity (ADI) would not change the scope of outward investors. They merely update the definitions to take account of the extension of the definition of associate entity in amendment 48.

Amendments 7, 10 to 14, 18 to 21, 25 to 29 and 70

1.3 Adjusted average debt has been amended in several ways. Broadly, 3 issues are addressed in these amendments.

1.4 Firstly, the operation of adjusted average debt has been amended to clarify its operation in relation to the treatment of interest-free debt. Only debt which generates no debt deductions in any income year at all is excluded from adjusted average debt at first instance. In the absence of this amendment, adjusted average debt would not include debt that simply does not give rise to debt deductions for a particular income year. This does not necessarily mean that there are no costs associated with the provision of finance under the particular instrument. For example, all interest payments in relation to a particular debt may be paid in the year of issue. For the remaining years during which the loan is outstanding, the financial arrangement would be treated as an interest-free loan or quasi equity. This is inappropriate. In the absence of rules to ensure that the interest deductions are spread over the life of the loan in such a case, it is important that debt capital includes any debt interest that gives rise to debt deductions at any time over its life. Step 1 of the method statement has been amended to ensure this treatment is effected.

1.5 There has been no substantive change to operation of the sections under either step 2 or 3 of the method statements.

1.6 Similar amendments have been made in relation to average debt in calculating the amount of debt deduction disallowed and in relation to average equity capital.

1.7 Secondly, a new step has been introduced. Both the assets and liabilities arising from a securities loan arrangement must be properly taken into account to avoid allowing more debt because of these arrangements which could be used to fund other assets. To do this, it is necessary to include the securities loan arrangement amount, where the securities loan arrangement does not give rise to a debt interest, as part of adjusted average debt for both outward and inward investing financial entities at subsections 820-85(3), 820-120(2), 820-185(3) and 820-225(2).

1.8 Thirdly, the meaning of adjusted average debt as calculated in the method statements is extended to include an integrity measure that recognises that where an entity receives short-term interest-free debt funding, that funding may potentially be used to inflate the safe harbour debt amount of the entity. It is the ease with which such interest-free funding may be provided and removed that causes concern. Provided that both the entity providing and the entity in receipt of the interest-free debt are taking account of that arrangement for the purposes of ascertaining their respective safe harbour debt amounts and adjusted average debt, the interest-free debt will retain its equity like treatment and continue to be excluded from adjusted average debt.

1.9 However, where the entity in receipt of the interest-free debt and the entity providing the interest-free debt use different measurement days for a period, the interest-free debt will be treated as debt. The relevant period for applying this test is determined by reference to the income year of the entity which issued the debt. It is the period during that income year when both the issuer and holder of the debt interest are subject to the thin capitalisation regime.

Amendments 8, 9, 16 and 17

1.10 Interest-free debt is a particular category of debt which does not produce any debt deductions in relation to any income year (see paragraph 1.4). Consequently, a debt interest that gives rise to debt deductions in any income year is not interest-free debt and should be encompassed in the concept of the arms length debt amount.

1.11 In the amended sections, intended references to debt interests that are not interest-free debt in the definition of the arms length debt amount are amended to ensure that they are appropriately framed.

Amendments 41 to 43

1.12 The definition of associate entity is extended to operate in 2 directions. In short, where Entity A is an associate entity of Entity B, Entity B will now also be an associate entity of Entity A (see amendment 50). The extension of associate entity in this way will have unintended consequences for the TC control interest rules. Therefore, these amendments have been introduced to exclude from the operation of sections 820-815, 820-820 and 820-825 this particular aspect of the extended definition of associate entity.

Amendments 46, 48 and 50

1.13 The current definition in section 820-905 does not apply associate entity treatment in some cases where it should because:

·
it does not recognise the relationship that exists between entities which are both controlled by the one entity yet do not have either a majority interest or satisfy the sufficient influence test, in relation to each other; and
·
it only applies in one direction and does not recognise the ability of an entity to direct its associate entity to supply it with equity or debt funding.

1.14 These amendments make entities A and B associate entities of each other if each is an associate entity of a third entity. They also make X an associate entity of Y if Y is an associate entity of X.

1.15 To facilitate this amendment it has been necessary to delete from both subsections 820-905(1) and (2) the words only if. However, to be clear, the requirements in one of subsection (1), (2), (3), (3A) or (3B) must be satisfied for one entity to be an associate entity of another entity.

1.16 The extension of this definition has a practical effect on the application of associate entity equity, associate entity debt and the de minimis rule at section 820-35.

Amendments 51 and 52

1.17 The intention of the associate entity debt concession is that it will only be provided to one entity where the debt is tested for thin capitalisation purposes in another associated entity. As currently drafted, the concession applies to debt funding provided to an inward investing entity that is a foreign entity that is not claiming interest deductions in Australia and so its debt will not be tested. In such cases, the concession should not be available and an amendment is required.

1.18 The amendment denies the concession on loans to an inward investor except where it carries on its business through an Australian permanent establishment. Where the inward investor is operating through a permanent establishment in Australia, the debt will be subject to the thin capitalisation test because the permanent establishment is able to claim debt deductions. The concession is still available on loans to a foreign controlled Australian entity and an outward investing Australian entity. Subsection 820-910(1) has been amended to effect this change.

1.19 As an integrity measure the amendment also seeks to ensure that total associate entity debt provided to the permanent establishment should be limited to the amount of debt attributable to the permanent establishment. This is to ensure that the preceding amendment is not effectively circumvented by providing loans to foreign entities through permanent establishments in Australia. The method statement in subsection 820-910(2) has been amended to effect this change. It is also intended that the total associate entity debt amounts supplied by all relevant entities to the associate entity would not be greater than the attributable debt of the permanent establishment.

Amendment 53

1.20 In the calculation of safe harbour debt amounts, the assets of an entity are reduced by the amount of equity the entity holds in its associate entities. This deduction is an integrity measure which ensures that the same equity is counted only once (in the hands of the associate) and not counted in the hands of the investing entity as well.

1.21 This provision could be circumvented by an entity providing a loan to an associate entity that does not give rise to debt deductions instead of injecting equity. This possibility arises because in the hands of the recipient, these loans are not counted as adjusted average debt and are therefore currently treated as quasi equity. That is, an interest-free loan to an associate would have the tax effect of equity, but would escape the associate entity equity integrity measure.

1.22 Consequently, this amendment extends the definition of associate entity equity to interest-free loans, that is, debt capital that does not give rise to debt deductions at any time.

Amendment 54

1.23 As an integrity measure, the calculation of associate entity excess amount will be amended to ensure that a non-financial entity is only able to carry up excess debt capacity based on its own safe harbour ratio and not that of a financial entity. This will ensure that equity capital is not moved from a non-financial entity to a financial entity to boost the safe harbour of the non-financial entity. Step 1 of the method statement in subsection 820-920(4) has been amended to effect this change.

1.24 There is an adjustment to the last 2 steps in this method statement to ensure that the equity treatment of interest-free loans is fully reflected in determining the safe harbour excess amount.

Amendments 55, 57 and 69

1.25 This amendment incorporates a number of substantive changes to the zero-capital amount method statement. In total, 5 issues have been addressed.

1.26 Firstly, commercial practice requires the recoupment of certain costs associated with the establishment of a loan by the imposition of fees and charges. The Thin Capitalisation Billrequires that a loan has no fees and charges associated with its provision to be a zero-capital amount. This particular concession may therefore have no practical operation as the majority of what would otherwise be considered to be low-margin loans would be excluded.

1.27 However, the possibility of manipulating the credit rating on a particular loan in order to satisfy the zero-capital requirement may occur where a payment is made for credit enhancement to the lender or its associates. Therefore, where any payment has been made either directly, indirectly or in kind to the lender or any of its associates as consideration for credit support for a loan, the loan is excluded from zero-capital amount. For compliance reasons, credit enhancement payments made to any non-resident render the loan ineligible for zero-capital treatment. This change is incorporated in new step 2(b) of the method statement.

1.28 Secondly, the margin on a particular loan may not always be that indicated by the general credit rating of the borrower. This is the case for subordinated debt, where the lender only has a claim on the assets of the borrower after all other creditors have been satisfied. This debt is therefore riskier, and may not fall into the low margin category. Rather than require a credit rating for every loan, a specific amendment is being made to deal with subordinated debt. Accordingly, subordinated debt will only qualify as a zero-capital amount if the borrower has a credit rating of A or better (rather than BBB as in all other instances). This change reflects the extent to which subordinated debt normally carries a lower credit rating than the credit rating of the borrower.

1.29 Not all subordinated debt is excluded from zero-capital treatment. Subordinated debt of an entity with a credit rating of A or higher will still satisfy the requirements for zero-capital treatment. This is on the grounds that whilst the margin on the loan may be greater than a secured loan to an entity with an A credit rating, the margin has not been extended to such an extent that the loan will no longer be considered low margin. The treatment afforded subordinated debt is included in new subsection 820-942(4) with the definition of subordinated debt being inserted in subsection 995-1(1).

1.30 Thirdly, again to recognise commercial practice in relation to the provision of these types of loans, the relevant time at which the issuer of the debt is required to have the specified rating has been extended from the exact time of issue of the instrument to a period within 6 months of that time.

1.31 Fourthly, instruments which satisfy step 3 may be purchased either from the issuing entity or on the secondary market. In order to satisfy step 3 of the method statement it is not necessary to have obtained the relevant debt interest from the issuer.

1.32 Finally, if a debt interest (e.g. a government bond) satisfies the requirements in both steps 2 and 3 of the method statement, step 3(c) applies to ensure that the interest is not counted as a zero-capital amount twice.

Amendment 67

1.33 This amendment to the definition of non-debt liabilities is necessary to prevent the possible double counting of values or amounts under the present application of the method statements for financial entities. This would result in an inappropriate safe harbour amount.

1.34 Double counting of amounts within the method statement can presently arise because securities loan arrangements, which are part of the zero-capital amount, may also fall within the definition of non-debt liability because some securities loan arrangements do not give rise to debt interests.

1.35 The amendment will ensure that where a securities loan arrangement is included as part of the zero-capital amount, it is excluded from being a non-debt liability if the securities loan arrangement is not a debt interest.

Explanation of amendments

Amendment 1

1.36 This amendment inserts an additional de minimis rule to ensure that Australian entities, which are not foreign controlled, with small overseas investments are excluded from the new thin capitalisation regime. The exclusion will apply where the foreign assets of the entity and its associates represent 10% or less of the combined total assets.

Amendments 2 and 58

1.37 These amendments operate to ensure that the terms debt deduction and overseas permanent establishment in Division 18 of Part III of the ITAA 1936 adopt the definitions used in the ITAA 1997.

Amendment 3

1.38 The primary intention of paragraph 820-40(3)(a) is to exclude from the definition of debt deduction foreign currency losses associated with hedging a currency risk in respect of a debt interest. The provision is to be extended to also exclude expenses associated with hedging or managing a financial risk in respect of a debt interest. For example, fees and legal costs associated with the hedge or in managing the financial risk. The term directly has also been added to clarify the limit of the scope of the concession provided by paragraph 820-40(3)(a).

Amendment 4

1.39 The intention of paragraph 820-40(3)(b) is to exclude from the definition of debt deduction foreign currency losses, and losses from non-Australian dollar denominated loans (e.g. gold loans) from the extinguishment, termination or other disposal of a debt interest where the losses are not attributable to the cost of the debt interest (e.g. interest cost). That is, where the loss arises only from the change in the Australian dollar value of the unit of account of the debt interest the loss will not be a debt deduction. The amendment will make the intention of the provision clear.

Amendment 5

1.40 The drafting of paragraph 820-40(3)(d) in the Thin Capitalisation Bill is unclear as it could be interpreted to exclude rental expenses associated with all leases including rental expenses on leases which are debt interests. In these cases, the rental expenses should be debt deductions. The amendment will make it clear that lease rental expenses are not debt deductions where the lease is not itself a debt interest. If the lease is a debt interest then rental expenses should be debt deductions regardless of whether the lease rentals may be an indirect expense associated with other debt interests.

Amendment 15

1.41 This amendment is designed to ensure that if the zero-capital amount of an inward investor (financial) is greater than the amount worked out under step 4 of the total debt amount method statement, the value of step 5 is zero. It ensures that the total debt amount of an inward investor financial can never be a negative amount.

Amendments 23, 24, 34, 38 and 66

1.42 These amendments ensure that the definition of equity capital is applicable to entities that are trusts or partnerships as well as to companies. They also more closely align the definition of equity capital for ADIs to that of non-ADIs. This was the original intention of the Thin Capitalisation Bill.

1.43 The reference to the capital and reserves of the trust or partnership equates to the beneficiaries or partners equity amounts in the trust or partnership in the same way as the wording in paragraph 1(a)(i) of the definition of equity capital equates to shareholders equity in the balance sheet of a company.

1.44 These amendments also change the definition of equity capital for ADIs. The existing definition in the bill is based on an ADIs eligible Tier 1 capital within the meaning of the prudential standards. The new definition is based on Tier 1 capital rather than eligible Tier 1 capital. This amendment will align the definition of equity capital for ADIs with that for non-ADIs.

1.45 One of the effects of the amendments is that Tier 1 prudential capital deductions will not be deducted in calculating an ADIs adjusted average equity capital. In the absence of such an amendment, ADIs may have been inappropriately penalised as Tier 1 prudential capital deductions would have been counted twice. That is, once in calculating adjusted average equity capital and a second time in calculating the safe harbour capital amount.

1.46 Consequential amendments are made to subsection 820-320(3) to ensure that this effect is reflected in calculating the worldwide capital amount and in the grouping provisions at sections 820-470 and 820-562.

Amendment 30

1.47 This amendment clarifies the original intention of the Thin Capitalisation Billas to how debt deductions of entities which are part of the resident TC group at the end of the income year are to be treated.

1.48 The amendment ensures that where an entity is part of the resident TC group, the debt deductions of each entity which comprise the resident TC group are considered to be debt deductions of the group even if they were incurred when the entity was not part of the resident TC group.

1.49 This is consistent with the concept that the resident TC group is considered to have been a company for the income year for thin capitalisation purposes.

Amendment 31

1.50 The changes to the notes are a consequence of the changes outlined in amendments 30 and 32.

Amendment 32

1.51 This amendment clarifies the original intention of the Thin Capitalisation Bill. It ensures that even if an entity was not in the resident TC group for the whole of the income year, the rest of the thin capitalisation provisions are not to apply separately to the member for the period of the income year when it was not actually in the group.

1.52 Therefore, provided an entity was part of a resident TC group at the end of the income year, its thin capitalisation position for the income year is determined by the resident TC groups thin capitalisation position notwithstanding that it may not have been a member of the TC group for the entire income year.

1.53 This amendment also clarifies the situation for Australian permanent establishments of foreign banks.

Amendment 33

1.54 The amendment inserts the additional words or amount into section 820-470 to provide clarity. It does not change the effect of the Thin Capitalisation Bill as introduced.

Amendment 34

1.55 This amendment removes any doubt that in applying the thin capitalisation provisions to the determination of the value or amount of a particular matter for the resident TC group it is to be on the basis of information that would be contained in a set of consolidated accounts covering the entities within the group.

1.56 The amendment confirms that all intra-group transactions are to be ignored for the resident TC group, ensuring that there is no double counting of values or amounts. This was the intention in the Thin Capitalisation Bill as introduced.

Amendment 35

1.57 This amendment clarifies which entity is a top entity in an Australian group.

Amendment 36

1.58 This amendment ensures that the heading for section 820-555 correctly reflects the scope of the provision following amendment 37.

Amendment 37

1.59 This amendment ensures that the thin capitalisation rules do not apply to a resident TC group (that is not an outward investor) headed by a foreign owned holding company where an Australian bank is the only asset of the holding company.

1.60 In such circumstances, APRA rules ensure that the bank subgroup is adequately capitalised and conditions added by the amendment (mainly that the holding company can have no debt) ensure that the entire group is adequately capitalised. This is considered to be sufficient for tax purposes.

Amendment 38

1.61 The outward investing ADI rules apply to a resident TC group where the group consists of an outward investing ADI or an ADI and an outward investing non-ADI entity. However, since the TC group may include entities that are not supervised by APRA and/or a branch of a foreign bank, the application of the outward investing ADI rules has been modified to include in the definition of adjusted average equity capital the following items:

·
the (consolidated) paid-up share capital (other than debt interests), retained earnings, interest-free debt and general reserves of the entities that are not supervised by APRA;
·
the equity capital of trusts and partnerships in a group not supervised by APRA; and
·
the equity capital of the foreign bank attributable to its Australian branch and any interest-free loans that are provided by the foreign bank to its Australian branch.

1.62 The risk-weighted assets of the resident TC group also need to be modified to include the risk-weighted assets of the foreign bank that are attributable to its Australian branch.

1.63 This approach adopts the concept of adjusted average equity capital from section 820-565 in the Thin Capitalisation Billwhich will be moved to new section 820-562 with 3 substantive changes.

1.64 The first ensures that the average value of adjusted average equity capital is the average for the year of the (consolidated) equity capital of all entities at each measurement date adopted by the group, rather than the sum of the average values of the equity capital of each entity.

1.65 Secondly, the values of matters (e.g. assets and debt capital) of entities that are members of the resident TC group will only be included where the entity is a member of the resident TC group on the particular measurement day. When an entity is not a member of the group on a measurement day (other than at the end of the income year), the values of its assets, etc, are not counted for that day.

1.66 For example, if an entity who is a member of the resident TC group is only a member on the last day of the year, the entity will only contribute to the valuation of the particular matter on the one measurement day - the last day of the year - that it is a member of the group.

1.67 Thirdly, interest-free debt is included in the equity capital of an entity that is not an ADI nor a 100% subsidiary of an ADI. This is consistent with the treatment accorded these entities when they are not part of an ADI group.

1.68 Three further minor amendments have been made. The first ensures that the reference to interest-free debt of certain Australian permanent establishments correctly identifies debt interests that do not give rise to debt deductions in any year. Secondly, an amendment is made to the dictionary definition of adjusted average equity capital to include the new definition of this term in new section 820-562. Thirdly, subsection 820-562(3) ensures that trusts and/or partnerships that are part of a resident TC group to which the outward investing entity (ADI) rules apply are included as part of adjusted average equity capital calculation. Trusts and partnerships, all of whose interests are beneficially owned by an ADI or a 100% subsidiary of the ADI, are included as part of the consolidated Tier 1 capital calculation. Any remaining trusts or partnerships in the resident TC group are included as part of the consolidated equity capital calculation.

Amendment 39

1.69 Section 820-565 has been amended as a result of the extension of the amended application of Subdivision 820-D in new section 820-562. Section 820-565 operates to provide outward investor (ADI) treatment to certain specified groups. This means that the groups identified in section 820-565 use the definitions of adjusted average equity capital and risk-weighted assets contained in section 820-562 (see amendment 38). Consequently, the rest of section 820-565 in the Thin Capitalisation Billhas been deleted.

1.70 Subdivision 820-D will also apply to a group consisting of a foreign-owned ADI subsidiary (and its subsidiaries) and a permanent establishment of a foreign bank. In this case the ADI subsidiary meets the requirements of both paragraphs 820-565(b) and (c). As part of new section 820-562, the possibility of double counting of items of equity capital in these situations has been removed by ensuring that companies, trusts and partnerships effectively within the APRA group are excluded from items 3 and 4 at subsection 820-562(3).

Amendment 40

1.71 This amends the definition of average equity capital in section 820-575 in a manner similar to the amendments made to adjusted average equity capital made by the introduction of section 820-562 (see amendment 38).

Amendments 44 and 45

1.72 These amendments attach an identifying asterisk to the defined terms foreign entities and Australian entities.

Amendments 47, 49 and 68

1.73 The definition of associate entity will be amended to ensure that a responsible entity of a managed investment scheme registered under the Corporations Act 2001 will not be an associate entity of another entity where that other entity holds an associate interest in the scheme of less than 20%.

1.74 It is not uncommon for a responsible entity to act in more than one capacity. For example, it will have its responsibilities as the responsible entity and it may also undertake other activities. The amendment will determine whether a responsible entity is an associate entity of another entity when acting in its capacity as a responsible entity. It will not apply to a responsible entity acting in its other capacities. The effect of the amendment will be that trusts, such as listed property trusts and funds management trusts, which meet the conditions will not be subject to the thin capitalisation rules simply because the responsible entity is a member of another group that is subject to the rules.

Amendment 56

1.75 The exception to the debt test in subsection 974-25(2) of the Debt and Equity Billmeans that assets which come within that exception will not qualify as securitised assets for the purposes of the zero-capital amount calculation. This subsection typically relates to short-term receivables (e.g. short-term trade credits). The securitisation of such short-term receivables is not uncommon. The reason for this result is that the 100 day qualification imposed by paragraph 974-25(2)(b) means that the scheme does not pass the debt test and is therefore not a debt interest for the purposes of subparagraph 820-942(3)(b)(i). This anomaly will be corrected by the amendment.

Amendment 58

1.76 The apportionment of debt deductions will no longer be required for the purposes of determining the amount of foreign tax credit allowable, provided the debt deduction is not attributable to the taxpayers overseas permanent establishments.

1.77 This amendment to subsection 160AF(8) is to ensure that no reduction to net foreign income is to be made for any debt deductions to the extent that they are not attributable to the taxpayers overseas permanent establishments. Net foreign income is the amount used to determine the adjusted net foreign income for the purposes of arriving at the maximum allowable foreign tax credit.

Amendment 59

1.78 The definition of debt deduction is divided into 3 subsections, each with a paragraph (a). An amendment to paragraph 25-90(c) is required to make it clear that the correct reference is to paragraph 1(a) of the definition of debt deduction.

Amendment 60

1.79 This amendment to item 19 of Schedule 1 to the Thin Capitalisation Bill ensures that the term financial entity is consistently defined throughout the bill.

Amendment 65

1.80 This amendment changes a reference from 820-565 to 820-562 as a result of changes outlined in amendments 38 and 39.

Application and transitional provisions

Amendment 61

1.81 A new application provision at section 820-12 ensures that the debt equity rules in the Debt and Equity Bill apply from 1 July 2001 for the purposes of the Thin Capitalisation Bill.

Amendments 62 and 63

1.82 Transitional treatment is provided to both issuers and holders of hybrid instruments that change character for the purposes of thin capitalisation from debt to equity or equity to debt as a result of the introduction of the Debt and Equity Bill. These instruments are identified by subsection (1) of sections 820-35 and 820-40 to be inserted into the Income Tax (Transitional Provisions) Act 1997.

Issuer

1.83 Under the Debt and Equity Bill, the issuer of these instruments may elect whether or not the debt and equity test amendments apply to the transactions of an instrument issued before 1 July 2001. If the issuer does not make such an election the debt and equity test amendments will only apply from 1 July 2004.

1.84 In order to give effect to that treatment for thin capitalisation purposes, only where such a hybrid instrument changes from equity to debt and the issuer elects debt treatment will the instrument be treated as a debt interest of the issuer during the transitional period (1 July 2001 to 1 July 2004). In all other cases the instrument will be treated for thin capitalisation purposes as an equity interest in the hands of the issuer. [Amendments 62 and 63, subsections 820-35(2) to (4) and 820-40(2)]

Holder

1.85 The holder of a hybrid instrument that was issued before 1 July 2001 does not have access to an election in relation to the application of the Debt and Equity Bill to that interest.

1.86 Therefore, the interest will be treated in the hands of the holder in such a way to ensure that the re-characterisation of the instrument will not result in either a windfall gain or windfall loss to the holder in its thin capitalisation calculations during the transitional period.

1.87 In practice, this means that where such an instrument changes from equity to debt, it will be treated as an equity asset of the holder during the transitional period. Conversely, where the instrument changes from debt to equity it will be a debt asset of the holder during that period. However, this general treatment is qualified by the need to ensure integrity in the treatment of these hybrid instruments. [Amendments 62 and 63, subsections 820-35(2), (3) and (5) and 820-40(3)]

1.88 The associate entity debt and associate entity equity rules are special rules that apply, broadly speaking, to the holder of an interest that is issued by an associate entity of the holder. Associate entity debt treatment is concessionary treatment available to the holder where that interest is a debt interest. This treatment excludes the amount of associate entity debt from being tested in the hands of the holder on the basis that it will be tested as debt of the associate entity. The associate entity equity rule is an integrity measure designed to prevent cascading of equity through chains of entities. As for associate entity debt, associate entity equity is principally counted only in the calculations of the associate entity.

1.89 However, where the interest was issued by a CFE the instrument receives CFE equity or debt treatment rather than associate entity equity or debt treatment.

1.90 Consequently, it is necessary to qualify the transitional treatment provided to the holder where the interest would be either associate entity equity or associate entity debt of the holder and was not issued by a CFE. In these circumstances, the interest must receive the same treatment in both the hands of the issuer and the holder. Otherwise, these rules will not apply as intended. [Amendments 62 and 63, subsections 820-35(6) and 820-40(4)]

1.91 Therefore, where a hybrid instrument changes character from debt to equity, it will generally be treated as debt in the hands of the holder. However, if the interest is either associate entity equity or associate entity debt and not issued by a CFE, it will receive equity treatment for all purposes and therefore be associate entity equity. If the instrument is issued by a CFE it will receive debt treatment. This qualification ensures that the interest is treated as equity in both the hands of the issuer and the holder in the specified circumstances.

1.92 On the other hand, where a hybrid instrument changes character from equity to debt, it will generally be treated as equity in the hands of the holder. However, the interest will receive debt treatment where:

·
the interest was not issued by a CFE;
·
the interest would be associate entity debt if it were treated as a debt interest; and
·
the issuer has elected that the transactions under the interest have debt treatment under the Debt and Equity Bill.

1.93 If any of these criteria are not satisfied, the interest will receive equity treatment. Again, this qualification on the general transitional treatment ensures that the interest is being treated as debt in the hands of the issuer and the holder in the specified circumstances.

Amendment 64

1.94 The amendments to section 160AF are to apply to a year of income that commences on or after 1 July 2001.

Correction to the explanatory memorandum

1.95 The following text should be inserted after paragraphs 6.58 and 6.65 to clarify how the safe harbour capital amount for a resident TC group that contains an ADI should be determined.

1.96 In determining the safe harbour capital amount for a resident TC group that contains an ADI, prudential rules are to apply in determining the risk-weighted assets of the resident TC group. Risk-weighted assets of the resident TC group are the sum of the resident TC groups risk exposures determined as follows.

·
For entities in the bank subgroup (a subgroup that contains an ADI) that would be part of a consolidated prudential group, the risk exposure for each entity is to be determined in accordance with prudential standards as if that entity were a member of a consolidated prudential group (i.e. the assets of the entity that are assets of the consolidated group would be risk weighted).
·
For entities in the bank subgroup that would not be part of a prudential consolidated group (e.g. securitisation vehicles), do not risk-weight the assets of those entities but determine the risk exposures to the prudential consolidated group from those entities as required by the prudential standards.
·
For entities in a subgroup that does not contain an ADI, prudential rules are to apply to those entities as if the node entity was a 100% subsidiary of an ADI (with the previous 2 rules applying as appropriate).


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