ATO Interpretative Decision

ATO ID 2005/252

Income Tax

Issue

Will the 'eligible collateral' as per the Guidance Note AGN 112.1 'Risk Weighted On-Balance Sheet Credit Exposures' (the Note) issued by Australian Prudential Regulation Authority (APRA) be included in the calculation of the safe harbour capital amount of an outward investing entity (ADI)?

Decision

Yes. The 'eligible collateral' as per the Note be included in the calculation of the safe harbour capital amount of an ADI.

Facts

The taxpayer is a company that is a resident of Australia.

The taxpayer has a resident subsidiary company in Australia.

The taxpayer and its subsidiary are consolidated for tax purposes.

The risk-weighted assets of the consolidated group consist of ordinary shares and redeemable preference shares in the subsidiary company.

There is 'eligible collateral' on the redeemable preference shares.

Reasons for Decision

Subdivision 820-D (sections 820-300 to 820-330) of the Income Tax Assessment Act 1997 (ITAA 1997) sets out the Thin Capitalisation rule for ADI. Paragraph 820-300(1)(b) of the ITAA 1997 disallows all or a part of each debt deduction of an entity for an income year (to the extent that it is not attributable to an overseas permanent establishment of the entity) if, for that year, the entity's adjusted average equity capital is less than the entity's minimum capital amount.

Adjusted average equity capital is defined in subsection 820-300(3) of the ITAA 1997. Subsection 820-300(3) states that

The entity's adjusted average equity capital for an income year is:

(a)

the average value, for that year, of all the ADI equity capital of the entity (other than ADI equity capital attributable to its overseas permanent establishments); minus

(b)

the average value, for that year, of all the controlled foreign entity equity of the entity (other than controlled foreign entity equity attributable to its overseas permanent establishments).

Section 820-305 of the ITAA 1997 states

The entity' s minimum capital amount for an income year is the least of the following amounts:

(a)

the safe harbour capital amount;

(b)

the arm's length capital amount;

(c)

the worldwide capital amount.

ADI equity capital is defined in subsection 995-1(1) of the ITAA 1997. It states:

ADI equity capital of an entity at a particular time means the total of the following:

(a)

all the entity's equity capital at that time; and

(b)

the total value of all the debt interests issued by the entity that satisfy all of the following:

(i)

at that time, the interests are on issue and have been on issue for 90 days or more;

(ii)

none of the interests gives rise to any cost, at any time, that is covered by paragraph 820-40(1)(a).

A debt interest is treated as having satisfied subparagraph (b)(i) at that time if it was on issue at that time, and the total period for which it remains on issue is 90 days or more."

Controlled foreign entity equity is defined in section 820-890 of the ITAA 1997.

The safe harbour capital amount of an ADI is calculated in accordance with the method statement sets out in section 820-310 of the ITAA 1997. The method statement is as follows:

Step 1:

Work out the average value, for the income year, of all the risk-weighted assets of the entity, other than risk-weighted assets attributable to any of the following:

(a)

the entity's overseas permanent establishments;

(b)

assets comprised by the controlled foreign entity equity of the entity (other than controlled foreign entity equity attributable to the entity's overseas permanent establishments);

(c)

assets for which prudential capital deductions must be made by the entity (other than prudential capital deductions attributable to the entity's overseas permanent establishments).

Step 2:

Multiply the result of step 1 by 4%.

Step 3:

Add to the result of step 2 the average value, for that year, of all the tire 1 prudential capital deductions for the entity (to the extent that they are not attributable to any of the entity's overseas permanent establishments or any Australian controlled foreign entities of which the entity is an Australian controller). The result of this step is the safe harbour capital amount.

If a resident company falls into the category of an ADI then it is subject to the provisions for ADI under Subdivision 820-D of the ITAA 1997.

Under the definition section in section 995-1 of the ITAA 1997 risk weighted assets are determined in accordance with the prudential standards set by the APRA.

APRA standard APS112 'Capital Adequacy: Credit Risk' aims to ensure that all locally incorporated ADIs adopt a uniform approach to the measurement of their on- and off-balance sheet credit exposures for capital adequacy purposes.

Paragraph 6 of APS112 provides that 'Although the primary determinant of the risk weight of a particular on- or off-balance sheet transaction is the nature of the underlying counterparty, APRA recognises qualifying collateral (e.g. cash, securities issued by recognised entities and residential mortgages)......'

The Note issued by APRA provides guidance on what APRA considers 'eligible collateral'. For the purpose of applying the Note in the present context, 'qualifying collateral' and 'eligible collateral' are identical. Paragraph 8(b) of the Note includes securities issued by governments in OECD countries as on-balance sheet credit exposure. In attachment A to the Note, risk weightings are allocated to various on-balance sheet assets. Claims secured against securities issued by central and state governments in OECD countries are allocated a risk weighting of zero.

Accordingly, to the extent that the 'eligible collateral' is secured against the government securities the risk weighting of the redeemable preference shares will be zero. The 'eligible collateral' as per the Note will be included in the calculation of the safe harbour capital amount of an ADI.

Year of income:  Year ended 30 June 2005 Year ended 30 June 2006 Year ended 30 June 2007 Year ended 30 June 2008 Year ended 30 June 2009 Year ended 30 June 2010 Year ended 30 June 2011 Year ended 30 June 2012 Year ended 30 June 2013

Legislative References:
Income Tax Assessment Act 1997
   section 820-310
   section 995-1
   section 820-890
   paragraph 820-40(1)(a)
   paragraph 820-40(1)(b)
   section 820-300
   section 820-305

Other References:
The Guidance Note AGN112.1 'Risk Weighted On-Balance Sheet Credit Exposures'
APRA Standard APS112 'Capital Adequacy: Credit Risk'
The Guidance Note AGN111.1 (Tier 1 Capital)
The Guidance Note AGN111.2 (Tier 2 Capital)

Keywords
Safe harbour capital amount
Thin capitalisation

Siebel/TDMS Reference Number:  4441212

Business Line:  Public Groups and International

Date of publication:  9 September 2005

ISSN: 1445-2782