House of Representatives

Taxation Laws Amendment Bill (No. 5) 2003

Explanatory Memorandum

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

Chapter 1 Thin capitalisation

Outline of chapter

1.1 Schedule 1 to 4 to this bill explains amendments to the thin capitalisation provisions contained in Division 820 of the ITAA 1997 and amendments to the ITAA 1936. Legislative references are to ITAA 1997 unless otherwise stated. The amendments ensure that the policy objectives of the thin capitalisation regime are achieved, promote equity between taxpayers, generally reduce compliance costs and clarify the operation of the law.

Context of amendments

1.2 The policy underlying the thin capitalisation regime is to ensure that multinational entities do not allocate an excessive amount of debt to their Australian operations. A number of outstanding thin capitalisation policy issues are addressed in these amendments. In addition, there are technical amendments and integrity measures to ensure the legislation operates as intended.

Summary of new law

1.3 This bill will amend the ITAA 1997 and the ITAA 1936 to:

·
exclude certain special purpose entities from the operation of the thin capitalisation regime;
·
allow qualifying financial entities to use the risk weighting rules that apply to ADIs;
·
align the definition of 'equity capital' for ADIs and non-ADIs;
·
vary the rules for the revaluation of assets;
·
amend the treatment of reciprocal purchase agreements, sell-buyback arrangements and securities loan arrangements;
·
clarify the definition of assets and liabilities;
·
amend the definition of financial entity;
·
amend record keeping requirements for permanent establishments; and
·
introduce a number of technical amendments and integrity measures.

Comparison of key features of new law and current law

New law Current law
Special purpose entities are to be excluded from the operation of the thin capitalisation rules. Securitisation vehicles are not required to hold equity in relation to securitised assets.
Financial entities may elect to use the risk weighted assets approach that applies to ADIs. Financial entities gearing levels are based on prescribed debt to equity ratios.
A generic definition of 'equity capital' based on 'equity interest' will apply to both ADIs and non-ADIs. Definition of equity capital is based on tier-1 capital for ADIs and paid-up share capital for non-ADIs.

Allow the revaluation of a single asset in a class of assets.

Relax the requirement for external expert valuations and ongoing revaluations.

Increase the record keeping requirements when revaluing assets.

Revaluations to be in accordance with the accounting standards and to be undertaken by an external expert valuer.
Amendments to definitions of adjusted average debt, non-debt liabilities, on-lent amount and zero capital amount provide more consistent outcomes for transactions associated with reciprocal purchase agreements, sell-buyback and securities loan arrangements. The thin capitalisation rules provide specific treatment for transactions associated with reciprocal purchase agreements, sell-buyback and securities loan arrangements.
The accounting standards determine assets and liabilities for thin capitalisation purposes. Assets and liabilities are not defined and have their normal legal meaning.

A financial entity will include an entity exempted from holding a financial services license where it is regulated by an overseas authority.

Financial entity will include qualifying derivatives dealers.

A financial entity is a financial services licensee within the meaning of the Corporations Act 2001.

Record keeping requirements for permanent establishments allow the use of certain overseas accounting standards.

Record keeping requirements will not apply in certain circumstances.

Record keeping requirements for permanent establishments are based on the Australian accounting standards.
An interest-free loan is not cost-free debt capital where it is on issue for more than 180 days even if this occurs after the valuation date. An interest-free loan is cost-free debt capital where it has been on issue for less than 180 days at valuation date.
An equity interest will not increase the calculation of maximum allowable debt where it is on issue for less than 180 days. A short term equity interest may increase the calculation of maximum allowable debt.
The calculation of associate entity debt will ensure that the assets threshold test does not exclude inward investors from accessing the benefit. The reference to the assets threshold test when determining associate entity debt is not limited to outward investing entities.
Associate entity debt includes assets that are held for the purposes of producing assessable income. The definition of associate entity debt only refers to permanent establishments.
Pre-1 July 2001 borrowing expenses deductible under section 67 of the ITAA 1936 will be excluded from the definition of debt deduction. Only pre-1 July 2001 borrowing expenses incurred under section 25-25 are excluded from the definition of a debt deduction.
The arm's length test will apply to the Australian business where appropriate. The arm's length test may allow an entity to look at their global operations rather than just their Australian operations.
Equity capital attributable to the permanent establishment and CFE equity is to be disregarded when calculating 'adjusted average equity capital' for groups and consolidated entities. Adjusted average equity capital for groups and consolidated entities can include equity that is not related to the Australian operations.
Debt deductions denied by the thin capitalisation rules are unable to be added to the cost base of a CGT asset. CGT rules do not prevent debt deductions disallowed from being included in the cost base of a CGT asset.
Expenditure deductible under section 25-90 in relation to exempt dividends will give rise to an FDA debit. Deductible expenditure incurred in relation to exempt income cannot give rise to an FDA debit.

Detailed explanation of new law

Exemption of certain special purpose entities

1.4 The zero capital amount provides a carve out of certain assets from the thin capitalisation regime and as a consequence allows full debt funding of those qualifying assets. Assets held by a securitisation vehicle are included in the zero capital amount provided that the definition of securitised asset and securitisation vehicle as set out in section 820-942 are satisfied.

1.5 This treatment reflects that securitisation vehicles are tax neutral entities established to pool assets and are generally funded entirely through the issue of debt interests without the need to hold equity.

1.6 The securitisation industry is complex and dynamic. Many securitisation programs are not able to avail themselves of the benefits of the zero capital treatment provided under the current thin capitalisation legislation. In particular, the current definitions do not contemplate origination, warehousing, two-tiered securitisation or synthetic securitisation. Nor do the current rules allow any residual equity holding in a securitisation vehicle. As a consequence, many bona fide securitisation vehicles will inappropriately have a proportion of their interest deductions denied under the thin capitalisation rules.

1.7 To address this, amendments will exclude special purpose entities from the thin capitalisation rules for all or part of the income year provided that the following conditions are met:

·
the entity is established for the purposes of managing some or all of the economic risk associated with assets, liabilities or investments (whether the entity assumes the risk from another entity or creates the risk itself);
·
At least 50% of the entity's assets are funded by debt interests; and
·
the entity is an insolvency remote special purpose entity according to the criteria of an internationally recognised rating agency applicable to the entity's circumstances.

[Schedule 1, item 2, subsections 820-39(1) to (3)]

1.8 The first condition is a purpose test that seeks to exclude entities that are not specifically established for what might be commonly referred to as securitisation or origination activity. It also seeks to exclude entities that undertake any activities not related to the process of securitisation or origination. The first condition seeks to cover items and risks that could be securitised or originated. For example, it covers a straightforward arrangement where assets are purchased by a special purpose entity. It also covers more complex arrangements, for example, where the risk associated with the assets is acquired by a special purpose entity but the underlying assets remain on the balance sheet of the originating entity.

1.9 The second condition recognises that while the overall objective of a securitisation or origination program is to fund the assets of the special purpose entity entirely through the issue of debt interests, there is the possibility that this may take some time to achieve or that there may be some residual equity holding in the vehicle or some other form of credit enhancement.

1.10 The third condition seeks to ensure that the special purpose vehicle meets or would meet an internationally recognised rating agency's requirements for an insolvency remote special purpose entity. A rating agency would attempt to ensure that the entity is unlikely to be subject to voluntary or involuntary insolvency proceedings. A rating agency may be satisfied where the entity can demonstrate that it:

·
is restricted to activities necessary to its role in the transaction;
·
is restricted from incurring additional indebtedness;
·
cannot be subject to reorganisation, merger or change of ownership; and
·
holds itself out to the world as a separate entity.

1.11 Some rating agencies publish general criteria whereas others have specific criteria for particular types of special purpose entities. For example, Standard and Poors have published Structured Finance Criteria for Australian and New Zealand Special Purpose Entities.

1.12 To take advantage of the exclusion from the thin capitalisation rules an entity must be able to demonstrate that it meets the criteria of an internationally recognised rating agency most applicable to its circumstances. This might be the criteria that is specific to that type of entity or that was relevant at the time the entity was established. It is not a requirement that the entity must have been rated by a rating agency. [Schedule 1, item 2, subsection 820-39(4)]

1.13 It is also possible for several legal entities to demonstrate that they meet the criteria of an internationally recognised rating agency where they are taken to be a single notional entity. [Schedule 1, item 2, subsection 820-39(5)]

1.14 The three conditions in subsection 820-39(3) seek to cover a broad and ever expanding range of securitisation activity and structures. For example, the conditions seek to include a warehousing type entity where securitised assets are temporarily placed pending their transfer to another entity. The conditions also seek to cover a two tiered securitisation structure where one entity holds the securitised assets and the other entity issues the debt interests.

1.15 A note has also been added signposting that if an entity does not qualify as a special purpose entity it may still be a securitisation vehicle under subsection 820-942(2) [Schedule 1, item 2, note 2 in section 820-39]. A similar note also covers the reverse situation where an entity may be exempt under section 820-39 even though it is not considered to be a securitisation vehicle for thin capitalisation purposes [Schedule 1, item 5, note in subsection 820-942(2)].

1.16 Where a special purpose entity is a member of a resident TC group it is not treated as part of that group for purposes of applying the thin capitalisation rules [Schedule 1, item 3, subsection 820-552(3)]. It does however remain part of the group for the purposes of maintaining the resident TC group's structure and to cover periods when it is a special purpose vehicle for part of the year but not at the end of the year. While it is considered a part of the group for these purposes, its presence will not affect the classification of the resident TC group [Schedule 1, item 3, subsections 820-552(1) and (2)].

1.17 Similarly, for the period that an entity is considered to be an exempt special purpose entity it is not part of a consolidated group or MEC group. [Schedule 1, item 4, section 820-584]

1.18 A note signposting this treatment for exempt special purpose entities has also been included. [Schedule 1, item 2, note 1 in section 820-39]

1.19 It should be noted that equity provided to a special purpose entity that meets the condition of subsection 820-39(3) will be treated as associate entity equity under section 820-915. Whereas a loan provided to a special purpose entity will not be treated as associate entity debt. [Schedule 1, item 32, paragraph 820-910(2)(c)]

1.20 This amendment applies in relation to income years commencing on or after 1 July 2001.

Choice by some financial entities to be treated as an ADI

1.21 The thin capitalisation methodology for banks is based on risk weighting assets and a minimum capital requirement. The methodology uses the approach that banking regulators use for prudential purposes. Under the existing law, the methodology is only available to ADIs.

1.22 The amendments extend this treatment to non-bank financial entities that meet certain conditions and elect to apply the ADI rules. This provides the opportunity for equivalent treatment for banks and non-banks that may be undertaking similar activities.

What are the conditions for making a choice to apply the ADI rules?

1.23 An entity must be a financial entity to qualify to be able to choose to apply the ADI rules. In addition, at least 80% of its assets must meet the definition of on-lent amount. (See paragraph 1.64 for discussion of changes to the definition of financial entity.) [Schedule 1, item 6, subsection 820-435(1)]

1.24 Where a financial entity's financial services licence covers dealing in derivatives, the total value of its on-lent amount plus the net unrealised gains from its derivative trading must be at least 80% of the value of its assets. This also applies to entities exempted from the requirement to hold a financial services licence covering dealings in derivatives by virtue of paragraph 911A(2)(h) or (l) of the Corporations Act 2001. The head company of a consolidated group or MEC group must also satisfy this requirement where the group contains a financial entity that meets these same licensing conditions. [Schedule 1, item 6, subsections 820-435(2) and (3)]

1.25 Where a financial entity's assets include precious metals, the value of the precious metals can be added to the on-lent amount in determining whether the 80% test is met. This also applies to the head company of a consolidated group or MEC group where the group contains a financial entity. [Schedule 1, item 6, subsections 820-435(4) and (5); item 12, definition of 'precious metal' in subsection 995-1(1)]

1.26 These conditions are referred to as the 80% rule in subsequent discussions.

How do the ADI rules apply to a non-ADI entity?

1.27 Where a financial entity elects to use the ADI methodology and the entity is an outward investor (financial) or an inward investment vehicle (financial), Division 820 applies as if the entity were an outward investing entity (ADI). Specifically, the entity would apply Subdivision 820-D. [Schedule 1, item 6, subsection 820-430(1)]

1.28 Where a financial entity elects to use the ADI methodology and that entity is an inward investor (financial) Division 820 applies as if the entity were an inward investing entity (ADI). Specifically, the entity would apply Subdivision 820-E. For the purposes of applying Subdivision 820-E all of the entity's business is considered to be its banking business. [Schedule 1, item 6, subsections 820-430(1) and (3)]

1.29 Where an entity elects to use the ADI methodology, this will not affect the calculation of an associate entity's associate entity debt. A loan that qualifies as associate entity debt will continue to be associate entity debt irrespective of whether a choice is made by the borrower to apply the ADI rules for thin capitalisation purposes. [Schedule 1, item 6, subsection 820-430(4)]

1.30 Similarly, where an entity elects to use the ADI methodology, this will not affect the calculation of an associate entity's associate entity equity. However, there will be no mechanism available to transfer any excess debt capacity back to the associate. Specifically, the associate will not be able to utilise section 820-920 - associate entity excess amount in relation to its equity investment in an entity that elects to apply the ADI rules.

How does the entity make the choice?

1.31 Provided that an entity meets the necessary conditions it may make the choice to apply the ADI rules. No formal notification of the choice is required. The choice will be evident in the entity's tax return. The choice will cease to have effect only in certain circumstances as discussed in paragraphs 1.32 to 1.34. [Schedule 1, item 6, subsection 820-430(2)]

Having made the choice can an entity revert back to the non-ADI rules?

1.32 Once having made the choice to apply the ADI rules, the taxpayer can only revert to using the non-ADI rules in 2 circumstances:

·
it no longer meets the 80% rule when tested at the end of the third year; or
·
the Commissioner approves a revocation of the choice.

1.33 Having satisfied the 80% rule, and made the choice to apply the ADI methodology, an entity is required to test for and satisfy the 80% rule every 3 years. Where the 80% rule is not satisfied in the third year, the entity must revert to using the non-ADI rules in the following year. Apart from the exception discussed in the following paragraph, the entity is not forced, nor does it have the option, to revert to the non-ADI rules in the intervening 3 years. This is irrespective of whether the entity would fail the 80% rule in those intervening years. [Schedule 1, item 6, subsections 820-430(6) and (7)]

1.34 Where an entity having qualified and made the choice to use the ADI methodology, wants to revert to the non-ADI rules it must demonstrate to the Commissioner that its business has substantially changed. An example of this might include situations where merger, acquisition or sale activity significantly modifies the operations of the entity. In such circumstances the Commissioner may approve the revocation of the choice. Where the Commissioner revokes the choice it has effect from that date or a date specified by the Commissioner. [Schedule 1, item 6, section 820-440]

1.35 Having made the choice to apply the ADI methodology at one point in time, an entity that reverts back to the non-ADI rules is prohibited from applying the ADI rules again at any point in the future. Specifically, an entity reverting to the non-ADI rules as prescribed in the 2 previous paragraphs cannot apply the ADI rules again. [Schedule 1, item 6, subsection 820-430(5)]

1.36 Notes signposting the availability of the ADI methodology for financial entities have been added to the definitions of inward investing entity (ADI), inward investment vehicle (financial), inward investor (financial), outward investing entity (ADI) and outward investor (financial). [Schedule 1, items 7 to 11]

ADI election interaction with resident TC grouping rules

1.37 Generally where an entity has made an election under section 820-430 to be treated as an ADI that choice will not flow into the classification process for resident TC groups as set out in section 820-550. The one exception to this is where the resident TC group could have made that same choice under section 820-430. In deciding if the group could make that choice the group is considered to have been a company for that year with each entity being a division of that company. [Schedule 1, item 6, subsection 820-445(1)]

1.38 The choice will also have no effect where the resident TC group would be treated as an inward investing entity (ADI) as a result of the application of section 820-575, were no choice to be made under section 820-430. In this situation the inward investing entity (ADI) rules will continue to apply to the resident TC group. [Schedule 1, item 6, subsection 820-445(2)]

1.39 This exception effectively acts as a tiebreaker where there would otherwise be a conflict between the ADI election and the resident TC grouping rules as to whether the inward or outward investing entity (ADI) rules should apply.

ADI election interaction with a head company and a single resident company

1.40 Where an entity is a member of a consolidated group or MEC group, a choice made under section 820-430 by that entity to apply the ADI rules will have no effect while that entity is a subsidiary member of that group. This means that a subsidiary is covered by the choice made by the head company of the consolidated group or MEC group while it is a member of that group. [Schedule 1, item 6, subsection 820-445(3)]

1.41 A choice made by an entity to apply the ADI rules will also have no effect for a grouping period where a head company or single resident company has made a choice under section 820-597 or 820-599 to include an Australian branch of a foreign bank as part of the entity. This is because a choice made under section 820-597 or 820-599 will already result in the entity being classified as either an inward or outward investing entity (ADI) for the grouping period. [Schedule 1, item 6, subsection 820-445(4)]

1.42 As was the case for resident TC groups, negating the effect of the ADI election under section 820-430 where a choice has been made under either section 820-597 or 820-599 effectively acts as a tiebreaker in deciding which ADI rules should apply to a head company or a single resident company.

1.43 It should be noted that an inward investor (financial) which has elected to be treated as if it were an inward investing entity (ADI) will still be unable to group with a head company or single resident company for thin capitalisation purposes. This is consistent with the policy that only Australian branches of foreign banks can be treated as part of a head company or a single resident company.

Revaluing assets for thin capitalisation purposes

1.44 Under the existing thin capitalisation rules, an entity may use a value of an asset for thin capitalisation purposes other than the value reflected in its books of account. The new value for thin capitalisation purpose must be determined by an independent valuer in accordance with the relevant accounting standards. It is assumed that only entities that carry assets on their balance sheet at the lesser of cost or recoverable amount would take advantage of these provisions.

1.45 The amendments modify the existing provisions to allow:

·
a suitably qualified employee to undertake the revaluation provided that it is verified by an external independent valuer;
·
the revaluation of one or more assets in an asset class provided that no asset in the asset class has fallen in value; and
·
an entity to cease revaluing its assets where it no longer wants to make use of that revaluation for thin capitalisation purposes.

1.46 The amendments also include record keeping requirements where an entity revalues an asset for thin capitalisation purposes.

1.47 The amendments clarify that where an entity undertakes a revaluation of its assets and that revaluation is reflected in its statutory accounts, those values can be used for thin capitalisation purposes. [Schedule 1, item 14, subsection 820-680(2A)]

External validation of a revaluation made internally

1.48 The existing law only allows an independent valuer to revalue the assets in accordance with the relevant accounting standards. This must be someone who is an expert in valuation and would not have a conflict of interest in undertaking the revaluation. The amendments allow an employee (or the like) of the entity (an internal expert) to undertake the revaluation in accordance with the accounting standards provided they have no other conflict of interest. [Schedule 1, item 14, paragraphs 820-680(2B)(a) and 820-680(2B)(c)]

1.49 However, the revaluation must be verified by someone who is also an expert but is not an employee of the firm (an external expert). That is a person who does not have a conflict of interest in verifying the revaluation. The external expert must review and agree to the methodology including the validity of any assumptions, the accuracy and reliability of the data and other information used. [Schedule 1, item 14, paragraph 820-680(2B)(b)]

Revaluation of individual assets

1.50 The existing provisions rely on the accounting standards to determine how assets are to be revalued, the asset class that can be revalued and the frequency of revaluations. Generally, the accounting standards require that all assets in an asset class be revalued. The amendments provide a variation to the requirements of the accounting standards by allowing an entity to revalue one or more assets in an asset class provided that no asset in the asset class has fallen in value (including unrealised gains and losses). [Schedule 1, item 14, subsection 820-680(2C)]

Example 1.1 Assets A (carrying value $100) and B (carrying value $100) are the only assets in a class of assets. The following shows potential unrealised gains or losses on assets A and B and indicates whether asset A can be revalued for thin capitalisation purposes.

Asset A (value reflecting unrealised gains and losses) Asset B (value reflecting unrealised gains and losses) Value of asset class in accounts (book value) Can asset A be revalued for thin capitalisation purposes? Additional value of asset A that can be used in the thin capitalisation calculation
150 120 200 yes 50
150 100 200 yes 50
150 80 200 no -
150 50 200 no -
200 0 200 no -

When further revaluation of assets is required

1.51 Where an entity undertakes a revaluation of assets specifically for thin capitalisation purposes it must continue to undertake the revaluation at the frequency required by the relevant accounting standard. This may require annual or less frequent revaluations. [Schedule 1, item 14, subsection 820-680(2D)]

1.52 Where an entity does not make a revaluation in accordance with the frequency requirements of the relevant accounting standard it must revert back to using the book value of the asset. This applies whether the entity is revaluing an asset class or a single asset (or more than one asset) in that class. [Schedule 1, item 14, subsection 820-680(2E)]

Records about asset revaluations

1.53 An entity must keep all records associated with a revaluation of assets under subsection 820-680(2). An exception to this obligation will be where the valuation is covered under subsection 820-680(2A). [Schedule 1, item 15, subsection 820-985(1); item 13, note in subsection 820-680(2)]

1.54 The records of a revaluation must contain details relating to:

·
the methodology used in the revaluation including any assumptions;
·
how the methodology was applied including any relevant data and other information used;
·
the name and credentials of the expert making the revaluations; and
·
the remuneration and expenses paid to the expert by the entity.

[Schedule 1, item 15, subsection 820-985(2)]

1.55 Where the revaluation is made by an independent internal expert, the entity must also keep records relating to:

·
name and credentials of the external expert;
·
the amount of remuneration the external expert received;
·
the expert's review of the methodology used to make the revaluation; and
·
the expert's agreement as to whether or not the methodology is suitable.

[Schedule 1, item 15, subsection 820-985(3)]

1.56 The records of the revaluation must be prepared before the entity lodges its income tax return for the income year to which the revaluation applies in whole or part. [Schedule 1, item 15, subsection 820-985(4)]

Arrangements for borrowing securities

1.57 The current thin capitalisation legislation includes specific rules for transactions associated with reciprocal purchase agreements, sell-buyback arrangements and securities loan arrangements. The underlying policy position is that the gross profit margin on such transactions is small and that entities should not be required to hold a high amount of capital against the assets generated from such transactions.

1.58 The amendments, some of which increase the equity requirement while others reduce it, refine the existing rules. A number of the amendments result in a greater equity requirement. Overall, the amendments should provide for more consistent thin capitalisation outcomes.

1.59 The amendments introduce the definition of borrowed securities amount. These are the liabilities of an entity incurred under a reciprocal purchase agreement, sell-buyback arrangement or securities loan arrangement. [Schedule 1, item 26, definition of 'borrowed securities amount' in subsection 995-1(1)]

1.60 The calculation of adjusted average debt has been amended to include the average value of the entity's borrowed securities amount. In addition, the definition of non-debt liabilities has been amended to include entity's borrowed securities amount. The effect of these amendments will increase the entity's equity requirement. However, without these amendments the existing treatment allows the sheltering of excess debt. [Schedule 1, item 18, subsection 820-85(3); item 19, subsection 820-120(2); item 20, subsection 820-185(3); item 21, subsection 820-225(2); item 27, definition of 'non-debt liabilities' in subsection 995-1(1)]

1.61 The definition of on-lent amount has been amended to include shares listed on an approved stock exchange. This will reduce the equity requirement so that it is equivalent to that required by APRA. However this treatment will only apply to genuine securities dealers and where market values can be easily verified. [Schedule 1, item 28, definition of 'on-lent amount' in subsection 995-1(1)]

1.62 The calculation of zero capital amount has been amended to only include amounts that have been received by the entity from the sale of debt interests under a reciprocal purchase agreement, sell-buyback arrangement or securities loan arrangement. This is similar to APRA equity requirements for such arrangements and reflects commercial practice. [Schedule 1, item 22, subsection 820-942(1)]

1.63 The calculation of zero capital amount has also been amended to include rights to the return of collateral where the entity has acquired securities under a reciprocal purchase agreement, sell-buyback arrangement or securities loan arrangement but where the entity has not repurchased the securities under the arrangement and the asset provided as security is not shares. Non-share assets such as cash or debt interests provided as security will be treated as zero capital amount. This new treatment will ensure that the right to the return of collateral has the same equity requirements as the collateral itself. [Schedule 1, item 23, subsection 820-942(1); item 24, subsection 820-942(1); item 25, subsection 820-942(1)]

Definition of financial entity

1.64 The thin capitalisation rules recognise that financial entities have a higher level of debt funding than non-financial entities in order to support their financial intermediation activities. A requirement for qualifying as a financial entity is to hold an Australian financial services licence within the meaning of the Corporations Act 2001 that covers dealing in securities, managed investment products and government debentures, stocks and bonds.

1.65 The definition of financial entity has been amended to include an entity whose Australian financial service licence covers dealings in derivatives. This will allow a qualifying entity that trades in derivatives to elect to be treated as an ADI for thin capitalisation purposes in Subdivision 820-EA. [Schedule 1, item 29, definition of 'financial entity' in subsection 995-1(1)]

1.66 The definition has also been amended so that an entity that is exempted from the need to hold an Australian financial service licence by paragraphs 911A(2)(h) and (l) of the Corporations Act 2001 will not be prevented from qualifying as a financial entity. These paragraphs relate to where an entity is regulated by an overseas authority or is covered by a specific ASIC exemption. This will ensure that an entity that is not required to hold an Australian financial services licence will not be prevented from qualifying as a financial entity provided that it meets the other relevant requirements. [Schedule 1, item 29, definition of 'financial entity' in subsection 995-1(1)]

Cost-free debt capital

1.67 The concept of cost-free debt capital in the thin capitalisation rules seeks to prevent the thin capitalisation calculations being manipulated by the injection of a loan that does not give rise to debt deductions (i.e. an interest-free loan) just prior to a valuation day, which is repaid shortly thereafter. Where an interest-free loan meets the definition of cost-free debt capital it is included in the entity's adjusted average debt.

1.68 An interest-free loan is cost-free debt capital where:

·
the borrower and lender are both subject to the thin capitalisation rules but have different valuation days or a different number of valuation days; or
·
only the borrower is subject to the thin capitalisation rules and the debt interest has been on issue for less than 180 days.

1.69 To ensure the genuine long term interest-free loans are not caught by the 180 day rule, the provision has been amended so that where the debt interest remains on issue for 180 days or more is not cost-free debt capital. [Schedule 1, item 31, subsection 820-946(4)]

1.70 For example, where an interest-free loan has been provided by an entity not subject to the thin capitalisation rules and is provided 60 days before the valuation day, it will currently be cost-free debt capital and added to the entity's adjusted average debt. This is irrespective of whether the loan is repaid the day after the valuation day or at some later date. Under the amended provision, if the loan is repaid up to 119 days after the valuation day it will remain cost-free debt capital. However, if the loan is repaid after 120 days or more it is not cost-free debt capital.

1.71 The definition of cost-free debt capital has been amended to exclude an entity that is not subject to the thin capitalisation rules because it is a special purpose entity and to clarify that the asset threshold test at section 820-37 only applies to outward investors. [Schedule 1, item 30, paragraphs 820-946(1)(c) and 820-946(1)(da)]

Associate entity debt

1.72 Associate entity debt seeks to ensure that there is no double counting of debt amounts that have been on-lent to an associate and the debt is tested in the associate.

1.73 The provision has been amended to ensure that the reference to the asset threshold test in section 820-37 is consistent with the policy intention. Under the existing law the reference to the asset threshold test could possibly apply to inward investors. The amendment ensures that it only applies to outward investors. [Schedule 1, item 32, paragraph 820-910(2)(b)]

1.74 An additional provision has also been included to ensure that a loan is not treated as associate entity debt where it has been on-lent to an associate if that entity is an exempt special purpose entity by virtue of section 820-39. [Schedule 1, item 32, paragraph 820-910(2)(c)]

1.75 Under the existing law, a loan to a foreign entity only qualifies as associate entity debt to the extent that it is attributable to the Australian operations of the foreign entity. Subparagraph 820-910(2)(a)(ii) defines Australian operations as carrying on business at or through a permanent establishment. [Schedule 1, item 32, subsections 820-910(2) and (2A)]

1.76 The provision has been amended to expand the definition of Australian operations to include situations where assets are held for the purposes of producing Australian assessable income. This change makes the definition of associate entity debt consistent with definitions of controlled foreign entity debt, controlled foreign entity equity and associate entity equity. [Schedule 1, item 32, paragraph 820-910(2A)(b)]

What borrowing expenses are excluded from being a debt deduction?

1.77 The definition of a debt deduction excludes borrowing expenses, deductible under section 25-25, that were incurred prior to 1 July 2001. This is to ensure that the deductibility of borrowing expenses incurred prior to the commencement of the present thin capitalisation regime are not affected.

1.78 To ensure consistency, borrowing expenses that were deductible under section 67 of the ITAA 1936 (the predecessor to section 25-25) will also be excluded from the definition of a debt deduction [Schedule 1, item 33, paragraph 820-40(1)(c)]. In effect this will only apply in relation to expenses incurred in the 1996-1997 income year as the 5 year period in which the deduction can be claimed expires in the 2001-2002 income year.

1.79 This amendment has effect for income years commencing on or after 1 July 2001.

What is a foreign controlled Australian partnership?

1.80 When determining what is a foreign controlled Australian partnership for partnerships that are not corporate limited partnerships, paragraph 820-795(2)(a) refers to a definition of Australian partnership. Australian partnership is not however defined for the purposes of the ITAA 1997. As a result paragraph 820-795(2)(a) is amended so that it takes its meaning from section 337 of Part X of the ITAA 1936. [Schedule 1, item 34, paragraph 820-795(2)(a)]

What is the basis underlying the arm's length debt amount

1.81 The arm's length debt amount seeks to determine an amount of debt that an independent lender would provide to the Australian operations of an entity. References in paragraphs 820-105(1)(b) and 820-215(1)(b) of the arm's length debt amount do not specifically mention Australian operations.

1.82 The policy intention is to compare the arm's length debt amount of the Australian operation with the actual level of Australian debt. To ensure this objective is achieved the factual assumptions that are to be used when calculating the arm's length debt amount have been amended so as to focus on only the Australian operations of the entity. [Schedule 1, item 36, paragraphs 820-105(2)(f) and 820-105(2)(g); item 38, paragraphs 820-215(2)(f) and 820-215(2)(g)]

1.83 This amendment has effect for income years commencing on or after 1 July 2001.

Records about Australian permanent establishments

1.84 Subdivision 820-L requires that an inward investor carrying on business in Australia at or through a permanent establishment will:

·
need to prepare separate financial statements for their permanent establishments;
·
need to prepare those statements in accordance with the Australian accounting standards; and
·
be liable for a penalty if they fail to comply with these requirements.

1.85 The law provides the Commissioner with a discretion to waive all or part of an accounting standard if the Commissioner decides that it is unreasonable for the entity to comply with that standard.

1.86 The provisions have been amended to exclude from the record keeping requirement entities with a permanent establishment in Australia:

·
where total revenue attributable to the Australian permanent establishment is less than $2 million [Schedule 2, item 2, subsection 820-960(1)]; or
·
where the carrying on of its business in Australia does not meet the definition of permanent establishment within the meaning of the relevant double tax agreement [Schedule 2, item 2, subsection 820-960(6)].

1.87 The provisions have been amended to allow an entity to satisfy the record keeping requirements by preparing financial statements for its Australian permanent establishment using the Australian accounting standards or the accounting standards of Germany, Japan, France, USA, UK, Canada, New Zealand or the international accounting standards. [Schedule 2, item 2, subsections 820-960(1A), (1B), (1C), (1D) and (2)]

1.88 The provisions extend the Commissioner's discretion to minimise the record keeping requirements to classes of entities. In addition, the Commissioner is required to publish details of the exercise of the discretion with respect to record keeping requirements in the Commonwealth Government Gazette. [Schedule 2, item 2, subsections 820-960(4) and (5)]

1.89 These amendments seek to reduce compliance costs for taxpayers and minimise ATO administrative arrangements in relation to the record keeping requirements.

Excluded equity interests

1.90 Previously, it was considered that the risk of manipulating the thin capitalisation rules by raising equity would be minimal as issuing shares is a protracted and costly exercise. However, the effect of the debt/equity rules is that some financial instruments commonly regarded as debt are now classified as equity although they do not necessarily have the features of a traditional equity instrument.

1.91 This has implications for the thin capitalisation regime as these types of equity interests can be readily moved in and out of entities at around the time that assets and debts are measured for thin capitalisation purposes (the valuation days). The effect of the transaction is that the assets of the borrowing entity are increased thereby increasing the maximum allowable debt of that entity. Where both the issuer and holder are subject to the thin capitalisation rules and have the same measurement days there is a no mischief, as an equity injection is deducted from the assets of the holder thereby reducing its maximum allowable debt. However, where this is not the case, the thin capitalisation outcome can be manipulated by such transactions.

1.92 The amendments introduce a new term excluded equity interest. An equity interest is an excluded equity interest where:

·
both the issuer and holder are subject to thin capitalisation rules but have different valuation days; or
·
only the issuer is subject to the thin capitalisation rules and the equity interest is on issue for less than 180 days.

[Schedule 2, item 33, definition of 'excluded equity interest' in subsection 995-1(1)]

1.93 Excluded equity interests are deducted from assets in the method statements for determining the safeharbour debt amount of the issuer. An excluded equity interest will reduce the maximum allowable debt of that entity. This is an integrity measure to ensure that the issuer does not get an advantage where equity interests are issued prior to a valuation day and cancelled shortly thereafter. [Schedule 2, item 5, section 820-95; item 7, subsection 820-100(2); item 9, subsection 100(3); item 11, section 820-195; item 13, subsection 820-200(2); item 15, subsection 820-200(3); item 17, section 205; item 19, subsection 210(2); item 21, subsection 820-210(3)]

1.94 To ensure that genuine long term equity interests are not caught by the 180 day rule, equity interests that remain on issue for 180 days or more are not cost-free debt capital. [Schedule 1, item 31, subsection 820-946(4)]

1.95 The concept of 'on issue' for an excluded equity interest has also been introduced. This concept is only relevant to an excluded equity interest and does not apply more broadly. It is designed to ensure that the provisions cannot be circumvented by extinguishing the value of the equity interest while it remains in existence. [Schedule 2, item 34, definition of 'on issue' in subsection 995-1(1)]

Excluding disallowed deductions from the CGT cost base

1.96 The CGT rules allow non-capital costs of ownership of a CGT asset acquired after 20 August 1991 to be included in the cost base of the asset to the extent that they are not deductible for income tax purposes.

1.97 However, it was not the intent of the thin capitalisation regime that inclusion in the cost base of the CGT asset be permitted where debt deductions were disallowed because an entity exceeded prescribed gearing levels. Such an outcome would undermine the policy intent of the thin capitalisation rules of preventing multinational entities allocating an excessive amount of debt to their Australian operations.

1.98 Accordingly, this bill introduces provisions that will exclude debt deductions disallowed as a result of the thin capitalisation rules from being included as part of the CGT cost base. [Schedule 2, item 41, section 110-54]

1.99 Notes signposting the CGT treatment have also been added to provisions which determine the amount of the debt deduction to be disallowed. The notes highlight that any debt deduction disallowed is not to be included as part of the cost base of a CGT asset. For debt deductions disallowed to entities that are members of a resident TC group or where a permanent establishment has joined a head company or a single company, a similar note has also been added. The sections that now include this note are sections 820-115, 820-220, 820-325, 820-415, 820-465 and 820-605. [Schedule 2, items 42 to 48]

1.100 These amendments apply to a capital gain made from a CGT event happening on or after 1 July 2002. [Schedule 2, item 49]

Premium excess amount

1.101 The premium excess amount in section 820-920(3) ensures that entities are not unfairly penalised under the thin capitalisation rules where the holding value of an investment in an associate is greater than the book value of the associate entity (i.e. where the investor has paid a premium). Currently, steps 1 and 2 of the premium excess amount use slightly different definitions to identify the investment. Step 2 in the method statement has been amended to ensure that the definitions are aligned. [Schedule 2, item 52, subsection 820-920(3)]

Attributable safeharbour excess amount

1.102 The attributable safeharbour excess amount determines the amount of excess debt capacity that an entity can carry back from its associate. Inward investors (financial) have been included in step 1 for completeness. [Schedule 2, item 53, subsection 820-920(4)]

Adjusted average equity capital for consolidated entities or groups

1.103 Subsection 820-589(3) provides the methodology for determining adjusted average equity capital for the head company of a consolidated group or MEC group that is required to use the outward investing entity (ADI) rules. Subsection 820-613(3) applies similarly when a head company or single resident company includes an Australian bank branch of a foreign bank as part of itself for thin capitalisation purposes.

1.104 Presently, these calculations are based on the entire operations of the relevant head company or single resident company. That is, it covers both their Australian and foreign based operations. This is inconsistent with both the policy underlying the thin capitalisation regime (that concentrates on only the Australian operations of an entity) and the definition of adjusted average equity capital for outward investing entities (ADI) contained in Subdivision 820-D.

1.105 In Subdivision 820-D adjusted average equity capital is determined by calculating the average value of the equity capital of the entity (net of any equity attributable to an overseas permanent establishment) less the average value of CFE equity (net of CFE equity attributable to the overseas permanent establishment).

Amendments necessary given the present definition of 'equity capital'

1.106 Subsection 820-589(3) is amended by this bill to align the calculation of adjusted average equity capital for a head company of a consolidated group or MEC group with methodology set out in Subdivision 820-D. This is achieved by excluding both the equity capital attributable to an overseas permanent establishment and CFE equity (net of CFE equity attributable to the overseas permanent establishment) from the head company's calculation. [Schedule 2, items 36 and 37, subsection 820-589(3)].

1.107 A similar amendment has also been made where an Australian bank branch of a foreign bank is included as part of the head company or single company. [Schedule 2, item 40, paragraphs 820-613(3)(a) and 820-613(3)(b)]

1.108 The information to be used by each entity that is a member of the group in the determination of the value of adjusted average equity capital is that which would be contained in a set of consolidated accounts prepared in accordance with accounting standards at the measurement time. [Schedule 2, item 39, subsection 820-589(4)]

1.109 The interim grouping provisions contained in Subdivision 820-F for entities that are members of a resident TC group are also to be amended to exclude both the equity capital attributable to an overseas permanent establishment and CFE equity (net of CFE equity attributable to the overseas permanent establishment) from the calculation of adjusted average equity capital. [Schedule 2, item 35, subsection 820-562(3)]

1.110 The amendments to align the definition of adjusted average equity capital apply for income years commencing on or after 1 July 2002.

Amendments following the change to 'equity capital' definition as from 1 July 2003

1.111 Provisions dealing with the determination of adjusted average equity capital and average equity capital for the head company of a consolidated group or MEC group and a single resident company are also to be amended. This is a result of the change to the definition of equity capital effective for income years commencing on or after 1 July 2003 (see paragraphs 1.120 to 1.126)

How does Subdivision 820-D apply to the head company of a MEC group?

1.112 The new definition of equity capital means that the head company of a consolidated group that is classified as an outward investing entity (ADI) would apply Subdivision 820-D as if it were a single entity when calculating adjusted average equity capital because the relevant value will now be reflected in the head company.

1.113 Additional rules to apply Subdivision 820-D are now only required in relation to the head company of a MEC group to ensure that equity capital not directly reflected in the head company of the MEC group is taken in account. This is necessary because the head company of the MEC group does not own the other tier-1 companies within the MEC group. Rather their common parent is an offshore entity.

1.114 The new provision in calculating adjusted average equity capital ensures the ADI equity capital of the head company of a MEC group takes into account any equity interest or debt interest in the head company that are held at the measurement time by entities that are not members of the group. It similarly assumes that equity interests and debt interest in other eligible tier-1 companies are treated as if they were an equity interest or debt interest of the head company, but again only if held at the measurement time by entities that are not members of the group. [Schedule 3, item 6, subsection 820-589]

1.115 Reflecting this, section 820-589 as amended (see paragraphs 1.106 and 1.108) is to be replaced for income years commencing on or after 1 July 2003.

How does Subdivision 820-D apply if the head company or single resident company includes an Australian bank branch?

1.116 The calculation of adjusted average equity capital has also been amended where the outward investing entity (ADI) rules in Subdivision 820-D are to be applied to a head company or single resident company that has included an Australia bank branch of a foreign bank in its group for thin capitalisation purposes.

1.117 In this situation the adjusted average equity capital of the head company or single resident company is adjusted and increased to include:

·
the ADI equity capital of the foreign bank attributable to each of its Australian branches (but not allocated to offshore banking activities of the foreign bank) and any interest-free loans that are provided by the foreign bank to its Australian branch.

[Schedule 3, item 8, subsections 820-613(2) and (3)]

1.118 This amendment to subsections 820-613(2) and (3) applies for income years commencing on or after 1 July 2003.

How does Subdivision 820-D apply to a resident TC group?

1.119 The new definition of equity capital has no application to resident TC groups as entities are unable to form a resident TC group for income years that commence on or after 1 July 2003.

Definition of equity capital

1.120 In the existing law, the meaning of equity capital varies depending on the classification of an entity. There are 3 different definitions depending on whether the entity is an outward investing ADI, a trust or partnership, or any other type of entity.

1.121 The amendments provide a new definition of equity capital that applies to all entities. The definition incorporates the concept of an 'equity interest' as defined in Subdivision 974-C and in section 820-930 for trusts and partnerships. An equity interest is valued at its issue price less any unpaid amount. [Schedule 3, items 11 and 12, definitions of 'equity capital' and 'equity interest in an entity' in subsection 995-1(1)]

1.122 Equity capital also includes:

·
general reserves and asset revaluation reserves;
·
opening retained earnings or accumulated losses (i.e. negative retained earnings);
·
current year earnings (net of expected tax and distributions) or losses; and
·
provisions for distributions.

1.123 These amendments clarify the initial policy intention by clearly stating that current year profits (or losses) and provisions for distributions are included in the definition of equity capital. It also clarifies that accumulated losses (or negative retained earnings) are a deduction against equity capital.

1.124 The change in the definition of equity capital gives rise to a number of consequential amendments. The definition of worldwide equity also has to be amended. [Schedule 3, item 14, definition of 'worldwide equity' in subsection 995-1(1)]

1.125 The amendments include a new definition - that of ADI equity capital. This allows an ADI (or an entity applying the ADI rules) to include cost-free loans in its adjusted average equity capital or average equity capital for thin capitalisation purposes [Schedule 3, items 8 and 9, subsections 820-613(2) and (3) and 820-615(2)]. This provides similar treatment of cost-free loans to that available to non-ADIs. To be included in ADI equity capital a debt interest must be on issue for 90 days or more and not give rise to any costs for the issuer [Schedule 3, item 10, definition of 'ADI equity capital' in subsection 995-1(1)].

1.126 These amendments take effect from income years commencing on or after 1 July 2003.

Average equity capital

1.127 In situations where a head company or single resident company is treated as an inward investing entity (ADI), that head company or single resident company is required to apply the rules in Subdivision 820-E.

1.128 Resulting from the change to the equity capital definition that is applicable for income years commencing on or after 1 July 2003, the definition of average equity capital is also to be amended.

1.129 For income years commencing on or after 1 July 2003 the average equity capital of a head company or single resident company for the period will be the sum of:

·
ADI equity capital of the company for the test period; plus
·
the ADI equity capital of the foreign bank attributable to each of its Australian branches (but not allocated to offshore banking activities of the foreign bank) and any interest-free loans that are provided by the foreign bank to its Australian branch.

[Schedule 3, item 9, subsection 820-615(2)]

Assets and liabilities

1.130 The thin capitalisation rules require an entity to comply with the accounting standards when determining the value of its assets, liabilities and equity. The terms 'assets' and 'liabilities' are not defined for the purposes of Division 820. Consequently, they have their normal legal meaning. This can lead to some assets or liabilities not being able to be valued using the accounting standards. Alternatively, some balance sheet items might not meet the normal legal meaning of asset or liability.

1.131 To overcome these anomalies the accounting standards are to be used to determine the definition of an asset and liability. [Schedule 3, item 16, subsection 820-680(1)]

1.132 An additional provision has also been inserted to remove any doubt that the requirements of subsection 820-680(1) to value assets and liabilities in accordance with accounting standards only covers those assets or liabilities that, according to the accounting standards, can or must be recognised at the relevant measurement time. [Schedule 3, item 17, subsection 820-680(1A)]

Foreign dividend account

1.133 The FDA operates so that an unfranked foreign sourced dividend paid to non-resident investors by a resident company is exempt from dividend withholding tax. Debiting the FDA account for non-deductible expenses incurred in relation to section 23AJ income is designed to ensure the FDA surplus correctly reflects the amount the company is able to pay its shareholders without there being any dividend withholding tax liability.

1.134 However, the interaction of section 25-90 with the FDA provisions has resulted in interest expenses that would otherwise give rise to an FDA debit now failing to satisfy the conditions for an FDA debit. This results in the FDA being overstated.

1.135 This amendment reinstates as an FDA debit, expenditure deductible due to the operation of section 25-90 that is incurred in respect to dividends exempt under section 23AJ. [Schedule 4, item 1, paragraph 128TB(1)(b)]

Application and transitional provisions

1.136 Amendments to Schedule 1 apply to income years that commence on or after 1 July 2001. [Schedule 1, item 1]

1.137 Amendments to Schedule 2 (except Part 5) and Schedule 4 apply to income years that commence on or after 1 July 2002. [Schedule 2, item 1; Schedule 4, item 2]

1.138 Amendments made by Schedule 2, Part 5 (except items 50 and 51) do not apply for the purposes of working out a capital gain made from a CGT event happening before 1 July 2002 [Schedule 2, item 49]. The amendment made by item 50 is to be taken always to have had effect [Schedule 2, item 51].

1.139 Amendments to Schedule 3, Parts 1 and 2 apply to income years that commence on or after 1 July 2003 [Schedule 3, items 15 and 18]. However, the application of Part 2 does not affect the interpretation of subsection 820-680(1) as it applies to income years that commence before that date.

Consequential amendments

1.140 The existing paragraphs 820-589(3)(a) and 820-589(3)(b) and the note to subsection 820-589(3) have been replaced by subsection 820-589(4) as a consequence of the amendments to subsection 820-589 (see paragraph 1.106). [Schedule 2, items 37 and 38]

1.141 Amendments to paragraphs 820-105(2)(d) and 820-215(2)(d) that change the reference from 'paragraph (e)' to 'paragraphs (e), (f) and (g)' results in the inclusion of additional factual assumptions when determining the arm's length debt amount. [Schedule 1, item 35, paragraph 820-105(2)(d); item 37, paragraph 820-215(2)(d)]

1.142 Amendments to subsections 262A(2AA), 262A(3) and paragraph 262A(3)(c) of the ITAA 1936 update references as a result of amendments to provisions covering both revaluation of assets and record keeping requirements for permanent establishments. [Schedule 1, items 16 and 17; Schedule 2, item 3]

1.143 Technical amendments to the calculation of safeharbour debt amount, cost-free debt capital are the result of the inclusion of the term excluded equity interest. [Schedule 2, items 4, 6, 7, 8, 10, 12, 14, 16, 18, 20 and 22 to 32]

1.144 A technical amendment to item 31 of Schedule 4 to the Taxation Laws Amendment Act (No. 7) 2000 ensures that section 110-37 is correctly located within the ITAA 1997 under the group heading 'What does not form part of the cost base'. At present, section 110-37 is inappropriately located above this heading. [Schedule 2, item 50]

1.145 Amendments to subsections 820-300(3), 820-330(3), 820-611(2) and paragraph 820-395(3)(a) result from the change in the definition of equity capital together with the inclusion of the term ADI equity capital. [Schedule 3, items 1 to 5 and 7]

1.146 The repeal of the definition of 'equity interest in a company' results from the change in the definition of an 'equity interest in an entity'. [Schedule 3, item 13]


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