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Ruling

Subject: Interaction of accounting standards and thin capitalisation provisions

AusCo

AusCo is an Australian resident company for income tax purposes. It is the parent entity of the accounting consolidated group and also the head company of the AusCo tax consolidated group.

AusCo directly holds 49% of the shares in OSCo

OSCo is a foreign resident for income tax purposes.

OSCo is an associate of AusCo for accounting purposes.

OSCo is not an associate entity of AusCo for income tax purposes.

Accounting for AusCo's investment in OSCo

AusCo has accounted for its investment in OSCo in both its separate company accounts as well as in its parent entity accounts.

In compliance with the AASB series of accounting standards, the value of this investment recorded in its consolidated accounts is different from the value recorded in its separate company accounts.

Additional facts relevant to the application of the thin capitalisation provisions

The Commissioner is advised that for each of the relevant income years, AusCo was subject to the thin capitalisation provisions contained in Division 820 of the ITAA 1997 as none of the exemptions in Subdivision 820-A of the ITAA 1997 applied.

The Commissioner is advised that for each of the relevant income years, AusCo was an 'outward investor (general)' in accordance with Item 1 of the table contained in subsection 820-85(2) of the ITAA 1997, and no member of the group was a financial entity or ADI, as those terms are used in paragraph 820-583(2)(b) of the ITAA 1997, at any time during those years.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 701-1

Income Tax Assessment Act 1997 Section 820-85

Income Tax Assessment Act 1997 Section 820-95

Income Tax Assessment Act 1997 Section 820-583

Income Tax Assessment Act 1997 Section 820-680

Question 1

Will AusCo as the head company of a tax consolidated group, which directly holds an investment that is not an associate entity for tax purposes and that the accounting standards requires to be valued using two values in accordance with the accounting standards, have a choice as to which value to apply so long as this methodology is applied consistently year on year for the purposes of the thin capitalisation provisions of Division 820 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 1

The core operative thin capitalisation rule for outward investing entities (non-ADI) is set out in subsection 820-85(1) of the ITAA 1997. Broadly, the core rule disallows all or part of the debt deductions of an entity for an income year where the entity's adjusted average debt exceeds its maximum allowable debt. As indicated in Note 4 to subsection 820-85(1) of the ITAA 1997, the operative rule applies to a consolidated group or a MEC group.

Subdivision 820-FA of the ITAA 1997 sets out the specific rules for how the thin capitalisation rules apply to consolidated groups. Relevantly, subsection 820-583(1) of the ITAA 1997 modifies the thin capitalisation rules to make the head company of a tax consolidated group the 'outward investing entity (non-ADI)' referred to in subsection 820-85(1) of the ITAA 1997. It provides that the head company of a tax consolidated group or MEC group is an outward investing entity (non-ADI) for a period that is all or part of an income year if it is an outward investor (general) or outward investor (financial) for that period. Accordingly, the head company of the tax consolidated group is the 'entity' for the purposes of subsection 820-85(1) of the ITAA 1997.

An outward investor (general) calculates its maximum allowable debt using the safe harbour debt amount calculation in section 820-95 of the ITAA 1997. Step 1 of the method statement for this calculation requires the entity to work out the average value, for the income year, of all its assets. To this end, subsection 820-680(1) of the ITAA 1997 provides that:

For the purposes of this Division, an entity must comply with the *accounting standards in… calculating:

(a) the value of its assets (including revaluing its assets for the purposes of that calculation)…

Neither section 820-680 of the ITAA 1997, nor any other provision, expressly provides which accounting standard is to be used by a head company for valuing an asset under section 820-680 of the ITAA 1997. However, when read in the context of the legislative history of the thin capitalisation rule, it is clear that in valuing an asset under section 820-680 of the ITAA 1997 by a head company of a tax consolidated group, it must use the value derived in using the accounting standard on consolidated accounts.

The legislative history will now be examined.

Valuation under the former thin capitalisation grouping rules

Prior to the introduction of the consolidation regime, the thin capitalisation rules contained their own grouping rules. Subdivision 820-F of the ITAA 1997 contained the specific rules for resident thin capitalisation groups (resident TC groups). A resident TC group was defined in subdivision 820-F (now repealed) to be a group of entities comprising of wholly-owned resident companies, certain trusts and partnerships and Australian branches of foreign banks resident companies.

The resident TC grouping rules were only intended to be in effect until the introduction of the consolidation rules and the TC grouping rules were intended to have the same effect to that of the consolidations regime in relation to the operation of the thin capitalisation rules for wholly-owned groups. As provided in the Explanatory Memorandum (EM) to the New Business Tax System (Thin Capitalisation) Bill 2001:

6.3 …the ability for 100% owned entities to group in determining their debt levels is seen as better reflecting group structures and the broader debt coverage of the new regime. This would have been consistent with the proposed Consolidation regime, which would treat the consolidated group as a single entity for tax purposes. Grouping or consolidation removes the possibly inequitable results that could arise with substantial amounts of intra-group debt.

6.4 With the implementation of the Consolidation regime deferred to 1 July 2002, the provision of an interim grouping rule will enable entities to determine their funding levels on a group basis until the Consolidation regime is implemented. It is contemplated that this rule will be replaced when the Consolidation regime commences.

Under the former grouping rules, a resident TC group could choose to have the thin capitalisation rules apply to the group as if it were a single notional entity for the relevant income year. Specifically, former subsection 820-460(3) of the ITAA 1997 provided that the resident TC grouping rule applied to each entity in the group as if the group had been a company and each entity in the group was treated as if it were a division or part of that company, rather than a separate entity.

The consolidation rule in section 820-460 of the ITAA 1997 was supported by a specific rule for valuing items including assets. Former subsection 820-470(1) of the ITAA 1997 required that:

For the purposes of this Division as applying because of this Subdivision to a *resident TC group for an income year, the value or amount of a particular matter as at a particular time is to be worked out, so far as practicable, on the basis of the information that would be contained in a set of consolidated accounts:

(a) prepared, in accordance with the *accounting standard on consolidated accounts, as at that time; and

(b) covering the entities of which the group consisted at that time.

The EM provides further guidance:

8.3 Values of assets and liabilities are to be determined by reference to the relevant accounting standards…

8.37 An entity must comply with the accounting standards in calculating the value of its assets, liabilities and equity. As with foreign currency conversions:

the relevant accounting standards are those made by the AASB; and

an entity must comply with the accounting standards whether or not it is otherwise required to do so under a particular standard.

8.40 Accounting standard AASB 1024 requires that parent entities must prepare consolidated accounts. Entities may also be able to group under the thin capitalisation provisions, as discussed in Chapter 6. The threshold tests for whether an entity can group under this Bill and whether they are required to prepare consolidated accounts are different. The former requires 100% ownership of subsidiaries (definitions in Subdivision 975-W of the ITAA 1997) and the latter relies on the ability to dominate the decision-making, directly or indirectly, in relation to the financial and operating policies of another (paragraph 9 definition of control). Thus, an entity that is required to prepare consolidated accounts under AASB 1024 may not necessarily be able to group under the thin capitalisation rules. However, it is considered that entities that may group under the thin capitalisation provisions will usually also be required to prepare consolidated accounts under AASB 1024. In order to comply with the accounting standards, the group for thin capitalisation purposes will be required to base its calculations on consolidated figures for the group prepared in accordance with AASB 1024.

Thus, there was a clear intention expressed in section 820-470 that the values of assets for the purposes of the thin capitalisation rules would be the values that would be calculated for the consolidated accounts. This is consistent with the Note to former subsection 820-470(1) of the ITAA 1997. See also paragraph 11.20 of the EM which states:

… The resident thin capitalisation group would determine its maximum allowable debt or minimum capitalisation as if it were a single entity using consolidated figures….

It can be gleaned from the EM that using values from the consolidated accounts as stipulated by the accounting standard on consolidated accounts was considered appropriate because the accounts reflected single entity treatment.

With the repeal of Subdivision 820-F of the ITAA 1997, the express reference to the use of calculations for the consolidated accounts by consolidated groups with respect to the valuation of assets, liabilities and equity capital was removed. However the fact that an equivalent provision was not enacted is not an indication that the legislation would allow the entity to use values from its separate company accounts because the single entity rule (SER) will secure the same result. That is, the reference to 'entity' in section 820-680 of the ITAA 1997 has the effect of requiring the head company to value its assets (i.e. the assets of the tax consolidated group) in accordance with how they would be valued in the consolidated accounts.

The SER under the consolidation regime secures the same result

Subdivision 820-F of the ITAA 1997 was repealed in its entirety and replaced with the rules in Subdivisions 820-FA of the ITAA 1997 and 820-FB of the ITAA 1997 which were all that were necessary (in addition to the consolidation provisions in Part 3-90 of the ITAA 1997) to bring consolidated groups within the thin capitalisation regime as single entities.

Subsection 701-1(1) of the ITAA 1997 within Part 3-90 of the ITAA 1997 states the SER as:

If an entity is a *subsidiary member of a *consolidated group for any period, it and any other subsidiary member of the group are taken for the purposes covered by subsections (2) and (3) to be parts of the *head company of the group, rather than separate entities, during that period.

Briefly the purposes of subsection 701-1(2) and (3) of the ITAA 1997 include the working out of a head company's liability for income tax at any period during and after the year consolidation occurred. The calculation of the safe harbour debt amount will impact the amount of debt deductions an entity is allowed to claim and, hence, the amount of income tax it will be liable for. Therefore, the SER will apply for the purposes of section 820-85 of the ITAA 1997.

By virtue of the SER each of the entities in the tax consolidated group, including the head company, lose their separate identities and are considered as a single entity under consolidation (for the purposes stated in the SER) and, therefore, the head company's separate financial accounts are irrelevant for the valuation of the consolidated group's assets. The thin capitalisation provisions only recognise the head company being the single entity comprising of the head company and its wholly-owned subsidiaries. Therefore, the appropriate way to value the assets, liabilities and equity capital of the 'entity' is in accordance with the consolidated accounts prepared by the parent, which is the head company of the tax consolidated group.

Further, while not determinative, this interpretation accords with the relevant legislative context of Division 820 of the ITAA 1997. It is noted that section 820-611 of Subdivision 820-FB of the ITAA 1997 contains an express provision that mandates that 'the value…of a particular matter…is to be worked out…on the basis of the information that would be contained in a set of consolidated accounts…prepared, in accordance with the accounting standard on consolidated accounts, as at that time…and covering the consolidated group'. In the context of Subdivision 820-FB, there is no requirement under the accounting standards to prepare consolidated accounts that include the Australian branch of a foreign bank or foreign financial entity. Also, there is no requirement for an Australian branch of a foreign bank to comply with Australia's accounting standards. In light of this disparity between the consolidations regime and accounting standards, a specific reference to the use of consolidated accounts was necessary to achieve the intended application of the thin capitalisation rules to consolidated groups and MEC groups, including the elimination of intra-group transactions. Accordingly, the presence of subsection 820-611(1) of the ITAA 1997 supports the conclusion that these rules extend, in particular circumstances, the general rule that the values that would be found in consolidated accounts are to be used for the purposes of the thin capitalisation rules.

The absence of any express or implicit change in policy upon the enactment of Part 3-90 of the ITAA 1997 and the subsequent repeal of Subdivision 820-F of the ITAA 1997 also supports the Commissioner's view that under the current law, the head company must value its assets and liabilities in accordance with the values that would be used to prepare consolidated accounts in compliance with the accounting standard on consolidated accounts. Furthermore given that one of the primary objectives of the consolidation rules is to 'allow wholly-owned groups of entities to make a choice to consolidate and therefore be treated as a single entity for the purposes of determining income tax liability' the use of consolidated accounts would achieve this purpose.

Added to the legislative history and the fact that the relevant entity is the head company of a consolidated group that prepares consolidated accounts means that the words in section 820-680 of the ITAA 1997 require a head company, being the relevant 'entity', to use the values derived from its notional consolidated accounts to the exclusion of values used in its separate company accounts.

Conclusion

Based on the reasons above, AusCo as an outward investing entity (non ADI), and as the head company of a tax consolidated group will be the entity that will be subject to the thin capitalisation rule contained in subsection 820-85 of the ITAA 1997. Subsection 820-583(1) of the ITAA 1997 modifies the thin capitalisation rules to make AusCo the 'outward investing entity (non-ADI)' referred to in subsection 820-85(1) of the ITAA 1997. In working out its maximum allowable debt, AusCo has elected to use the safe harbour debt amount which will be calculated in accordance with section 820-95 of the ITAA 1997. In working out the average value of its assets in compliance with step 1 of the method statement in section 820-95 of the ITAA 1997, it must have regard to section 820-680 of the ITAA 1997, which for the reasons specified above, requires AusCo to use a value worked out in accordance with the accounting standard on consolidated accounts.

Question 2

Summary

Where the response to Question 1 is no, is AusCo required to use the value of the directly held investment that is worked out in accordance with the accounting standard that applies to separate company accounts?

No

Detailed reasoning

Question 2

As discussed in the Reasons for Question 1 above, in applying the thin capitalisation rule in Subdivision 820-B of the ITAA 1997, AusCo must work out the value of its investment in OSCo based on information contained in its consolidated accounts and which is in compliance with the accounting standards on consolidated accounts. As such AusCo does not have recourse to its separate company accounts in determining the value of its investment in OSCo for the purposes of section 820-680 of the ITAA 1997.