Edited version of private advice

Authorisation Number: 5010090739729

Date of advice: 20 July 2023

Ruling

Subject: Thin capitalisation

Question 1

Is the XYZ Joint Venture eligible to calculate its maximum allowable debt using the worldwide gearing debt amount under paragraph 820-90(1)(c) of the Income Tax Assessment Act 1997 (ITAA 1997).

Answer

Yes

Question 2

Is the methodology stated in this ruling for calculating the worldwide gearing debt amount under section 820-110 of the ITAA 1997 correct?

Answer

Yes

Question 3

Will all or part of the XYZ Joint Venture's debt deductions be disallowed under section 820-85 of the ITAA 1997 for the XXXX income year?

Answer

Yes

This ruling applies for the following period:

1 July XXXX to 30 June XXXX

The scheme commences on:

1 July XXXX

Relevant facts and circumstances

1.            On XX/XX/XXXX, the following entities entered into a Joint Venture Agreement (JV Agreement) and agreed to establish an unincorporated joint venture and tax law partnership known as the XYZ Joint Venture (XYZ JV).

•                     A Pty Ltd as trustee for the K Unit Trust (K), and

•                     C Pty Ltd as agent for the Joint Venture between:

-   D Pty Ltd as trustee for the D Trust, and

-   E Pty Ltd as trustee for the E E Trust.

Subsequently referred to as the F Joint Venture.

2.            The JV interests, aligned to respective capital contributions of each party to the XYZ JV, are:

•                     K (X%), and

•                     F Joint Venture (Y%).

3.               The proportional return for each of the XYZ JV participants will be:

4.            The objectives of the XYZ JV are to:

•                     undertake the development of the Development Land in accordance with the Development Agreement

•                     maximise the profitability of the development project, and

•                     successfully complete the Project.

Developer

5.            K and F Joint Venture incorporated L Pty Ltd (the Developer).

6.            The shares in the Developer are held in the following proportions:

•                     F Joint Venture - X%

•                     K - Y%

7.            The JV Agreement appoints the Developer as an agent for the XYZ JV.

8.            The Developer will not hold assets in its own capacity other than assets it holds as agent for and on behalf of the XYZ JV. This includes the Developer's interest under the Development Agreement.

9.            All expenses incurred by the Developer in relation to the Project are incurred on behalf of the XYZ JV.

The Project

10.          T is an incorporated association registered in XXX since XX/XX/XXXX.

11.          T owns a parcel of land and adjacent blocks (Development Land).

12.          T wishes to develop the Development Land and sought tenders for the sale or development of the Development Land in conjunction with their plans for redevelopment.

Development Agreement

13.          T entered into a development agreement (Development Agreement) with the Developer to develop the Development Land owned by T and to jointly share in the sale proceeds.

14.          Under the Development Agreement, T received an upfront payment of $X m (Commitment Fee) and will receive proceeds after the sale of the Development Land with priority up to the value of $XXX m (Priority Payment Amount).

15.          T has a right to terminate the Development Agreement if certain agreed timeframes are not met under the Development Agreement.

16.          T's right to terminate will be abrogated if the XYZ JV enters into a deed with T whereby the XYZ JV pays the difference between $E and what T has or will receive at a specified date as a part of the Priority Payment Amount (Milestone Shortfall Amount).

17.          T will retain ownership of the Development Land up until the development is complete and the subdivided land with the finished buildings have been sold and settled.

18.          To the extent that work done on the Development Land become fixtures, T becomes the owner of such fixtures.

19.          However, the XYZ JV is entitled to sever any part of such fixtures from the Development Land, remove any chattel, and remain in possession and control of such fixtures until the Development Land is sold and settled.

20.          T has the option of retaining any Developed Product either by obtaining a freehold title or through a leaseback arrangement.

K

21.          K is a unit trust wholly owned by the V Trust. V Trust is wholly owned by the W Trust.

22.          The W Trust is an outward investing entity for the purpose of Division 820 of the ITAA 1997.

C

23.          C is a company incorporated in Australia.

24.          C is owned in equal proportions by:

•                     D Trust, and

•                     E Trust.

25.          The capital contributions to the F Joint Venture were made in equal proportions by:

•                     D Trust, and

•                     E Trust.

26.          The F Joint Venture is a tax law partnership.

27.          The D Trust and E Trust are Australian discretionary trusts controlled by 2 key individuals that form part of the C Group.

28.          D Trust and E trust are not inward investors or outward investors for the purpose of Division 820 of the ITAA 1997.

29.          C Group is a property developer based in Australia.

XYZ Joint Venture

30.          The XYZ JV's debt deductions for the XXXX income year totalled $XXX.

31.          The total debt deductions of the XYZ JV and its associate entities exceeded $X for the XXXX income year.

32.          The XYZ JV is not an exempt special purpose entity under section 820-39 of the ITAA 1997.

33.          The XYZ JV is not a financial entity for the purpose of Division 820 of the ITAA 1997.

34.          The Balance Sheets of the XYZ JV disclose the following:

35.          The XYZ JV does not hold any equity interest in any associate entities and therefore does not have any associate entity equity.

36.          The XYZ JV has issued debt interests to the Senior Financier (discussed below). There are no other debt interests issued by the XYZ JV.

Bank Facility

37.          L Pty Ltd (the Developer) on behalf of the XYZ JV entered into a Loan Agreement with the Bank on XX/XX/XXXX. The Loan Agreement was subject to multiple amendments.

38.          The Guarantors for the Loan Agreement are:

•                     C in its own capacity and as the nominee for the D Trust and E Trust

•                     D Pty Ltd in its own capacity and as trustee of the D Trust

•                     E Pty Ltd in its own capacity and as trustee of the E Trust, and

•                     A Pty Ltd in its own capacity and as trustee for K.

39.          The Bank committed to the following amounts:

•                     Early Works Facility of up to $X

•                     Development Facility of up to $X

•                     GST Overdraft Facility of up to $X.

40.          Interest accrues from day to day on the outstanding principal amount of each Loan drawn under the Early Works Facility or the Development Facility at the rate determined by the Lender to be the sum of the applicable Margin for that Facility and the BBR for the relevant Funding Period.

41.          Prior to the Repayment Date and assuming the Borrower is in compliance with the Facility Agreement (for example, no Event of Default continues) the interest for the Early Works Facility and Development Facility will be capitalised monthly in arrears on the last Business Day of the relevant Funding Period.

42.          The Borrower will pay interest in relation to the GST Overdraft Facility on the last business day of each calendar month.

43.          In addition to the interest rate payable, the XYZ JV is also required to pay an Establishment fee and Line fee.

44.          The Sponsor Support Documents comprise of a Deed of Guarantee and Indemnity and an Equity Subscription Deed dated around the date of the Facility Agreement. The Deed of Guarantee and Indemnity is between the C Sponsor and the Lender, and the Equity Subscription Deed is between the K Sponsor and the Lender.

45.          Under the terms of the Sponsor Support Documents, the C Sponsor and K Sponsor would be required to pay the Subscription Amount. In the event of default, the Subscription Amounts would be used to repay the Secured Moneys.

46.          Under the terms of the facility agreement, the Bank did not require the XYZ JV participants to make upfront Capital Contributions to the capital stack of the arrangement.

47.          To secure the debt facility, the Bank required both K and the F Joint Venture to make a Capital Contribution Commitment (the Commitment). This Commitment meant that in the event of a default under the facility agreement the Bank could require both JV participants to make a Capital Contribution to the XYZ JV in proportion to their Respective Portions provided in the JV Agreement. For completeness it is noted that the Bank took a security interest over part/all of the Land owned by the XYZ JV. This security interest was subordinate to the Commitment and would only be called where in the event that the funds available under the Commitment were insufficient.

48.          The Borrower has Security over the following assets:

•                     Freehold Mortgage - in respect of the property comprised in certificate of title Volume X Folio Y (and in respect of each resulting lot upon registration of the Stage A Plan of Subdivision), and certificate of title Volume X - Folio Y granted by the XYZ JV in favour of the Borrower.

•                     General Security Deed - under which the XYZ JV granted a Security Interest in favour of the Borrower in respect of the assets and undertaking of the XYZ JV that relates to or may be used in connection with the Development Parcel.

•                     Ancillary Security - any Security Interest, Guarantee or other.

49.          In conjunction with the Loan Agreement, the Bank entered into a mortgage deed over the Secured Property with the XYZ JV.

Assumptions

50.          The W Trust has controlled foreign entities.

51.          The average Australian assets of the XYZ JV and its associates is less than X% of the total assets of XYZ JV and its associates.

52.          The XYZ JV's arm's length debt amount is less than the worldwide gearing debt amount for the purpose of this ruling.

53.          The XYZ JV is a tax law partnership.

54.          The $X Commitment Fee paid by the XYZ JV to T is correctly recognised as an asset under the accounting standards.

Relevant legislative provisions

Income Tax Assessment Act 1936 paragraph 318(3)(a)

Income Tax Assessment Act 1936 paragraph 318(4)(a)

Income Tax Assessment Act 1936 paragraph 336(a)

Income Tax Assessment Act 1936 section 337

Income Tax Assessment Act 1997 Division 820

Income Tax Assessment Act 1997 Subdivision 820-B

Income Tax Assessment Act 1997 subsection 820-85(1)

Income Tax Assessment Act 1997 subsection 820-85(2)

Income Tax Assessment Act 1997 subsection 820-85(3)

Income Tax Assessment Act 1997 subsection 820-90(1)

Income Tax Assessment Act 1997 paragraph 820-90(1)(c)

Income Tax Assessment Act 1997 section 820-95

Income Tax Assessment Act 1997 section 820-110

Income Tax Assessment Act 1997 section 820-115

Income Tax Assessment Act 1997 subsection 820-185(2)

Income Tax Assessment Act 1997 paragraph 820-185(2)(a)

Income Tax Assessment Act 1997 subsection 820-630(1)

Income Tax Assessment Act 1997 section 820-680

Income Tax Assessment Act 1997 subsection 820-680(3)

Income Tax Assessment Act 1997 section 820-750

Income Tax Assessment Act 1997 section 820-755

Income Tax Assessment Act 1997 section 820-760

Income Tax Assessment Act 1997 subsection 820-760(1)

Income Tax Assessment Act 1997 subsection 820-760(2)

Income Tax Assessment Act 1997 paragraph 820-780(c)

Income Tax Assessment Act 1997 section 820-795

Income Tax Assessment Act 1997 paragraph 820-795(2)(b)

Income Tax Assessment Act 1997 section 820-815

Income Tax Assessment Act 1997 subsection 820-815(1)

Income Tax Assessment Act 1997 paragraph 820-815(1)(a)

Income Tax Assessment Act 1997 paragraph 820-815(1)(b)

Income Tax Assessment Act 1997 paragraph 820-815(1)(c)

Income Tax Assessment Act 1997 paragraph 820-815(1)(d)

Income Tax Assessment Act 1997 subsection 820-815(2)

Income Tax Assessment Act 1997 section 820-885

Income Tax Assessment Act 1997 section 820-890

Income Tax Assessment Act 1997 section 820-905

Income Tax Assessment Act 1997 paragraph 820-905(1)(a)

Income Tax Assessment Act 1997 subsection 820-905(3A)

Income Tax Assessment Act 1997 subsection 820-905(3B)

Income Tax Assessment Act 1997 subsection 820-905(6)

Income Tax Assessment Act 1997 paragraph 820-905(8)(b)

Income Tax Assessment Act 1997 subparagraph 820-905(8)(c)(i)

Income Tax Assessment Act 1997 section 820-910

Income Tax Assessment Act 1997 section 820-930

Income Tax Assessment Act 1997 subsection 820-930(2)

Income Tax Assessment Act 1997 section 820-932

Income Tax Assessment Act 1997 subsection 820-932(2)

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

All references are to the ITAA 1997 unless otherwise stated.

Question 1

Is the XYZ Joint Venture eligible to calculate its maximum allowable debt using the worldwide gearing amount under paragraph 820-90(1)(c).

Summary

The XYZ JV is eligible to calculate its maximum allowable debt using the worldwide gearing amount under paragraph 820-90(1)(c).

Detailed reasoning

1.            For an entity that is an 'outward investing entity (non-ADI)[1] and not an 'inward investment vehicle (general)' or an 'inward investment vehicle (financial)[2] for all or part of the income year, the entity's maximum allowable debt can be the worldwide gearing debt amount unless the entity has nil or negative worldwide equity.[3]

2.            For 'outward investing entities (non-ADI), subsection 820-90(1) states:

The entity's maximum allowable debt for an income year is the greatest of the following amounts if the entity is not also an inward investment vehicle (general) or an inward investment vehicle (financial) for all or any part of that year:

(a) the safe harbour debt amount;

(b) the arm ' s length debt amount,

(c) unless the entity has worldwide equity of nil or a negative amount - the worldwide gearing debt amount.

Outward investing entity (non-ADI)

3.            The XYZ JV is an outward investing entity (non-ADI) for the XXXX income year.

4.            An outward investing entity (non-ADI) is defined in subsection 820-85(2) as including:

•                     an Australian entity which controls at least one Australian controlled foreign entity or carries on a business through at least one overseas permanent establishment, and is not an ADI,[4] or

•                     an associate entity of an Australian entity which satisfies the above.[5]

5.            An entity meeting the above criteria is an 'outward investor (general)'. This would include HPST under the first bullet point above.

6.            The XYZ JV does not control any Australian controlled foreign entities or carry on a business through an overseas permanent establishment. However, the XYZ JV will be an 'outward investor (general)' if it satisfies the following conditions.[6]

7.            Based on the above, the XYZ JV meets all the conditions to be an 'outward investing entity (non-ADI)' of the 'outward investor (general)' entity type.[17]

Inward Investment vehicle

8.            An entity, that is not a financial entity or an ADI, is an inward investment vehicle (general) for a period that is all or a part of an income year if the entity is a foreign controlled Australian entity throughout a period that is all or a part of an income year.[18] A foreign controlled Australian entity includes a foreign controlled Australian partnership.[19]

9.            A partnership other than a corporate limited partnership is a foreign controlled Australian partnership (or an FCAP) at a particular time if, and only if, at that time the following conditions are satisfied:[20]

10.          Accordingly, the XYZ JV is not an inward investment entity for the XXXX income year.

Eligibility to apply worldwide gearing debt amount

11.          As noted in paragraph 820-90(1)(c), eligibility to use the worldwide gearing debt amount is dependent on the entity not having nil or negative worldwide equity.

Worldwide equity

12.          Subsection 820-932(2) states:

An entity's worldwide equity at a particular time, means the total of the following amounts:

(a) all the equity capital of the entity as at that time, but worked out disregarding equity interests in the entity held at that time by Australian controlled foreign entities (the controlled entities) of which the entity is an Australian controller at that time;

(b) all the equity capital of the controlled entities as at that time, but worked out disregarding equity interests in the controlled entities held at that time by:

(i) the entity; or

(ii) other controlled entities.

13.          There are no equity interests in the XYZ JV that are held by Australian controlled foreign entities (CFE). Any equity capital in CFE controlled by W Trust will not be counted in relation to the worldwide equity of the XYZ JV.[23] Therefore, the worldwide equity amount of the XYZ JV will be its equity capital and no further adjustments are required to be made.

14.          The calculation of the worldwide equity amount must be based on average values.[24] The XYZ JV has chosen the opening/closing method to calculate the average value for thin capitalisation purposes.

15.          'Equity capital' is defined in subsection 995-1(1), which includes the calculation method shown below. Applicable amounts for the XYZ JV for the XXXX income year are as follows:

16.          In the context of the equity capital calculation method and for the purposes of the thin capitalisation provisions, we consider that equity capital represents net equity of the entity, being shareholders' equity of a company, participants funds of a partnership or net equity of a trust however described including capital contributions, unpaid beneficiary entitlements and net accumulated losses.

17.         In this regard, the Explanatory Memorandum (EM) to the New Business Tax System (Thin Capitalisation) Bill 2001 that enacted the thin capitalisation provisions states the following in paragraph 1.15:

18.          Current and prior year losses made by the XYZ JV will accrue to the partners and would therefore be included within the XYZ JV's equity capital as part of the 'total amount of owner's funds'.

19.         In calculating 'equity capital' under subsection 995-1(1), current year losses are captured in paragraph (g) regarding the entity's net loss (if any) for the current year.

20.         In relation to prior year profits and losses, you have stated that the 'XYZ JV does not have retained earnings'.

21.         The terms 'retained earnings' and 'negative retained earnings' are not defined in the Tax Acts or Australian accounting standards. Further, Australian accounting standards are expressed as applying to 'entities', as opposed to companies or any specific entity type, and accordingly, the terms 'retained earnings' and 'negative retained earnings' are not limited to companies. In our view, these terms would take their ordinary meaning as 'accumulated profits' or 'accumulated losses' of the relevant entity.[27]

22.         In the Statement of Changes in Partnership Funds in the XYZ JV Financial Statements for the XXXX income year (with XXXX comparative) there is a column titled 'Retained earnings'. This column includes the loss made by the XYZ JV for the current year (as applicable), but this is then cleared to the 'Participants Funds' column as a 'Distribution to Participants' within the same income year, leaving a nil balance of Retained earnings in each income year. Similarly, the opening balance of Participants Funds includes prior year profits/losses as a result of 'distribution' or transfer of those profits/losses to Participants Funds in prior income years. These distributions were not paid and so remained within Participant Funds as equity capital amounts belonging to the participants.

23.         It is our view that prior year profits and losses would be included in the equity capital of a partnership, within the definition of' equity capital' in paragraph 995-1(1)(a), as part of the 'the issue price (however described) of each equity interest in the entity that is still on issue, reduced by so much (if any) of the issue price as remains unpaid.' Alternatively, the profits/losses would be included under paragraph

24.         995-1(1)(b) or (f) to the extent that the profits and losses have been transferred to Participants Funds as a reserve or provision for distributions payable to the participants. If neither of these applied, then we would consider that despite the method of accounting adopted by the XYZ JV, then accumulated net profits or losses of the partnership would be included in the equity calculation under paragraphs 995-1(1)(d) or (g) as retained earnings or negative retained earnings. These are considered in turn below.

25.         Our view that the losses made by the XYZ JV are captured within the equity capital definition is consistent with the intended meaning of equity capital in the EM as representing 'the total amount of owners funds'. The total amount of owners funds is equivalent to the net assets of an entity.[28] Net assets will be reduced by current and prior year losses, by virtue of a decrease in cash on hand, an increase in liabilities or a disposal of assets for consideration that is less than their carrying value.

26.         Further, this is consistent with the intent as set out in the EM to the Taxation Laws Amendment Act (No. 5) 2003 which replaced separate definitions of equity capital for different types of entities including partnerships with the present single definition:

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.

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. (Emphasis added).

27.         The above EM indicates that there should be no difference in outcome of the equity capital calculation as applied to partnerships and companies. While the manner in which companies and partnerships may prepare their accounts may differ, and therefore there may be differences in amounts included in the various components of the equity capital calculation of each, the net result of the calculation should be the same, in that equity capital should be equal to net assets of the applicable entity.

Paragraph 995-1(1)(a): Issue price of each equity interest

28.         Section 820-930 provides that 'equity interest' in a partnership has the meaning given by Division 974 as modified for partnerships. Subsection 820-930(2) revises the table in section 974-75, which applies to equity interests in companies, for the purposes of determining equity interests in partnerships and trusts. This states that an equity interest in a partnership is an 'interest as a partner in the partnership'.

29.         The 'issue price' of the equity interest as a partner in the XYZ JV will include partner capital contributions, as referred to in clause X of the JV Agreement and disclosed in the XYZ JV Statement of Cashflows as 'Proceeds from Participant contributions', but would also, in our view, include the partners share of profits and losses made by the partnership (to the extent these were not separately disclosed as retained profits or losses at year end or paid out to the partners).

30.         In the XYZ JV Statement of Changes in Participants Funds for the XXXX income year (including XXXX comparative), capital contributions and partnership profits/losses distributed to the partners are disclosed as a single net amount in the 'Movement in current accounts' line, under the sub-heading 'Transactions with participants in their capacity as participants'. They are not separately disclosed as retained earnings at year end, paid out to the partners in cash or other property. Rather, the losses disclosed as distributions to the partners were booked by the XYZ JV as a decrement to Participant Funds, representing the partners equity interests as partners in the partnership.

31.         Section 820-680 requires that, for the purposes of Division 820, the entity complies with the accounting standards in determining what its assets and liabilities are and in calculating the value of its assets, liabilities and equity capital. This requirement has effect regardless of whether the accounting standards otherwise apply to the entity, according to subsection 820-680(3).

32.         In this regard, AASB 101 Presentation of Financial Statements states the following:

106 An entity shall present a statement of changes in equity as required by paragraph 10. The statement of changes in equity includes the following information:

(a) total comprehensive income for the period, showing separately the total amounts attributable to owners of the parent and to non-controlling interests;

(b) for each component of equity, the effects of retrospective application or retrospective restatement recognised in accordance with AASB 108; and

(c) [deleted]

(d) for each component of equity, a reconciliation between the carrying amount at the beginning and the end of the period, separately (as a minimum) disclosing changes resulting from:

(i) profit or loss;

(ii) other comprehensive income; and

(iii) transactions with owners in their capacity as owners, showing separately contributions by and distributions to owners and changes in ownership interests in subsidiaries that do not result in a loss of control.

107 An entity shall present, either in the statement of changes in equity or in the notes, the amount of dividends recognised as distributions to owners during the period, and the related amount of dividends per share.

108 In paragraph 106, the components of equity include, for example, each class of contributed equity, the accumulated balance of each class of other comprehensive income and retained earnings.

109. Changes in an entity's equity between the beginning and the end of the reporting period reflect the increase or decrease in its net assets during the period. Except for changes resulting from transactions with owners in their capacity as owners (such as equity contributions, reacquisitions of the entity's own equity instruments and dividends) and transaction costs directly related to such transactions, the overall change in equity during a period represents the total amount of income and expense, including gains and losses, generated by the entity's activities during that period. (Emphasis added).

33.         The AASB Conceptual Framework recognises that the legal and regulatory framework for certain entity types, such as partnerships, will differ from corporate entities, for example in that there are few if any restrictions regarding distributions to equity holders:

4.67 Business activities are often undertaken by entities such as sole proprietorships, partnerships, trusts or various types of government business undertakings.The legal and regulatory frameworks for such entities are often different from frameworks that apply to corporate entities. For example, there may be few, if any, restrictions on the distribution to holders of equity claims against such entities. Nevertheless, the definition of equity in paragraph 4.63 of the Conceptual Framework applies to all reporting entities (Emphasis added).[29]

34.         In the XYZ JV Statement of Changes in Participants Funds for the XXXX income year (with XXXX comparative), profits or losses made in each income year are 'distributed' to the partners, resulting in nil retained earnings in each income year. While the financial accounts of the XYZ JV do not disclose an accumulated balance of retained earnings at the end of each income year, if the distributions are accepted as being distributions under Australian accounting standards, then the financial statements would be considered to comply with AASB 101 in that they disclose the opening balance of retained earnings, profit or loss made in each income year, distributions to partners and a closing balance (nil in each income year).

35.         The distributions have, however, not been paid to partners and instead are represented in the financial accounts as a reduction of 'Participant Funds'. Therefore, the distributions have not been recognised as a separate reserve or any other 'component' of equity within the Statement of Changes in Equity (as required by paragraph 106 of AASB 101 if the distributions made but not paid were a separate 'component' of equity at year end). Indeed, there are no other components of equity disclosed in the XYZ JV accounts that have a carrying value at the end of each income year, other than Participants Funds.

36.         The net Participant Funds alone therefore represent the partners' 'equity interests as partners in the partnership'.

37.         In this regard, AASB 101 Presentation of Financial Statements states the following:

79 An entity shall disclose the following, either in the statement of financial position or the statement of changes in equity, or in the notes:

(a) for each class of share capital:

(i) the number of shares authorised;

(ii) the number of shares issued and fully paid, and issued but not fully paid;

(iii) par value per share, or that the shares have no par value;

(iv) a reconciliation of the number of shares outstanding at the beginning and at the end of the period;

(v) the rights, preferences and restrictions attaching to that class including restrictions on the distribution of dividends and the repayment of capital;

(vi) shares in the entity held by the entity or by its subsidiaries or associates; and

(vii) shares reserved for issue under options and contracts for the sale of shares, including terms and amounts; and

(b) a description of the nature and purpose of each reserve within equity.

80 An entity without share capital, such as a partnership or trust, shall disclose information equivalent to that required by paragraph 79(a), showing changes during the period in each category of equity interest, and the rights, preferences and restrictions attaching to each category of equity interest (Emphasis added).

38.         Accordingly, AASB 101 requires disclosure of the Participants Funds as the 'issue price' of the partnership equity interests, being the equivalent to paid up share capital of a company.

39.         The issue price of XYZ equity interests to be included in working out the 'equity capital' under paragraph 995-1(1)(a) is therefore $X as at 30 June XXXX and ($X) as at 30 June XXXX, as disclosed in the XYZ JV's Statement of Changes in Participant Funds.

Paragraph 995-1(1)(b): Reserves, or Paragraph 995-1(1)(f): Provision for distributions

40.         If Participants Funds does not represent the 'issue price' of equity interests in the partnership (i.e., only the contributed capital correctly represents the Issue price), then it is our view the distribution of partnership profits and losses to partners included within Participant's Funds would be included in the equity capital definition as either a reserve or provision for distributions under paragraph 995-1(1)(b) or (f).

41.         Note 8 of the Financial Statements discloses Participant Funds separated into each participant's Share of losses and Contributions for each income year, together with combined opening and closing balances for each participant and overall. However, if the partners Contributed capital alone was to be included under paragraph 995-1(1)(a) as the issue price of equity interests then, to comply with Australian accounting standards,[30] the contributed capital would have to be disclosed separately from other items of equity as the issue price of equity interests, in accordance with paragraphs 79, 80, 106(d) and 108 of AASB 101, including separate opening and closing balances. This would require, in turn, that the partners' Share of profits/losses for current and prior income years were disclosed elsewhere, either as a separate component of equity such as a reserve within the Statement of Changes in Participant Funds pursuant to paragraphs 106(d) and 107 of AASB 101, or as a provision for distribution within the Statement of Financial Position.[31]

42.          Accordingly, if the financial statements were restated to comply with Australian accounting standards such that a reserve or provision for distribution was included for distributions made but not paid to partners in each income year, then these would be included as such in the equity capital calculation for the XYZ JV.

43.          Reserves or provisions for distributions, if accounted for separately in accordance with Australian accounting standards by the XYZ JV such that these were not included in working out 'equity capital' under paragraph 995-1(1)(a), and instead were included under paragraph 995-1(1)(b) or (f), would have balances of ($X) as at 30 June XXXX and ($X) as at 30 June XXXX.

Paragraph 995-1(1)(g): the entity's negative retained earnings

44.         If the distributions as disclosed in the XYZ JV Financial Statements are NOT accepted as being distributions under Australian accounting standards, then our view in paragraph 33 above would not apply.

45.         Instead, if the XYZ JV Financial Statements were restated to comply with Australian accounting standards, as required by section 820-680, the XYZ JV Statement of Changes in Participants Funds would disclose an accumulated balance of negative retained earnings in the XXXX and XXXX income years.[32]

46.         For completeness, current year profits and losses are included in the equity capital calculation in paragraphs 995-1(1)(d) and (h). There is clearly no intention for these profits or losses to be double-counted within paragraphs 995-1(1)(d) and (c) for profits or paragraphs 995-1(1)(g) and (h) for losses, or in other paragraphs referred to above where they may be double counted. Accordingly, current year profits and losses should be excluded from one of these paragraphs in the equity capital calculation to the extent of any double-counting.

Conclusion

47.         We consider that the profits and losses made in both current and prior income years by the XYZ JV would be included within the equity capital definition under one of the following provisions in paragraph

48.         995-1(1)(a), (b), (c), (d), (f), (g) or (h) as applicable.

49.         This is consistent with the intent of the equity capital definition and the thin capitalisation provisions as set out in the 2001 and 2003 EM's and accounting standards which provide that an entity's equity is equal to the entity's net assets.[33]

50.         Further, it is our view, there is no policy reason or intent for the thin capitalisation provisions to differentiate between entity types in determining maximum allowable debt and any debt deductions disallowed. That is, there is no indication in the black letter law or the EM that companies should be treated differently to partnerships when determining maximum allowable debt of the applicable entity. In fact, paragraphs 1.120 to 1.123 in the EM to the Taxation Laws Amendment Act (No. 5) 2003 clearly refers to the definition applying to all entities, replacing previous definitions of equity capital for different entity types.

51.         Worldwide equity of the XYZ JV is $378,305 for the XXXX income year. As this amount is not nil or negative, the XYZ JV is eligible to calculate its XXXX income year maximum allowable debt using the worldwide gearing debt amount method.

Question 2

Is the methodology stated in this ruling for calculating the worldwide gearing debt amount under section 820-110 correct?

Summary

The methodology referred to in this ruling for calculating the worldwide gearing debt amount under section

820-110 is considered to be correct.

Detailed reasoning

52.          For an entity that is an outward investor (general) that is not an inward investment vehicle, the worldwide gearing debt amount is calculated using the following method statement in subsection 820-110(1):

•                     Step 1 - Divide the average value of all the entity's worldwide debt for the income year by the average value of all the entity's worldwide equity for that year.

•                     Step 3 - Add 1 to the result of step 1.

•                     Step 4 - Divide the result of step 1 by the result of step 3.

•                     Step 5 - Multiply the result of step 4 in this method statement by the result of step 6 in the method statement in section 820- 95.

•                     Step 6 - Add to the result of step 5 the average value, for that year, of the entity's associate entity excess amount. The result of this step is the worldwide gearing debt amount.

Worldwide debt

53.          Subsection 820-932(1) states:

An entity's worldwide debt at a particular time, means the total of the following amounts:

(a) all the debt interests issued by the entity:

(i) to entities other than any Australian controlled foreign entities (the controlled entities) of which the entity is an Australian controller at that time; and

(ii) that are still on issue at that time;

(b) all the debt interests issued by the controlled entities:

(i) to entities other than the entity or other controlled entities; and

(ii) that are still on issue at that time.

54.          For the XXXX and XXXX income years, the only debt interest issued by the XYZ JV are the debt interests issued to the Bank.

Controlled entities

55.          Section 820-750 defines when an entity will be an 'Australian controller' of an Australian controlled foreign company (except a corporate limited partnership) as follows:

An entity is an Australian controller of a controlled foreign company mentioned in paragraph

820-745(a) at a particular time if, and only if, at that time:

(a) that entity is an Australian entity holding a TC control interest in the controlled foreign company that is 10% or more; or

(b) all of the following subparagraphs apply:

(i) the controlled foreign company is such a company because of paragraph 340(c) of the Income Tax Assessment Act 1936;

(ii) not more than 5 Australian entities, including that entity, control that controlled foreign company (either alone or together with *associate entities and whether or not any associate entity is also an Australian entity);

(iii) that entity holds a TC control interest in the controlled foreign company that is at least 1%.

Note: A corporate limited partnership that is a foreign entity may be a controlled foreign corporate limited partnership, see section 820-760.

56.          Section 870-755 defines when an entity will be an Australian controller of an Australian controlled foreign trust as:

An entity is an Australian controller of a controlled foreign trust at a particular time if, and only if, at that time, the entity is an Australian entity holding a *TC control interest in the trust that is 10% or more.

57.          Section 820-760 defines when an entity will be an Australian controller of an Australian controlled foreign corporate limited partnership as follows:

Australian controller of a controlled foreign corporate limited partnership

(1) An entity is an Australian controller of a *controlled foreign corporate limited partnership at a particular time if, and only if, at least one of the following paragraphs applies to the entity at that time:

(a) the entity is an Australian entity that is a general partner of the partnership;

(b) the entity is an Australian entity holding a TC control interest in the partnership that is 10% or more.

Controlled foreign corporate limited partnership

(2) A corporate limited partnership is a controlled foreign corporate limited partnership at a particular time if, and only if, at that time:

(a) it is not an Australian entity; and

(b) at least one of the following subparagraphs applies to it:

(i) at least one *general partner of the partnership is an Australian entity or an *Australian controlled foreign entity;

(ii) not more than 5 Australian entities (each of which holds a TC control interest in the partnership that is at least 1%) hold a total of *TC control interests in the partnership that is 50% or more.

TC control interest

58.          'TC control interest' is defined in section 820-815 as follows:

(1)The thin capitalisation control interest (or TC control interest) that an entity holds in a company, trust or partnership at a particular time is the total of the following interests:

(a) the TC direct control interest (if any) held by the entity in the company, trust or partnership at that time;

(b) the TC indirect control interest (if any) held by the entity in the company, trust or partnership at that time;

(c) the TC direct control interests (if any) held by the entity's associate entities in the company, trust or partnership at that time;

(d) the TC indirect control interests (if any) held by the entity's associate entities in the company, trust or partnership at that time.

This section has effect subject to sections 820-820 to 820-835 (which set out special rules to avoid double counting).

Note: For the rules about a TC direct control interest, see sections 820-855 to 820-865. For the rules about a TC indirect control interest, see sections 820-870 to 820-875

(2)This section does not apply to an associate entity of the entity if:

(a) the associate entity is a foreign entity and the associate entity is such an associate entity only because of subsection 820-905(3A); or

(b) the associate entity is such an associate entity only because of subsection

820-905(3B).

59.          Subsections 820-905(3A) and (3B) state:

(3A) If:

(a) an entity (the first entity) is an associate entity of another entity (the head entity ) under subsection (1), (2), (2A) or (3) at a particular time; and

(b) a third entity is also an associate entity of the head entity under subsection (1), (2), (2A) or (3) at that time;

the first entity is an associate entity of the third entity at that time.

(3B)If an entity (the first entity) is an associate entity of another entity under subsection (1), (2), (2A), (3) or (3A) at a particular time, that other entity is also an associate entity of the first entity at that time.

60.          For the purposes of subsection 820-815(1), it is helpful to first understand the meaning of the phrase 'the entity's associate entities', given the different phrasing here to that used in section 820-905. In this regard:

•                     under subsection 820-905(1), the XYZ JV will be an associate entity of W Trust and V Trust - W Trust and V Trust's associate entities will include the XYZ JV. However, the XYZ JV's associate entities will not include W Trust or V Trust.[34]

•                     under subsection 820-905(3A), all subsidiaries of W Trust (or that W Trust holds an interest in) that are associate entities of it will also be associate entities of the XYZ JV - the XYZ JV's associate entities will include all such subsidiaries/interests of HPST (i.e., sister entities of the XYZ JV)

•                     under subsection 820-905(3B), W Trust and V Trust are associate entities of the XYZ JV - the XYZ JV's associate entities will include W Trust and V Trust under subsection (3B).

61.          Prima facie, under paragraphs 820-815(1)(c) and (d), the XYZ JV will hold 'TC control interests' in all entities in which W Trust holds TC control interests, including CFE's of W Trust, as W Trust is an associate entity of the XYZ JV under subsection 820-905(3B). The CFE's of W Trust would therefore become 'Australian controlled foreign entities of which the XYZ JV is an Australian controller' in calculating 'worldwide debt' and 'worldwide equity' of the XYZ JV, pursuant to sections 820-932 and 820-750,

62.          820-755 and 820-760.

63.          However, both W Trust and V Trust are excluded from being associate entities of the XYZ JV, for the purposes of determining entities in which XYZ JV holds a TC control interest, by operation of subsection 820-815(2). This subsection excludes an entity from being an associate entity of another entity if it would be such an associate entity 'only because of subsection 820-905(3B)'. Similarly, foreign entities that are only associate entities of the XYZ JV because of subsection 820-905(3A) are also excluded from being associate entities of the XYZ JV for the purposes of determining the XYZ JV's TC control interests in other entities.

64.          The effect of subsection 820-815(2), in determining entities in which the XYZ JV has TC control interests under subsection 820-815(1) and therefore entities in which the XYZ JV is an 'Australian controller' under sections 820-750 to 820-760, is that:

•                     under paragraphs 820-815(1)(a) or (b), the XYZ JV will only have 'TC control interests' in entities in which it holds direct or indirect interests, which is nil

•                     paragraphs 820-815(1)(c) and (d) will have no application to the XYZ JV in relation to foreign entities which are only associate entities of the XYZ JV due to subsection 820-905(3A), and

•                     the XYZ JV will not be an Australian controller of any Australian controlled foreign entities.

Conclusion regarding Worldwide Debt

65.          The Worldwide debt of the XYZ JV will be the debt interest issued by the XYZ JV to the Bank.

66.          It does not include the debt interests issued by controlled foreign entities of which W Trust is the controller.

Worldwide Equity

67.          For the same reasons as set out above, the XYZ JV will not be an Australian controller of any Australian controlled foreign entities.

68.          Accordingly, its Worldwide Equity will consist solely of its own equity capital as set out in Issue 1 above.

Safe harbour debt amount- outward investor (general)

69.         The method statement for calculation of the Worldwide gearing debt amount includes the result of Step 6 of the Safe harbour debt amount calculation. Accordingly, calculation of the Safe harbour debt amount (at least up to Step 6) is required for the purposes of Question 2 in this ruling. The Safe harbour debt amount is also required for the purposes of determining XYZ JV's maximum allowable debt, and therefore whether any debt deductions are denied under Question 3 in this ruling.

70.          Section 820-95 provides the Safe harbour debt amount test for an outward investor (general). The calculation of the Safe harbour debt amount test for the XYZ JV is set out below:

Calculation of worldwide gearing debt amount

71.          The calculation of the XYZ JV's worldwide gearing debt amount is determined by the method statement in section 820-110. Applicable amounts for the XYZ JV for the XXXX income year are as follows:

72.          The XYZ JV's worldwide debt gearing amount is therefore $X.

73.          As this is higher than the XYZ JV's safe harbour debt amount and arm's length debt amount (per the requested assumption), this amount will also be the XYZ JV's maximum allowable debt for the XXXX income year.

Question 3

Will all or part of the XYZ JV's debt deductions be disallowed under section 820-85 for the XXXX income year?

Summary

Part of the XYZ JV's debt deductions will be disallowed under sections 820-85 and 820-115.

Detailed reasoning

74.         Subsection 820-85(1) states:

This subsection 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:

(a) the entity is an outward investing entity (non-ADI) (see subsection (2)); and

(b) the entity's adjusted average debt (see subsection (3)) exceeds its maximum allowable debt (see section 820-90).

75.          The amount of debt deduction to be disallowed is calculated under section 820-115 as follows:

The amount of debt deduction disallowed under subsection 820-85(1) is worked out using the following formula:

Debt deduction × Excess debt

Average debt

where:

average debt means the sum of:

(a) the average value, for the income year, of the entity's debt capital that is covered by step 1 of the method statement in subsection 820-85(3); and

(b) the average value, for that year, of the entity' s cost-free debt capital that is covered by step 5 of that method statement;

(disregarding any amount that is attributable to the entity's overseas permanent establishments in working out the average values).

debt deduction means each debt deduction covered by subsection 820-85(1).

excess debt means the amount by which the entity's adjusted average debt for that year (see subsection 820-85(3)) exceeds its maximum allowable debt for that year.

76.          The XYZ JV is an outward investing entity and its maximum allowable debt (calculated under the worldwide gearing debt amount) is $X.

77.          The adjusted average debt of the XYZ JV is calculated under the method statement in subsection

78.          820-85(3) as follows:

79.          As the adjusted average debt ($X) is more than the maximum allowable debt ($X), $X of the XYZ JV's debt deductions ($X) will be disallowed for the XXXX income year.

[1] Defined in subsection 820-85(2)

[2] Defined in subsection 820-185(2)

[3] Paragraph 820-90(1)(c)

[4] Item 1 of the table in subsection 820-85(2)

[5] Item 3 of the table in subsection 820-85(2)

[6] Item 3 of subsection 820-85(2)

[7] Section 336(a) of the ITAA 1936

[8] Section 337 of the ITAA 1936

[9] Paragraph 820-905(1)(a)

[10] Paragraph 820-905(8)

[11] Paragraph 318(4)(a) of the ITAA 1936

[12] Subparagraph 820-905(8)(c)(i)

[13] Paragraph 318(3)(a) of the ITAA 1936; subsections 820-905(3B) and (6)

[14] Paragraph 318(3)(a) of the ITAA 1936; subsections 820-905(3B) and (6)

[15] Subsection 995-1(1) definition of 'financial entity'

[16] Subsection 995-1(1) definition of 'ADI'

[17] The other outward investing entity (non-ADI) type being 'outward investor (financial)'.

[18] Paragraph 820-185(2)(a)

[19] Paragraph 820-780(c)

[20] Section 820-795

[21] Paragraph 820-795(2)(b)

[22] Subsection 995-1(1) definition of 'foreign entity'

[23] The meaning of 'Australian controlled foreign entities' (the controlled entities) is referred to in detail in Question 2.

[24] Section 820-110 and subsection 820-630(1)

[25] Refer to modified equity test for partnerships in section 820-930; the Statement of Changes in Participants Funds and Note X of the XYZ JV Financial Statements for the XXXX income year (with YYYY comparable).

[26] Paragraph 820-90(1)(c) allows for the situation of an entity having negative worldwide equity. As worldwide equity is based on equity capital, this therefore extends to negative equity capital being allowed where this is the result of the equity capital method statement in subsection 995-1(1).

[27] Paragraph 1.123 of EM to the Taxation Laws Amendment Bill (No 5) 2003

[28] AASB Conceptual Framework para 4.63, AASB 101 paragraph 109

[29] Paragraph 4.63 of the AASB Conceptual Framework state 'Equity is the residual interest in the assets of the entity after deducting all its liabilities.'

[30] As required by section 820-680

[31] Paragraph 54 of AASB 101 requires that provisions are disclosed as a separate line item in the Statement of financial position of an entity.

[32] As required by paragraph 106 of AASB 101

[33] Paragraph 4.63 of the ASSB Conceptual Framework and paragraph 109 in AASB 101

[34] EM in paragraph 7.86, "under the thin capitalisation rules, a [holding] company will not normally be an associate entity of its subsidiary". This aligns with the phrase "the relevant entity is an associate entity of another Australian entity .. that... is an outward investing entity" in s820-85 Item 3 in the table, where the other Australian entity would be a head company of the group, for example. Refer also EM example 7.7 which asks which entities are associate entities of Company C, with the answer being a 100% subsidiary of company C and a partnership in which the subsidiary has a 50% share.

[35] Section 820-946

[36] Section 820-910

[37] Section 820-915

[38] Section 820-885

[39] Section 820-890