Worked example of calculations for an ADI inward investing entity

The four steps an ADI inward investing entity takes to calculate if they have met the thin capitalisation rules are:

• Step 1: Calculate the average equity capital
• Step 2: Calculate the safe harbour capital amount
• Step 3: Calculate the arm's length capital amount
• Step 4: Calculate the debt deductions disallowed.

This worked example goes through each of these steps.

See also:

• Thin capitalisation

Worked example

The income year is 2014–15. Foreign Bank is a foreign entity that is an ADI. It carries on its banking business in Australia through a permanent establishment; that is, a branch. Foreign Bank's average risk-weighted assets, according to the prudential standards applying in Foreign Bank's jurisdiction of residence, are $800 million, of which $200 million is attributable to the Australian branch.

Foreign Bank has debt capital of $900 million, of which $250 million is attributable to the Australian branch. Foreign Bank has also made $2 million available to the Australian branch. This $2 million does not give rise to debt deductions for Foreign Bank – to be a debt deduction the borrowing expense must be deductible in Australia. The Australian branch has $5 million in retained earnings and has incurred $20 million of debt deductions in the 2014–15 income year. The Australian branch applies the corporate tax rate to all its taxable income and does not have any offshore banking activities. These facts are illustrated in the diagram below.

Step 1: Calculate Foreign Bank's average equity capital

Worksheet 1: Foreign Bank's step 1

Steps			$m
Step 1.1: The average value of Foreign Bank's ADI equity capital attributable to Australian permanent establishments through which it carries on its banking business in Australia is the $5m of retained earnings	Average ADI equity capital attributable to Australian permanent establishments through which it carries on its banking business in Australia	(A)	5
Step 1.2: The average value of the loans made available to the Australian permanent establishments through which it carries on its banking business in Australia that do not give rise to debt deductions is $2m	Average debt deduction free amounts made available to the Australian permanent establishments through which it carries on its banking business in Australia	(B)	2
Step 1.3: Foreign Bank's average equity capital is $7m	A + B		7

Foreign Bank's average equity capital is $7 million. This is compared to its minimum allowable capital, which is the lesser of its:

• safe harbour capital amount
• arm's length capital amount.

Foreign Bank can calculate the amounts in any order it chooses and does not necessarily have to calculate both amounts.

Step 2: Calculate Foreign Bank's safe harbour capital amount

Worksheet 2: Foreign Bank's step 2

Steps			$m
Step 2.1: The average value of Foreign Bank's risk-weighted assets that are attributable to its Australian banking permanent establishment is $200m	Average risk-weighted assets attributable to Australian permanent establishments through which it carries on its banking business in Australia	(C)	200
Step 2.2: Foreign Bank's safe harbour capital amount is $12m	C X 6%		12

Foreign Bank's safe harbour capital amount is $12 million. Foreign Bank's average equity capital is $7 million. As average equity capital is less than the safe harbour capital amount, Foreign Bank can choose to calculate an arm's length capital amount or have debt deductions disallowed on the basis that the safe harbour capital amount is the minimum capital amount.

Step 3: Calculate the arm's length capital amount

For the purposes of this exercise, assume Foreign Bank chooses not to calculate an arm's length capital amount.

Find out more

• Thin capitalisation

Step 4: Calculate debt deductions disallowed

Foreign Bank's minimum capital amount is $12 million – the safe harbour capital amount. As Foreign Bank's average equity capital is less than its minimum capital amount, a proportion of its debt deductions will be disallowed.

Foreign Banks debt deductions are $20 million.

Worksheet 4: Foreign Bank's step 4

Steps
Step 4.1: Foreign Bank's average equity capital is $7m and its minimum capital amount is $12m	Capital shortfall ($12m – $7m)	(D)	$5m
Step 4.2: Foreign Bank's average debt capital that gives rise to debt deductions in Australia is $250m	Average debt capital	(E)	$250m
Step 4.3: Divide the amount at D by the amount at E to get the proportion to be applied to Foreign Bank's debt deductions	D / E ($5m / $250m)	(F)	0.02
Step 4.4: Calculate Foreign Bank's debt deductions for the income year	Debt deductions	(G)	$20m
Step 4.5: Multiply the amount at F by amount at G. This is the total debt deductions disallowed to Foreign Bank	F x G (0.02 x $20m)	=	$400,000

Foreign Bank cannot deduct $400,000 of its debt deductions.

The steps an ADI inward investing entity takes to determine whether it will have debt deductions disallowed.