How to calculate
There are 5 steps an inward investment vehicle (financial) that has not made a choice to use the third party debt test needs to take to calculate if they have met the thin capitalisation rules:
- Step 1: Calculate the adjusted average debt
- Step 2 and 3: Calculate the safe harbour debt amount
- Step 4: Calculate Aust Fin's worldwide gearing debt amount
- Step 5: Calculate debt deductions disallowed
For more information, see Thin capitalisationExternal Link.
Worked example
The following worked example for a fictional company 'Aust Fin' demonstrates each of the steps required to calculate if they have met the thin capitalisation rules.
For the purposes of this exercise, assume 'Aust Fin' has not made a choice to use the third-party debt test.
Worked example: Aust Fin and Ozzie Co
Aust Fin is a financial entity. It is wholly owned by a foreign company, Foreign Parent Co. This makes Aust Fin an inward investment vehicle (financial).
Aust Fin owns 75% of the equity in an Australian company (Ozzie Co), which is a general class investor. Foreign Parent Co owns the remaining 25% equity in Ozzie Co.
Aust Fin has:
- borrowed $19 million from its foreign parent
- borrowed $40 million from unrelated financial institutions
- non-debt liabilities of $3 million
- lent $45 million to unrelated third parties – $3 million of this is a 0% risk-weighted loan
- invested $7.5 million equity in Ozzie Co and lent it $1 million. The $7.5 million invested as equity represents a third party payment it made for 75% of the equity in Ozzie Co.
Neither Aust Fin nor Ozzie Co has any overseas permanent establishments.
All loans are interest-bearing and at commercial interest rates.
A consolidated group cannot be formed as there is no resident entity that is 100% owned.
Aust Fin is the only entity being tested under the thin capitalisation rules for this example. The test year is the 2019–20 income year.
Diagram of the facts for Aust Fin and Ozzie Co
Aust Fin's financial position for 2019–20
The following tables show Aust Fin's financial position for the 2019–20 income year. These are average values using the opening and closing balances method.
Assets | Assets amount |
|---|---|
Current | $2m |
Loans receivable, including low risk-weighted loan of $3m | $46m |
Equity in Ozzie Co (see note) | $7.5m |
Other assets | $10.5 |
Total assets | $66m |
Liabilities | Liabilities amount |
Non-debt liabilities | $3m |
Loan payable | $59m |
Total liabilities | $62m |
Equity capital | Equity capital amount |
Equity | $4m |
Total equity capital | $4m |
Total equity capital plus total liabilities | $66m |
Note: Assume the equity investment in Ozzie Co always remains valued at $7.5 million throughout the income year.
Aust Fin has debt deductions worth $2.7 million in the 2014–15 income year and fails the debt deduction de-minimus test. Because Aust Fin is foreign controlled, it cannot apply the asset de-minimus test.
Assets | Assets amount |
|---|---|
Current | $4m |
Non-current | $8m |
Total assets | $12.5m |
Liabilities | Liabilities amount |
Non-debt liabilities | $500,000 |
Loan payable | $1m |
Total liabilities | $1.5m |
Equity capital | Equity capital amount |
Equity | $10m |
Retained earnings | $1m |
Total equity capital | $11m |
Total equity capital plus total liabilities | $12.5m |
Assets | Assets amount |
|---|---|
Current | $3.5m |
Non-current | $8.5m |
Total assets | $12.5m |
Liabilities | Liabilities amount |
Non-debt liabilities | $500,000 |
Loan payable | $1m |
Total liabilities | $1.5m |
Equity capital | Equity capital amount |
Equity | $10m |
Retained earnings | $500,000 |
Total equity capital | $10.5m |
Total equity capital plus total liabilities | $12m |
Steps to take
An inward investment vehicle (financial) must follow these steps to calculate if they have met the thin capitalisation rules:
Step 1: Calculate Aust Fin's adjusted average debt
Steps | Label | Label description | Amount |
|---|---|---|---|
Step 1.1: The average value of all Aust Fin's debt capital that gives rise to debt deductions is $59m | (A) | Average debt capital | $59m |
Step 1.2: Aust Fin's associate entity debt is the $1m debt interest issued by Ozzie Co | (B) | Average associate entity debt | $1m |
Step 1.3: Aust Fin does not have any borrowed securities amounts | (C) | Average borrowed securities amounts | $0 |
Step 1.4: All Aust Fin's debt capital gives rise to debt deductions | (D) | Average cost-free debt capital | $0 |
Step 1.5: Aust Fin's adjusted average debt is $58m | = | Adjusted average debt (A − B + C + D) | $58m |
Aust Fin's adjusted average debt is $58 million. This is now compared to Aust Fin's maximum allowable debt, which is the greater of its:
- safe harbour debt amount, which is the lesser of the total debt amount and the adjusted on-lent amount
- worldwide gearing debt amount.
Alternatively, Aust Fin could also compare its debt deductions against its third party earnings limit, which if supported could make a choice to instead apply the third party debt test.
For the purposes of this exercise, assume Aust Fin has not made a choice to use the third-party debt test.
Step 2: Calculate Aust Fin's total debt amount
Steps | Label | Label description | Amount |
|---|---|---|---|
Step 2.1: The average value of Aust Fin's assets is $66m | (E) | Average assets | $66m |
Step 2.1A: None of the equity interests issued by Aust Fin are excluded equity interests | (MM) | Average excluded equity interest | $0 |
Step 2.2: The average value of Aust Fin's associate entity debt is $1m | (B) | Average associate entity debt from B in Worksheet 1 | $1m |
Step 2.3: The average value of Aust Fin's associate entity equity is the $7.5m invested in Ozzie Co | (F) | Average associate entity equity | $7.5m |
Step 2.4: The average value of Aust Fin's non-debt liabilities is $3m | (G) | Average non-debt liabilities | $3m |
Step 2.5: The average value of Aust Fin's zero-capital amount is $3m. The only zero-capital amount Aust Fin has is the low risk-weighted loan to the unrelated company | (ZC) | Average zero-capital amount | $3m |
Step 2.6: Reduce Aust Fin's average assets by the amounts at MM, B, F, G and ZC | (H) | E − MM − B − F − G − ZC | $51.5m |
Step 2.7: Multiply the result at H by 15 divided by 16 | (J) | H × (15 ÷ 16) | $48,281,250 |
Step 2.8: The average value of Aust Fin's zero-capital amount is $3m – see Step 2.5 | (ZC) | Average zero-capital amount | $3m |
Step 2.9: The average value of Aust Fin's associate entity excess amount is $4,537,500 – see Worksheet 2A | (K) | Average associate entity excess amount from K on Worksheet 2A | $4,537,500 |
Step 2.10: Aust Fin's total debt amount is $55,818,750 | = | Total debt amount | $55,818,750 |
Step 2A: Calculate Aust Fin's average associate entity excess amount for the total debt amount
Aust Fin's associate entity excess amount is calculated on each of its measurement days. Aust Fin uses the opening and closing balances method so its measurement days are 1 July 2019 – the first day of the period – and 30 June 2020 – the last day of the period.
Steps | Label | Label description | Amount as at 1 July 2019 | Amount as at 30 June 2020 |
|---|---|---|---|---|
Step 2A.1: Aust Fin's associate entity equity on both measurement days is the $7.5m invested in Ozzie Co | (L) | Aust Fin's associate entity equity on a measurement day | $7.5m | $7.5m |
Step 2A.2: The value of Ozzie Co's equity capital attributable to Aust Fin (75%) is $8.25m on 1 July 2019 and $7,875,000 on 30 June 2020 | (M) | Ozzie Co's equity capital attributable to Aust Co on a measurement day | $8.25m | $7,875,000 |
Step 2A.3: Aust Fin's premium excess amount is calculated by deducting from the amount at L the amount at M and multiplying the result by 15 divided by 16. This result is negative and is taken to be nil. | (N) | (L − M) × (15 ÷ 16) | $0 | $0 |
Step 2A.4: Ozzie Co's safe harbour debt amount on a measurement day – calculated using Step 2 and Worksheet 2 of this guide – is its assets less non-debt liabilities multiplied by 3 divided by 5 | (P) | Ozzie Co's safe harbour debt amount on a measurement day | $7.2m | $6.9m |
Step 2A.5: Ozzie Co's adjusted average debt – calculated using Step 1 and Worksheet 1 of this guide – is the $1m it has borrowed from Aust Fin | (Q) | Ozzie Co's adjusted average debt on a measurement day | $1m | $1m |
Step 2A.6: Ozzie Co's excess borrowing capacity is calculated by reducing its safe harbour debt amount by its adjusted average debt | (R) | P − Q | $6.2m | $5.9m |
Step 2A.7: The value of Ozzie Co's equity capital attributable to Aust Fin (75%) is the same as M | (S) | Value of equity capital attributable to Aust Fin on a measurement day | $8.25m | $7,875,000 |
Step 2A.8: Ozzie Co's total equity capital is $11m on 1 July 2019 and $10.5m on 30 June 2020 | (T) | Value of Ozzie Co's total equity capital | $11m | $10.5m |
Step 2A.9: The proportion of Ozzie Co's equity capital held by Aust Fin on both measurement days is 75% | (U) | S ÷ T | 0.75 | 0.75 |
Step 2A.10: The attributable safe harbour excess amount is the proportion of equity held by Aust Fin (75%) multiplied by Ozzie Co's excess borrowing capacity (Q) | (V) | R × U | $4.65m | $4.425,000 |
Step 2A.11: The associate entity excess amount is the sum of the premium excess amount and the attributable safe harbour excess amount | (W) | N + V | $4.65m | $4,425,000 |
Step 2A.12: Associate entity excess amount on a measurement day for all associate entities. Aust Fin has only one associate entity so X is the same as W. Step 2A.13 – X is calculated for the other measurement day for all associate entities. For this exercise, this has been done in the fifth column. | (X) | Transfer from W | $4.65m | $4,425,000 |
Step 2A.14: the average associate entity excess amount is calculated by adding the results at X ($4.65m and $4.425m) and dividing by 2 (the number of measurement days) | (K) | ($4.65m + $4.425m) ÷ 2 | $4,537,500 | Transfer to K on Worksheet 2 |
Aust Fin's total debt amount is $55,818,750. It must now calculate its adjusted on-lent amount. The lesser of these two amounts is its safe harbour debt amount.
Step 3: Calculate Aust Fin's adjusted on-lent amount
Steps | Label | Label description | Amount |
|---|---|---|---|
Step 3.1: The average value of Aust Fin's assets is $66m | (E) | Average assets | $66m |
Step 3.2: None of the equity interests issued by Aust Fin are excluded equity interests | (MM) | Average excluded equity interests | $0 |
Step 3.3: The average value of Aust Fin's associate entity equity is $7.5m | (F) | Average associate entity equity | $7.5m |
Step 3.4: The average value of Aust Fin's non-debt liabilities is $3m | (G) | Average non-debt liabilities | $3m |
Step 3.5: The average value of Aust Fin's on-lent amount is $46m; that is, a $42m loan to unrelated third parties, a $3m low-risk weighted loan and a $1m loan to Ozzie Co, its associate entity | (OA) | Average on-lent amount | $46m |
Step 3.6: Reduce Aust Fin's assets by the amounts at MM, F, G and OA | (Y) | E − MM − F − G − OA | $9.5m |
Step 3.7: Multiply the result at Y by 3 divided by 5 | (Z) | Y × (3 ÷ 5) | $5.7m |
Step 3.8: The average value of Aust Fin's on-lent amount is $46m – see Step 3.5 | (OA) | Average on-lent amount | $46m |
Step 3.9: The average value of Aust Fin's associate entity debt is $1m | (B) | Average associate entity debt | $1m |
Step 3.10: The average value of Aust Fin's associate entity excess is $4,537,500 – see Worksheet 3A | (AA) | Average associate entity excess from AA on Worksheet 3A | $4,537,500 |
Step 3.11: Aust Fin's adjusted on-lent amount is $55,237,500 | = | Adjusted on-lent amount | $55,237,500 |
Step 3A: Calculate Aust Fin's average associate entity excess amount for the adjusted on-lent amount
Steps | Label | Label description | Amount as at 1 July 2014 | Amount as at 30 June 2015 |
|---|---|---|---|---|
Step 3A.1: The value of Aust Fin's associate entity equity on both measurement days is $7.5m | (L) | Aust Fin's associate entity equity on a measurement day | $7.5m | $7.5m |
Step 3A.2: The value of Ozzie Co's equity capital attributable to Aust Fin is $8.25m on 1 July 2019 and $7,875,000 on 30 June 2020 | (M) | Ozzie Co's equity capital on a measurement day | $8.25m | $7,875,000 |
Step 3A.3: Aust Fin's premium excess amount is calculated by reducing the amount at L by the amount at M and multiplying the result by 3 divided by 5. This result is negative and is taken to be nil. | (BB) | (L − M) × (3 ÷ 5) | $0 | $0 |
Step 3A.4: The attributable safe harbour excess amount has already been worked out at V in Worksheet 2A | (V) | Attributable safe harbour excess amount from V on Worksheet 2A | $4.65m | $4,425,000 |
Step 3A.5: The associate entity excess amount is the sum of the premium excess amount and the attributable safe harbour excess amount | (CC) | BB + V | $4.65m | $4,425,000 |
Step 3A.6: Associate entity excess amount for each associate entity. Aust Fin has only one associate entity so DD is the same as CC. Step 3A.7 – DD is calculated for the other measurement day for all associate entities. For this example, this has been done in the right-hand column | (DD) | Transfer from CC | $4.65m | $4,425,000 |
Step 3A.8: The average associate entity excess amount is calculated by adding results at DD ($4,650,000 and $4,425,000) and dividing by 2 (the number of measurement days) | (AA) | (4.65m + $4,425,000) ÷ 2 | $4,537,500 | Transfer to AA on Worksheet 3 |
The safe harbour debt amount is the lesser of the total debt amount ($55,718,750) and the adjusted on-lent amount ($55,237,500). Therefore, the safe harbour debt amount for Aust Fin is the adjusted on-lent amount of $55,237,500. Aust Fin's adjusted average debt ($58 million) is more than this amount.
Aust Fin's maximum allowable debt is the highest of its safe harbour debt amount, arm's length debt amount and worldwide gearing debt amount. Aust Fin has the option to calculate an alternative amount under the arm's length debt test or the worldwide gearing debt test. Aust Fin can also choose to use the safe harbour debt amount as its maximum allowable debt.
Step 4: Calculate Aust Fin's worldwide gearing debt amount
For the purposes of this exercise, assume Aust Fin chooses not to calculate a worldwide gearing debt amount.
For more information, see section 820-217 of the ITAA 1997.
Step 5: Calculate Aust Fin's debt deductions disallowed
Aust Fin's maximum allowable debt is $55,237,500 – the safe harbour debt amount, being the lesser of the total debt amount and the adjusted on-lent amount. As Aust Fin's adjusted debt ($58,000,000) is more than its maximum allowable debt, a proportion of its debt deductions will be disallowed.
Aust Fin's debt deductions are $2,700,000.
Steps | Label | Label description | Amount |
|---|---|---|---|
Step 5.1: Aust Fin's adjusted average debt is $58m and its maximum allowable debt is $55,237,500 | (EE) | Excess debt | $2,762,500 |
Step 5.2: Aust Fin's average debt capital is $59m. This includes the $1m loan to its associate entity. | (FF) | Average debt | $59m |
Step 5.3: Divide the amount at EE by the amount at FF to get the proportion to be applied to Aust Fin's debt deductions | (GG) | EE ÷ FF | 0.046822 |
Step 5.4: Calculate Aust Fin's debt deductions for the income year | (HH) | Debt deductions | $2.7m |
Step 5.5: The debt deductions disallowed is calculated by multiplying the amount at GG by the amount at HH | = | GG × HH | $126,419 |
Aust Fin is disallowed $126,419 of its debt deductions.