Worked example of calculations for an ADI outward investing entity

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

• Step 1: Calculate the adjusted average equity capital
• Step 2: Calculate the safe harbour capital amount
• Step 3: Calculate the worldwide capital amount
• Step 4: Calculate the arm's length capital amount
• Step 5: Calculate the debt deductions disallowed.

This worked example goes through each of these steps.

See also:

• Thin capitalisation

Worked example

Bank Oz is an Australian ADI that carries on an international banking business through Australian entities, foreign permanent establishments and through foreign entities it controls.

Bank Oz has total assets (adjusted for risk) of $570 million, of which $100 million is attributable to its overseas permanent establishments. Bank Oz has debt capital of $530 million (all interest-bearing), $80 million of which is attributable to its overseas permanent establishments.

Bank Oz has equity capital of $35 million. Its total prudential capital deductions are $10 million, of which $6 million is goodwill (a tier 1 prudential capital deduction) and $4 million is an equity investment in a funds management subsidiary that is not consolidated for capital adequacy purposes. Both assets relate to its Australian operations. It has controlled foreign entity equity of $10 million and equity attributable to its foreign branches of $4 million. Its controlled foreign entities have, between them, retained earnings of $4 million and risk-weighted assets of $50 million.

All figures stated are average values.

Bank Oz's debt deductions are $30 million.

Step 1: Calculate Bank Oz's adjusted average equity capital

Worksheet 1: Bank Oz's step 1

Steps			$m
Step 1.1: Bank Oz has $35m of equity capital less the equity capital attributable to its overseas permanent establishment of $4m. Its average equity capital is $31m	Average ADI equity capital	(A)	31
Step 1.2: Bank Oz has invested $10m equity in its controlled foreign entities	Average controlled foreign entity equity	(B)	10
Step 1.3: Bank Oz's adjusted average equity capital is $21m	Adjusted average equity capital (A – B)	=	21

Bank Oz's adjusted average equity capital is $21 million. This is now compared to Bank Oz's minimum capital amount, which is the least of its:

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

Bank Oz can calculate these amounts in any order it chooses and does not necessarily have to calculate all three amounts.

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

Worksheet 2: Bank Oz's step 2

Steps			$m
Step 2.1: The average value of Bank Oz's risk-weighted assets is $570m. This is reduced by the $100m attributable to its overseas permanent establishment, the $10m of risk weighted assets comprised by the controlled foreign entity equity, and $10m of assets in respect of which prudential capital deductions must be made. Bank Oz's Australian net risk-weighted assets are $450m	Average Australian risk-weighted assets	(C)	450
Step 2.2: Multiply the amount at C by 6%	C x 6%	(D)	27
Step 2.3: Bank Oz must make a tier 1 capital prudential deduction of $6m. For the goodwill, the $4m investments in the unconsolidated funds management subsidiary does not have to be deducted from tier 1 capital – see Prudential Standard APS 111External Link	Average tier 1 capital prudential deductions	(E)	6
Step 2.4: Bank Oz's safe harbour capital amount is $24m	Safe harbour capital amount (D + E)	=	33

Bank Oz's safe harbour capital amount is $33 million and its adjusted average equity capital is $21 million. As its adjusted average equity capital is less than its safe harbour capital amount, Bank Oz can choose to calculate the worldwide capital amount or the arm's length capital amount, though neither amount may be less than the safe harbour capital amount.

Step 3: Calculate Bank Oz's worldwide capital amount

Worksheet 3: Bank Oz's step 3

Steps
Step 3.1: The average value of the eligible tier 1 capital for the worldwide group of which Bank Oz is a member is $39m. Bank Oz has eligible tier 1 capital of $35m and its controlled foreign entities have tier 1 capital – the retained earnings – of $4m	Worldwide group's average tier 1 capital	(F)	$39m
Step 3.2: The value of the risk-weighted assets of the worldwide group is $620m. Bank Oz has risk-weighted assets of $570m – this includes the $100m attributable to its overseas permanent establishment – and its controlled foreign entities have risk-weighted assets of $50m	Worldwide group's risk-weighted assets	(G)	$620m
Step 3.3: Bank Oz's worldwide capital ratio is calculated by dividing the amount at F by the amount at G	F / G	(H)	6.29032%
Step 3.4: The average value of Bank Oz's risk-weighted assets is $570m. This is reduced by the: $100m attributable to its overseas permanent establishment $10m of risk weighted assets comprised by the controlled foreign entity equity $10m of assets in respect of which prudential capital deductions must be made Bank Oz's Australian net risk-weighted assets are $450m	Bank Oz's risk-weighted assets	(I)	$450m
Step 3.5: The worldwide capital ratio is the amount at H	H	(J)	6.29032%
Step 3.6: The capital ratio is applied to Bank Oz's Australian risk-weighted assets by multiplying the amount at C by the amount at J	I x J	(K)	$28.30644m
Step 3.7: The value of Bank Oz's tier 1 prudential capital deductions has already been calculated at E on worksheet 2 and is $6m	Average tier 1 prudential capital deductions from E on worksheet 2	(E)	$6m
Step 3.8: Bank Oz's worldwide capital amount is $34,306,440	Worldwide capital amount (K) + (E)		$34.30644m

Bank Oz's worldwide capital amount is $34,306,440. This is more than its safe harbour capital amount. Bank Oz can calculate an alternative amount under the arm's length capital test. Bank Oz could also choose to not calculate an arm's length capital amount (as this may also be more than the safe harbour capital amount) and calculate what debt deductions are disallowed on the basis that the safe harbour capital amount is its minimum capital amount.

Step 4: Calculate Bank Oz's arm's length capital amount

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

See also:

• Thin capitalisation

Step 5: Calculate Bank Oz's debt deductions disallowed

Bank Oz's minimum capital amount is $33 million, the safe harbour capital amount, being the least of the safe harbour and worldwide capital amounts. As Bank Oz's adjusted average equity capital ($21 million) is less than its minimum capital amount, a proportion of its debt deductions will be disallowed.

Worksheet 5: Bank Oz's step 5

Steps
Step 5.1: Bank Oz's average equity capital is $21m and its minimum capital amount is $33m	Capital shortfall ($33m – $21m)	(L)	$12m
Step 5.2: Bank Oz's average debt capital that gives rise to debt deductions (in Australia) is $450m	Average debt capital	(M)	$450m
Step 5.3: Divide the amount at L by the amount at M to get the proportion to be applied to Bank Oz's debt deductions	L /M ($12m / $450m)	(N)	0.026667
Step 5.4: Bank Oz's debt deductions for the income year are $30m	Debt deductions	(P)	$30m
Step 5.5: The amount of debt deductions disallowed is calculated by multiplying the amount at N by the amount at P	N X P (0.026667 x 30m)	=	$800,000

Bank Oz cannot deduct $800,000 of its debt deductions.

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