How to calculate
There are 5 steps an outward investing financial entity (non-ADI) that has not made a choice to use the third party debt test takes to calculate if they have met the thin capitalisation rules:
- Step 1: Calculate the adjusted average debt
- Steps 2 and 3: Calculate the safe harbour debt amount
- Step 4: Calculate the worldwide gearing debt amount
- Step 5: Calculate the debt deductions disallowed
For more information, see Thin capitalisation.
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 has a wholly-owned foreign subsidiary (For Sub) and a wholly-owned Australian subsidiary (Ozzie Co) that is a general class investor. Aust Fin has borrowed $5 million from its Australian parent and $19 million from unrelated financial institutions and has $3 million of non-debt. It has lent $23 million to unrelated third parties, $3 million of which is a 0% risk-weighted loan. Aust Fin has invested $7 million equity in For Sub and $1 million in Ozzie Co. The $1 million equity investment in Ozzie Co represents what Aust Fin paid a third party for 100% of the equity. For Sub has borrowed $3 million from an unrelated financial institution and has $2 million in retained earnings.
Aust Parent Co, Aust Fin and Ozzie Co have not formed a consolidated group for tax purposes.
None of the Australian companies have any overseas permanent establishments. All loans are at commercial interest rates.
For the purposes of this example, Aust Fin is the only entity being tested under the thin capitalisation rules. The test year is the 2019–20 income year.
Diagram: Financial information 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 |
|---|---|
Loans | $20m |
Low risk-weighted load | $3m |
Equity in Ozzie Co (see note) | $1m |
Equity in For Sub | $7m |
Other assets | $4m |
Total assets | $35m |
Liabilities | Liabilities amount |
Loans | $24m |
Non-debt liabilities | $3m |
Share capital | $8m |
Total liabilities | $35m |
Note: Assume the equity investment in Ozzie Co always remains valued at $1 million throughout the income year.
As Aust Fin has $2.7 million worth of debt deductions in the 2019–20 income year, it fails the 'debt deduction de-minimus' test. Assume it also fails the 'asset de-minimus' test and is not exempt under section 820-39 – (this section exempts certain special purpose vehicles).
Assets | Assets amount |
|---|---|
Non-current | $900,000 |
Total assets | $900,000 |
Liabilities | Liabilities amount |
Share capital | $850,000 |
Retained earnings | $50,000 |
Total liabilities | $900,000 |
Ozzie Co's assets and liabilities at 30 June 2020
Assets | Assets amount |
|---|---|
Non-current | $950,000 |
Total assets | $950,000 |
Liabilities | Liabilities amount |
Share capital | $850,000 |
Retained earnings | $100,000 |
Total liabilities | $950,000 |
Steps to take
An outward investing financial entity (non-ADI) 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 the debt capital of Aust Fin that gives rise to debt deductions is $24m | (A) | Average debt capital | $24m |
Step 1.2: Aust Fin has not lent any debt to its associate entities and does not have any associate entity debt | (B) | Average associate entity debt | $0 |
Step 1.3: Aust Fin does not have any controlled foreign entity debt | © | Average controlled foreign entity debt | $0 |
Step 1.4: Aust Fin does not have any borrowed securities amount | (D) | Borrowed securities amount | $0 |
Step 1.5: All Aust Fin's debt capital gives rise to debt deductions | (E) | Average cost-free debt capital | $0 |
Step 1.6 Aust Fin's adjusted average debt is $24m | = | Adjusted average debt (A – B – C + D + E) | $24m |
Aust Fin's adjusted average debt is $24 million. This is now compared to Aust Fin's maximum allowable debt, which is the greatest 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.
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 $35m | (F) | Average assets | $35m |
Step 2.2: None of the equity interests issued by Aust Fin are excluded equity interests | (XX) | Average excluded equity interests | $0 |
Step 2.3: Aust Fin has not lent any debt to its associate entities and does not have any associate entity debt | (B) | Average associate entity debt (from B in worksheet 1) | $0 |
Step 2.4: The average value of Aust Fin's associate entity equity is $1m. The equity invested in For Sub is not included in associate entity debt because it is not attributable to For Sub's Australian permanent establishments or other assets held by For Sub for the purpose of producing Australian assessable income | (G) | Average associate entity equity | $1m |
Step 2.5: Aust Fin has not lent any amounts to For Sub and so does not have any controlled foreign entity debt | (C) | Average controlled foreign entity debt from C in worksheet 1 | $0 |
Step 2.6: The average value of Aust Fin's controlled foreign entity equity is the $7m invested in For Sub | (H) | Average controlled foreign entity equity | $7m |
Step 2.7: The average value of Aust Fin's non-debt liabilities is $3m | (J) | Average non-debt liabilities | $3m |
Step 2.8: The only zero-capital amount Aust Fin has is the low-risk weighted loan to the unrelated company so the average value of Aust Fin's zero-capital amount is $3m | (ZC) | Average zero-capital amount | $3m |
Step 2.9: Reduce Aust Fin's average assets by the amounts at XX, B, G, C, H, J and ZC | (K) | F − XX − B − G − C − H − J − ZC | $21m |
Step 2.10: Multiply the result at K by 15 divided by 16 | (L) | K × 15 ÷ 16 | $19,687,500 |
Step 2.11: The average value of Aust Fin's zero-capital amount is $3 million, as established in step 2.7 | (ZC) | Average zero-capital amount | $3m |
Step 2.12: The average value of Aust Fin's associate entity excess amount is $625,312 – see worksheet 2A | (M) | Average associate entity excess amount (from M on worksheet 2A) | $625,312 |
Step 2.13: Aust Fin's total debt amount is calculated by adding the amounts at L, ZC and M | = | Total debt amount | $23,312,812 |
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 | 1 July 2015 amount | 30 June 2020 amount |
|---|---|---|---|---|
Step 2A.1: The value of Aust Fin's associate entity equity on both measurement days is the $1m invested in Ozzie Co | (N) | Aust Fin's associate entity equity on a measurement day | $1m | $1m |
Step 2A.2: The value of Ozzie Co's equity capital attributable to Aust Fin's equity interests in Ozzie Co is $900,000 on 1 July and $950,000 on 30 June | (P) | Ozzie Co's equity capital attributable to Aust Fin's equity interests on a measurement day | $900,000 | $950,000 |
Step 2A.3: Aust Fin's premium excess amount is calculated by taking P from N and multiplying the result by 15 divided by 16 | (Q) | (N – P) × 15 ÷ 16 | $93,750 | $46,875 |
Step 2A.4: Ozzie Co's safe harbour debt amount on a measurement day is its assets multiplied by 3 divided by 5 | (R) | Ozzie Co's safe harbour debt amount on a measurement day | $540,000 | $570,000 |
Step 2A.5: Ozzie Co does not have any debt capital so its adjusted average debt on both measurement days is $0 | (S) | Ozzie Co's adjusted average debt on a measurement day | $0 | $0 |
Step 2A.6: Ozzie Co's excess borrowing capacity is calculated by reducing its safe harbour by its adjusted average debt | (T) | R − S | $540,000 | $570,000 |
Step 2A.7: The value of Ozzie Co's equity capital attributable to Aust Fin is the same as P | (U) | Ozzie Co's equity capital attributable to Aust Fin on a measurement day | $900,000 | $950,000 |
Step 2A.8: Ozzie Co's total equity capital is the same as U because Aust Fin owns Ozzie Co 100% | (V) | Value of Ozzie Co's total equity capital on a measurement day | $900,000 | $950,000 |
Step 2A.9: The proportion of Ozzie Co's equity capital held by Aust Fin on both days is 100% | (W) | U ÷ V | 1 | 1 |
Step 2A.10: The attributable safe harbour excess amount is the proportion of equity capital (100%) held by Aust Fin multiplied by Ozzie Co's excess borrowing capacity | (X) | T × W | $540,000 | $570,000 |
Step 2A.11: The associate entity excess amount on a measurement day is the sum of the premium excess amount and the attributable safe harbour excess amount | (Y) | Q + X | $633,750 | $616,875 |
Step 2A.12: Aust Fin has only one associate entity so Z is the same as Y | (Z) | Transfer from Y | $633,750 | $616,875 |
Step 2A.13:Z is calculated on the other measurement day. This has been done in the far right-hand column above |
| |||
Step 2A.14: The average associate entity excess amount is calculated by adding the results at Z ($633,750 and $616,875) and dividing by 2 (the number of measurement days) | ($633,750 + $616,875) ÷ 2 | (M) $625,312 Transfer to M on worksheet 2 |
Aust Fin's total debt amount is $23,312,812. 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 $35m | (F) | Average assets from F on worksheet 2 | $35m |
Step 3.2: None of the equity interests issued by Aust Fin are excluded equity interests | (XX) | Average excluded equity interests | $0 |
Step 3.3: The average value of Aust Fin's associate entity equity is $1m – see step 2.4 | (G) | Average associate entity equity from G on worksheet 2 | $1m |
Step 3.4: Aust Fin has not lent any amounts to For Sub so its controlled foreign entity debt is $0 | (C) | Average controlled foreign entity debt from C on worksheet 1 | $0 |
Step 3.5: The average value of Aust Fin's controlled foreign entity equity is the $7m invested in For Sub | (H) | Average controlled foreign entity equity from H on worksheet 2 | $7m |
Step 3.6: The average value of Aust Fin's non-debt liabilities is $3m | (J) | Average non-debt liabilities from J on worksheet 2 | $3m |
Step 3.7: The average value of Aust Fin's on-lent amount is $23m, which is the $20m lent to unrelated third parties and the $3m low-risk weighted loan | (OA) | Average on-lent amount | $23m |
Step 3.8: Reduce Aust Fin's assets by the amounts at XX, G, C, H, J and OA | (AA) | F − XX − G − C − H − J − OA | $1m |
Step 3.9: Multiply the result at AA by 3 divided by 5 | (BB) | AA × (3 ÷ 5) | 0.6 |
Step 3.10: The average value of Aust Fin's on-lent amount is $23m, as calculated in step 3.7 | (OA) | Average on-lent amount | $23m |
Step 3.11: The average value of Aust Fin's associate entity debt is $0 | (B) | Average associate entity debt from B on worksheet 1 | $0 |
Step 3.12: The average value of Aust Fin's associate entity excess is $600,000 – see worksheet 3A | (CC) | Average associate entity excess from CC on worksheet 3A | $600,000 |
Step 3.13: Aust Fin's adjusted on-lent amount is calculated by adding the amounts at BB, OA and CC and reducing the result by the amount at B | = | Adjusted on-lent amount; that is, BB + OA − B + CC | $24.2m |
Step 3A: Calculate Aust Fin's average associate entity excess amount for the adjusted on-lent amount
Steps | Label | Label description | 1 July 2019 amount | 30 June 2020amount |
|---|---|---|---|---|
Step 3A.1: The value of Aust Fin's associate entity equity on both measurement days is the $1m invested in Ozzie Co | (N) | Aust Fin's associate entity equity on a measurement day | $1m | $1m |
Step 3A.2: Calculate the value of Ozzie Co's equity capital attributable to Aust Fin's equity interests in Ozzie Co is $900,000 on 1 July and $950,000 on 30 June | (P) | Ozzie Co's equity capital attributable to Aust Fin's equity interests on a measurement day | $900,000 | $950,000 |
Step 3A.3: Aust Fin's premium excess amount is calculated by reducing the amount at N by the amount at P and multiplying the result by 3 divided by 5 | (DD) | (N − P) × 3 ÷ 5 | $60,000 | $30,000 |
Step 3A.4: The attributable safe harbour excess amount has already been calculated at X in worksheet 2A | (X) | Attributable safe harbour excess amount from X on worksheet 2A | $540,000 | $570,000 |
Step 3A.5: The associate entity excess amount is the sum of the premium excess amount and the attributable safe harbour excess amount | (EE) | DD + X | $600,000 | $600,000 |
Step 3A.6: Aust Fin has only one associate entity so FF is the same as EE | (FF) | Transfer from EE | $600,000 | $600,000 |
Step 3A.7: FF is calculated on Aust Fin's each other measurement day. This has been done in the right-hand column above | ||||
Step 3A.8: the average associate entity excess amount is calculated by adding results at FF ($600 000 and $600 000) and dividing by 2 (the number of measurement days) | (CC) | (0.6 + 0.6) ÷ 2 |
| $600,000 Transfer to CC on worksheet 3 |
As Aust Fin's total debt amount is the lesser of the two amounts, the total debt amount is the safe harbour debt amount; that is, $23,312,812. Aust Fin's adjusted average debt ($24 million) is more than this amount. Aust Fin can calculate an alternative amount under either the worldwide gearing debt test or the arm's length debt test, though neither amount may be higher than the safe harbour debt amount. It 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
Aust Fin is not foreign controlled so the method statement contained in section 820-111(2) is used to calculate its worldwide gearing debt amount.
Steps | Label | Label description | Amount |
|---|---|---|---|
Step 4.1: Aust Fin's worldwide debt is $27m; that is, $24m owed by Aust Fin to third parties and $3m owed by For Sub to a third party | (GG) | Worldwide debt | $27m |
Step 4.2: Aust Fin's worldwide equity is $10m; that is, $8m equity interest held in Aust Fin and $2m retained earnings in For Sub. The $7m equity invested in For Sub by Aust Fin is excluded because amounts lent to entities within the worldwide group are disregarded | (HH) | Worldwide equity | $10m |
Step 4.3: Aust Fin's worldwide gearing ratio is calculated by dividing the worldwide debt by the worldwide equity | (JJ) | GG ÷ HH | $2.7m |
Step 4.4: Insert the amount of JJ at KK | (KK) | JJ | $2.7m |
Step 4.5: Add 1 (one) to the amount at KK | (LL) | KK + 1 | $3.7m |
Step 4.6: Divide the amount at KK by the amount at LL | (MM) | KK ÷ LL | 0.7297297 |
Step 4.7: The gearing ratio is applied to Aust Fin's net assets as calculated at K in worksheet 2 | (NN) | 0.729729 × $21m | $15,324,309 |
Step 4.8: Aust Fin's zero capital amount has already been worked out at ZC on worksheet 2 | (ZC) | Average zero-capital | $3m |
Step 4.9: The average value of Aust Fin's associate entity excess amount is $609,608 – see worksheet 4A | (PP) | Average associate entity excess amount | $609,608 |
Step 4.10: Aust Fin's worldwide gearing debt amount is calculated by adding the amounts at NN, ZC and PP | = | Worldwide gearing debt amount | $18,933,917 |
Step 4A: Calculate Aust Fin's average associate entity excess for the worldwide gearing debt amount
Steps | Label | Label description | 1 July 2019 amount | 30 June 2020 amount |
|---|---|---|---|---|
Step 4A.1: The value of Aust Fin's associate entity equity on both measurement days is the $1m invested in Ozzie Co | (N) | Aust Fin's associate entity equity on a measurement day | $1m | $1m |
Step 4A.2: The value of Ozzie Co's equity capital attributable to Aust Co's equity interests in Ozzie Co is $900,000 on 1 July and $950,000 on 30 June | (P) | Ozzie Co's equity capital attributable to Aust Fin's equity interests on a measurement day | $900,000 | $950,000 |
Step 4A.3: Aust Fin's premium excess amount is calculated by reducing the amount at N by the amount at P and multiplying the result by the uplifted worldwide gearing ratio worked out at MM on worksheet 4 | (QQ) | (N – P) × MM | $72,973 | $36,486 |
Step 4A.4: The attributable safe harbour excess amount has been calculated at X on worksheet 2A | (X) | Attributable safe harbour excess amount (from X on worksheet 2A) | $540,000 | $570,000 |
Step 4A.5: The associate entity excess amount is the sum of the premium excess amount and the attributable safe harbour excess amount | (RR) | QQ + X | $612,729 | $606,486 |
Step 4A.6: Aust Fin has only one associate entity so SS if the same as RR | (SS) | Transfer from RR | $612,729 | $606,486 |
Step 4A.7: SS is calculated for the other measurement day. This has been done in the right-hand column above |
| |||
Step 4A.8: The average associate entity excess amount is calculated by adding the results at SS ($612,729 and $606,486) and dividing by 2 (the number of measurement days) | (PP) | ($612,729 + $606,486) ÷ 2 | $609,608 Transfer to PP on worksheet 4A |
Aust Fin's worldwide gearing debt amount is $18,933,917. This is less than its safe harbour debt amount. Aust Fin can calculate an alternative amount under the arm's length debt test. Aust Fin could also choose to not calculate an arm's length debt amount (as this may be less than the safe harbour debt amount as well) and calculate what debt deductions are disallowed on the basis that the safe harbour debt amount is its maximum allowable debt.
Step 5: Calculate debt deductions disallowed
Aust Fin's maximum allowable debt is $23,312,812 – the safe harbour debt amount, being the greatest of the 3 amounts. As Aust Fin's adjusted debt ($24 million) is more than its maximum allowable debt, a proportion of its debt deductions will be disallowed.
Aust Fin's debt deductions are $2.7 million.
Steps | Label | Label description | Amount |
|---|---|---|---|
Step 6.1: Aust Fin's adjusted average debt is $24m and its maximum allowable debt is $23,312,812 | (TT) | Excess debt | $687,188 |
Step 6.2: Aust Fin's average debt is $24m | (UU) | Average debt | $24m |
Step 6.3: Divide the amount at TT by the amount at UU to get the proportion to be applied to Aust Fin's debt deductions | (VV) | TT ÷ UU | 0.0286328 |
Step 6.4: Aust Fin's debt deductions for the income year are $2.7m | (WW) | Debt deductions for the income year | $2.7m |
Step 6.5: The amount of debt deductions disallowed is calculated by multiplying the amount at VV by the amount at WW | = | VV x WW | $77,308 |
Aust Fin cannot deduct $77,308 of its debt deductions.