House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 3 - Outward investing entities (non-ADI)

Outline of chapter

3.1 This chapter explains how the thin capitalisation rules in Subdivision 820-B will apply to an Australian entity that either directly or indirectly has offshore investments and is a non-ADI. It explains how such an entity works out its maximum allowable debt and by how much it needs to reduce its debt deductions where the thin capitalisation rules have been breached.

3.2 A threshold requirement will exclude small investors from the thin capitalisation regime. The exclusion will operate where the debt deductions of the entity, either alone or together with associate entities, are $250,000 or less.

Context of reform

3.3 An Australian entity may invest overseas via an investment in a foreign entity that it controls or by carrying on a business at or through an overseas branch. In a similar manner to foreign entities, an Australian entity with offshore operations in either form can allocate excessive amounts of debt to its Australian operations to maximise deductions for interest, thereby reducing tax paid in Australia. The existing thin capitalisation rules do not impose limits on the debt levels of these entities.

3.4 However, certain provisions deal with the deductibility of interest expenses for outward investors. These are contained in section 8-1 of the ITAA 1997 and sections 79D and 160AFD of the ITAA 1936. The rules in section 79D prevent a foreign loss being deducted from domestic assessable income and section 8-1 denies deductions incurred in earning exempt (foreign) income. However, because all of these rules rely on tracing the use of borrowed funds, it is relatively easy to circumvent their operation by establishing a use of funds that ensures deductibility.

3.5 Another problem with the rules is that they apply on a single entity basis, and it is therefore possible to circumvent them by using interposed entities to separate the foreign income from the expenditure.

3.6 Australias DTAs also require that taxpayers with foreign branches calculate the taxable (or exempt) income of those branches consistent with the business profits article of the relevant DTA. Chapter 4 outlines some of the problems with the rules for determining the appropriate capital funding of a branch in accordance with that article.

3.7 The new thin capitalisation regime will impose a limit on the extent to which the Australian operations of Australian outward investors can be funded by debt. Accordingly, the current limitations imposed by section 79D and section 8-1 (in relation to exempt income) on interest deductions will be removed in so far as they apply to debt deductions and do not relate to an entitys overseas permanent establishment. Therefore, expenses relating to those deductions will be able to be deducted when incurred in earning exempt foreign income and will no longer be quarantined, subject to the limits imposed by the new thin capitalisation provisions.

3.8 The new thin capitalisation regime is designed to prevent excessive debt deductions being claimed. However, the new rules will apply to all of the debt of the entity and not just to the debt borrowed from foreign related parties as is the case with the existing rules. This will strengthen the integrity of the new rules.

3.9 Under the new regime the maximum debt to equity ratio allowed is 3:1, compared to 2:1 under the current provisions. However, in recognition of the fact that financial entities on-lend large amounts of their debt, such entities are allowed a debt to equity ratio of up to 20:1 under the new rules, compared to 6:1 under the current provisions. Nevertheless, in certain circumstances a ratio above 20:1 may be permitted where an entity holds a specific class of assets.

3.10 The prescribed safe harbour debt to equity ratio may be exceeded in circumstances where the funding structure could be maintained on an arms length basis. In such a situation, no deductions will be disallowed. This change recognises that some funding arrangements may be commercially viable notwithstanding that they exceed the prescribed limits. It also makes the rules more consistent with Australias DTAs.

3.11 The new rules also:

•

incorporate comprehensive concepts of debt and debt deductions that arise from debt arrangements rather than being restricted to the narrow concept of interest as in the existing rules, reflecting a move to economic form over substance; and

•

apply to groups of entities where they choose to group for thin capitalisation purposes. The application of the thin capitalisation rules to groups is discussed in detail in Chapter 6.

Summary of new law

Detailed explanation of new law

Overview

3.12 The outward investing rules will apply to Australian entities that either directly or indirectly have offshore operations. Such operations could include a foreign subsidiary or carrying on business at or through an overseas permanent establishment. This chapter describes only those provisions that apply to these types of entities.

3.13 The rules for outward investing entities will take precedence over the rules for inward investing entities. For example, if an Australian entity has an overseas permanent establishment but is also foreign controlled, the rules discussed in this chapter will apply. [Schedule 1, item 1, subsection 820-85(1) and paragraph 820-185(1)(a)]

3.14 The thin capitalisation rules seek to limit the amount of debt that can be allocated to the Australian operations of entities with offshore investments. Where the prescribed gearing limits are breached the rules disallow some of the debt deductions attributed to the Australian operations. If the prescribed thin capitalisation limits are not breached, this does not mean that the entity will automatically be allowed deductions for expenses associated with its debt. The rules operate to disallow debt deductions that are otherwise allowable under the income tax law.

3.15 In determining whether an entity has breached the safe harbour or the worldwide gearing rule (where available), the gearing level of the entitys net Australian assets will be tested. Australian assets consist of the entitys total assets (other than assets attributable to any of its foreign permanent establishments) less its equity and debt investments in its controlled foreign entities. Certain other amounts are subtracted to arrive at the entitys net Australian assets.

3.16 Broadly, the thin capitalisation rules applying to outward investing entities have the same rationale as, and operate in a similar manner to, the rules which apply to inward investing entities (see Chapter 2). There is an additional rule for outward investing entities which will allow, in certain circumstances, the gearing of the Australian operations to be up to 120% of the Australian entitys worldwide gearing level.

3.17 The outward investing rules will also apply to a group of entities who have elected to group for thin capitalisation purposes if it has similar foreign operations (see Chapter 6).

What is an outward investing entity (non-ADI)?

3.18 This is a term used in the legislation to describe Australian entities with offshore investments. Firstly, they are not banks or other ADIs. Secondly, the legislation further categorises them as either an:

•

outward investor (general); or

•

outward investor (financial).

[Schedule 1, item 1, subsection 820-85(2); Schedule 2, item 52, definition of outward investing entity (non-ADI) in subsection 995-1(1)]

3.19Further, the rules classify these entities as either financial or general entities. This is done so as to ensure that the gearing levels permitted under the rules take into account the different debt levels required by each type of entity .

Outward investor (general)

3.20 An outward investor (general) is an entity that is neither a financial entity nor an ADI at any time during the period, and is one or more of the following:

•

an Australian controller of at least one Australian controlled foreign entity (not necessarily the same Australian controlled foreign entity throughout the period) [Schedule 1, item 1, subsection 820-85(2), item 1(a) in the table] ;

•

an Australian entity that carries on a business at or through at least one overseas permanent establishment (not necessarily the same permanent establishment throughout the period) [Schedule 1, item 1, subsection 820-85(2), item 1(b) in the table] ; and/or

•

an Australian entity (referred to here as the relevant entity for ease of explanation) where:

-

the relevant entity is an associate entity of an outward investing entity (ADI) or (non-ADI); or

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an outward investing entity (ADI) or (non-ADI) is an associate entity of the relevant entity [Schedule 1, item 1, subsection 820-85(2), item 3 in the table] .

3.21 These types of entities will be referred to as Australian general investors throughout this chapter. The terms Australian controller , Australian controlled foreign entity and associate entity are discussed in Chapter 7.

3.22 An overseas permanent establishment is a permanent establishment that is located in a country other than Australia at or through which the Australian entity carries on business. [Schedule 2, item 55, definition of overseas permanent establishment in subsection 995-1(1)]

Outward investor (financial)

3.23 An outward investor (financial) is defined in the same way as an outward investor (general) except that it must be a financial entity throughout the period [Schedule 1, item 1, subsection 820-85(2), item 2 in the table] . These will be referred to as Australian financial investors throughout this chapter.

3.24 A financial entity is an entity that is not an ADI and:

•

is a registered corporation under the Financial Corporations Act 1974 ;

•

is a securitisation vehicle; or

•

holds a dealers licence granted under Part 7.3 of the Corporations Law where:

-

the entity carries on a business of dealing in securities; and

-

that business is not carried on predominantly for the purpose of dealing in securities with, or on behalf of, the entitys associates (the term associate is discussed in Chapter 7).

[Schedule 2, item 31, definition of financial entity in subsection 995-1(1)]

3.25 This definition will be updated to take account of changes to the Financial Corporations Act 1974 and the Corporations Law .

What is the thin capitalisation rule for outward investing entities (non-ADI)?

Thin capitalisation rule

3.26 The thin capitalisation rules will operate where the gearing of the Australian operations of outward investing entities exceeds a prescribed limit. The prescribed limit is exceeded where the entitys adjusted average debt exceeds its maximum allowable debt . In these circumstances, the thin capitalisation rule will disallow part or all of an entitys debt deductions for the income year. However, a debt deduction will not be disallowed under the rules (although, it could be disallowed under either section 8-1 of the ITAA 1997 or section 79D of the ITAA 1936) to the extent that it is an expense attributable to an overseas permanent establishment of the entity. [Schedule 1, item 1, subsection 820-85(1)]

3.27 The terms debt capital and debt deductions are explained in Chapter 1. The provisions that set out the methods of calculating an average value are discussed in Chapter 8.

3.28 The rules also operate where the entity is an outward investing entity for part of the year. [Schedule 1, item 1, section 820-120]

What is an entitys adjusted average debt?

3.29 An entitys adjusted average debt for an income year is:

•

the average value of its debt capital that gives rise to its debt deductions (other than debt capital attributable to its foreign permanent establishments); less

•

the average value of its loans toassociate entities(other than any loans to its controlled foreign entities); less

•

the average value of any loans to its controlled foreign entities.

[Schedule 1, item 1, subsection 820-85(3)]

3.30 In calculating an entitys adjusted average debt, amounts attributable to the entitys permanent establishments need to be disregarded. This is to ensure that only the debt of the Australian operations is tested. In certain circumstances, there is potential for double counting because amounts which need to be deducted may also be attributable to an overseas permanent establishment. For example, a loan to a controlled foreign entity raised overseas by the Australian entitys permanent establishment may be attributable to the permanent establishment. To avoid possible double-counting, amounts attributable to any of the entitys overseas permanent establishments should be disregarded when calculating adjusted average debt.

3.31 By lending to its controlled foreign entities, the Australian entity effectively shifts deductions from itself to the other entity and to that extent its debt funding is not used to fund its Australian assets. For this reason, the amount of loans to controlled foreign entities is deducted from an entitys debt before comparing it with the maximum allowable debt. As a result, the Australian entity is allowed a deduction in respect of an amount of its debt equal to the amount lent to its controlled foreign entities.

3.32 It should be noted that loans to an Australian entitys controlled foreign entities do not have to be traced to the entitys borrowings or to funds raised overseas and attributed to its permanent establishments.

3.33 The rationale for deducting associate entity debt is discussed in paragraphs 2.34 and 2.35.

3.34 Where the entity has debt capital which does not give rise to debt deductions, that debt capital is not taken into account for thin capitalisation purposes. For example, loans on which interest or other expenses are not claimed as allowable deductions are not included. In addition, debt that does not give rise to debt deductions is also not deducted from assets in calculating the safe harbour debt amount. This treatment recognises that, although these amounts are not equity, they provide capital to fund the entitys operations for which no debt deductions are claimed. The term debt deductions is discussed in paragraphs 1.57 to 1.62.

3.35 Transitional measures which apply in relation to the characterisation of instruments as debt or equity are discussed in paragraphs 1.86 to 1.88.

3.36 An entitys adjusted average debt does not exceed its maximum allowable debt if the adjusted average debt is nil or a negative amount. This may occur where an entity borrows funds and on-lends all of these funds to its controlled foreign entities. No adjustment to the entitys debt deductions will arise where an amount equal to or greater than the amount borrowed is on-lent by the Australian entity to its controlled foreign entity. [Schedule 1, item 1, subsection 820-85(3)]

3.37 An entitys adjusted average debt is calculated in the same way for both general and financial entities.

What is an entitys maximum allowable debt?

3.38 An entitys maximum allowable debt is the maximum amount of debt that can be used to fund its Australian assets and thereby not breach the thin capitalisation rules [Schedule 2, item 45, definition of maximum allowable debt in subsection 995-1(1)] . To determine if a breach has occurred the entitys adjusted average debt is compared with the maximum allowable debt.

3.39 The entitys maximum allowable debt will differ depending on whether the entity is also foreign controlled. For example, an Australian entity may be an outward investing entity because it has a foreign subsidiary. However, at the same time the Australian entity may itself be foreign controlled making it an inward investment vehicle. For integrity reasons, where an entity is both an outward investor and an inward investment vehicle it will not be able to use the worldwide gearing debt test to demonstrate that its debt funding is acceptable.

3.40 The maximum allowable debt for Australian general investors and Australian financial investors that are not foreign controlled is the greatest of:

•

the safe harbour debt amount;

•

the worldwide debt amount; or

•

the arms length debt amount.

[Schedule 1, item 1, subsection 820-90(1)]

3.41 If the entity is foreign controlled the maximum allowable debt is the greater of:

•

the safe harbour debt amount; or

•

the arms length debt amount.

[Schedule 1, item 1, subsection 820-90(2)]

3.42 Although entities will be required to calculate their maximum allowable debt level, they will not be required to do so under all the tests. They will have the option to choose one of these tests. However, since the first of these is a safe harbour amount, the second will normally only be determined where the entitys adjusted average debt capital is greater than the safe harbour debt amount. If the entitys adjusted average debt capital is less than the safe harbour amount there is no need to calculate the worldwide debt amount or arms length debt amount. Additionally, an entity that fails the safe harbour debt test or the worldwide debt test could choose not to calculate the arms length debt amount and have debt deductions disallowed on the basis of the other tests.

What is the safe harbour rule for outward investing entities that are not ADIs?

Australian general investors

3.43 In the case of an Australian general investor, the safe harbour rule requires that its Australian assets be funded by a debt to equity ratio of not more than 3:1.

3.44 The safe harbour debt amount is calculated by applying the following steps using average values for the income year:

Step 1: Work out the average value of all the assets of the entity (other than assets that are attributable to any of its overseas permanent establishments).

Step 2: Reduce the result of step 1 by the average value of all the associate entity debt of the entity (other than controlled foreign entity debt of the entity).

Step 3: Reduce the result of step 2 by the average value of all the associate entity equity of the entity (other than controlled foreign entity equity of the entity).

Step 4: Reduce the result of step 3 by the average value of all the controlled foreign entity debt of the entity for that year.

Step 5: Reduce the result of step 4 by the average value of all the controlled foreign entity equity of the entity for that year.

Step 6: Reduce the result of step 5 by the average value of all the non-debt liabilities of the entity (other than the non-debt liabilities that are attributable to any of its overseas permanent establishments).

Step 7: Multiply the result of step 6 by three-quarters.

Step 8: Add to the result of step 7 the entitys associate entity excess amount.

The result is the safe harbour debt amount.

[Schedule 1, item 1, section 820-95]

3.45 The thin capitalisation rule for outward investing entities is based on the principle that the level of debt attributable to the Australian operations is the Australian entitys total amount of debt less any debt loaned to its controlled foreign entities. Similarly, the level of the equity attributable to the Australian operations is the total amount of equity in the Australian entity less any equity contributed to the controlled foreign entities.

3.46 Assets attributable to overseas permanent establishments are not used in Australian operations and hence are not included in the calculation of the Australian assets of the entity. Similarly, non-debt liabilities attributable to overseas permanent establishments are excluded from the calculation. [Schedule 1, item 1, section 820-95]

What is associate entity debt, associate entity equity and an associate entity excess amount?

3.47 The terms associate entity debt , associate entity equity and associate entity excess amount are discussed in paragraphs 2.34 to 2.49.

What is controlled foreign entity equity?

3.48 The controlled foreign entity equity is the amount of the entitys assets that is equity held by the entity in a controlled foreign entity of which it is an Australian controller [Schedule 2, item 23, definition of controlled foreign entity equity in subsection 995-1(1)] . The meaning of equity in a company, trust or partnership is discussed in paragraphs 1.67 to 1.71. The controlled foreign entity equity is subtracted in the process of calculating the net Australian assets. Likewise controlled foreign entity debt which is the debt owed to the entity by its controlled foreign entities is deducted in the calculation of Australian assets [Schedule 2, item 22, definition of controlled foreign entity debt in subsection 995-1(1)] .

What are non-debt liabilities and why are they subtracted from the entitys assets?

3.49 The term non-debt liabilities and their treatment is discussed in paragraphs 2.50 to 2.54.

Why are the net Australian assets of the entity multiplied by three-quarters in calculating the safe harbour debt amount?

3.50 This issue is discussed in paragraph 2.55.

Comparing adjusted average debt with the safe harbour debt amount

3.51 An entitys adjusted average debt is compared with the safe harbour debt amount. If the safe harbour debt amount is nil the entitys net Australian assets (as described earlier) will be taken to have been funded entirely by its non-debt liabilities. However, the entitys entitlement to debt deductions in respect of debt equal to what it has lent to its controlled foreign entities or associate entities will not be reduced.

3.52 Where the adjusted average debt exceeds the safe harbour debt amount, the entity has not satisfied the 3:1 debt to equity requirement and some debt deductions will be disallowed unless it can demonstrate that its debt funding is acceptable under either the worldwide gearing rule (where available) or on an arms length basis.

3.53 However, if the adjusted average debt is less than the safe harbour debt amount the entity has satisfied the safe harbour rule and no debt deductions are denied.

Example 3.1: Australian general investor

AustTwo borrows $3 million from an unrelated financial entity. AustTwo acquires a 75% interest in AustOne for $4.5 million. AustOne makes a loan of $2 million to its wholly-owned controlled foreign company (ForCo).

The ownership structure and relevant transactions can be represented in the following diagram:

AustTwos average assets are $9.5 million and consist of the following:

Current assets - $3 million

Investment in AustOne - $4.5 million

Buildings - $1 million

Plant and equipment -$1 million

Chapter 8 discusses the methods used to calculate average values.

AustTwo has non-debt liabilities of $0.5 million.

The average value of AustTwos debt capital is $3 million.

AustOnes average assets are as follows:

Current assets - $3 million

Loan to ForCo - $2 million

Investment in ForCo - $5 million

Other non-current assets - $2 million

AustOne has no non-debt liabilities.

The average value of AustOnes debt capital is $6 million.

Both Australian entities are outward investors (general) because of the control tests, which are discussed in Chapter 7. Accordingly, each entity will be subject to the thin capitalisation rules.

Calculations - safe harbour debt amount

AustTwo

Step 1: The average value of the assets of AustTwo is $9.5 million.

Step 2: The average value of AustTwos associate entity debt is zero. The result of step 2 is $9.5 million.

Step 3: The average value of AustTwos associate entity equity is $4.5 million. Therefore, the result of step 3 is $5 million.

The $4.5 million invested in AustOne does not increase the maximum debt that AustTwo may have unless there is excess debt capacity in AustOne or AustTwo has paid a premium for the purchase of AustOne.

Step 4: The average value of AustTwos average controlled foreign entity debt is zero. Although AustTwo is an Australian controller of the CFC, the CFC does not owe any amount to AustTwo. Therefore, the result of step 4 is $5 million.

Step 5: The average value of AustTwos controlled foreign entity equity is zero because it does not have any direct investment in ForCo. Therefore, the result of step 5 is $5 million.

Step 6: The average value of AustTwos non-debt liabilities is $0.5 million. Therefore, the result of step 6 is $4.5 million.

Step 7: Multiplying the result of step 6 by three-quarters equals $3.375 million.

Step 8: The average value of the associate entity excess is zero. The result of this step is $3.375 million. This is the safe harbour debt amount.

The associate entity excess amount for AustTwo is determined by adding the premium excess amount from its interest in AustOne (zero in the example) to the safe harbour excess amount of AustOne (zero, because AustOne fails the safe harbour test). There is no associate entity excess available to AustTwo. [Schedule 1, item 1, section 820-920]

The safe harbour debt amount of $3.375 million represents the maximum level of debt permitted under the general safe harbour rule of 3:1. That is, after taking into account non-debt liabilities, AustTwos average net Australian assets of $4.5 million could be funded by a maximum debt amount of $3.375 million and an average equity amount of not less than $1.125 million. This would satisfy the maximum debt to equity gearing ratio of 3:1.

AustTwos loan of $3 million is the only debt capital amount that gives rise to its debt deductions. This amount is its adjusted average debt amount and is compared with the safe harbour debt amount of $3.375 million. AustTwo has not exceeded the safe harbour debt amount and will not suffer any loss of debt deductions.

AustOne

Step 1: The average value of the assets of AustOne is $12 million.

Step 2: The average value of AustOnes associate entity debt is zero (other than debt in ForCo). Therefore, the result of step 2 is $12 million.

Step 3: The average value of AustOnes associate entity equity is zero (other than equity in ForCo). Therefore, the result of step 3 is $12 million.

Step 4: The average value of all of AustOnes controlled foreign entity debt is $2 million. Therefore, the result of step 4 is $10 million.

Step 5: The average value of AustOnes controlled foreign entity equity is $5 million. Therefore, the result of step 5 is $5 million.

Step 6: The average value of AustOnes non-debt liabilities is zero. Therefore, the result of step 6 is $5 million.

Step 7: Multiplying the result of step 6 by three-quarters equals $3.75 million.

Step 8: The average value of the associate entity excess is zero. (AustOne does not have any associate entity equity). The result of this step is $3.75 million. This is the safe harbour debt amount.

The safe harbour debt amount of $3.75 million represents the maximum level of debt permitted under the general safe harbour rule of 3:1. That is, AustOnes average net Australian assets of $5 million could be funded by a maximum debt amount of $3.75 million and average equity amount of not less than $1.25 million. This would satisfy the maximum debt to equity gearing ratio of 3:1.

AustOnes adjusted average debt is calculated by deducting the loan of $2 million provided to its CFC from its average debt capital. Hence, AustOnes adjusted average debt equals $4 million. This amount is compared to AustOnes safe harbour debt amount. Accordingly, AustOne has not satisfied the safe harbour rule.

An adjustment to its debt deductions for the period will arise if AustOne is not able to demonstrate that the level of debt funding is acceptable under the worldwide gearing rule or under the arms length rule. The application of the worldwide gearing rule is discussed in paragraphs 3.61 to 3.72 and the arms length rule is discussed in Chapter 10.

Australian financial investors

3.54 In the case of Australian financial investors, the safe harbour rule reflects the greater debt funding required to support their lending and other financing activities. The on-lending rule for outward investing financial entities operates in the same manner, and for the same reasons, as the on-lending rule for foreign controlled Australian financial entities.

3.55 The safe harbour debt amount ,the total debt amount and adjusted on-lent amount are discussed in detail in paragraphs 2.63 to 2.93. However, a brief explanation of these concepts follows. [Schedule 1, item 1, section 820-100]

The total debt amount

3.56 The total debt amount is calculated by applying the following method statement using average values for the income year.

Step 1: Work out the average value of all the assets of the entity (other than assets that are attributable to any of its overseas permanent establishments).

Step 2: Reduce the result of step 1 by the average value of all the associate entity debt of the entity (other than controlled foreign entity debt of the entity).

Step 3: Reduce the result of step 2 by the average value of all the associate entity equity of the entity (other than controlled foreign entity equity of the entity).

Step 4: Reduce the result of step 3 by the average value of all the controlled foreign entity debt of the entity.

Step 5: Reduce the result of step 4 by the average value of all the controlled foreign entity equity of the entity.

Step 6: Reduce the result of step 5 by the average value of all the non-debt liabilities of the entity (to the extent that they are not attributable to its overseas permanent establishments).

Step 7: Reduce the result of step 6 by the zero-capital amount .

Step 8: Multiply the result of step 7 by 2021.

Step 9: Add to the result of step 8 the zero-capital amount.

Step 10: Add to the result of step 9 the entitys associate entity excess amount.

The result is the total debt amount.

[Schedule 1, item 1, subsection 820-100(2)]

What is the zero-capital amount?

3.57 Where the financial entity has assets that are zero-capital amounts, higher gearing levels will be permitted. These amountsare effectively taken out of the thin capitalisation safe harbour test. Full debt funding is permitted for assets which fall within the zero-capital amount. This is discussed further in paragraphs 2.66 to 2.80.

The adjusted on-lent amount

3.58 The adjusted on-lent amount is the second amount that must be calculated to determine the safe harbour debt amount. The adjusted on-lent amount calculation operates to remove assets which fall within the definition of on-lent amount so as to ensure that the entitys other assets are funded by a debt to equity ratio of not more than 3:1. If the adjusted on-lent amount is equal to or greater than the total debt amount, the safe harbour debt amount is thetotal debt amount. This will ensure that the gearing of the entity is capped at 20:1 with an allowance for assets which fall within the zero-capital amount. [Schedule 1, item 1, subsections 820-100(1) and (3)]

3.59 The adjusted on-lent amount is calculated as follows using average values for the income year.

Step 1: Work out the average value of all the assets of the entity (other than assets that are attributable to any of its overseas permanent establishments).

Step 2: Reduce the result of step 1 by the average value of all the associate entity equity of the entity (other than controlled foreign entity equity of the entity).

Step 3: Reduce the result of step 2 by the average value of all the controlled foreign entity debt of the entity.

Step 4: Reduce the result of step 3 by the average value of all the controlled foreign entity equity of the entity.

Step 5: Reduce the result of step 4 by the average value of all the non-debt liabilities of the entity (other than the liabilities that are attributable to its overseas permanent establishments).

Step 6: Reduce the result of step 5 by the average value, for that year, of the entitys on-lent amount (to the extent that it is not attributable to any of the entitys overseas permanent establishments and is not part of the entitys controlled foreign entity debt). This average value is the average on-lent amount .

If the result of this step is negative, it is reset to zero.

Step 7: Multiply the result of step 6 by three-quarters.

Step 8: Add to the result of step 7 the average on-lent amount.

Step 9: Reduce the result of step 8 by the average value of all the associate entity debt of the entity (other than controlled foreign entity debt of the entity).

Step 10: Add to the result of step 9 the entitys associate entity excess amount.

The result is the adjusted on-lent amount.

[Schedule 1, item 1, subsection 820-100(3)]

What is the on-lent amount?

3.60 The on-lent amount is described in paragraphs 2.86 to 2.93. [Schedule 2, item 50, definition of on-lent amount in subsection 995-1(1)] . Assets included as part of the zero-capital amount are also treated as on-lent amounts for the purpose of calculating the average on-lent amount. Because the on-lent amount is deducted at step 6, there is no separate step to deduct associate entity debt which will be part or all of the on-lent amount. This avoids double counting.

Example 3.2: Australian financial investor

AustFin is a financial entity that provides a range of financial services. It has provided loans to unrelated parties of $30 million and to its wholly-owned controlled foreign entity amounting to $2 million. In addition, it has assets of $20 million which falls within the zero-capital amount. AustFin principally funds its activities through debt financing.

The relevant transactions can be represented in the following diagram:

AustFins average assets ($66.5 million) are as follows:

Current assets - $1 million

Loan to ForCo - $2 million

Investment in ForCo - $6 million

Loans to unrelated entities - $30 million

Assets in the zero-capital amount - $20 million

Other non-current assets - $7.5 million

AustFin has non-debt liabilities of $0.5 million.

AustFins average debt is $54 million.

AustFin is an Australian financial investor. Accordingly the entity will be subject to the thin capitalisation rules.

Calculations - safe harbour debt amount

AustFin

Total debt amount

Step 1: The average value of the assets of AustFin is $66.5 million.

Step 2: The average value of the associate entity debt is zero. The result of step 2 is $66.5 million.

Step 3: The average value of AustFins associate entity equity (other than equity in its CFC) is zero. The result of step 3 is $66.5 million.

Step 4: The average value of AustFins controlled foreign entity debt is $2 million. The result of step 4 is $64.5 million.

Step 5: The average value of AustFins controlled foreign entity equity is $6 million. The result of step 5 is $58.5 million.

Step 6: The average value of AustFins non-debt liabilities is $0.5 million. The result of step 6 is $58 million.

Step 7: The zero-capital amount is $20 million. The result of step 7 is $38 million.

Step 8: Multiplying the result of step 7 by 20/21 equals $36.19 million.

Step 9: Adding the zero-capital amount to the result of step 7 equals $56.19 million.

Step 10: The entitys associate equity excess amount is zero.

The total debt amount is therefore $56.19 million.

Adjusted on-lent amount

Step 1: The average value of the assets of AustFin equals $66.5 million.

Step 2: The average value of AustFins associate entity equity is zero. The result of step 2 is $66.5 million.

Step 3: The average value of AustFins controlled foreign entity debt is $2 million. The result of step 3 is $64.5 million.

Step 4: The average value of AustFins controlled foreign entity equity is $6 million. The result of step 3 is $58.5 million.

Step 5: The average value of AustFins non-debt liabilities is $0.5 million. The result of step 5 is $58 million.

Step 6: The average value of AustFins on-lent amount (that does not include controlled foreign entity debt) is $50 million. This is the average on-lent amount. The result of step 6 is $8 million.

Note: The assets that fall within the zero-capital amount are included in the on-lent amount.

Step 7: Multiplying the result of step 6 by three-quarters equals $6 million.

Step 8: Adding on the average on-lent amount to the result of step 7 equals $56 million.

Step 9: The average value of the associate entity debt is zero. The result of this step is $56 million.

Step 10: The entitys associate equity excess amount is zero .

Therefore, the adjusted on-lent amount is $56 million.

As the adjusted on-lent amount ($56 million) is less than the total debt amount ($56.19 million), the safe harbour debt amount is the adjusted on-lent amount.

The safe harbour debt amount of $56 million represents the maximum level of debt funding available to AustFin to fund its Australian operations. The amount is compared with AustFins adjusted average debt.

AustFins adjusted average debt is $52 million. This amount is calculated by deducting the $2 million loan to ForCo from its average debt capital ($54 million). This amount is compared to the safe harbour debt amount of $56 million. Hence, AustFin has satisfied the safe harbour rule for outward investing financial entities. As a result, no adjustment will be made to its debt deductions for the relevant period.

If AustFins debt financing had exceeded the safe harbour debt amount it would need to demonstrate that its level of gearing is acceptable under the worldwide gearing test or the arms length test, to avoid losing debt deductions.

What is the worldwide gearing rule for outward investing entities?

3.61 In the event that an entity exceeds the safe harbour gearing level, the outward investing rules will allow the Australian operations, in certain circumstances, to be geared at up to 120% of the gearing of the Australian entitys worldwide group. This recognises that Australian businesses may need to borrow funds in order to expand offshore. Where the entity is able to satisfy the worldwide gearing test its debt deductions will not be reduced.

3.62 In the case of an entity that is also foreign controlled, the worldwide gearing test will not apply. This is because under this rule only the gearing level of the Australian entity and its controlled foreign entities is used and not the gearing of the foreign controller and other entities it controls. Therefore, the gearing level of the Australian entitys worldwide group could be greater than the actual worldwide gearing of the group controlled by the foreign controller because it is not completely determined by the market. Excluding these entities from the test will ensure the integrity of the worldwide gearing rule. [Schedule 1, item 1, subsection 820-90(2)]

3.63 If an entity is foreign controlled for only part of a year it will not be able to apply the worldwide gearing test for any part of the year it is not also foreign controlled. [Schedule 1, item 1, subsection 820-90(2)]

3.64 The worldwide gearing rule will also apply to a group. If the group is also foreign controlled the group will not be able to apply the worldwide gearing test in the event that it fails the safe harbour test. The application of the thin capitalisation rules to groups is discussed further in Chapter 6.

3.65 The method statement used to calculate the allowable debt amount under the worldwide gearing rule is essentially the same as themethod statements used to calculate the safe harbour debt amount. However, under the worldwide gearing test the entity is permitted to have a gearing level as high as 120% of the gearing of the Australian entitys worldwide group. The allowable gearing ratio is determined from the actual worldwide gearing of the Australian entity and is not predetermined. [Schedule 1, item 1, section 820-110]

3.66 The worldwide gearing debt amount is calculated by applying the following method statement using average values for the income year:

Step 1: Divide the average value of all the entitys worldwide debt for the income year by the average value of the entitys worldwide equity.

Step 2: Multiply the result of step 1 by 1.2.

Step 3: Add 1 to the result of step 2.

Step 4: Divide the result of step 2 by the result of step 3.

Step 5: If the entity:

•

is not a financial entity, multiply the result of step 4 by the result of step 6 in the method statement for the safe harbour debt amount; or

•

is a financial entity, multiply the result of step 4 by the result of step 7 in the method statement used to calculate the total debt amount.

Step 6: If the entity is a financial entity add to the result of step 5 the zero-capital amount.

Step 7: Add to the result of step 6 the entitys associate entity excess amount.

The result is the worldwide gearing debt amount.

[Schedule 1, item 1, subsections 820-110(1) and (2)]

3.67 The effect of step 1 and step 2 of the method statement is to apply a 20% uplift factor to the actual worldwide gearing of the entity. The worldwide gearing level is calculated by dividing the worldwide debt by the worldwide equity . This is done in order to determine what the allowable gearing ratio is for the entitys Australian operations.

3.68 The worldwide debt of the Australian entity consists of all of the debt owed by the entity and its controlled foreign entities (excluding any debt they owe to each other). [Schedule 2, item 71, definition of worldwide debt in subsection 995-1(1)]

3.69 The worldwide equity of the Australian entity consists of all of the equity capital in the entity and its controlled foreign entities (excluding equity held by each other). [Schedule 2, item 72, definition of worldwide equity in subsection 995-1(1)]

3.70 Steps 3 and 4 convert the allowable gearing ratio into a debt to net assets fraction in the same way that 3:1 and 20:1 have been converted for the purposes of the other method statements.

3.71 The net Australian assets (from method statements for the safe harbour debt amount) are then multiplied by the new debt to net assets fraction (step 5). Any associate entity excess amount or zero-capital amount (in the case of a financial entity) is then added.

3.72 In the case of a financial entity, the on-lending rule is ignored in working out the allowable worldwide gearing ratio. For example, if the safe harbour gearing ratio of a financial entity is effectively 12:1 (because of the on-lending rule) then the worldwide gearing ratio of the Australian entity would have to be greater than 10:1 for this method to be of benefit to the financial entity. That is, if the worldwide gearing ratio is less than 10:1 the uplift factor of 20% would not raise the allowable gearing level above the entitys safe harbour ratio of 12:1.

Example 3.3: Australian general investor: 120% worldwide gearing test

The following example is based on the facts of Example 3.1. In summary, AustTwo borrows $3 million from an unrelated financial entity. It acquires a 75% interest in AustOne for $4.5 million. AustOne makes a loan of $2 million to its wholly-owned controlled foreign company (ForCo).

The ownership structure and relevant transactions can be represented in the following diagram.

Both Australian entities are Australian controllers of ForCo (see Chapter 7). The worldwide gearing test is available to both entities as neither is also foreign controlled. [Schedule 1, item 1, sections 820-90 and 820-110]

AustTwo

As discussed in Example 3.1, AustTwo has satisfied the safe harbour test as its adjusted average debt amount of $3 million does not exceed its safe harbour debt amount of $3.375 million. Accordingly, there is no need to calculate its worldwide debt amount.

AustOne

As discussed in Example 3.1, AustOne has not satisfied the safe harbour test as its adjusted average debt of $4 million exceeds its safe harbour debt amount of $3.75 million. An adjustment to its debt deductions for the period will arise if AustOne is not able to demonstrate that the level of debt funding is acceptable under the worldwide gearing rule or under the arms length rule.

AustOnes balance sheet using average values for the year is as follows:

Assets		Liabilities
Current assets	$3m	Loan	$6m
Investment in ForCo	$5m	Non-debt liabilities	$0m
Loan to ForCo	$2m	Equity	$6m
Other non-current assets	$2m
	$12m		$12m

Relevant information concerning ForCo

ForCo has a total debt capital of $18 million of which $2 million is owed to AustOne and $16 million is owed to an unrelated foreign bank.

ForCos equity capital is $7 million (it has $2 million in retained earnings).

Calculation - worldwide debt amount

Step 1: AustOnes average worldwide debt equals $22 million. This amount consists of the $6 million owed by AustOne to the unrelated financial entity plus $16 million owed by ForCo to entities other than AustOne.

AustOne s average worldwide equity equals $8 million. This amount consists of AustOnes equity of $6 million plus the $2 million retained earnings in ForCo.

The result of dividing the worldwide debt by the worldwide equity equals 2.75.

This amount is AustOnes worldwide gearing, and can be expressed as a debt to equity ratio of 2.75:1.

Step 2: Multiplying the result of step 1 by 1.2 equals 3.3.

This amount is AustOnes actual worldwide gearing ratio increased by 20%, and can be expressed as a ratio of 3.3:1.

Step 3: Adding 1 to the result of step 2 equals 4.3.

Step 4: Dividing the result of step 2 by the result of step 3 equals 0.767.

This amount represents what the allowable gearing ratio of 3.3:1 is as a proportion of net assets of the entity.

Step 5: Multiplying the result of step 4 by AustOnes net assets of $5 million (AustOnes step 6 in Example 3.1) equals $3.837 million.

Step 6: The entitys associate entity excess amount is zero.

The worldwide gearing debt amount is therefore $3.837 million.

The worldwide gearing debt amount is greater than AustOnes safe harbour debt amount of $3.75 million. The difference represents the additional debt that the entity is permitted to have in excess of the safe harbour level without breaching the thin capitalisation rules. However, as AustOnes adjusted average debt of $4 million exceeds its worldwide gearing debt amount an adjustment to its debt deductions will be made unless it can demonstrate that its gearing is acceptable on an arms length basis.

Arms length debt amount

3.73 Chapter 10 discusses the arms length debt amount.

What is the amount of debt deduction disallowed under the thin capitalisation rules?

3.74 In circumstances where an entity breaches the thin capitalisation rule an adjustment to disallow all or part of each debt deduction must be calculated [Schedule 1, item 1, sections 820-85 and 820-115] . The amount of debt deduction disallowed is calculated in the same way for both financial and general entities.

3.75 The formula for non-ADI outward investing entities operates in the same manner as the formula for non-ADI inward investing entities (this is explained in more detail in paragraphs 2.105 to 2.108). For outward investing entities, debt deductions will not be disallowed by this formula to the extent that it is an expense attributable to any of its overseas permanent establishments. [Schedule 1, item 1, subsection 820-85(1) and section 820-115]

Application to part year periods for outward investing entities

3.76 The thin capitalisation rule outlined in this chapter will apply to an entity that was a non-ADI outward investing entity for part(s) of an income year. The method statements in this chapter only apply to values relating to that period. The entitys adjusted average debt and its maximum allowable debt for part of an income year are calculated using average values of the various items during each period [Schedule 1, item 1, section 820-120] . Different thin capitalisation rules, for example the inward investing entity (non-ADI) rules, may apply during the period in which the entity was not an outward investing entity. Alternatively, if the entity was neither an inward investing entity nor an outward investing entity for a period, no thin capitalisation rules may apply.

3.77 The method of calculating the entitys maximum allowable debt and the amount of each deduction disallowed, for the part of a year the entity is an outward investing entity, operates in the same manner as for non-ADI inward investing entities (this is explained in paragraph 2.111). [Schedule 1, item 1, section 820-120]

Diagram 3.1: When will an adjustment be made to disallow all or part of an outward investing (non-ADI) entitys debt deductions?

Application and transitional provisions

3.78 The application and transitional provisions for this measure are discussed in Chapter 1.

Consequential amendments

3.79 Consequential amendments are discussed in Chapter 1. Note, in particular, the changes to section 160AFD of the ITAA 1936 and the insertion of section 25-90 in the ITAA 1997. It should be noted that neither of these amendments relates to debt deductions attributable to foreign branches of Australian entities. [Schedule 1, items 5, 16, 20 and 24]