House of Representatives

Explanatory Memorandum

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

Chapter 6 - Consolidation and thin capitalisation

Outline of chapter

6.1 This chapter explains amendments to the thin capitalisation provisions contained in Division 820 of the ITAA 1997. With the consolidation regime largely replacing all existing grouping provisions in the ITAA 1936 and ITAA 1997, including Subdivision 820-F of the thin capitalisation provisions, the amendments ensure that the thin capitalisation regime continues to operate as intended. Legislative references are to the ITAA 1997 unless otherwise stated.

6.2 This chapter also explains that, with some important exceptions, the existing grouping provisions in Subdivision 820-F will continue to operate until the end of the 2002-2003 income year for entities that consolidate. Where entities do not consolidate the existing grouping rules will cease to operate from 1 July 2003.

Context of reform

6.3 Division 820 introduced a new thin capitalisation regime consistent with recommendations of A Tax System Redesigned . The objective of the regime is to ensure that multinational entities do not allocate an excessive amount of debt to their Australian operations. Following the introduction of the consolidation regime, a number of amendments are required to ensure that the thin capitalisation rules continue to operate as intended for a consolidated or MEC group and to phase out the existing grouping rules in the thin capitalisation regime.

Summary of new law

6.4 The main features outlined in this chapter are:

Detailed explanation of new law

6.5 The introduction of the consolidation regime means that all other grouping provisions within the ITAA 1936 and ITAA 1997 will be largely repealed or phased out. Entities will generally have to form a consolidated group or MEC group in order to access benefits that were previously available under the various grouping provisions.

6.6 Thin capitalisation, however, contains an exception to this in that it will allow an Australian branch of a foreign bank to be part of a groups head company or part of a single resident company for the purpose of determining their thin capitalisation position.

6.7 This chapter describes:

•

the application of the thin capitalisation rules to a head company of a consolidated group or MEC group (see paragraphs 6.9 to 6.33) [Schedule 13, item 3, section 820-579] ;

•

the application of the thin capitalisation rules where a foreign bank branch becomes part of the head company or a single resident company (see paragraphs 6.34 to 6.66) [Schedule 13, item 3, section 820-595] ; and

•

when the resident TC grouping rules cease to operate (see paragraphs 6.67 to 6.85) [Schedule 13, item 2, sections 820-455 to 820-458].

6.8 The thin capitalisation rules will generally apply to the head company of a consolidated group or MEC group or to a single company as a consequence of the head company or single company being classified as either:

•

an outward investing entity (non-ADI);

•

an inward investing entity (non-ADI);

•

an outward investing entity (ADI); or

•

an inward investing entity (ADI).

When do the thin capitalisation rules apply to consolidated groups and MEC groups?

6.9 The thin capitalisation rules will apply to any head company that is classified according to the preceding paragraph where that head company does not meet the requirements of either the limit for debt deductions or the Australian assets threshold test. These de minimis tests are set out in sections 820-35 and 820-37, respectively.

6.10 The rules will also apply to consolidated groups or to MEC groups that have either commenced or ceased their existence during the income year. The determination of the thin capitalisation position of the head company for the income year needs to take account of such changes in relationships among entities to be equitable. In these cases, the thin capitalisation rules will either have a single application or 2 or more applications for each of the following parts of the income year (e.g. if the classification described in paragraph 6.8 changes during the year):

•

a period throughout which a company is the head company of that group;

•

a period throughout which that company is the head company of a different consolidated group or MEC group; or

•

a period throughout which that company is not a member of any consolidated group or MEC group.

[Schedule 13, item 3, section 820-581]

Example 6.1

Austco Ltd is not a member of a consolidated group for the first 6 months of an income year, but then becomes the head company of a consolidated group which continues in existence for the rest of the income year.

For those first 6 months Austco is an outward investor (general) under section 820-85. For the rest of the income year Austco is an outward investor (general) under subsection 820-583(2).

This section ensures that section 820-120 (about part-year periods) applies to Austco instead of section 820-85, so that Subdivision 820-B has 2 separate applications to Austco: one for the first 6 months and the other for the rest of the income year. Under the second application, account is taken of the subsidiary members that are taken to be part of Austco as head company of the consolidated group.

When do the outward investing entity (non-ADI) rules apply to a head company?

6.11 The head company of a consolidated group or MEC group is an outward investing entity (non-ADI) for a period that is all or part of an income year if it is either:

•

an outward investor (general) for that period; or

•

an outward investor (financial) for that period.

[Schedule 13, item 3, subsection 820-583(1)]

When is a head company an outward investor (general)?

6.12 The head company is an outward investor (general) if it would be classified as such for a period that is all or part of an income year. This occurs where the head company meets the requirements of being an outward investing entity set out in Subdivision 820-B and no other member of its group is a financial entity or an ADI during that period [Schedule 13, item 3, subsection 820-583(2)] . This is the case even if a member within the group is a foreign-controlled Australian entity, because the thin capitalisation rules for outward investing entities take priority over the thin capitalisation rules for inward investing entities. The head company will be an outward investing entity if it is so in its own right or if because of the single entity rule it is so because one of the subsidiary members of the group is.

6.13 Being an outward investor (general) means that the head company would apply the rules set out in Subdivision 820-B to determine its thin capitalisation position. It should be noted that section 820-100 would not apply to the head company in this instance as that section only applies to outward investing entities that are financial entities.

When is a head company an outward investor (financial)?

6.14 The head company is an outward investor (financial), for a period that is all or part of an income year, if:

•

it meets the requirements for an outward investing entity set out in Subdivision 820-B for that period;

•

throughout the period, there is at least one member of the group that is a financial entity; and

•

no member of the group is an ADI during that period.

[Schedule 13, item 3, subsection 820-583(3)]

6.15 Being an outward investor (financial) means that the head company would apply the rules set out in Subdivision 820-B to determine its thin capitalisation position. It should be noted that section 820-95 would not apply to the head company in this instance as that section only applies where the taxpayer is treated as outward investor (general).

6.16 For the head company, as an outward investor (financial), this also means that the special rules about on-lent amounts and zero-capital amounts would apply to all such assets held by the group, whether held legally by the actual financial entities in the group or by other group entities.

What if the consolidated group or MEC group includes an ADI?

6.17 Subdivision 820-B does not apply to a head company that would otherwise be an outward investor (non-ADI) for a period if one of the group members is an ADI for that period. In this instance, the head company would be treated as an outward investing entity (ADI) for that period (see paragraph 6.24).

When do the inward investing entity (non-ADI) rules apply to a head company?

6.18 The head company of a consolidated group or MEC group is an inward investing entity (non-ADI) for a period that is all or part of an income year if it is either:

•

an inward investment vehicle (general) for that period; or

•

an inward investment vehicle (financial) for that period.

[Schedule 13, item 3, subsection 820-583(4)]

When is a head company an inward investment vehicle (general)?

6.19 The head company is an inward investment vehicle (general), for a period that is all or part of an income year if:

•

it is a foreign-controlled Australian entity for that period; and

•

provided no other member of the group is a financial entity or an ADI at any time during that period.

This classification only holds where the head company could not be classified as an outward investing entity (non-ADI) during that period. [Schedule 13, item 3, subsection 820-583(5)]

6.20 Being an inward investment vehicle (general) means that the head company would apply the rules set out in Subdivision 820-C to determine its thin capitalisation position. It should be noted that section 820-200 would not apply to the head company in this instance as that section only applies to inward investment vehicles that are financial entities. Sections 820-205 and 820-210 also do not apply as those sections apply to foreign entities only.

When is a head company an inward investment vehicle (financial)?

6.21 The head company is an inward investment vehicle (financial) for a period that is all or part of an income year if:

•

it is a foreign-controlled Australian entity for that period;

•

at least one member of that group is a financial entity throughout the period; and

•

no other member of the group is an ADI during that period.

This classification only holds where the head company could not be classified as an outward investing entity (non-ADI) during that period. [Schedule 13, item 3, subsection 820-583(6)]

6.22 Where the head company is an inward investment vehicle (financial) the special rules about on-lent amounts and zero-capital amounts would apply to all such assets held by the group, whether held legally by the actual financial entities in the group or by other group entities.

What if the consolidated group or MEC group includes an ADI?

6.23 Subdivision 820-C does not apply to a head company that would otherwise be an inward investor (non-ADI) for a period if one of its members is an ADI for that period. In this instance, the head company would be treated as an ADI for that period and apply the relevant rules accordingly.

When do the outward investing entity (ADI) rules apply to a head company?

6.24 The head company of a consolidated group or MEC group is an outward investing entity (ADI) for a period that is all or part of an income year if either:

•

one member of the group is an outward investing entity (ADI) for that period; or

•

the group includes at least one outward investing entity (non-ADI) and another entity that is an ADI, for that period.

[Schedule 13, item 3, subsection 820-583(7)]

6.25 Being an outward investing entity (ADI) means that the head company would apply the rules set out in Subdivision 820-D to determine its thin capitalisation position.

6.26 If, however, the head company of a MEC group is not an outward investing entity (ADI) for the period, but the group includes at least one foreign-controlled Australian ADI and another member that is not a wholly-owned subsidiary of a foreign-controlled Australian ADI, then Subdivision 820-D will also apply to that group as if it were an outward investing entity (ADI) [Schedule 13, item 3, section 820-587] . An example of this would be a MEC group where a foreign bank has 2 wholly-owned Australian subsidiaries, one being a bank and the other not a bank, where the latter is not owned by the Australian bank and so does not come under APRA supervision.

6.27 As stated previously, the outward investing ADI rules apply to a consolidated group or MEC group where the head entity is an outward investing (ADI). However, a MEC group may include entities that are not supervised by APRA. To account for these cases, the outward investing ADI rules are modified to include in the definition of adjusted average equity capital the following item:

•

the (consolidated) paid-up share capital (other than debt interests), capital of other entities (other than debt interests), retained earnings, interest-free debt and general reserves of the entities that are not supervised by APRA.

This is then combined with the total value of the tier 1 capital (net of any debt capital that is part of that tier 1 capital) for entities in the group that are ADIs or wholly-owned subsidiaries of an ADI. This is the adjusted average equity capital for the MEC group. Where a consolidated group or MEC group consists solely of entities that are ADIs or wholly-owned subsidiaries of an ADI then the calculation of the adjusted average equity capital is based solely on the total value of tier 1 capital (net of debt capital that is part of that tier 1 capital). [Schedule 13, item 3, section 820-589] .

6.28 The information used by the head company in determining the value of adjusted average equity capital for the group is that which would be contained in a set of consolidated accounts prepared in accordance with accounting standards at the measurement time. [Schedule 13, item 3, subsection 820-589(3)]

6.29 For the purposes of determining the safe-harbour capital amount of the head company of a consolidated group or MEC group special rules apply where an ADI subsidiary of that group has issued debentures under section 128F. This occurs where the ADI subsidiary has on-lent the debentures to an Australian permanent establishment of the foreign bank that is not part of the same consolidated group or MEC group because of a choice made under Subdivision 820-FB [Schedule 13, item 3, subsection 820-591(1)] . For these cases, in determining the safe-harbour capital amount for the consolidated group or MEC group which includes the ADI subsidiary, the rule adjusts the risk-weighted assets of the group by not including any amount for the section 128F funds on-lent to the permanent establishment [Schedule 13, item 3, subsection 820-591(2)] . The rationale for the rule is to ensure that the same pool of section 128F funds is not counted twice for thin capitalisation purposes.

6.30 This rule may also have effect where the head company has included an Australian permanent establishment as part of its group in accordance with a choice made under section 820-597. This will occur where the debenture funds are lent to a permanent establishment of a group foreign bank that is not covered by the choice in section 820-597. [Schedule 13, item 3, subsection 820-591(3)]

6.31 The rule applies for 4 years to allow time for foreign banks to refinance their section 128F programs by issuing the debentures through their Australian branches [Schedule 13, item 3, subsection 820-591(4)] . The section will cease to have effect from the 2006-2007 income year of the head company.

When are the thin capitalisation rules not applied to the head company of a consolidated group?

6.32 In addition to de minimis cases, the thin capitalisation rules will not operate to disallow a debt deduction where the head company of the consolidated group, in its own right, is either:

•

a foreign-controlled Australian bank that does not qualify as an outward investing entity (ADI); or

•

a foreign-controlled Australian company which, if it were not for the consolidation rules, has an Australian bank as its only asset and has no debt capital (i.e. it is a pure bank holding company).

[Schedule 13, item 3, section 820-585]

6.33 The thin capitalisation rules do not apply in these situations because the capital adequacy requirements of APRA are considered sufficient for tax purposes.

Is a foreign bank branch able to be grouped with a head company or single Australian resident company for thin capitalisation purposes?

6.34 For thin capitalisation purposes, provided certain conditions are met a choice can be made so that the Australian bank branches of foreign banks (foreign bank branches) are able to be treated as part of either the head company of a consolidated group or MEC group or part of a single Australian resident company. This allows these branches to be grouped with subsidiaries of the foreign bank when determining the thin capitalisation positions of both the branches and the subsidiaries. The conditions to be met and how the thin capitalisation rules then apply in these cases are contained in Subdivision 820-FB.

When is a foreign bank branch able to be treated as part of a head company of a consolidated group or MEC group?

6.35 It is the head company that is able to make a choice to treat the foreign bank branch as part of itself for thin capitalisation purposes. It may do this for a period (called the grouping period) in which the foreign bank and the head company are members of the same wholly-owned group and in which the foreign bank carries on banking business in Australia through at least one Australian permanent establishment. It can make this choice provided certain other conditions are met.

6.36 The necessary conditions are that:

•

the grouping period began on or after 1 July 2002;

•

the period was all or part of an income year of the head company; and

•

the consolidation or MEC group was in existence throughout the period.

[Schedule 13, item 3, subsections 820-597(1) and (2)]

6.37 The grouping period where the foreign bank branch in Australia is considered to be part of the head company may be either all or part of the relevant income year of the head company. However, the head company is unable to choose a shorter grouping period in instances where the necessary conditions are met for longer periods during the head companys income year. [Schedule 13, item 3, subsection 820-597(3)]

6.38 In determining these periods it is not necessary that the head company and the foreign bank have income years that end on the same day. Where income years overlap it is necessary for separate calculations to be performed for each period that relates to different income years for the respective taxpayers. For example, if the head company has a standard income year but the foreign bank has an end-December SAP, separate calculations will have to be made for each half of each calendar year. [Schedule 13, item 3, section 820-607]

When is a foreign bank branch able to be treated as part of a single Australian resident company?

6.39 An Australian resident company is able to make a choice to treat the foreign bank branch as part of itself for thin capitalisation purposes in similar circumstances to a head company. The same requirements as for a head company must be met but in addition the resident company cannot be a dual resident company and it cannot be a member of a consolidatable group or of a potential MEC group. [Schedule 13, item 3, subsections 820-599(1) and (2)]

6.40 The extent of the grouping period is governed by similar rules as for head companies and in like fashion the income years of the single resident company and the foreign bank do not have to be the same. [Schedule 13, item 3, subsection 820-599(3) and section 820-607]

Is the choice made by the head company or single company binding?

6.41 Where either the head company of a consolidated or MEC group or the single company choose to treat the foreign bank branch as part of itself for thin capitalisation purposes then that decision binds both the taxpayer making the choice and the foreign bank for the grouping period in relation to that income year. The decision made to include the foreign bank branch cannot be revoked in relation to that period [Schedule 13, item 3, subsection 820-603(1)] . However, because the choice is only made for the income year (or part of it that is the grouping period), a new choice may be made each income year.

6.42 Where a choice is made to include the foreign bank branch as part of the head company or single company then it is the rules in Subdivision 820-FB that will be applicable. [Schedule 13, item 3, section 820-601]

What is the effect of a foreign bank branch being treated as part of a head company or single Australian resident company?

6.43 Where a foreign bank branch is treated as part of a head company or single Australian resident company for the grouping period, then for that period, and each test time in that period, it is not considered to be part of the foreign bank. For that period it is considered to be part of the head companys consolidated group or MEC group or part of a consolidated group which encompasses the single resident company and the foreign bank branch only. [Schedule 13, item 3, subsections 820-603(2) to (4)]

6.44 Where these requirements are met, the head company or single company is treated as if it had incurred all the debt deductions for that period, including those costs actually incurred by the foreign bank branch. [Schedule 13, item 3, subsection 820-603(7)]

6.45 The inclusion of the foreign bank branch as part of a head company or single resident company does not affect the requirements set out in Subdivision 820-L for the foreign bank to keep records in relation to its Australian permanent establishment(s). [Schedule 13, item 3, subsections 820-603(3) to (5)]

6.46 However, while not limiting what was stated in paragraphs 6.43 and 6.44, but for the purpose of disallowing any debt deduction under section 820-605, the foreign bank branch is also considered to be an entity for the purposes of applying the thin capitalisation rules. Therefore, each asset and liability of the foreign bank that is attributable to the foreign bank branch is considered to be an asset or liability of the foreign bank branch at the test time. They are not considered to be assets and liabilities of the foreign bank. Similarly, debt deductions incurred by the foreign bank that are attributable to the foreign bank branch are considered to be debt deductions of the foreign bank branch. [Schedule 13, item 3, subsection 820-603(5)]

What is the classification of a head company or single company when a foreign bank branch is included?

6.47 The appropriate thin capitalisation rules to apply to the head company or single resident company depend upon what classification is given to the head company or single company as a result of rules set out in Subdivision 820-FB. [Schedule 13, item 3, subsection 820-603(6)]

6.48 With one exception, where a head company or single company makes the choice to include the foreign bank branch as part of itself, the head company or single company will be classified as an outward investing entity (ADI). This includes a head company or single ADI that, prior to the inclusion of the foreign bank branch, would have been excluded from applying the thin capitalisation because it was considered that the capital adequacy rules of APRA were sufficient for tax purposes (see paragraphs 6.32 and 6.33). Also covered by this classification are head companies of MEC groups to which section 820-587 would have applied if not for the inclusion of the foreign bank branch (see paragraph 6.26). [Schedule 13, item 3, subsections 820-609(1) and (2)]

6.49 The one exception is where the head company or single company would have been either an inward investment vehicle (general) or inward investment vehicle (financial). In this instance, the inclusion of a foreign bank branch as part of the head company or single company will result in that company being classified as an inward investing entity (ADI) for the test period. [Schedule 13, item 3, subsections 820-609(1) and (3)]

6.50 Classification of the head company or single resident company as a result of section 820-609 takes precedence over any other classification resulting from this Division. [Schedule 13, item 3, subsection 820-609(4)]

What rules apply if the head company or single resident company is treated as an outward investing entity (ADI)?

6.51 Being classified as an outward investing entity (ADI) means that the head company or single resident company would apply the rules set out in Subdivision 820-D to determine its thin capitalisation position.

6.52 When a head company or single company makes the choice to include the foreign bank branch the definition of adjusted average equity capital (see paragraphs 6.27 and 6.28) set out in subsection 820-589(3) is adjusted further to include:

•

the equity capital of the foreign bank attributable to its Australian branch (but not allocated to offshore banking activities of the foreign bank) and any interest-free loans that are provided by the foreign bank to its Australian branch.

Note that for a foreign bank branch it is paragraph 820-613(3)(c) that includes the amounts in the calculation of adjusted average equity capital . Amounts attributable to the foreign bank branch are not to be included as a result of either paragraph 820-613(3)(a) or (b).

[Schedule 13, item 3, subsections 820-613(1) to (3)]

6.53 The risk-weighted assets of the head company or single company also need to be modified to include the risk-weighted assets of the foreign bank that are attributable to its Australian branch (but not allocated to offshore banking activities of the foreign bank). [Schedule 13, item 3, subsection 820-613(4)]

What rules apply if the head company or single resident company is treated as an inward investing entity (ADI)?

6.54 Where the inclusion of the foreign bank branch results in the head company or single company being treated as an inward investing entity (ADI), then that head company or single resident company will apply the rules in Subdivision 820-E as if it were an inward investing entity (ADI) for the test period. [Schedule 13, item 3, subsection 820-615(1)]

6.55 The calculation of theaverage equity capital will now include the consolidated paid-up share capital (less amounts that are debt interests), capital of other entities (other than debt interests), retained earnings, general reserves and asset revaluation reserves of each member of the head companys group or of the single company itself. It will also include the equity capital of the foreign bank branch which is included as part of the head company or single resident company. [Schedule 13, item 3, subsection 820-615(2)]

6.56 The safe-harbour capital amount of the head company or single resident company for the grouping period is calculated by determining the risk-weighted assets of the head company or single resident company. For the foreign bank branch these are the risk-weighted assets attributable to the foreign bank branch (not including risk-weighted assets attributable to offshore banking activities) [Schedule 13, item 3, subsection 820-615(4)] . The total of the risk-weighted assets of the group formed by the choice is multiplied by 4% to determine the safe-harbour capital amount [Schedule 13, item 3, subsection 820-615(3)] .

6.57 Where a choice has been made to include a foreign bank branch as part of a single company, then for the purposes of determining the safe-harbour capital amount of that single company special rules may apply where it has issued debentures under section 128F. This occurs where the single company, being a wholly-owned subsidiary of a foreign bank and an ADI, has on-lent the debenture funds to an Australian permanent establishment of another foreign bank in the same wholly-owned group. Furthermore, that permanent establishment cannot be part of the single company because of a choice made under Subdivision 820-FB [Schedule 13, item 3, subsection 820-617(1)] . For these cases, the rule adjusts the risk-weighted assets of the single company by not including anything for the section 128F funds on-lent to the permanent establishment [Schedule 13, item 3, subsection 820-617(2)] . The rationale for the rule is to ensure that the same pool of section 128F funds is not counted twice for thin capitalisation purposes.

6.58 As was the case for the head company of a consolidation group or MEC group, this rule applies for 4 years to allow time for foreign banks to refinance their section 128F programs by issuing the debentures through their Australian branches [Schedule 13, item 3, subsection 820-617(3)] . The section will cease to have effect from the 2006-2007 income year of the single resident company.

What happens if the test period overlaps the grouping period applicable to foreign bank branches?

6.59 For an income year, when applying the thin capitalisation rules either the head company/single resident company or the foreign bank, as separate taxpayers, may have a test period that overlaps with the grouping period relevant to the head company/single resident company and the foreign bank branch. Where this occurs separate applications of the thin capitalisation rules are required for the relevant entity in respect of the following periods during that income year:

•

the period of the overlap;

•

the part (if any) of the test period for that entity that is before the overlap period; and

•

the part (if any) of the test period for that entity that is after the overlap period.

[Schedule 13, item 3, section 820-607]

Example 6.2

Austcos income year ends on 30 June 2003. Forbanks income year ends on 30 September 2003. Both Austco and Forbank are subject to the thin capitalisation rules for the 2002-2003 income year. From 1 July 2002, Austco treats the Australian bank branch of Forbank as part of its consolidated group for thin capitalisation purposes.

The grouping period is Austcos income year being 1 July 2002 to 30 June 2003. Separate thin capitalisation calculations are necessary for the following periods as a result of the overlapping income years:

•

1 July 2002 to 30 September 2002;

•

1 October 2002 to 30 June 2003; and

•

1 July 2003 to 30 September 2003.

The first two calculations combined determine any disallowed deductions for Austco for the 2002-2003 income year, while the second two calculations do the same for Forbank.

How are the calculations done for the purposes of Subdivision 820-FB?

What is the value of the head companys or single resident companys assets and liabilities?

6.60 The value of the assets and liabilities to be used by the head company or single resident company when determining the value of a particular matter, at a particular time, for thin capitalisation purposes is to be calculated as if either:

•

the head company of the consolidated group or MEC group and the foreign bank branch; or

•

the single resident company together with the foreign bank branch,

were a single entity. This means that all intra-group transactions and balances are ignored.

6.61 The information to be used is that which would be contained in a set of consolidated accounts prepared in accordance with the accounting standards at the measurement time. [Schedule 13, item 3, paragraph 820-611(1)(a)]

6.62 The information required is only in relation to those entities that are considered to be part of either the head company or the single resident company at that measurement time (and so include the permanent establishments of the foreign bank). [Schedule 13, item 3, paragraph 820-611(1)(b)]

6.63 This information is also to be used for the purposes of determining the value of any matter mentioned in sections 820-613 to 820-617. [Schedule 13, item 3, subsection 820-611(2)]

How is a debt deduction disallowed to the foreign bank where its bank branch is part of the head company or single resident company?

6.64 Because a foreign bank branch is considered to be part of the head company or single company where the choice is made in accordance with Subdivision 820-FB, any disallowance is only in relation to debt deductions that are external to the head company or single resident company combined with the branch. This calculation does not affect any debt deduction claimed by either the foreign bank or the head company/single resident company to the extent that it was incurred or owed to the other, if the expense/cost was incurred during the grouping period. [Schedule 13, item 3, Notes 1 and 2 to section 820-605]

6.65 Any debt deduction partly or wholly disallowed to the head company or single resident company because of Subdivision 820-FB and Division 820, that would otherwise be a debt deduction of the foreign bank, is disallowed to the foreign bank to the same extent [Schedule 13, item 3, section 820-605] . The proportion of the debt deductions of the foreign bank which remain external to the head company or single resident company that are disallowed (if any) is the proportion calculated under Subdivision 820-D or 820-E, as appropriate. For example where a head company is classified as an outward investing entity (ADI) as a result of a choice under section 820-597, the fraction (capital shortfall/average debt) in section 820-325 would be the relevant proportion for the head company and for the foreign bank in relation to the external debt deductions of each.

6.66 It should be noted that if a debt deduction is disallowed to the foreign bank, what are otherwise the debt deductions of the head company or single company are not affected solely because of that. For example, if the foreign bank is denied debt deductions but all the head companys interest expenses are paid to the foreign banks branches, the head company would not be denied any deductions. If some or all of a debt deduction is to be denied it is denied to the entity which has incurred the cost and not to both entities. Nevertheless, because Division 820 disallows all debt deductions equally, in this situation the actual (external) debt costs of the head company/single company would be denied to the same extent.

Example 6.3

Head company, Austbank, has included AustPE as part of itself for thin capitalisation purposes. Assume a $10 million capital shortfall and average group debt of $100 million.

The $6 million intra-group debt deductions are ignored for thin capitalisation purposes.

The disallowance to both Austbank, as head company of the consolidated group, and to Forbank is based on what would have been disallowed to the group. That is:

•

Austbanks debt deductions disallowed are:

-

$8 million $10 million / $100 million = $800,000; and

•

Forbanks debt deductions disallowed are:

-

$2 million $10 million / $100 million = $200,000.

Removal of thin capitalisation grouping

6.67 With some important exceptions, the resident TC grouping rules in Subdivision 820-F will cease to operate from the time a group consolidates. Once a group consolidates, the thin capitalisation rules will apply to the head company of the consolidated group or MEC group.

Example 6.4

Entities with a SAP ending 31 December 2003 consolidate on 1 January 2004. The top entity can make the choice to form a resident TC group for the period 1 January 2003 to 31 December 2003. From 1 January 2004 to 31 December 2004 the TC rules will apply to the head company of the consolidated group or MEC group.

Cut-off day

6.68 The day on which the existing TC grouping rules will generally cease to operate is known as the cut-off day . The cut-off day will be the consolidation day (when the group is first formed) or 1 July 2003 depending on when, and if, members of the group form a consolidated group or MEC group. It is the cut-off day that is used as the basis for determining whether or not the top entity can continue to apply the TC grouping rules. Generally, the option to apply the TC grouping rules is not available beyond the cut-off day. The top entitys ability to choose to form a resident TC group is not affected at all if the income year ends before the cut-off day. [Schedule 13, item 2, paragraph 820-455(1)(b)]

6.69 The cut-off day is the consolidation day if:

•

the first day on which at least one of the potential TC group members becomes a member of a consolidated group or MEC group occurs on or before 1 July 2003; or

•

the consolidation day is before 1 July 2004 and that day is the first day of the first income year starting after 30 June 2003 for the head company of the consolidated group or MEC group.

For all other cases the cut-off day will be 1 July 2003.

[Schedule 13, item 2, subsection 820-455(1)]

6.70 If all entities in the potential resident TC group become part of a consolidated group or MEC group on the cut-off day, then a choice is no longer available for the top entity to form a resident TC group past that day.

6.71 The top entity cannot make a choice to use the TC grouping rules in an income year if:

•

the cut-off day is before 1 July 2003 and the income year starts on or after 1 July 2003; or

•

the cut off day is on or after 1 July 2003 and the income year starts on or after the cut-off day.

[Schedule 13, item 2, subsection 820-455(2)]

Where top entity may choose to form a resident TC group

The income year starts on or after a pre-1 July 2003 cut-off day but before 1 July 2003

6.72 If the cut-off day is before 1 July 2003 and the income year starts on or after the cut-off day but before 1 July 2003, the top entity may make a choice to use the TC grouping rules for those potential group members of the resident TC group that have not become members of any consolidated group or MEC group. The resident TC group cannot include any members of a consolidated or MEC group. The top entity is only able to make this choice for the period from the start of the income year until 30 June 2003. This will be treated as being the end of the income year for TC grouping purposes. Note that this section could apply to cases to which section 820-457 also applies (where the cut-off day occurs during an income year ending before 1 July 2003) in relation to the following income year. [Schedule 13, item 2, subsections 820-456(1) and (2)]

6.73For the potential group members that continue to use the resident TC grouping rules, the thin capitalisation rules will either have a single application or 2 or more applications for each of the following periods:

•

the period from the start of the income year to 30 June 2003; and

•

the rest (if any) of the income year.

[Schedule 13, item 2, subsection 820-456(3)]

6.74 These periods reflect the fact that resident TC grouping in these circumstances is only available until 30 June 2003.

Example 6.5

Entities with income years ending on 30 September 2003 choose not to consolidate on 1 October 2003. The cut-off day is 1 July 2003. For the period 1 October 2002 until 30 June 2003, the top entity can make the choice to form a resident TC group for thin capitalisation purposes. From 1 July 2003 until 30 September 2003 the thin capitalisation rules will apply separately to each entity that was previously part of the resident TC group.

The income year includes but does not start on the cut-off day

6.75 The top entity may also continue to use the TC grouping rules where the income year includes but does not start on a cut-off day that is on or before 1 July 2003. (A cut-off day cannot be after 1 July 2003 unless it is the start of an income year.) In this situation the income year end is considered to be immediately before the cut-off day for the purposes of the TC grouping rules. [Schedule 13, item 2, subsections 820-457(1) and (2)]

6.76 This permits the TC grouping rules to continue to work as intended given the composition of the resident TC group is determined at the end of an income year. That is, the resident TC group would now be determined immediately before the cut-off day.

Example 6.6

Entities with an income year ending 30 June consolidate on 1 May 2003. From 1 July 2002 until 30 April 2003 the top entity can make the choice to group for TC purposes those entities that qualify on 30 April 2003. From 1 May 2003 until 30 June 2003 the TC rules apply to the head company of the consolidated group.

6.77 Where the cut-off day is before 1 July 2003 the top entity may continue to choose to group for TC purposes from the cut-off day until:

•

30 June 2003; or

•

the day when the income year would otherwise have ended, whichever is the earlier.

This applies only to the potential group members of the resident TC group that do not become members of any consolidated group or MEC group. [Schedule 13, item 2, subsection 820-457(3)]

6.78 For each of those potential group members of a resident TC group, the thin capitalisation rules will either have a single application or 2 or more applications for each of the following periods:

•

the period from the beginning of the income year to immediately before the cut-off day; and

•

if the cut-off day is before 1 July 2003:

-

the period from the cut-off day to 30 June 2003; and separately

-

the rest (if any) of the income year; or

•

if the cut-off day is 1 July 2003 - the period from the cut-off day to the end of the income year.

[Schedule 13, item 2, subsection 820-457(4)]

Limitations on foreign bank including its permanent establishment in the resident TC group

6.79 Currently, the inclusion of the foreign bank branch as part of the resident TC group is based on a choice being made by the foreign bank. With the introduction of the consolidation regime, it is necessary to ensure that the continued availability of this choice for the foreign bank is the same as that which will apply for the top entity.

6.80 The foreign bank is, therefore, prevented from making a choice to include the foreign bank branch as part of a resident TC group in circumstances where the top entity would also have been prevented from making a choice if the foreign bank branch were considered to be a potential group member of the resident TC group. That is, if it was the top entity, rather the foreign bank, which had to make the choice under Subdivision 820-F to include the foreign bank branch as part of the resident TC group, would it be permitted to do so given the limitation imposed by subsection 820-455(2)? If the answer is no, then the foreign bank is also prevented from making a choice to include the foreign bank branch in a resident TC group. The cut-off day in subsection 820-455(1) could be determined by a choice made under Subdivision 820-FB because for the relevant grouping period the bank branch is considered to be part of a consolidated group.

6.81 In these circumstances a choice by the top entity, and therefore the foreign bank, could not be made to form a resident TC group that included the foreign bank branch if:

•

the relevant cut-off day is on or after 1 July 2003, and the income year starts on or after the cut-off day; or

•

the income year starts on or after 1 July 2003 where the cut-off day is before 1 July 2003.

[Schedule 13, item 2, subsection 820-458(1)]

6.82 Where, however, a choice to form a resident TC group is able to be made by the top entity and the foreign bank, then each Australian permanent establishment for which a choice has been made is treated as if it had been a member of the resident TC group. [Schedule 13, item 2, subsection 820-458(2)]

What if entities do not consolidate?

6.83 Where wholly-owned entities do not consolidate before 1 July 2004, the cut-off day is 1 July 2003. [Schedule 13, item 2, subsection 820-455(1), item 3 in the table]

6.84 The top entity may choose to group for thin capitalisation purposes from the beginning of the income year up until 30 June 2003. The thin capitalisation rules will apply to each entity individually from 1 July 2003 as the top entity is unable to make a choice to form a resident TC group for income years that commence on or after 1 July 2003.

6.85 Table 6.1 illustrates the operation of sections 820-455 to 820-457 for companies with different income year ends depending on if and from when they choose to consolidate. It ignores the existence of any potential resident TC group members which do not become members of a consolidated group or MEC group before 1 July 2003 when other potential members do (see paragraphs 6.72 to 6.78).

Application and transitional provisions

6.86 In subsection 820-10(1) of the IT(TP) Act 1997 the reference to subsection (2) has been replaced with the words this section as a result of the introduction of a new subsection (1A) dealing with the application of Subdivisions 820-FA and 820-FB. [Schedule 13, item 15, subsection 820-10(1) of the IT(TP) Act 1997]

6.87 Subdivisions 820-FA and 820-FB of the ITAA 1997 apply on and after 1 July 2002. [Schedule 13, item 16, subsection 820-10(1A) of the IT(TP) Act 1997]

Consequential amendments

6.88 Changes to the map of Division 820 in section 820-10 are needed as a result of the inclusion of Subdivisions 820-FA and 820-FB into the ITAA 1997 and phasing out the existing TC grouping provisions contained in Subdivision 820-F. [Schedule 13, item 1, item 3 in the table in section 820-10]

6.89 Amendments to subsection 995-1(1) update dictionary items following the inclusion of Subdivisions 820-FA and 820-FB into the ITAA 1997. [Schedule 13, items 4 to 14]