House of Representatives

Explanatory Memorandum

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

Chapter 4 - Thin capitalisation - transitional provision

Outline of chapter

4.1 Schedule 4 to this Bill explains a transitional provision that allows taxpayers who are subject to the thin capitalisation regime, to use values based on Australian accounting standards as they existed on 31 December 2004 for thin capitalisation purposes. The transitional arrangements are available for three income years commencing on or after 1 January 2005.

4.2 This measure will ensure that a taxpayer's thin capitalisation position is not immediately affected by changes made to the Australian accounting standards from 1 January 2005. On 1 January 2005 Australian accounting standards were aligned with International Financial Reporting Standards.

4.3 This chapter covers:

•

electing to use the transitional provision

•

reconstructing accounts and record keeping

•

transitional arrangements for authorised deposit-taking institutions

•

asset revaluations

•

associate entity excess amount

•

consolidated and multiple entry consolidated (MEC) groups.

Context of amendments

4.4 The measure implements the Treasurer's announcement of 24 January 2005 in Press Release No. 2 that taxpayers will be able to undertake calculations for thin capitalisation purposes using Australian accounting standards as they existed on 31 December 2004, for a three year transitional period.

4.5 For reporting periods commencing on or after 1 January 2005 Australian accounting standards are the equivalent of International Financial Reporting Standards. International Financial Reporting Standards have been adopted as the basis for accounting in Australia to allow for direct comparisons between Australian and foreign country financial statements.

4.6 There are a number of differences between Australian accounting standards as they existed on 31 December 2004 (AGAAP) and Australian accounting standards post-31 December 2004 (AIFRS). For example, AIFRS takes a more conservative approach to balance sheet values, in particular intangible assets.

4.7 As thin capitalisation calculations are derived from financial accounts prepared on the basis of Australian accounting standards, there is the possibility that a number of taxpayers will be disadvantaged from a tax perspective from 2005. The full impact of such a change on the thin capitalisation regime cannot be assessed until taxpayers prepare accounts using the new standards. For most taxpayers this will not be until the end of the 2005-06 financial year.

4.8 In order to allow time to properly assess the impact of the new accounting standards on the thin capitalisation regime, the transitional amendments seek to ensure that taxpayers are not immediately disadvantaged.

Summary of new law

4.9 For a period of three income years commencing on or after 1 January 2005, taxpayers can choose, for any or all of those three years, to use AGAAP as a basis for undertaking their thin capitalisation calculations.

4.10 This includes taxpayers using the authorised deposit-taking institution outward or inward rules. Such taxpayers will be able to calculate their thin capitalisation position on the basis of AGAAP and prudential standards as they existed on 31 December 2004. If an authorised deposit-taking institution chooses to use AGAAP for any of the three income years, that authorised deposit-taking institution must also use prudential standards as they existed on 31 December 2004 in that year.

Comparison of key features of new law and current law

Detailed explanation of new law

Broad outline

4.11 Under the proposed measure, taxpayers subject to the thin capitalisation regime will be able to choose to use AGAAP for thin capitalisation purposes. The transitional arrangements are available for three income years commencing on or after 1 January 2005.

4.12 The measure seeks to ensure that taxpayers are not disadvantaged in determining their thin capitalisation position from 1 January 2005 when Australian accounting standards were aligned with International Financial Reporting Standards.

4.13 The thin capitalisation provisions (Division 820 of the Income Tax Assessment Act 1997 (ITAA 1997)) operate when the amount of debt used to finance the Australian operations of an entity exceeds specified limits. They disallow a certain proportion of otherwise allowable debt deductions (eg interest).

4.14 Debt deductions are denied where an entity's debt to asset ratio exceeds certain limits under the safe harbour debt test, the arms length debt test, or the worldwide gearing debt test. The classification and values of the assets and liabilities of the entity used in these tests are determined by accounting standards (subsection 820-680(1) of the ITAA 1997). Accounting standards has the same meaning as in the Corporations Act 2001 .

4.15 In regards to authorised deposit-taking institutions, debt deductions will be reduced where the equity capital used to fund the Australian operations is less than the minimum equity requirement as determined by either the safe harbour capital amount, the arm's length capital amount or, in the case of outward investing authorised deposit-taking institutions, the worldwide capital amount.

4.16 The minimum equity requirement for authorised deposit-taking institutions is a function of the risk-weighted assets and prudential capital deductions of the entity. The risk-weighted assets and prudential capital deductions of the entity are determined in accordance with accounting standards and prudential standards. The prudential standards are determined by the Australian Prudential Regulation Authority (APRA) and are influenced by accounting standards.

4.17 On 1 January 2005, Australian accounting standards were aligned with International Financial Reporting Standards. This could have a significant impact on thin capitalisation outcomes for some taxpayers and that will ultimately affect their tax position.

Electing to use the transitional provision

4.18 Taxpayers can choose to use AGAAP for thin capitalisation purposes in any year covered by the transitional arrangement. The transitional provision covers the income years 2005-06, 2006-07 and 2007-08. For late December balancers, it will cover the income years 2004-05, 2005-06 and 2006-07. [Schedule 4, item 1, subsection 820-45(1)]

4.19 Where the thin capitalisation provisions apply to a taxpayer for a part-year period, the taxpayer may choose to use the transitional provisions for that period if it falls within the three year transitional period.

4.20 There is no requirement that having used the transitional arrangement in one year (or part-year period) the taxpayer must continue to use the arrangements for the rest of the transitional period. For example, a taxpayer may choose to use the transitional arrangement in 2005-06. In 2006-07 the taxpayer may rely on AIFRS and in 2007-08 the taxpayer may choose to use the transitional arrangement.

4.21 Where a taxpayer chooses to use the transitional provision, calculations will be based on AGAAP in determining adjusted average debt and maximum allowable debt . It is expected that most taxpayers will determine the maximum allowable debt using the safe harbour debt amount . Where a taxpayer uses the arms' length debt amount or the worldwide gearing debt amount , calculations should reflect AGAAP. [Schedule 4, item 1, subsection 820-45(2)]

4.22 Where a taxpayer chooses to use the transitional provision, all calculations for the year (or part-year period) must be based on AGAAP. For example, opening and closing balances or more frequent measurements must reflect AGAAP.

4.23 The calculation of associate entity excess amount allows a minor departure from the principle that all calculations must be based on AGAAP (discussed below).

4.24 The transitional provision is only for the purposes of undertaking thin capitalisation calculations in Division 820 of the ITAA 1997. [Schedule 4, item 1, subsection 820-45(2 ), note ( 2)]

4.25 All taxpayers subject to the thin capitalisation rules can choose to use the transitional arrangement. For example, a taxpayer that did not exist as at 31 December 2004 may choose to use the transitional arrangement. Similarly, a taxpayer whose operations have changed significantly over the transitional period may choose to use the transitional arrangement. This is to ensure that all taxpayers face a similar thin capitalisation regime over the transitional period.

4.26 If a taxpayer does not choose to use the transitional provision, AIFRS must be used when calculating its thin capitalisation position. [Schedule 4, item 1, subsection 820-45(5)]

Reconstructing accounts and record keeping

4.27 To take advantage of the transitional arrangement it is not a requirement that taxpayers maintain accounting systems based on AGAAP. Nor is it necessary that taxpayers produce a set of accounts based on AGAAP. [Schedule 4, item 1, subsection 820-45(2 ), note ( 1)]

4.28 For the purposes of the transitional arrangement while the recognition and measurement requirements of AGAAP will apply, the disclosure requirements will not.

4.29 However, for the purposes of undertaking calculations under the thin capitalisation transitional arrangement, taxpayers must use figures that are reasonable approximations for figures that would have been produced using AGAAP.

4.30 Taxpayers must keep sufficient records to be able to demonstrate how they determined the figures they are using for thin capitalisation calculations under the transitional arrangement. What is sufficient will depend on the materiality of any differences between values based on AGAAP and AIFRS.

4.31 Taxpayers will not need to prepare a full set of financial statements under AGAAP in order to use the transitional provision. Taxpayers may take their AIFRS accounts as a base, and then make appropriate adjustments to reflect any material differences between the old and new standards. The AIFRS accounts so adjusted, may be used to calculate amounts under Division 820 of the ITAA 1997.

4.32 Most affected taxpayers will have already identified and disclosed the areas of any material difference between the AGAAP and AIFRS standards in their financial reports for the periods that immediately preceded their transition from AGAAP to AIFRS. With those areas identified, it would generally be sufficient for taxpayers to consider only those differences in making adjustments to their AIFRS accounts for thin capitalisation calculations. However, if there has been a change in a taxpayer's business since transition, the taxpayer will need to consider whether this change has given rise to any 'new' material differences. The level of materiality that the taxpayer adopted for the purposes of disclosing differences at transition, should suggest the level of materiality that would be expected for thin capitalisation purposes.

Example 4.1

DM Ltd is an early December balancer. Its income year is 1 January 2005 to 31 December 2005. DM Ltd's balance sheet at 31 December 2004 (prepared under AGAAP) shows assets of $40 million including $10 million of internally generated intangible assets. The balance sheet prepared at 1 January 2005 (under AIFRS) shows assets of $30 million with intangible assets valued at $0. (Under AIFRS internally generated intangible assets are not recognised.)

The balance sheet prepared at 31 December 2005 (under AIFRS) has assets of $50 million with intangible assets valued at $0.

For thin capitalisation purposes the opening balance will be $30 million and the closing balance will be $50 million.

Should the taxpayer choose to use the transitional provision, the opening balance will be:

$30 million + $10 million = $40 million

and the closing balance:

$50 + $10 million = $60 million.

(Assuming the intangibles would still be valued at $10 million under AGAAP.)

Example 4.2

Wendy Ltd is an early December balancer. Its income year is 1 January 2005 to 31 December 2005. Wendy Ltd's balance sheet at 31 December 2004 (prepared under AGAAP) shows assets of $40 million including $10 million of internally generated intangible assets. The balance sheet at 1 January 2005 (under AIFRS) shows assets of $30 million with intangible assets valued at $0. (Under AIFRS internally generated intangible assets are not recognised.)

During the year the value of the internally generated intangible assets increased by $5 million to $15 million. The balance sheet at 31 December 2005 (under AIFRS) shows assets of $50 million with intangible assets valued at $0.

For thin capitalisation purposes the opening balance will be $30 million and the closing balance will be $50 million.

Should the taxpayer choose to use the transitional provision the opening balance will be:

$30 million + $10 million = $40 million

and the closing balance:

$50 + $15 million = $65 million.

(Assuming that the increase in internally generated intangible assets is recognised under AGAAP.)

Example 4.3

NK Ltd is an early December balancer. Its income year is 1 January 2005 to 31 December 2005. NK Ltd's balance sheet at 31 December 2004 (prepared under AGAAP) shows assets of $40 million including $10 million of internally generated intangible assets. The balance sheet at 1 January 2005 (under AIFRS) shows assets of $30 million with intangible assets valued at $0. (Under AIFRS internally generated intangible assets are not recognised.)

During the year the value of the internally generated intangible asset decreases by $5 million. The balance sheet as at 31 December 2005 (under AIFRS) has assets of $50 million with intangible assets valued at $0.

For thin capitalisation purposes the opening balance will be $30 million and the closing balance will be $50 million.

Should the taxpayer choose to use the transitional provision the opening balance will be:

$30 million + 10 million = $40 million

and the closing balance:

$50 million + $5 million = $55 million.

(Assuming that the decrease in internally generated intangible assets is recognised under AGAAP.)

Authorised deposit-taking institutions

4.33 Authorised deposit-taking institutions and other taxpayers using authorised deposit-taking institution outbound and inbound rules at Subdivisions 820-D and 820-E can choose to use the transitional provision. If they do, calculations will be based on AGAAP in determining adjusted average equity capital or average equity capital . In determining the minimum capital amount , taxpayers will be required to apply AGAAP and prudential standards as at 31 December 2004 to determine amounts used in the calculations, for example, in determining risk-weighted assets and prudential capital deductions. [Schedule 4, item 1, subsections 820-45(2) and (4)]

4.34 The transitional provision is only for the purposes of undertaking thin capitalisation calculations in Division 820 of the ITAA 1997. [Schedule 4, item 1, subsections 820-45(2) and (4 ), note ( 2)]

4.35 To take advantage of the transitional arrangement it is not a requirement that taxpayers maintain a full set of accounts based on AGAAP and a full set of capital adequacy calculations based on prudential standards at 31 December 2004. [Schedule 4, item 1, subsections 820-45(2) and (4 ), note ( 1)]

4.36 For the purposes of undertaking calculations under the thin capitalisation transitional arrangement, authorised deposit-taking institutions must use figures that are reasonable approximations for figures that would have been produced using AGAAP and prudential standards at 31 December 2004. Authorised deposit-taking institutions must keep sufficient records to be able to demonstrate how they determined the figures they are using for thin capitalisation calculations under the transitional arrangements. What is sufficient will depend on the materiality of any differences between values based on AGAAP and AIFRS and the relevant prudential standards.

4.37 In the case of authorised deposit-taking institutions, if the taxpayer does not choose to use the transitional provision, AIFRS and current prudential standards apply to that entity's thin capitalisation calculations. [Schedule 4, item 1, subsection 820-45(6)]

Asset revaluations

4.38 Subsection 820-680(2A) of the ITAA 1997 excludes taxpayers from certain record keeping requirements associated with the revaluation of assets for thin capitalisation calculations. For the purposes of applying the transitional arrangement, the requirements of subsection 820-680(2A) can be satisfied where it is reasonable to expect that the revaluation of an asset would have been reflected in statutory financial statements based on AGAAP for the period. For example, where a class of assets has been revalued at regular intervals and this has been reflected in past statutory financial statements.

Associate entity excess amount

4.39 Subdivision 820-I of the ITAA 1997 sets out thin capitalisation rules related to associate entities. The associate entity excess amount allows the taxpayer to take advantage of excess debt capacity in an associate entity.

4.40 Where both the taxpayer and the associate are using the transitional arrangement the calculation of the associate entity excess amount will be based on AGAAP figures for the associate entity.

4.41 Where the taxpayer does not use the transitional arrangement but the associate does, the calculation of the associate entity excess amount will be based on the AIFRS accounts of the associate entity. [Schedule 4, item 1, subsection 820-45(2)]

4.42 Where the taxpayer is using the transitional arrangement and the associate entity does not, the taxpayer has a choice whether to calculate its associate entity excess amount on the basis of the AIFRS accounts used by the associate entity or on the basis of AGAAP figures constructed by the taxpayer from the AIFRS accounts of the associate entity. [Schedule 4, item 1, subsection 820-45(3)]

4.43 The taxpayer is given the choice of using AIFRS to calculate its associate entity excess amount notwithstanding it is using AGAAP for its other thin capitalisation calculations, because of the potential compliance costs and difficulties that it might have accessing information to construct AGAAP figures from the associate entity's AIFRS accounts. This choice is the only departure from the general principle that a taxpayer using the transitional arrangement must use AGAAP figures when undertaking all of its thin capitalisation calculations.

4.44 Where the taxpayer bases its thin capitalisation calculations on AGAAP figures constructed from the associate entity's AIFRS accounts the taxpayer must maintain appropriate records that demonstrate how the taxpayer determined the figures.

Consolidated groups and MEC groups

4.45 Where a head company or single company chooses to use the transitional arrangement, this applies to all entities in the thin capitalisation group, including permanent establishments.

Application and transitional provisions

4.46 The amendments apply to three income years commencing on or after 1 January 2005.