House of Representatives

Explanatory Memorandum

(Circulated by authority of the Minister for Housing and Assistant Treasurer the Hon. Michael Sukkar MP)

Chapter 1 - Thin capitalisation

Outline of chapter

1.1 Schedule 1 to this Bill amends the ITAA 1997 to tighten Australia's thin capitalisation rules by:

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requiring an entity to use the value of the assets, liabilities (including debt capital) and equity capital that are used in its financial statements;

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removing the ability for an entity to revalue its assets specifically for thin capitalisation purposes; and

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ensuring that non-ADI foreign controlled Australian tax consolidated groups and multiple entry consolidated groups that have foreign investments or operations are treated as both outward investing and inward investing entities.

1.2 All references in this Chapter are to provisions in the ITAA 1997 unless otherwise stated.

Context of amendments

1.3 The thin capitalisation rules apply to foreign controlled Australian entities, Australian entities that operate internationally and foreign entities that operate in Australia. These entities are classified as:

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outward investing entities;

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inward investing entities; or

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both outward investing and inward investing entities.

1.4 In the case of an entity that is not an ADI, the thin capitalisation rules operate to, broadly, deny a deduction for debt financing expenses to the extent that the entity's debt exceeds a prescribed level (and the entity is therefore thinly capitalised). A thin capitalisation exposure (where debt deductions are disallowed) will arise where the level of adjusted average debt exceeds the maximum allowable debt during an income year.

1.5 In the case of an entity that is an ADI, the rules operate to, broadly, deny a deduction for debt financing expenses if the ADI's minimum capital amount is not reached during an income year. A thin capitalisation exposure will arise where an entity has a capital shortfall between its adjusted average equity capital amount and its minimum capital amount.

1.6 There are a number of tests available to determine whether the entity has a thin capitalisation exposure. These rules vary depending on the thin capitalisation classification of the entity.

Asset recognition and revaluations

1.7 An entity is generally required to comply with accounting standards in:

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determining what are its assets and liabilities; and

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calculating the value of its assets, liabilities (including debt capital) and equity capital.

1.8 However, the thin capitalisation rules allow an entity to recognise certain assets and revalue its assets in a different way in certain circumstances.

1.9 Recently, there has been a significant increase in the use of asset revaluations by taxpayers in order to generate additional debt capacity under the safe harbour debt amount. This enables these taxpayers to claim greater debt deductions. Concerns have been raised about the rigour and accuracy of some of these asset revaluations.

Classification of head companies of tax consolidated groups

1.10 Under the thin capitalisation provisions, a head company of an Australian tax consolidated group or a multiple entry consolidated group is classified as an outward investing entity if it:

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is a foreign controlled non-ADI; and

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controls foreign entities or has foreign permanent establishments.

1.11 As a result, some head companies may have benefited from certain thin capitalisation rules that are only intended for outward investing entities that are not foreign controlled Australian entities.

Summary of new law

1.12 Schedule 1 to this Bill amends the ITAA 1997 to tighten Australia's thin capitalisation rules by:

•

requiring an entity to use the value of the assets, liabilities (including debt capital) and equity capital that are used in its financial statements;

•

removing the ability for an entity to revalue its assets specifically for thin capitalisation purposes; and

•

ensuring that non-ADI foreign controlled Australian tax consolidated groups and multiple entry consolidated groups that have foreign investments or operations are treated as both outward investing and inward investing entities.

1.13 A transitional rule will allow an entity to rely on revaluations of assets supported by the entity's most recent valuation made prior to the time of announcement of the measure on 8 May 2018. These revaluations can be used until the last day before the start of the income year commencing on or after 1 July 2019.

Comparison of key features of new law and current law

Detailed explanation of new law

1.14 Schedule 1 to this Bill amends the ITAA 1997 to tighten Australia's thin capitalisation rules by:

•

requiring an entity to use the value of the assets, liabilities (including debt capital) and equity capital that are used in its financial statements;

•

removing the ability for an entity to revalue its assets specifically for thin capitalisation purposes; and

•

ensuring that non-ADI foreign controlled Australian tax consolidated groups and multiple entry consolidated groups that have foreign investments or operations are treated as both outward investing and inward investing entities.

Alignment with financial statement values

1.15 Under subsection 820-680(1), for the purposes of the thin capitalisation rules, an entity must comply with accounting standards in:

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determining what are its assets and liabilities; and

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calculating the value of its assets, liabilities (including debt capital) and equity capital.

1.16 An entity must determine or calculate these matters (the relevant matters), for the purposes of the thin capitalisation rules in the same way as they are determined or calculated in the entity's financial statements if:

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the entity is required by an Australian law to prepare financial statements for a period in accordance with the accounting standards; and

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the relevant matters are determined or calculated in accordance with the accounting standards for the purpose of the entity's financial statements in relation to the period.

[Schedule 1, item 11, subsection 820-680(2)]

1.17 The entity's assets and liabilities for thin capitalisation purposes are those recognised in its financial statements. The entity must calculate the value of each of its assets, liabilities, debt capital and equity capital as measured in its financial statements.

1.18 For these purposes, debt capital and equity capital are defined in subsection 995-1(1) and are based on the concepts of debt interest and equity interest as defined in the debt and equity rules in Division 974.

1.19 A modification applies if:

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a period for which the entity must determine or calculate a relevant matter (the current period) is not the same as the period to which the requirements in paragraphs 820-680(2)(a) and (b) are satisfied - that is, broadly, the period to which the relevant matters are determined or calculated in accordance with the accounting standards for the purpose of the entity's financial statements; and

•

the current period overlaps with one or more periods to which those requirements are satisfied.

[Schedule 1, item 11, subsection 820-680(3)]

1.20 In these circumstances, the entity must determine or calculate the relevant matters in relation to the current period in the same way as they are determined or calculated in the financial statements for the most recent of the overlapping periods. [Schedule 1, item 11, subsection 820-680(3)]

1.21 Under the thin capitalisation rules, an entity can choose to adopt the opening and closing averaging method for its thin capitalisation calculations. This method requires calculating the average value of the following amounts:

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the opening value of the assets, liabilities (including debt capital) and equity capital on the first day of the income year; and

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the closing value of the assets, liabilities (including debt capital) and equity capital on the last day of the income year.

1.22 In this situation, the entity would recognise the assets, liabilities (including debt capital) and equity capital, and their respective opening and closing values, contained in the entity's financial statements for those periods. These periods would typically be the year end values of these assets, liabilities (including debt capital) and equity capital reflected in the prior income year financial statements (for the opening values) and the current year financial statements (for the closing values).

Example 1.1 : Part year periods

An entity acquires a foreign subsidiary three months into the 2021-22 income year. The acquisition changes the entity's classification for thin capitalisation purposes from an inward investment vehicle (general) to an outward investor (general). The entity:

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only prepares financial statements at 30 June each year; and

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uses the opening and closing measurement day method for thin capitalisation purposes.

The entity is an inward investing entity for the period from 1 July 2021 to 30 September 2021 - that is, for the first part year period. During this period, the entity:

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determines and calculates the value of its assets, liabilities (including debt capital) and equity capital as at 1 July 2021 (the opening measurement point) using the financial statements prepared for 30 June 2021; and

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determines and calculates the value of its assets, liabilities (including debt capital) and equity capital as at 30 September 2021 (the closing measurement point) in the same way as they are measured in the financial statements prepared for 30 June 2022 (the current income year) reflecting any changes in assets, liabilities (including debt capital) and equity capital over that three month period.

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The entity is an outward investing entity for the period from 1 October 2021 to 30 June 2022 - that is, for the second part year period. During this period, the entity:

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determines and calculates the value of its assets, liabilities (including debt capital) and equity capital as at 1 October 2021 (the opening measurement point) in the same way as they are measured in the financial statements prepared for 30 June 2022; and

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determines and calculates the value of its assets, liabilities (including debt capital) and equity capital as at 30 June 2022 (the closing measurement point) using the financial statements prepared for 30 June 2022.

1.23 If an entity adopts another method for calculating average values permitted by the thin capitalisation rules, then there may be points in time throughout that income year period where the values would not be reflected in the year end financial statements.

1.24 For example, if an entity adopts the quarterly period averaging method, it may not prepare financial statements at each measurement point.

1.25 In these circumstances, an entity must determine or calculate its assets, liabilities (including debt capital) and equity capital for those quarterly periods in the same way as they are determined or calculated in the entity's financial statements.

1.26 For example, if an entity adopts a cost less depreciation accounting methodology for its asset values in its financial statements, the entity must also adopt that same accounting methodology for determining and calculating the value of those assets for each of the intervening quarterly end periods.

Example 1.2 : Half year and full year financial reports

A & P Co is a company that has a 30 June year end. A & P Co is required to prepare half yearly financial statements (at 31 December) and full year financial statements (at 30 June) in accordance with the accounting standards under an Australian law.

A & P Co recognises certain land and building assets which are reflected in its financial statements. It values these assets using a cost less depreciation accounting methodology.

For thin capitalisation purposes, A & P Co adopts the quarterly period averaging method.

For the first quarterly period of the 2019-20 income year (that is, for the quarter ending 30 September 2019), A & P Co must determine and calculate the value of the land and buildings.

The first quarterly period is not the same period as the period covered by either the half yearly financial statements or the full year financial statements. However, the first quarterly period overlaps with the periods contained in the half yearly and full yearly financial statements.

Therefore, A & P Co must determine or calculate the value of the land and buildings in the same way as it is determined or calculated in the full year financial statements (at 30 June 2020) - that is, as for the most recent of the overlapping periods.

Example 1.3 : Change of measurement basis during a financial reporting period

Continuing on from Example 1.2, assume that A & P Co decides to revalue its land and building assets for accounting purposes on 1 January 2021.

In the financial statements for the year ended 30 June 2021, A & P Co records the revalued amount of the asset less depreciation from 1 January 2021 to 30 June 2021.

Consistent with the objective of aligning thin capitalisation, accounting standards and financial statements, A & P Co would use:

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amortised cost for the thin capitalisation measurement points of 1 July 2020, 30 September 2020 and 31 December 2020; and

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fair value minus depreciation for the thin capitalisation measurement points of 31 March 2021 and 30 June 2021.

1.27 If an entity is not required to prepare financial statements in accordance with accounting standards under an Australian law, the entity must determine its assets, liabilities (including debt capital) and equity capital, and calculate the value of those assets, liabilities (including debt capital) and equity capital, in accordance with the Australian accounting standards (subsection 820-680(1)). This applies even if the Australian accounting standards do not apply to the entity (subsection 820-680(3)).

Removing the ability for an entity to revalue assets

1.28 As a result of these amendments, the ability for an entity to revalue its assets and recognise certain intangible assets specifically for thin capitalisation purposes is being removed. Therefore, the following provisions are being repealed:

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subsections 820-680(2) to (2E); and

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sections 820-683, 820-684 and 820-985.

[Schedule 1, items 11, 13 and 16]

1.29 Consequently, any revaluation and recognition of assets by an entity must comply with accounting standards

Thin capitalisation classification of the head companies of tax consolidated groups

1.30 Schedule 1 to this Bill amends the thin capitalisation rules to remove provisions which deem the head company of an Australian tax consolidated group or multiple entry consolidated group to be an outward investing entity only. [Schedule 1, items 5 and 7, subsections 820-583(5) and (6)]

1.31 Consequently, an entity that is the head company of an Australian tax consolidated group or a multiple entry consolidated group will be classified as both an outward investing and inward investing entity if the following conditions apply:

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it is foreign controlled; and

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it holds investments in a foreign entity or has a foreign permanent establishment.

1.32 Entities that are classified as both outward investing and inward investing entities are disqualified from applying certain thin capitalisation rules (such as, for example, sections 820-37, 820-110, 820-216 and 820-217 which are only available for outward investing entities).

Example 1.4 : Head company that is both an outward investing and inward investing entity

Kev Co is the head company of an Australian tax consolidated group. Kev Co is wholly controlled by a foreign parent and also wholly controls a foreign entity.

Kev Co is both an outward investing entity and an inward investing entity.

Consequential amendments

1.33 Schedule 1 to this Bill makes consequential amendments to the ITAA 1997 and ITAA 1936 to:

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remove the record keeping requirements relating to the revaluation of assets;

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remove references to the ability for an entity to revalue its assets for the purpose of the thin capitalisation rules; and

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repeal headings and references to the repealed provisions relating to the revaluation of assets.

[Schedule 1, items 1 to 4, 6, 8 to 10, 12, 14 and 15, section 262A of the ITAA 1936, sections 820-583, 820-680, 820-682, 820-933 and 820-985]

Application and transitional provisions

Valuation of assets

1.34 The amendments relating to the requirement for an entity to adopt the same methodology for determining its assets, liabilities (including debt capital) and equity capital, and for calculating the value of those assets, liabilities (including debt capital) and equity capital, as reflected in the entity's financial statements apply after 7.30 pm (by legal time in the Australian Capital Territory) on 8 May 2018 (the transition time). [Schedule 1, subitem 17(1)]

1.35 The amendments relating to the repeal of the provisions which enabled an entity to revalue its assets for thin capitalisation purposes for the determination and calculation of an entity's assets, liabilities (including debt capital) and equity capital apply also after the transition time. [Schedule 1, subitem 17(1)]

1.36 These amendments apply from time of announcement to prevent taxpayers from being able to obtain unintended benefits under the thin capitalisation rules by undertaking opportunistic revaluations. In this regard, the amendments are necessary to improve the integrity of the thin capitalisation rules and will protect a significant amount of revenue that would otherwise be at risk.

1.37 A transitional rule applies for an entity that has determined or calculated its assets, liabilities (including debt capital) and equity capital prior to the transition time. The transitional rule will apply if:

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the revaluation of assets is supported by the entity's most recent valuation that complies with the thin capitalisation rules made prior to the transition time; and

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those revaluations can only be relied upon by the entity for income years beginning before 1 July 2019 (that is, until the last day before the start of the income year commencing on or after 1 July 2019).

[Schedule 1, subitem 17(2)]

1.38 The value of these revalued assets will effectively be frozen at the value reflected in the entity's most recent valuation made before the transition time that is compliant with the requirements of Division 820.

1.39 In order to be compliant with Division 820, the entity must satisfy the revaluation and record-keeping requirements in Subdivisions 820-G and 820-L.

1.40 Entities relying on the transitional rule will not be required to undertake further valuations for thin capitalisation purposes.

1.41 An entity can choose to adopt the requirement to use the same methodology as reflected in the entity's financial statements, rather than rely upon the transitional rule if it wishes.

Example 1.5 : Valuation of assets for transition

Tea Co prepares financial statements under an Australian law and has a 30 June year end. Tea Co accounts for its assets using a cost less depreciation methodology in its financial statements.

Tea Co acquired an asset that cost $100 million in 2016. The asset was revalued for thin capitalisation purposes to $110 million (being its most recent valuation of the asset). This revaluation of the asset is supported by a compliant valuation that satisfies the requirements under Division 820. The valuation was completed prior to 8 May 2018.

Therefore, Tea Co can rely on the transitional rule in subitem 17(2).

Under the transitional rule, for the purposes of applying the thin capitalisation rules in the 2017-18 and 2018-19 income years, Tea Co may rely on the $110 million revaluation. That is, there is no need for Tea Co to further update this valuation.

Thin capitalisation classification of the head companies of tax consolidated groups

1.42 The amendments to remove the deeming of a head company of an Australian tax consolidated group or multiple entry consolidated group to be an outward investing entity applies in relation to income years beginning on or after 1 July 2019. [Schedule 1, item 18]