Taxation Ruling

TR 2002/20

Income tax: Thin Capitalisation - Definition of assets and liabilities for the purposes of Division 820.

• Please note that the PDF version is the authorised version of this ruling.
  On 8 April 2024, the Treasury Law Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Act 2024 was enacted. The amendments apply to assessments for income years commencing on or after 1 July 2023, with the exception of new integrity rules (debt deduction creation rules) which apply in relation to assessments for income years starting on or after 1 July 2024.

  Under the new thin capitalisation rules:

  •

  the newly classified 'general class investors' will be subject to one of 3 new tests

  o

  fixed ratio test

  o

  group ratio test

  o

  third party debt test

  •

  financial entities will continue to be subject to the existing safe harbour test and worldwide gearing test or may choose the new third party debt test

  •

  ADIs will continue to be subject to the previous thin capitalisation rules

  •

  the arm's length debt test has been removed for all taxpayers.

  ADIs, securitisation vehicles and certain special purpose entities are excluded from the debt deduction creation rules.

  Entities that are Australian plantation forestry entities are excluded from the new rules. For these entities, the previous rules will continue to apply.

FOI status:

may be released

Preamble

What this Ruling is about

Definition of 'assets' and 'liabilities'

1. This Ruling considers what is included in the term 'assets' in the context of the thin capitalisation rules contained in Division 820 of the Income Tax Assessment Act 1997 ('ITAA 1997'). It also considers what is included in the term 'liabilities' for the purpose of the definition of 'non-debt liabilities' in the same thin capitalisation context. These terms are used to calculate the maximum allowable debt a non-ADI entity can have for the purpose of the safeharbour debt amount. A non-ADI entity is an entity which is not an authorised deposit-taking institution under the Banking Act 1959.

2. The rules applicable to ADIs for the purposes of the safeharbour capital amount and the worldwide capital amount are based upon the term 'risk-weighted assets'. This term takes its meaning from the appropriate prudential standards applicable to the ADI. This Ruling does not deal with this definition. The concept of 'non-debt liabilities' is not relevant to ADI entities.

Valuation of assets and liabilities under accounting standards

3. This Ruling also discusses the requirement under section 820-680 that an entity calculates the value (including revaluations) of its assets and liabilities, identified for the purposes of the thin capitalisation rules, in accordance with the accounting standards.

Ruling

Assets

4. In the thin capitalisation provisions the term 'assets' is not defined, and accordingly takes its ordinary meaning in law relevant to the context. In this particular context we consider that the term 'assets' for the purposes of Division 820 carries its accounting meaning. The accounting meaning is defined in Statement of Accounting Concepts 4, at paragraph 14, (SAC 4) as:

'future economic benefits controlled by the entity as a result of past transactions or other past events'.

Liabilities

5. The term 'liabilities' is similarly undefined in Division 820 and so takes its ordinary meaning in law relevant to the context. It is also appropriate to adopt the accounting meaning of the term 'liabilities' for the purposes of Division 820. Liabilities are also defined in SAC 4 (at paragraph 48) as:

'the future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events'.

Valuation of assets and liabilities

6. The values adopted for assets and liabilities, as well as the entity's debt capital and equity capital must comply with the accounting standards. The accounting standards for this purpose are the accounting standards as per the meaning in the Corporations Act 2001.

7. In the absence of a specific accounting standard relevant to an asset or liability in question, we consider the valuation must be in accordance with an appropriate accounting policy selected and applied as per paragraph 4 of accounting standard AASB 1001 Accounting Policies. We consider that conformity with the requirements of 'relevance' and 'reliability' specified in paragraph 4.1 of AASB 1001 for thin capitalisation purposes would include demonstrating that the process of selecting the accounting policy has followed the order of preference set out in the commentary in paragraph 4.1.2 of that standard.

Date of effect

8. This Ruling (and the new thin capitalisation regime) applies from the start of an entity's first year of income beginning on or after 1 July 2001.

9. It may be the case that some taxpayers have relied on a traditional legal interpretation of the terms assets and liabilities, rather than upon the accounting meanings adopted in this Ruling, and accordingly on this basis, may have:

•

restructured their financial affairs;

•

chosen not to restructure their financial affairs; or

•

incurred costs undertaking activities to identify and value assets and/or liabilities.

In addition, using the traditional legal analysis approach to define the assets and non-debt liabilities of the entity, which in turn are then valued on at least one measurement day during a period, will affect the average value for the entire period. This in turn affects the entity's safe harbour debt amount or worldwide gearing debt amount^[F1] for that period.

10. In consideration of these factors, the timing of the release of this Ruling, and having regard to the explanatory memorandum ('EM'), any taxpayer who has relied on the traditional legal analysis consistently for both assets and liabilities may adopt that alternative meaning for the income year commencing on or after 1 July 2001 and the following income year.

11. However, if a taxpayer has not relied on a traditional legal analysis for both assets and liabilities, the accounting approach must be adopted for all income years commencing on or after 1 July 2001. For income years commencing on or after 1 July 2003, all taxpayers must adopt the accounting approach.

12. Changing from a traditional legal analysis to an accounting analysis approach may result in the total value of assets or liabilities on the first measurement day of the new period being different from the total value on the last measurement day of the previous period. This may occur because more assets or liabilities may be recognised under the accounting analysis. For example, a standard income year balancer who has relied on the traditional legal view will use a value based on the legal view of assets and liabilities on 30 June 2002 (or 30 June 2003), and will use a value based on the accounting meaning of assets and liabilities on 1 July 2002 (or 1 July 2003).

Explanations

13. The thin capitalisation rules in Division 820 applying to non-ADI entities specify a maximum amount of debt that such an entity can have before the thin capitalisation rules are breached. If the entity's debt exceeds this maximum amount, it cannot deduct a proportion of its otherwise allowable debt deductions. The maximum allowable debt is the greatest of:

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the safe harbour debt amount (see sections 820-95, 820-100, 820-195, 820-200, 820-205, and 820-210);

•

the arm's length debt amount (see sections 820-105, and 820-215); and

•

the worldwide gearing debt amount (relevant to entities which are outward investing only, see section 820-110).

14. The safe harbour debt amount and the worldwide gearing debt amount calculations use, as their starting point, the average value of an entity's 'assets'. This value is then reduced by various amounts including the value of 'non-debt liabilities'. Total average assets are reduced by non-debt liabilities and other specific items to isolate the value of the entity's Australian assets upon which thin capitalisation calculations are based. The definition of assets is also integral to other areas of Division 820 such as the de minimis rule in section 820-37 and various definitions.

15. In the safe harbour capital amount and worldwide capital amount calculations, relevant only to ADI entities, the concept of 'risk-weighted assets' is used and is defined by reference to the prudential standards. The notion of 'non-debt liabilities' is not relevant to these calculations.

16. The term 'assets' is not defined in the ITAA 1997. The EM states, at paragraph 1.72, that the term is used in its 'normal, legal meaning', in other words its ordinary meaning in law relevant to this context. The Macquarie Dictionary (2nd revised edition) gives several alternate meanings of the term 'assets' as follows:

1.

Comm resources of a person or business consisting of such items as real property, machinery, inventories, notes, securities, cash etc;

2.

Property or effects (opposed to liabilities);

3.

Accounting, the detailed listing of property owned by a firm and money owing to it; or

4.

Law:

(a)

property in the hands of an executor or administrator sufficient to pay the debts or legacies of the testator or intestate;

(b)

any property available for paying debts, etc.

In the context of thin capitalisation it is our view that the appropriate context from which to take definitions is an accounting context, so that the term 'assets' adopts its accounting meaning in all areas of Division 820 where that unqualified term is used. These contextual factors are discussed below at paragraphs 18-21.

17. The term 'liabilities' is used in the context of the compound phrase 'non-debt liabilities' for the purpose of the safeharbour tests. The term 'non-debt liabilities' is defined in subsection 995-1(1) ITAA 1997 as meaning:

'...liabilities that the entity has at the time, other than:

a)

any *debt capital of the entity;

b)

any *equity interest in the entity;

c)

a provision for a *distribution of profit if the entity is a *corporate tax entity; or

d)

any liability of the entity under a securities loan arrangement if, as at that time, the entity:

(i)

has received amounts for the sale of securities (other than any fees associated with the sale) under the arrangement; and

(ii)

has not repurchased the securities under the arrangement.'

The term 'liabilities' is itself undefined in the ITAA 1997 and takes its ordinary meaning in this context. As with assets, the contextual factors are discussed below.

Contextual Factors

18. The broad context in which the terms are used is a regime determining an acceptable mix of debt and equity capital for funding a business. For commercial purposes, when deciding whether to lend, and how much to lend, a commercial lender would generally turn to the entity's accounting records that detail assets and liabilities to commence their analysis. By analogy this would also seem to be the logical basis under which a thin capitalisation analysis would be commenced as well.

19. In more specific terms, the safe harbour debt amount calculations (and the worldwide gearing debt amount calculation which is based on the safe harbour debt amount) determine the safe harbour debt/equity mix based on the entity's assets and liabilities. The calculation is broadly based on the fundamental accounting equation of assets = liabilities + equity. In thin capitalisation terms, the equation is modified by dissecting liabilities into debt liabilities and non-debt liabilities. The safe harbour debt calculation applies a fraction to a figure which represents net Australian assets funded by debt and equity. This requires all liabilities which are neither debt nor equity as defined, to be taken out of the equation in order to isolate the amount of assets funded by debt liabilities and by equity. This requires a link between asset values on the one hand and equity, debt and other liabilities on the other hand. The accounting meanings of 'assets' and 'liabilities' provide this link.

20. Furthermore, the legislation relies on the valuation rules in the accounting standards to provide the values of, among other things, assets and non-debt liabilities.

21. In this context, we consider that the ordinary meaning of the terms is the accounting meaning.^[F2]

Accounting meaning of assets and liabilities

22. For the purpose of preparing general purpose financial statements the Accounting Bodies^[F3] have defined assets in the Statement of Accounting Concepts 4 Definition and recognition of the elements of financial statements (SAC 4), at paragraph 14 as follows:

'"Assets" are future economic benefits controlled by the entity as a result of past transactions or other past events'.

23. This meaning is explained further at paragraph 15 of SAC 4:

'The definition of assets identifies three essential characteristics. First, there must be future economic benefits. Second, the entity must have control over the future economic benefits such that it is able to enjoy the benefits and deny or regulate the access of others to the benefits. Third, the transaction or other event giving rise to the entity's control over the future economic benefits must have occurred.'

24. For accounting purposes 'liabilities' is defined in SAC 4 at paragraph 48 as:

'the future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events'.

25. The Statement notes that equitable obligations and constructive obligations may be liabilities and comments at paragraph 57:

'...[T]he concept of liabilities adopted in this Statement encompasses the financial obligations imposed by notions of equity or fairness, and by custom or usual business practices, as well as those resulting from legally enforceable contracts, from imposition by legally authorised bodies, from statutes or from torts.'

26. This explanation of the meaning of liabilities is different to the explanation in the EM accompanying the New Business Tax System (Thin Capitalisation) Act 2001 which introduced Division 820 into the ITAA 1997. That explanation (at paragraph 2.53) stated that to be a liability the obligation had to be 'presently existing' in the sense that the event triggering the obligation had to have already occurred. The EM then provided an example of long service leave stating that it would not become a present obligation until the employee concerned actually took the leave.

27. Under the accounting definition, a liability is recognised if there is a present obligation to make a probable future sacrifice of economic benefits. Under this definition, something may be a liability even if the triggering event has not yet occurred provided that the entity has little if any discretion to avoid the obligation and it is probable that the obligation will arise. For example, if a business has an employee who has met the requisite qualifying period under the relevant award then, even though the employee has not taken the leave, at some time in the future the business will be required to pay that employee long service leave. In these circumstances a business would be expected to show an accounting liability for the accrued leave in its balance sheet.

28. Having regard to the totality of factors which in combination form the thin capitalisation context, we consider that the accounting meaning of the word is the ordinary meaning in this context. Furthermore, notwithstanding the examples in the EM, all liabilities (excluding the specific items mentioned in the legislative definition) recognised under the accounting analysis are non-debt liabilities. If the accounting definition is used for assets we consider that it would not be appropriate to use another definition for liabilities.

29. With regard to this point it has also been put, that in the thin capitalisation context, whilst assets should have an accounting meaning, liabilities should have a modified accounting meaning under which employee entitlements and other accounting provisions should be excluded. Again we consider that the contextual factors do not permit an interpretation which adopts an accounting approach which is then modified to exclude specified accounting liabilities. Furthermore, in this regard we do not consider that, whether an expense is or is not deductible under the general deduction provisions has any bearing on the meaning of the word 'liability' in Division 820. The question of whether something is deductible is relevant to ascertaining a taxpayer's taxable income. By contrast, the question of whether something is a 'non-debt liability' in Division 820 is relevant to determining a net asset figure which forms the basis of a safe harbour debt amount. This amount in turn is a proxy for how much an entity can borrow before they are considered to be 'thinly capitalised'. The question of whether or not any particular unrelated expense or cost is deductible is not directly relevant to the balance of funding between debt and equity.

30. A significant alternative view to that outlined above is that the definition of 'assets' and 'liabilities' takes a traditional legal meaning. Such an approach does not rely on the accounting standards for the basis of its analysis, but looks to the legal concepts underpinning both of these terms. Some support for this view may be gained from the EM (as an example refer to paragraph 26 above). However, having regard to the contextual factors discussed in paragraphs 18 to 21, we consider that the ordinary meaning of these terms in the thin capitalisation context is the accounting meaning.

Valuation of assets and liabilities

31. The thin capitalisation legislation requires, in terms of section 820-680 that entities need to comply with accounting standards for the purpose of valuing (including revaluing) their assets and liabilities identified in accordance with paragraphs 4 and 5 of this Ruling. Additionally an entity's debt capital and equity capital is also to be valued in accordance with the accounting standards, as well as any revaluations for thin capitalisation purposes. The accounting standards for these purpose are the accounting standards as per the meaning in the Corporations Act 2001 being the AASB series of accounting standards.

32. AASB 1001 Accounting Policies requires an entity to adopt an accounting policy that will result in financial information that is 'relevant' and 'reliable'. The accounting policies to be adopted in many circumstances are contained in the accounting standards that deal with particular topics. A non-exhaustive list of accounting standards relevant for this Ruling include AASB 1001 Accounting Policies, AASB 1008 Leases, AASB 1010 Recoverable Amount of Non-Current Assets, AASB 1011 Accounting for Research and Development, AASB 1013 Accounting for Goodwill, AASB 1015 Acquisition of Assets, AASB 1016 Accounting for Investments in Associates, AASB 1019 Inventories, AASB 1020 Income Taxes, AASB 1021 Depreciation, AASB 1022 Accounting for the Extractive Industries, AASB 1024 Consolidated Accounts, AASB 1041 Revaluation of Non-Current Assets.

33. In the absence of a particular accounting standard relevant to the item in question, paragraph 4 of AASB 1001 sets out the criteria for selection and application of an appropriate accounting policy. In this process to select an accounting policy, paragraph 4.1.2 of the standard lists, in the order of preference in which they should be applied, the pronouncements on accounting policies to be used. The order of preference contained in that standard is as follows:

a)

the requirements and guidance in Accounting Standards or other authoritative pronouncements of the AASB and/or the PSASB (the Public Sector Accounting Standards Board) dealing with similar or related issues;

b)

the requirements and guidance in UIG (Urgent Issues Group) Consensus Views dealing with similar or related issues;

c)

the definitions and recognition criteria for assets, liabilities, equity, revenues and expenses set out in Statement of Accounting Concepts SAC 4 'Definition and Recognition of the Elements of Financial Statements';

d)

International Accounting Standards and Interpretations of the Standing Interpretations Committee of the International Accounting Standards Committee (only to the extent that these are consistent with (a), (b) and (c) of this paragraph); and

e)

the pronouncements of other national accounting standard setting bodies and accepted industry practices (only to the extent that these are consistent with (a), (b) and (c) of this paragraph).

34. In valuing matters not dealt with by a specific standard, for thin capitalisation purposes we would expect compliance with AASB 1001 would include being able to demonstrate that the process and judgement used for selecting the accounting policy that was used to value the matters has followed the order of preference set out in paragraph 4.1.2 of that standard as detailed above.

Detailed Contents List

35. Below is a detailed contents list for this Ruling:

Commissioner of Taxation
30 October 2002

Previously released as Draft Taxation Ruling TR 2002/D6.

References

ATO references:
NO T2002/007330

Related Rulings/Determinations:

TR 92/1
TR 97/16

Subject References:
thin capitalisation
assets
CGT asset
liabilities
valuations

Legislative References:
ITAA 1997 Div 820
ITAA 1997 820-90
ITAA 1997 820-95
ITAA 1997 820-100
ITAA 1997 820-105
ITAA 1997 820-110
ITAA 1997 820-195
ITAA 1997 820-200
ITAA 1997 820-205
ITAA 1997 820-210
ITAA 1997 820-215
ITAA 1997 820-680
ITAA 1997 995-1(1)
Banking Act 1959
Corporations Act 2001
New Business Tax System (Thin Capitalisation) Act 2001
TAA 1953 Pt IVAAA