House of Representatives

Explanatory Memorandum

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

Chapter 1 - Overview and key concepts of the thin capitalisation regime

Outline of chapter

1.1 This chapter provides an overview of Division 820, which contains the new thin capitalisation regime. Division 820 limits the allowance of debt deductions arising from debt used to finance the Australian operations of certain multinational investors. It applies to:

•

Australian entities that operate internationally and some of their associates;

•

Australian entities that are foreign controlled; and

•

foreign entities that operate in Australia.

1.2 Division 820 operates when the amount of debt used to finance the Australian operations exceeds specified limits. It disallows a proportion of the finance expenses (such as interest) attributable to the Australian operations of both Australian and foreign multinational investors.

1.3 For non-banks the tests set a maximum debt level. For ADIs, (principally banks), the tests are framed as a minimum requirement for equity capital. The requirement for ADIs is based on prudential regulatory requirements.

1.4 There is a de minimis protection from the effects of the Division for taxpayers whose annual finance expenses do not exceed $250,000.

1.5 The New Business Tax System (Debt and Equity) Bill 2001 contains a definition of a debt interest. This concept forms the basis for measuring debt levels as well as being used to determine what deductions may be disallowed under the thin capitalisation regime. That bill also contains the rules for determining what constitutes an equity interest.

Context of reform

1.6 The new thin capitalisation regime is aimed at improving both the integrity and fairness of the income tax law. It will do that by preventing multinational entities allocating an excessive amount of debt to their Australian operations. The bill implements Recommendations 22.1 to 22.9 and 22.11 (b) and (c) of A Tax System Redesigned.

1.7 The existing thin capitalisation regime is deficient as it:

•

only applies to foreign controlled Australian operations and non-residents deriving Australian assessable income; and

•

only seeks to limit debt borrowed from a foreign controller or from other foreign parties related to the controller, and (in the case of companies) third-party debt guaranteed by a related party.

1.8 As the current regime does not cover all debt of entities, foreign multinationals can choose the level of debt funding of their Australian operations within the constraint of the overall gearing at which markets will permit them to operate globally.

1.9 The current provisions that regulate the deductibility of interest expenses for outward investors are also deficient. These rules rely on tracing the use of borrowed funds. It is relatively easy to circumvent their operation by establishing a use of funds that ensures deductibility. Another problem with the rules is that they apply only on a single entity basis, and it is possible to circumvent them by using interposed entities to separate foreign income from the expenditure.

1.10 The current provisions dealing with the capitalisation of foreign bank branches operate arbitrarily. Further, it is arguable that the definition of interest is not broad enough to capture all finance expenses and the provisions could, because of their nature, give rise to double taxation.

1.11 The new thin capitalisation regime applies to income years beginning on or after 1 July 2001. From that date it replaces the current thin capitalisation regime, the provisions dealing with the capitalisation of foreign bank branches and the debt creation rules. Amendments will also be made to the provisions that govern the deductibility of interest expenses for entities with offshore investments.

1.12 The bill will also amend section 128F of the ITAA 1936 to allow Australian branches of non-residents access to the withholding tax exemption for interest paid on certain types of debentures. This change will:

•

remove the cost of operating special Australian subsidiaries currently used to gain access to the exemption;

•

provide branches with direct access to section 128F funding; and

•

remove the need for ongoing special rules to avoid the double application of the thin capitalisation rules where funds raised under section 128F are on-lent by a subsidiary to a branch.

1.13 Chapter 4 contains a detailed explanation of the section 128F amendment.

Summary of new law

1.14 The new thin capitalisation regime represents 2 significant changes from the old regime:

•

it expands the application of the measures to include the Australian operations of both inbound and outbound investors; and

•

it limits the deductions relating to the total debt of the Australian operations of those investors, rather than the foreign debt only.

1.15 The following summarises key features of Division 820.

Detailed explanation of new law

What is thin capitalisation?

1.16 Thin capitalisation is an investment funding issue that arises in the context of international investment. The issue is principally about the extent to which an investment is financed by way of debt funding compared to equity funding. An entitys debt to equity funding can be expressed as a ratio. For example, a ratio of 3:1 means that for every dollar of equity the entity is funded by $3 of debt. This is also known as gearing. If an investment is funded by excess debt, it is said to be thinly capitalised (i.e. not enough equity is used to fund that investment).

1.17 The difference in the income tax treatment of debt compared to equity funding provides an incentive to finance investments using debt rather than equity. While this is not the only consideration, multinational investors have an incentive to allocate a higher proportion of their debt to particular investments and utilise their equity to fund investments outside Australia. It is where this results in a relatively high level of debt funding of the Australian operations that the thin capitalisation regime applies.

What is the legislation about?

1.18 The thin capitalisation rules will limit the amount of debt that can be used to finance Australian operations of certain investors by reducing debt deductions where an entitys debt to equity ratio exceeds certain limits. Those investors (companies, trusts, partnerships or individuals) that will be subject to the new regime are:

•

foreign entities that carry on business at or through Australian branches;

•

foreign entities with direct investments within Australia (e.g. land and buildings);

•

Australian entities that are foreign controlled;

•

Australian controllers of foreign entities; and

•

Australian entities that carry on business at or through overseas branches.

Some associates of these are also subject to the new regime.

1.19 Whether an entitys debt funding is excessive or not will be determined by comparing the amount of debt, or equity in the case of ADIs, used to finance the Australian business or investment with the maximum allowable amount of debt, or minimum equity requirement, specified in the legislation.

1.20 The proportion of the entitys debt deductions that are disallowed is the entitys excess debt (or capital shortfall) as a proportion of its total debt. The aim of calculating the disallowed deductions in this manner is to achieve the same level of taxable income as would have been the case had the entitys debt funding been within the prescribed limits.

Non-ADI foreign entities with Australian investments

1.21 There are several ways to determine the maximum debt level. For foreign entities investing in Australia, the maximum amount of debt will be the greater amount determined under:

•

the safe harbour debt test; or

•

the arms length debt test.

1.22 Under the safe harbour debt test, the amount of debt used to finance the Australian investments will be treated as being excessive when it is greater than that permitted by the safe harbour gearing limit of 3:1.

1.23 For financial entities, the safe harbour gearing ratio of 3:1 only applies to their non-lending business. An on-lending rule will operate to remove from the calculations any debt that is on-lent to third parties or that is used for similar financing activities. The application of this on-lending rule will be limited by an additional safe harbour gearing ratio of 20:1 which will apply to the financial entitys total business. There are also special rules that result in higher allowable gearing ratios for financial entities that have assets which are allowed to be fully debt funded.

1.24 The arms length debt amount is determined by conducting an analysis of the entitys activities and funding to determine a notional amount that represents what would reasonably be expected to have been the entitys maximum debt funding of its Australian business during the period. To do that, it is assumed that the entitys Australian operations were independent from any other operations that the entity or its associates had during the period, and that they had been financed on arms length terms.

Non-ADI Australian entities with foreign investments

1.25 For Australian entities investing offshore, the maximum debt amount will be the greatest amount determined under either:

•

the safe harbour debt test;

•

the arms length debt test; or

•

the worldwide gearing debt test.

1.26 The safe harbour limit and the arms length test are fundamentally the same as those described for non-ADI foreign entities with Australian investments. They take account, however, of the amount and form of investment in the Australian non-ADIs controlled foreign investments.

1.27 The worldwide gearing debt test will allow an Australian entity with foreign investments to fund its Australian investments with gearing up to 120% of the gearing of the worldwide group that it controls. However, this test is not available if the Australian entity is itself controlled by foreign entities.

Foreign ADI entities with Australian permanent establishments

1.28 A separate regime applies to foreign ADIs that carry on business at or through Australian permanent establishments (i.e. foreign bank branches). That regime operates to ensure that these entities maintain a minimum amount of equity capital within their Australian operations. If this minimum amount is not maintained, debt deductions may be disallowed.

1.29 The minimum amount of equity capital for foreign ADIs is the lesser of:

•

the safe harbour capital amount; and

•

the arms length capital amount.

1.30 The safe harbour capital amount is 4% of the risk-weighted assets of the Australian banking business.

1.31 The arms length capital amountis determined in a similar but not identical manner to the arms length debt amount for non-ADIs. In this case, the analysis results in a notional amount that represents what would reasonably be expected to have been the entitys minimum capital funding of its Australian business throughout the year.

Australian ADI entities with foreign investments

1.32 Australian ADI entities that control foreign investments are also subject to a regime that operates to ensure that these entities maintain a minimum amount of equity capital within their Australian operations. If this minimum amount is not maintained, then debt deductions may be disallowed.

1.33 The minimum amount of equity capital, for outward investing ADIs is the least of:

•

the safe harbour capital amount;

•

the arms length capital amount; and

•

the worldwide capital amount.

1.34 The principal component of the safe harbour capital amount is 4% of the risk-weighted assets of the Australian banking business.

1.35 The arms length capital amount analysis results in a notional amount that represents what would reasonably be expected to have been the banks minimum capital funding of its Australian business throughout the year.

1.36 The worldwide capital amount will allow an Australian ADI with foreign investments to fund its Australian investments with a minimum capital ratio equal to 80% of the Tier 1 capital ratio of its worldwide group.

1.37 Rules are not required for an Australian bank (or bank group) that does not have any foreign operations. A purely Australian group does not have the opportunity to shift debt between jurisdictions and is thereby prevented from debt loading their Australian operations. Even where the bank is foreign controlled, the prudential rules set by APRA require capital levels that are considered to be adequate for tax purposes.

What are the key elements of thin capitalisation?

1.38 There are 4 key elements that will guide an entity in determining whether the thin capitalisation rules apply and, if so, which particular rules. These elements are:

•

the de minimis rule;

•

whether the entity is an Australian or foreign multinational;

•

whether the entity is an ADI or a non-ADI; and

•

whether it is a general entity or a financial entity.

Application of the rules on a group basis is also permitted.

De minimis rule

1.39 The thin capitalisation de minimis rule is intended to remove the need for certain entities to comply the thin capitalisation regime. All entities (regardless of their nature or business) that either alone or together with associate entities, claim no more than $250,000 in debt deductions per income year, will not be subject to the new regime. [Schedule 1, item 1, section 820-35]

The entities

1.40 Subject to the de minimis exception, Australian entities that are either foreign controlled or are themselves controllers of foreign entities, their associate entities and foreign entities with operations or investments in Australia will be subject to the new thin capitalisation regime.

1.41 Entities will be classified as being either inward investing entities or outward investing entities. An inward investing entity is a foreign controlled Australian resident entity, and any foreign entity that carries on business at or through an Australian permanent establishment, or has direct investments within Australia.

1.42 An outward investing entity is an Australian resident entity that controls any foreign entity or carries on business at or through an overseas permanent establishment, and an Australian associate entity of another outward investor.

1.43 If an entity is neither an inward investing entity nor an outward investing entity, it will not be subject to the new thin capitalisation regime. If an entity is both an inward and an outward investing entity (e.g. a foreign controlled Australian resident entity that itself controls a foreign entity), the outward investing entity rules take precedence and will apply.

1.44 Comprehensive control rules, based on the control rules in the CFC provisions of the ITAA 1936, determine whether an Australian entity is an outward investor. Broadly, that will be the case where the entity is an Australian controller or an Australian associate entity of an Australian controller. The same rules will determine whether an Australian entity is foreign controlled.

ADI or non-ADI

1.45 Once it has been determined that an entity is either an inward investing entity or an outward investing entity, and therefore subject to the thin capitalisation regime, it is then necessary to know if that entity is an ADI. An ADI entity will be subject to a minimum capital requirement similar to capital requirements imposed by regulatory agencies such as APRA. If an entity is a non-ADI entity, it will be subject to a maximum amount of debt based on a safe harbour gearing ratio, an arms length debt amount, or in the case of outward investing entities only, a worldwide gearing debt test.

General investor or financial investor

1.46 A non-ADI entity is further classified as being either a financial entity or a general entity. A general entity is any entity that is neither a financial entity nor an ADI.

1.47 This classification is necessary because special rules apply to financial entities. These rules recognise that financial entities have different requirements for debt funding.

Grouping

1.48 Resident entities can choose to have the thin capitalisation rules apply to them as a group. The group can include, subject to certain conditions, wholly owned resident companies, certain trusts and partnerships and Australian branches of foreign banks.

1.49 Where entities choose to group, the nature of the entities in the group at the end of the income year will determine whether the inward investing entity rules or the outward investing entity rules apply to that group, and whether the group is an ADI or non-ADI.

1.50 The thin capitalisation calculations made in relation to the group are to be based on the information which would have been contained in a set of consolidated accounts prepared for that group.

1.51 If the thin capitalisation rules disallow all or part of a debt deduction of the group, the amount disallowed is apportioned to the individual entities within the group.

What are the key concepts used in the thin capitalisation rules?

What is debt capital?

1.52 The debt capital of an entity is the sum of the amounts outstanding on debt interests issued by the entity that are still on issue. [Schedule 2, item 26, definition of debt capital in subsection 995-1(1)]

What is a debt interest?

1.53 The meaning of a debt interest is determined generally in accordance with the tests contained in the New Business Tax System (Debt and Equity) Bill 2001. To promote certainty and facilitate the categorisation of new types of financial instruments as debt or equity, the tests provided in that bill may be modified or supplemented by the regulations. [Schedule 1, item 34 of the New Business Tax System (Debt and Equity) Bill 2001, subsection 974-10(5)]

1.54 Debt interests can take different forms including various types of project finance and, in certain circumstances, trade finance. Discounted securities such as bills of exchange are another form of debt interest.

1.55 A scheme or a number of integrated related schemes gives rise to a debt interest if, when it comes into existence, it satisfies the debt test . [Schedule 1, item 34 of the New Business Tax System (Debt and Equity) Bill 2001, subsections 974-15(1) and (2)]

What is the debt test?

1.56 The debt test provides that a debt interest arises under a scheme if:

•

the scheme is a financing arrangement or is one that constitutes a share;

•

an entity or associate receives or will receive financial benefits under the scheme;

•

the entity or a related entity has an effectively non-contingent obligation under the scheme to provide a financial benefit(s) in the future; and

•

it is substantially more likely than not that the value of the benefit to be provided will equal or exceed the value of the benefit received (depending on the term of the scheme, the relevant values may be calculated in nominal value or present value terms).

[Schedule 1, item 34 of the New Business Tax System (Debt and Equity) Bill 2001, subsection 974-20(1)]

What is a debt deduction?

1.57 The thin capitalisation regime disallows all or part of the debt deductions of certain thinly capitalised entities. A debt deduction encompasses the cost incurred in connection with a debt interest that, in the absence of the thin capitalisation provisions, would be deductible. Two broad types of costs are incurred in connection with debt interests:

•

costs for the use of the financial benefit received by the entity under its debt interest arrangement; and

•

costs directly incurred in obtaining or maintaining that benefit.

[Schedule 1, item 1, section 820-40; Schedule 2, item 27, definition of debt deduction in subsection 995-1(1)]

1.58 The cost of debt capital may not be explicit in an arrangement. For example, it may be embedded in a payment that does not differentiate between payment for acquisition of a physical asset and payment for not having to pay for that asset when it is delivered. Nevertheless, these costs are debt deductions to the extent that they are otherwise deductible.

1.59 An entity can incur costs directly in connection with debt capital other than interest or other amounts that compensate the provider of debt finance for the time the acquirer of the finance has the use of the funds. For example, there are costs of raising debt finance, such as establishment fees, fees for restructuring a transaction, stamp duty and legal costs of preparing documentation. These sorts of costs are costs of receiving the funds.

1.60 Once the funds have been raised, there may be other costs that the entity has to pay the finance provider that are directly incurred in maintaining the financial benefit received, for example, costs that are to maintain the right to draw down funds. To the extent that these costs can be deducted by the entity they are debt deductions.

1.61 The definition contains a list of costs which are debt deductions under paragraph (1)(a) of the definition. For example, amounts in substitution for interest, discounts in respect of a security and losses in respect of certain securities arrangements are costs incurred in relation to a debt interest and therefore debt deductions [Schedule 1, item 1, subsection 820-40(2)] . An amount remains a debt deduction notwithstanding that the party to whom the amount is owed, assigns or in any other way deals with the amount [Schedule 1, item 1, paragraph 820-40(2)(f)] .

1.62 In order to avoid doubt, the definition also contains a list of amounts which are not debt deductions. Examples of these amounts include:

•

foreign currency losses associated with hedging a currency risk in respect of a debt interest;

•

foreign currency losses associated with extinguishing a debt interest where the losses are attributable to the outstanding principal; and

•

salary or wages paid to employees of an entity.

[Schedule 1, item 1, subsection 820-40(3)]

1.63 Where a borrowing expense would be fully deductible under section 25-25 of the ITAA 1997, over the term of the loan or 5 years (whichever is the shorter) and it has not been fully deducted by 1 July 2001, then a deduction would have been denied if the entity is thinly capitalised. The definition excludes these expenses to ensure that the rules will not affect the deductibility of borrowing expenses incurred prior to 1 July 2001 and not fully deducted in the year in which they were incurred. [Schedule 1, item 1, paragraph 820-40(1)(c)]

What is equity for thin capitalisation purposes?

1.64 The term equity is not itself defined in the thin capitalisation rules. Rather, the rules contain a number of terms which define equity for different classes of entities and for different purposes. These terms are:

•

associate entity equity;

•

controlled foreign entity equity;

•

equity capital; and

•

worldwide equity.

What is equity capital and worldwide equity?

1.65 Equity capital, which is mainly relevant for inward and outward investing ADIs, is discussed in Chapters 4 and 5 [Schedule 2, item 29, definition of equity capital in subsection 995-1(1)] . Worldwide equity is discussed in detail in the context of the worldwide gearing debt amount in Chapter 3 [Schedule 2, item 72, definition of worldwide equity in subsection 995-1(1)] . Both of these are measures of the total equity funds of an entity (e.g. shareholders funds in the case of a company).

What is associate entity equity and controlled foreign entity equity?

1.66 The term associate entity equity is defined as the value of the equity interests that an entity holds in its associate entities [Schedule 2, item 11, definition of associate entity equity in subsection 995-1(1)] . Controlled foreign entity equity means the value of the equity interests that an entity holds in its Australian controlled foreign entities [Schedule 2, item 23, definition of controlled foreign entity equity in subsection 995-1(1)] . These terms are used mainly for inward and outward investing entities that are not ADIs. They are measures of one entitys equity interest in another entity (e.g. shares in a company).

What are equity interests?

1.67 Broadly speaking, an equity interest is an interest which an entity has in a company, partnership or trust and which has sufficient equity-like features. For example, a share in a company and a beneficiarys interest in a trust are equity interests. It should be noted that equity interests in a trust or partnership are only relevant for the purposes of the thin capitalisation rules and include:

•

an interest that carries a right to a variable or fixed return where the amount is contingent on the economic performance of the partnership or trust;

•

an interest that carries a right to a variable or fixed return from the trust or partnership if the right or the amount of the return is at the discretion of the entity;

•

an interest that gives its holder a right to be issued with an equity interest in the trust or partnership; and

•

an interest that will or may convert into an equity interest in the trust or partnership.

[Schedule 1, item 1, subsection 820-930(2)]

1.68 The provisions dealing with equity interests in companies are contained in the New Business Tax System (Debt and Equity) Bill 2001. The explanatory memorandum which accompanies that bill discusses equity interests in companies. Similar rules to those that apply to equity interests in a company apply to equity interests in a trust or a partnership for the purposes of the thin capitalisation rules.

1.69 An equity interestin a trust or partnership is determined by reference to Division 974 of the New Business Tax System (Debt and Equity) Bill 2001. Division 974 is modified by Division 820 to enable that definition to apply to trusts and partnerships.

1.70 The concept of equity interest in Division 974 extends the range of interests that are recognised as equity beyond the traditional share or stock. The threshold condition for equity interests other than shares or stock, is that the relevant scheme giving rise to the interest is a financing arrangement. If an interest satisfies both the debt test and the equity test, it is treated as a debt interest.

1.71 The table in subsection 820-930(1) outlines the modifications made to Division 974 to enable concepts used in the debt/equity rules to apply when determining an equity interest in a trust or a partnership being:

•

Subdivision 974-C, which provides the basic test to determine when an interest is an equity interest in a company, is modified. In particular, section 974-75 is replaced by subsections 820-930(2) to (4) to extend the test [Schedule 1, item 1, subsection 820-930(1), item 3 in the table] .

•

References to a company in Subdivisions 974-C will be taken to include a reference to a trust or a partnership. Where a reference is made to an equity interest in a company it will be taken to be an equity interest listed in the table in subsection 820-930(2). However, certain provisions which are inappropriate when applied to a trust or a partnership, such as subsection 974-95(4) and the example following section 974-80, will not apply [Schedule 1, item 1, subsection 820-930(1), items 1 to 6 in the table] .

•

In a similar fashion, Subdivision 974-D is modified to enable concepts in relation to equity interest to apply. Subdivision 974-D contains provisions common to the debt test and the equity test. The Subdivision provides guidance on, among other things, conversion of, and material changes to, debt and equity interests [Schedule 1, item 1, subsection 820-930(1), items 1 and 2 in the table] .

•

Subdivision 974-F, which defines certain concepts such as financing arrangements and non-contingent obligations, will apply in total. In addition, a reference to regulations in Subdivisions 974-C, 974-D and 974-F is taken to be areference to the regulations made under the provisions applied by subsection 820-930(1) [Schedule 1, item 1, subsection 820-930(1), items 7 and 8 in the table] .

Assets

1.72 Assets are an important element in the application of the new regime. This is because the level of acceptable debt funding determined under the various safe harbours is calculated by reference to the amount of Australian assets. Assets are not specifically defined in the thin capitalisation regime. Rather, the term assets adopts its normal legal meaning. The value of these assets must be determined in accordance with Australian accounting standards.

Average values

1.73 The various tests in the thin capitalisation rules require measurement of amounts of what are generally balance sheet items (e.g. debt and assets). To obtain more reliable results, entities have to use average values of these items during a period (involving a minimum of 2 measurements) rather than simply using a single end of year figure. How frequently items are measured is largely, with some safeguards, left to the entity.

Inter-relationship between thin capitalisation rules and transfer pricing provisions

1.74 Some cases will attract the operation of the thin capitalisation rules and the transfer pricing rules in Division 13 of Part III of the ITAA 1936 and comparable provisions of DTAs.

1.75 A consideration of the scope and purpose of each set of provisions is relevant in determining which provisions are more appropriate to apply in the circumstances of an individual case.

1.76 The thin capitalisation rules collectively make up a comprehensive regime. They are specifically directed at debt deductions which, broadly, relate to interest and other costs of borrowing. These features of the regime show that it is intended to cover the whole subject matter to which the thin capitalisation rules apply.

1.77 The thin capitalisation rules limit the amount of debt deductions by reference to levels of debt and capital of the taxpayer. The formulations for arriving at acceptable levels of debt and capital incorporate, as part of the arms length amount calculations, arms length principles that would be applied in the application of Division 13 and comparable provisions of DTAs. Accordingly, the same result should eventuate under the different regimes in practice. In these circumstances, the arms length tests in the thin capitalisation rules apply. To the extent that the thin capitalisation rules apply to a specific debt deduction, it is appropriate, therefore, to determine under the thin capitalisation rules by how much, if any, the deduction for interest or other borrowing costs should be reduced.

1.78 However, the thin capitalisation rules do not have the same scope as Division 13 and comparable provisions of DTAs - the latter apply to a wider range of transactions. Further, there may be instances where the purpose of the application of the arms length principle under Division 13 and comparable provisions of DTAs to a particular case is not the same as for applying the arms length test under the thin capitalisation rules. In these cases, the arms length principle articulated in Division 13 and comparable provisions of DTAs should apply. For example, the application of the arms length principle to determine whether a rate of interest is greater than an arms length amount can only be done under Division 13 and comparable provisions of DTAs.

1.79 The thin capitalisation rules also interact with Division 13 and comparable provisions of DTAs may interact is in relation to the amount of a debt deduction which would otherwise be allowable. In normal circumstances, the amount otherwise allowable is that determined under section 8-1 of the ITAA 1997. However, Division 13 and comparable provisions of DTAs may also impact on the amount otherwise allowable. The thin capitalisation rules apply, therefore, to the amount of a debt deduction which is otherwise allowable having regard to any other provision in the income tax law or in the DTAs.

Further detail about the thin capitalisation regime

1.80 The key features of the new regime along with other key concepts, are discussed in detail in the following chapters.

Application and transitional provisions

1.81 The new thin capitalisation regime applies to an entity or a group of entities for its income year beginning on or after 1 July 2001. This will remove the need for entities with substituted accounting periods to apply the old and the new rules for parts of their 2000-2001 year of income that includes 1 July 2001. [Schedule 1, item 22, subsection 820-10(1)]

1.82 Australian permanent establishments will be required to prepare financial statements for the income year beginning on or after 1 July 2002. [Schedule 1, item 22, subsection 820-10(2)]

1.83 The extension of the section 128F exemption to debentures issued by non-resident companies applies to debentures issued on or after 1 July 2001. [Schedule 1, item 23]

1.84 A transitional measure applies for the first year of application to all entities. While the new thin capitalisation rules will apply from the start of an entitys first income year beginning on or after 1 July 2001, taxpayers do not have to test their compliance with the rules until the end of that year (or the first period of their application if it finishes earlier). The majority of taxpayers have at least until 30 June 2002 to comply with the new rules. [Schedule 1, item 22, section 820-25]

1.85 All consequential amendments that depend on the commencement of the new thin capitalisation regime (see paragraphs 1.90 to 1.101) apply from the taxpayers income year that commences on or after 1 July 2001. [Schedule 1, items 20 to 22, sections 820-15 and 820-20 and items 24 to 26]

Transitional rules for hybrid instruments

1.86 An entity may elect to have the treatment of transactions (e.g. dividends and interest) relating to interests on issue that will be reclassified under the New Business Tax System (Debt and Equity) Bill 2001 (that takes effect on 1 July 2001) preserved for a 3 year transitional period (until 30 June 2004). Transitional provisions in the thin capitalisation rules apply for the same period to these interests to ensure the value of this concession is not reduced. [Schedule 1, item 22, section 820-35]

1.87 A debt interest is disregarded in calculating adjusted average debt and average debt where an interest that was formerly equity becomes debt and an election has been made for equity treatment of the transactions [Schedule 1, item 22, subsection 820-35(2)] . This will ensure that non-ADIs will have these amounts treated as equity for thin capitalisation purposes. In the same set of circumstances, the debt interest will be disregarded in calculatingaverage equity capital [Schedule 1, item 22, subsection 820-35(3)] . This will ensure that ADIs (and non-ADIs applying the worldwide gearing test) will have these amounts treated as equity for thin capitalisation purposes.

1.88 Where an interest that was formerly debt has become equity and an election has been made for debt treatment of the transactions, transitional thin capitalisation provisions are not required. In the case of non-ADIs such an interest will not be included in the definition of adjusted averagedebt and average debt. For ADIs (and non-ADIs applying the worldwide gearing test), average equity capital will include the value of the equity interest.

Consequential amendments

1.89 As a result of the application of the new thin capitalisation regime, there will be consequential amendments to the ITAA 1936 and to the ITAA 1997.

Repeal of existing thin capitalisation and debt creation regimes

1.90 The current thin capitalisation regime and the debt creation rules which are contained in Divisions 16F and 16G of Part III of the ITAA 1936 will be repealed. [Schedule 1, item 4]

1.91 Section 12-5 of the ITAA 1997 includes a checklist that refers to provisions which contain rules about specific deductions. The repeal of Divisions 16F and 16G of Part III of the ITAA 1936 requires a consequential amendment to refer to the thin capitalisation provisions as Division 820. [Schedule 1, items 14 and 15]

Attributable income of a CFC

1.92 Section 389 will be amended to continue the exclusion of the thin capitalisation and debt creation rules from the calculation of attributable income of an eligible CFC. Therefore, the references to Divisions 16F and 16G of Part III of the ITAA 1936 will be removed and replaced with a reference to Division 820. [Schedule 1, items 12 and 13]

Record keeping

1.93 Section 262A will be amended in order to incorporate new record keeping requirements for permanent establishments operating within Australia, and for the calculation of the arms length amounts. These requirements are discussed further in Chapter 9. [Schedule 1, items 10 and 11]

Section 128F - definition of associate

1.94 Subsection 128F(9) currently defines the term associate by reference to its meaning in Division 16F of the ITAA 1936. Once Division 16F is repealed, the definition contained within it will no longer be available. Subsection 128F(9) will be amended to adopt the definition of associate in section 318 of the ITAA 1936.

1.95 For the purposes of section 128F, paragraphs 318 (1)(b), (2)(a), and (4)(a) will be disregarded. The effect of this modification is that a partner of the entity or a partnership in which the entity is a partner will not be associates for section 128F purposes. This is consistent with the existing definition of associate in subsection 128F(9). [Schedule 1, item 3]

Section 79D - quarantining foreign losses

1.96 Unless the exclusion for foreign investment fund deductions applies, section 79D of ITAA 1936 presently prevents a foreign loss from being deducted against domestic assessable income.

1.97 This restriction on deductions imposed by section 79D will no longer limit debt deductions, with the exception of debt deductions that are attributable to an overseas permanent establishment. Section 79D will continue to apply in these latter cases because debt deductions attributable to foreign permanent establishments are not covered by the thin capitalisation regime.

1.98 To give effect to this change, the reference in section 79D to foreign income deduction, which is defined in subsection 160AFD(9), will be amended to effectively exclude debt deductions from the operation of section 79D. [Schedule 1, item 5]

Deductions relating to foreign exempt income

1.99 Debt deductions will, in certain instances, no longer be denied to taxpayers because they were incurred in earning exempt foreign income. These debt deductions, provided they are otherwise allowable under the general deduction provisions, will come within the scope of the thin capitalisation regime when determining the amount to be allowed.

1.100 The relevant debt deductions are those incurred in earning foreign income that is exempt income under sections 23AI, 23AJ and 23AK of the ITAA 1936.

1.101 Debt deductions incurred in deriving income which is exempt under section 23AH will continue to be subject to the exempt income exception in section 8-1. [Schedule 1, item 16, section 25-90]

Consequential amendments as a result of other bills

1.102 The bill also contains 3 consequential amendments necessary as a result of 3 other bills. These are the Corporations Bill 2001, the Financial Sector (Collection of Data) Bill 2001 and the Financial Services Reform Bill2001.

1.103 Two of the amendments will replace references to existing legislation which will be repealed. The third amendment relates to dealers licences granted under Part 7.3 of the Corporations Law . A single licensing regime will be introduced which will replace the licensing requirements currently applying to securities dealers, investment advisers, futures advisers and brokers, general and life insurance brokers, and foreign exchange dealers. The consequential amendments will ensure that reference is made to the appropriate licence under the new regime.

1.104 Specifically, the consequential amendments will:

•

replace the reference to Corporations Law in the definition of accounting standards with a reference to the Corporations Act 2001 ;

•

replace the reference to Financial Corporations Act 1974 in the definition of financial entity with a reference to the Financial Sector (Collection of Data) Act 2001 ; and

•

repeal paragraph (c) of the definition of financial entity in order to substitute the type of licence an entity must hold to qualify under the definition. [Schedule 1, items 17 to 19]

1.105 Clause 2 of the bill provides that the amendment to the definition of accounting standards and the substitution of the licensing requirement will commence on the later of 1 July 2001 or at the time when the Corporations Act 2001 commences. Similarly, the remaining amendment will commence on the later of 1 July 2001 or at the time when the Financial Sector (Collection of Data) Act 2001 commences.