House of Representatives

Explanatory Memorandum

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

Chapter 2 - Inward investing entities (non-ADI)

Outline of chapter

2.1 This chapter explains how the thin capitalisation rules in Subdivision 820-C will apply to a foreign investor or a foreign controlled Australian entity that is not an ADI (henceforth referred to as non-ADIs). This chapter explains how such an entity works out its maximum allowable debt, and by how much it needs to reduce its debt deductions when the thin capitalisation rules have been breached. It also explains how the rules apply to part year periods.

2.2 A threshold requirement will exclude small investors from the thin capitalisation regime. The exclusion will operate where the debt deductions of the foreign investor or the foreign controlled Australian entity, either alone or together with associate entities, are $250,000 or less.

Context of reform

2.3 A foreign entity may invest in Australia either directly (e.g. through a branch) or indirectly via an Australian entity which it controls. Such investment can be financed via debt or equity. If debt is used, the Australian investment generates interest deductions, which reduce tax in Australia. The differential tax treatment between debt and equity encourages foreign investors to allocate debt to the Australian investments. To prevent excessive interest deductions being claimed and hence loss of Australian tax revenue, the current law disallows deductions where the related party debt levels relating to the Australian investment exceed a prescribed level.

2.4 The new thin capitalisation regime is designed to prevent excessive debt deductions being claimed. However, the new rules will apply to all of the debt of the entity and not just to the debt borrowed from foreign related parties, as is the case with the existing rules. This will strengthen the integrity of the new rules.

2.5 Under the new regime the maximum debt to equity ratio allowed is 3:1, compared to 2:1 under the current provisions. However, in recognition of the fact that financial entities on-lend large amounts of their debt, such entities are allowed a debt to equity ratio of up to 20:1 under the new rules, compared to 6:1 under the current provisions. Nevertheless, in certain circumstances a ratio above 20:1 may be permitted where an entity holds a specific class of assets.

2.6 The prescribed safe harbour debt to equity ratio may be exceeded in circumstances where the funding structure could be maintained on an arms length basis. In such a situation, no deductions will be disallowed. This change recognises that some funding arrangements may be commercially viable notwithstanding that they exceed the prescribed limits. It also makes the rules more consistent with Australias DTAs.

2.7 The new rules also:

•

incorporate comprehensive concepts of debt and debt deductions that arise from debt arrangements rather than being restricted to the narrow concept of interest as in the existing rules, reflecting a move to economic substance over form;

•

apply to Australian entities with controlled foreign operations, to improve the operation of the law in relation to interest deductions in these cases (see Chapter 3); and

•

apply to groups of entities where they choose to form a group for thin capitalisation purposes (see Chapter 6).

Summary of new law

Detailed explanation of new law

Overview

2.8 The thin capitalisation rules seek to limit the amount of debt that can be allocated to Australian entities which are foreign controlled and to non-residents with Australian investments. Where the prescribed gearing limits are breached, the rules operate to disallow some or all of the debt deductions attributed to the Australian operations or investments.

2.9 The inward investing rules will apply to Australian entities which are foreign controlled and to non-residents who invest in Australia directly instead of through an Australian entity, for all or part of an income year. If an Australian entity is foreign controlled but also has offshore investments (such as a foreign subsidiary), the rules for outward investing entities will take priority (see Chapter 3 for a discussion of the rules affecting Australian entities with offshore investments). [Schedule 1, item 1, subsections 820-85(2) and 820-185(1)]

2.10 Different rules apply depending on whether the entity is classified as a general or financial entity. The rules take into account the different gearing levels required for each type of business. Generally, it is expected that financial entities require a higher level of debt funding to support their lending and securities business.

2.11 Broadly, the gearing of the Australian operations of foreign controlled Australian entities or the Australian investments of non-residents will be limited to a general safe harbour level of 3:1 debt to equity. Where these entities are foreign controlled financial entities an on-lendingrule will operate to remove any debt from the thin capitalisation rules that has been on-lent to third parties either through loans or certain other arrangements. The remaining assets of the entity that are not on-lent amounts will be subject to the general safe harbour level of 3:1. In order to prevent the assets of a financial entity from being totally debt funded, an overall gearing level of 20:1 is imposed on the entity. However, where the financial entity has assets that are effectively allowed to be fully debt funded (its zero-capital amount ), higher gearing levels than the 20:1 ratio will be permitted.

2.12 Where an entitys debt funding exceeds the safe harbour limit an adjustment to reduce the debt deductions will ordinarily occur unless the entity demonstrates that the debt funding of the Australian operations would be acceptable under arms length principles.

2.13 The inward investing rules will also apply to groups of entities where the groups are foreign controlled (see Chapter 6 for details).

What is an inward investing entity (non-ADI)?

2.14 This is a term used in the legislation to encompass a number of types of foreign and Australian entities that are not banks or other ADIs. The legislation further categorises them as either an:

•

inward investment vehicle (general);

•

inward investment vehicle (financial);

•

inward investor (general); or

•

inward investor (financial).

[Schedule 1, item 1, subsection 820-185(2); Schedule 2, item 40, definition of inward investing entity (non-ADI) in subsection 995-1(1)]

2.15 An inward investment vehicle is a foreign controlled Australian entity and an inward investor is a foreign entity which invests directly in Australia rather than through an Australian resident vehicle. The rules further classify entities as either financial or general entities. This is done to ensure that the gearing levels permitted under the rules take into account the different debt levels required by each type of entity to undertake its business activities.

2.16 An inward investment vehicle (general) is an Australian entity that is neither a financial entity nor an ADI at any time during the period, and is a foreign controlled Australian entity throughout the period [Schedule 1, item 1, subsection 820-185(2), item 1 in the table] . These will be referred to as general foreign controlled Australian entities throughout this chapter. The term foreign controlled Australian entity is discussed in detail in Chapter 7. However, for the purposes of this chapter it should be noted that the term includes foreign controlled Australian companies, trusts and partnerships.

2.17 An inward investment vehicle (financial) is a financial entity and not an ADI throughout the period and is a foreign controlled Australian financial entity throughout the period [Schedule 1, item 1, subsection 820-185(2), item 2 in the table] . These will be referred to as foreign controlled Australian financial entities in this chapter.

2.18 A financial entity is an entity that is not an ADI and:

•

is a registered corporation under the Financial Corporations Act 1974 ;

•

is a securitisation vehicle; or

•

holds a dealers licence granted under Part 7.3 of the Corporations Law where:

-

the entity carries on a business of dealing in securities; and

-

that business is not carried on predominantly for the purpose of dealing in securities with, or on behalf of, the entitys associates (the term associate is discussed in Chapter 7).

[Schedule 2, item 31, definition of financial entity in subsection 995-1(1)]

2.19 An inward investor (general) is a non-resident that is neither a financial entity nor an ADI at any time during the period and claims debt deductions against its Australian assessable income for the period. These will be referred to as foreign general investors in this chapter. [Schedule 1, item 1, subsection 820-185(2), item 3 in the table]

2.20 Similarly, an inward investor (financial) is a non-resident financial entity that is a non-ADI which claims debt deductions against its Australian assessable income for the period. These will be referred to as foreign financial investors in this chapter. [Schedule 1, item 1, subsection 820-185(2), item 4 in the table]

What is the thin capitalisation rule for inward investing entities (non-ADI)?

Thin capitalisation rule

2.21 The thin capitalisation rules disallow all or part of an entitys debt deductions for the income year where the gearing of the Australian operations or investment exceeds a prescribed limit. The prescribed limit is exceeded where an entitys adjusted average debt exceeds its maximum allowable debt . [Schedule 1, item 1, subsection 820-185(1)]

What is an entitys adjusted average debt?

2.22 An entitys adjusted average debt for an income year is:

•

the average value of its debt capital that gives rise to its debt deductions ; less

•

if the entity is a (general or financial) foreign controlled Australian entity, the average value of the entitys associate entity debt ; or

•

if the entity is a foreign (general or financial) investor, the average value of the entitys associate entity debt but only to the extent that debt is attributable to the entitys permanent establishments in Australia.

[Schedule 1, item 1, subsection 820-185(3)]

2.23 Where the entity has debt capital which does not give rise to debt deductions, that debt capital is not taken into account for thin capitalisation purposes. For example, loans on which interest or other expenses are not claimed as allowable deductions. This treatment recognises that, although these amounts are not equity, they provide capital to fund the entitys operations for which no debt deductions are claimed. The term debt deduction is discussed in paragraphs 1.57 to 1.62.

2.24 The characterisation of an instrument as debt or equity is determined by the New Business Tax System (Debt and Equity) Bill 2001. That bill also provides transitional treatment in relation to that characterisation for some instruments. Transitional measures are also required in the thin capitalisation measures to give effect to those debt/equity transitionals. For a detailed discussion of these characterisation issues see paragraphs 1.86 to 1.88.

2.25 The rules also operate where the entity or Australian investment is foreign controlled for only part of the year. [Schedule 1, item 1, section 820-225]

What is the average value of an entitys debt capital?

2.26 The term debt capital is discussed in paragraph 1.52. The provisions that set out the methods of calculating an average value are discussed in Chapter 8. [Schedule 2, item 26, definition of debt capital in subsection 995-1(1)]

2.27 The thin capitalisation rules seek to limit the amount of debt used to fund the Australian operations or investment. However, at this point, it should be noted that for a foreign controlled Australian entity, whether general or financial, this debt amount is all of its debt capital. For a foreign investor, whether general or financial, it is only the debt that is attributable to its Australian investments [Schedule 1, item 1, subsections 820-185(1) and 820-185(3)] . The term Australian investments is described in paragraph 2.97.

What is an entitys maximum allowable debt?

2.28 When added to an amount equal to its associate entity debt (if any), an entitys maximum allowable debt gives the maximum amount of debt that can be used to fund its Australian assets. In other words, this total amount is the maximum amount of debt that an entity can have so as not to breach the thin capitalisation rules. To determine if a breach has occurred, the entitys adjusted average debt is compared with the maximum allowable debt amount. [Schedule 1, item 1, section 820-185]

2.29 Reflecting the fact that there are 2 tests, the entitys maximum allowable debt is the greater of:

•

the safe harbour debt amount; and

•

the arms length debt amount.

[Schedule 1, item 1, section 820-190]

2.30 Although entities will be required to calculate their maximum allowable debt level, they will not be required to do so under both the safe harbour and the arms length tests. They will have the option to choose either one of these tests. However, since the first of these is a safe harbour amount, the second will normally only be determined where the entitys adjusted average debt is greater than the safe harbour debt amount. If the entitys adjusted average debt capital is less than the safe harbour amount there is no need to calculate the arms length amount. Additionally, an entity that fails the safe harbour debt test could choose not to calculate the arms length debt amount and have debt deductions disallowed on the basis of the safe harbour debt amount.

2.31 The safe harbour rule is calculated differently for each of the 4 types of entities that can be affected by the rules. However, the arms length debt amount is worked out in the same way for all 4 types of inward investing entities but different factors may have greater importance in the calculation for each type of entity.

What is the safe harbour rule for inward investing entities that are not ADIs?

General foreign controlled Australian entities

2.32 In the case of a foreign controlled Australian entity that is not a financial entity, the safe harbour rule requires that its Australian assets be funded by a debt to equity ratio of not more than 3:1.

2.33 The safe harbour debt amount is calculated by applying the following steps:

Step 1: Work out the average value, for the income year, of all the assets of the entity.

Step 2: Reduce the result of step 1 by the average value, for that year, of all the associate entity debt of the entity.

Step 3: Reduce the result of step 2 by the average value, for that year, of all the associate entity equity of the entity.

Step 4: Reduce the result of step 3 by the average value, for that year, of all the non-debt liabilities of the entity for that year.

Step 5: Multiply the result of step 4 by three-quarters.

Step 6: Add to the result of step 5 the average value for that year of the entitys associate entity excess amount .

The result is the safe harbour debt amount.

[Schedule 1, item 1, section 820-195; Schedule 2, item 60, definition of safe harbour debt amount in subsection 995-1(1)]

Why are loans provided to associates deducted from the adjusted average debt of the entity?

2.34 Where an entity borrows funds and on-lends those funds to its associate, the same pool of debt could be tested in both entities when in economic terms there is really only one loan transaction. The associate entity debt rule eliminates the debt in the interposed lending entity so that the same pool of debt is not tested twice. For example, the associate entity debt rule would operate where 2 or more companies are involved in a joint venture and the joint venture entity is an associate entity of the companies. The entity through which the joint venture is operated may be prevented from borrowing in its own right from unassociated lenders. Where the debt is raised by the joint venturers and on-lent to the joint venture entity in these circumstances, it will be ignored for thin capitalisation purposes in the hands of the joint venturers.

2.35 Associate entity debt is deductedin the calculation of adjusted average debt which is compared with the maximum allowable debt. It is also deducted from assets in the calculation of the safe harbour amount. The deduction from average debt and from assets is to ensure that the loan asset may be fully funded by borrowings. [Schedule 1, item 1, subsection 820-185(3) and section 820-195]

When does the associate entity debt rule apply?

2.36 To qualify for associate entity debt treatment there are a number of conditions that must be satisfied. The conditions are:

•

the associate entity is either an outward investing entity (non-ADI) or an inward investing entity (non-ADI);

•

the debt interest in relation to the loan to the associate entity remains on issue at that time;

•

payments by the associate entity for the costs of the loan must be assessable income of the lending entity. The costs of the loan may include fees or charges including application fees, lines fees, service fees, brokerage and stamp duty. Some of these fees would ordinarily be payable to parties other than the test entity. The fact that such amounts will not be assessable income of the lending entity will not preclude this condition from being met; and

•

the terms and condition of the loan to the associate entity are arms length.

2.37 These conditions seek to ensure that the associate entity debt is being tested for thin capitalisation purposes in one entity. They also seek to ensure that the debt deductions claimed in the test entity in relation to the associate entity debt are matched with an arms length amount of assessable income for the test entity from the associate entity debt. [Schedule 1, item 1, section 820-910]

How is associate entity debt calculated?

2.38 The associate entity debt amount is calculated using the method statement in subsection 820-910(2). [Schedule 2, item 10, definition of associate entity debt in subsection 995-1(1)]

Example 2.1

Entities A Co and B Co, both inward investors, each hold 50% equity in a joint venture vehicle, C Co, which undertakes purely domestic Australian operations. A Co has provided a loan to C Co of $100 million. The terms and conditions of the loan are consistent with normal commercial arrangements and the interest is assessable income for A Co.

A Cos loan to C Co may be treated as associate entity debt as described in section 820-910 provided C Co is an associate entity of A Co and C Co is subject to thin capitalisation rules.

To determine whether C Co is an associate entity of A Co, we look to section 318(2)(e)(i)(A) of the ITAA 1936 which provides that if A Co can sufficiently influence C Co then C Co is an associate. Sufficiently influence is further explained in subsection 318(6) of the ITAA 1936. In deciding whether a company is sufficiently influenced by another entity it is not necessary that the company is controlled by the other, only that it can be reasonably expected to act in accordance with the directions, instructions or wishes of the other. Generally speaking, C Co would be an associate of the 2 joint venturers, A Co and B Co, because it is expected each would have sufficient influence over C Co.

Having established that C Co is an associate entity of A Co and that C Co will be subject to the thin capitalisation rules, A Co is able to deduct $100 million from its average debt amount. A Co must also deduct $100 million from its assets in the calculation of its safe harbour amount (at step 2 in the method statement).

Why is equity in associates of the entity deducted from the assets of the entity?

2.39 An entitys associate entity equity is the total value of equity interests that an entity holds in any entities that are its associate entities. [Schedule 1, item 1, section 820-915; Schedule 2, item 11, definition of associate entity equity in subsection 995-1(1)] . This amount is deducted from the assets of the entity as an integrity measure to prevent double counting or the cascading of equity through a chain of entities. The net effect of not deducting associate entity equity would be to permit a group of associated entities to gear up in excess of the safe harbour amount. This deduction rule will not apply where the associates and the entity form a group, therefore it only applies to equity in ungrouped associate entities. Moreover, where the associate entity does not gear up on its equity funds to the extent permitted by the thin capitalisation regime, there will be a reduction in the penalty effect of deducting associate entity equity from assets. This is done through the addition of what is called the associate entity excess amount .

2.40 Example 2.2 illustrates the rationale behind the deduction of the equity held in associate entities.

Example 2.2

Foreign parent invests $100 into its wholly-owned Australian holding company (AusHold). The subsidiary uses the funds to invest in Ausub1. Ausub1 then invests the funds in Ausub2.

The ownership structure is depicted in the following diagram:

Each of the Australian entities is a foreign controlled entity (see Chapter 7) and accordingly the thin capitalisation rules will apply to each entity.

By deducting the associate entity equity from the assets of each entity in the chain of companies, the measures ensure that there is no double counting of the $100 equity. In this case only $100 has been introduced as equity and not $300.

The result of deducting the associate entity equity held by each Australian entity in the chain (except Ausub2 - which does not have any associate entity equity) is that each entity is unable to increase its maximum allowable debt because its assets include the investment in its associate.

Why is the associate entity excess amount added to the safe harbour calculation?

2.41 The deduction of associate entity equity from assets in the calculation of the safe harbour debt amount, assumes that the value of the associate entity equity is used to fully leverage debt in the associate entity. Where this is not the case, the associate entity equityrule can produce a harsh outcome. In order to address this, the rules allow excess debt capacity of an associate entity to be carried back to the entity with the equity investment (the investing entity). The carry back seeks to reduce the full impact of the associate entity equity rule by recognising the actual gearing of the associate and any premium/discount in the carrying value of the associate entity equity amount. At the extremes, (and apart from any premium or discount in the value of the associate entity) there is:

•

a full carry back of the associate entity equity amount where the associate entity has no debt; and

•

no carry back where the associate entitys debt exceeds its safe harbour debt amount.

What is the associate entity excess amount?

2.42 The associate entity excess amount is relevant for an entity that is either an outward investing entity (non-ADI), or an inward investing entity (non-ADI). It is calculated as follows:

Step 1: Determine the premium excess amount for the associate at the measurement date.

Step 2: Add to step 1 the attributable safe harbour excess amount for the associate at the measurement date.

Step 3: Aggregate the associate entity excess amounts for each associate where the associate entity excess amounts are positive.

[Schedule 1, item 1, subsection 820-920(2); Schedule 2, item 12, definition of associate entity excess amount in subsection 995-1(1)]

2.43 The result of step 3 is the amount of associate entity excess at the measurement date. This is done for each measurement day which the investing entity is using to calculate its average values and its safe harbour debt amount.

What is the premium excess amount?

2.44 The premium excess amount arises where the books of account of the investing entity and those of its associate place different values on the assets of the associate. The debt capacity of any such difference is the premium excess amount. Where the amount is negative (i.e. the equity investment is valued at a discount to net assets) it is treated as a negative amount.

How is the premium excess amount calculated?

2.45 The entitys premium excess amount is calculated as follows:

Step 1: Determine the associate entity equity for the associate entity.

Step 2: Step 1 minus the equity capital of the associate entity attributable to the investing entity.

Step 3: Step 2 is multiplied by the fraction that is used to determine the maximum allowable debt of the investing entity (i.e. 3/4, 20/21 or the worldwide gearing amount fraction).

[Schedule 1, item 1, subsection 820-920(3)]

How is the attributable safe harbour excess amount calculated?

2.46 The entitys attributable safe harbour excess amount is calculated as follows:

Step 1: Determine the safe harbour debt amount for the associate entity.

Step 2: Step 1 minus the adjusted average debt of the associate entity.

Step 3: Step 2 multiplied by the proportion of the associate entitys equity capital that is attributable to the investing entity.

[Schedule 1, item 1, subsection 820-920(4)]

2.47 The result of Step 3 is the amount of excess debt capacity in the associate entity that is transferable to the investing entity. Where the outcome is negative (i.e. the associate entitys adjusted debt is greater than its safe harbour amount), it is treated as a nil amount.

Example 2.3

TR Co is a general foreign controlled Australian entity. TR Co purchases 90% of equity in B Co for $3 million. (TR Co pays a premium of $1.65 million to acquire equity capital worth $1.35 million). B Co is a general foreign controlled Australian entity. All values are for a particular measurement day of TR Co.

Premium excess

Step 1: TR Cos associate entity equity for B Co = $3 million.

Step 2: Step 1 minus equity capital of B Co attributable to TR Co$1.35 million = $1.65 million.

Step 3: Step 2 multiplied by the fraction that it is used to determine the maximum allowable debt of TR Co (3/4) = $1.2375 million.

Attributable safe harbour excess

Step 1: B Cos safe harbour amount ($4 million 3/4) = $3 million.

Step 2: Step 1 minus adjusted debt of B Co ($2.5 million) = $0.5 million.

Step 3: Step 2 multiplied by the proportion of B Co equity attributable to TR Co (90%) = $0.45 million.

Associate entity equity excess

Step 1: Attributable safe harbour excess is $0.45 million.

Step 2: Step 1 plus premium excess of $1.2375 million gives $1.6875 million.

$1.6875 million is the associate entity excess from B Co at the measurement date.

Note that this is not the full 75% of TR Cos associate entity equity amount of $3 million. This is because B Co has used the equity capital paid for by TR Co to increase its own debt.

Does the equity in the associate entity have to be held for the whole period?

2.48 The associate entity excess amount is calculated at each measurement date used by the investing entity, for each associate entity. It is a point in time calculation, so that differing tax years of associates can be accommodated. The values used for this calculation are those that exist at the time of measurement and the investing entity does not have to have held the equity interest in the associate entity for the period prior to the measurement date. The calculation of the safe harbour debt amount of the associate entity and its adjusted debt are for the period of one day at the measurement date.

2.49 Where the associate entity excess amount for a particular associate entity is negative, it is disregarded. That is, there is no further penalty for the investing entity. The associate entity excess amounts for all other associate entities are aggregated at each measurement date. The aggregate associate entity excess amount at each measurement date is averaged to determine the average associate entity excess amount for the entity for the income year or part thereof.

Example 2.4

E Co, a general foreign controlled entity with 3 measurement dates owns J Co with an associate entity excess amount of $300 at each measurement date. E Copurchased 60% of H Co on the day before E Cos secondmeasurement date. The associate entity excess for H Co is nil on the first measurement date, $120 on the second measurement date and $90 on the third measurement date. The associate entity excess for the year is:

(($300 + $0) + ($300 + $120) + ($300 + $90)) / 3 = $370.


E Co can add $370 to its safe harbour debt amount for the year.

Why are non-debt liabilities deducted from assets?

2.50 The thin capitalisation safe harbour debt amounts are based on gearing ratios of3:1 and 20:1 for general and financial businesses respectively. For general businesses, the maximum allowable debt is equal to three-quartersof the entitys assets, after deducting non-debt liabilities (amongst certain other items). That approach recognises that if the 4 funding parts (i.e. 3 parts debt and 1 part equity) of a 3:1 gearing ratio are used to finance an entitys assets, then neither debt nor equity funds the amount of assets above the combined debt and equity sum.

2.51 The accounting equation recognises that the value of a firms assets equals the sum of its liabilities and equity. Given that debt is a subset of liabilities, it follows that the value of a firms assets equals the sum of its debt, non-debt liabilities and equity. Accordingly, in setting a 3:1 debt to equity safe harbour ratio based on the value of a firms assets, the maximum debt is equal to three-quarters of the net assets (i.e. assets minus non-debt liabilities).

2.52 An entitys non-debt liabilities are presently existing obligations that an entity owes to another entity. However, the following are specifically excluded:

•

its debt capital;

•

any equity interests in the entity; and

•

a provision for a distribution of profits where the entity is a corporate tax entity.

[Schedule 2, item 48, definition of non-debt liabilities in subsection 995-1(1)]

2.53 Non-debt liabilities must be a present obligation. An obligation will be present if the event giving rise to the obligation has already occurred. That is, the obligation cannot be contingent. An obligation that will arise in the future is therefore not present unless the actual event triggering the obligation occurs. For example, a requirement to pay long service leave does not become a present obligation until the relevant employee takes the leave accrued. Obligations under insurance policies are not present obligations until the event that gives rise to the claim has occurred.

2.54 The exclusion of provisions for profit distributions recognises that although these provisions represent liabilities of an entity, provisions for dividends and like distributions are seen as representing part of an entitys equity capital, rather than liabilities, for the purposes of thin capitalisation. Similarly the exclusion of equity interests in an entity recognises that the application of the debt/equity rules to a liability, within the ordinary meaning of the term, could characterise a non-debt liability as an equity interest for tax purposes. That interest should then be treated as equity for thin capitalisation purposes.

Why are the net Australian assets of the entity multiplied by three-quarters in calculating the safe harbour debt amount?

2.55 The safe harbour debt amount is determined by multiplying the average value of the net Australian assets of the entity by three-quarters [Schedule 1, item 1, section 820-195, step 5 of the method statement] . This amount represents the maximum amount of debt that the entity can use to fund its net assets (as calculated), so as to satisfy the safe harbour rule. Similarly, the remaining one quarter represents the minimum amount of equity that the entity must have to satisfy the equity requirements of the rule. This safe harbour funding mix reflects the policy of a maximum gearing ratio for debt to equity of 3:1.

Comparing average debt with the safe harbour amount

2.56 If the adjusted average debt exceeds the safe harbour debt amount then the entity has not satisfied the 3:1 debt to equity requirement. Conversely, if the adjusted average debt is less than the safe harbour debt amount the entity has satisfied the safe harbour rule. Example 2.5 illustrates the rationale behind the rule.

Example 2.5

The following average values have been extracted from Safecos balance sheet for the year ended 30 June 2002. The company is foreign controlled during the whole year.

Assets		Liabilities		Ratio
Current Assets	$20	Loan	$75	3 (debt)
Non-current assets	$80	Equity	$25	1 (equity)
	$100		$100

Safeco does not have any non-debt liabilities, associate entity debt or associate entity equity.

Under the safe harbour rule Safecos average asset figure of $100 is multiplied by three-quarters to arrive at its safe harbour debt amount (i.e. $100 = $75). Hence, Safecos assets can be funded by no more than $75 of debt and at least $25 of equity (i.e. $100 ). Given Safecos level of debt funding it has satisfied the 3:1 debt to equity ratio permitted under the safe harbour rule.

What if an entitys adjusted average debt exceeds its safe harbour debt amount?

2.57 If an entitys adjusted average debt capital exceeds its safe harbour debt amount an adjustment to disallow some or all of its debt deductions will occur unless the entity can demonstrate that the level of debt is acceptable on an arms length basis. The arms length debt amount is discussed in Chapter 10.

Example 2.6: General foreign controlled Australian entity

ForCo is a non-resident company that wholly owns Austco. ForCo has loaned Austco $2.5 million. Austco has also borrowed $2.5 million from an unrelated Australian financial entity.

The ownership structure and relevant transactions can be represented in the following diagram:

Austcos average assets are $7 million and consist of the following:

Current assets: $2 million

Non-current assets

•

buildings - $3.5 million

•

plant and equipment - $1.5 million

Austcos total assets have an average value of $7 million (Chapter 8 discusses the methods used to calculate average values).

Austco has non-debt liabilities of $0.5 million.

Austcos average value of debt capital is $5 million.

Austco is a foreign controlled Australian entity and accordingly will be subject to the thin capitalisation rules. [Schedule 1, item 1, subsection 820-185(2), item 1 in the table]

Calculations - safe harbour debt amount

Austco

Step 1: The average value of all of the assets of Austco equals $7 million.

Step 2: The average value of Austcos associate entity debt is zero. Therefore, the result of step 2 is $7 million.

Step 3: The average value of Austcos associate entity equity is zero. Therefore, the result of step 3 is $7 million.

Step 4: The average value of Austcos non-debt liabilities is $0.5 million. Therefore, the result of step 4 is $6.5 million.

Step 5: Multiplying the result of step 4 by three-quarters equals $4.875 million.

Step 6: The average value of the associate entity excess amount is zero. Therefore, the safe harbour debt amount equals $4.875 million.

The safe harbour debt amount of $4.875 million represents the maximum level of debt permitted under the general safe harbour of 3:1. That is, after taking into account non-debt liabilities, Austcos average net Australian assets of $6.5 million could be funded by a maximum debt amount of $4.875 million and average equity amount of not less than $1.625 million. This would satisfy the maximum debt to equity gearing ratio of 3:1.

Given that Austcos average debt capital for the period is $5 million it has not satisfied the general safe harbour rule. It has exceeded the safe harbour debt amount by $125,000.

An adjustment to its debt deductions for the period will arise if Austco is not able to demonstrate that the level of debt funding is acceptable under the arms length rule.

Foreign controlled Australian financial entity

2.58 In the case of foreign controlled Australian financial entities, the safe harbour rule takes into account the need for greater debt funding to support their financial intermediation activities. The on-lending rule will operate to remove certain amounts from the thin capitalisation rules where those amounts essentially represent lending to other parties, including associates. However, this does not require the entity to trace its borrowings to those amounts.

2.59 Debt which falls within the associate entity debt rule will also fall within the definition of on-lent amount . The method statements that apply to financial entities ensure that there is no double counting of these amounts. [Schedule 2, item 50, definition of on-lent amount in subsection 995-1(1)]

2.60 The remaining part of the entitys business that is not subject to the on-lending rule will be subject to the general safe harbour rule of 3:1. However, generally this will be subject to an overall gearing limit of 20:1. Therefore, depending on the level of lending activity (as a proportion of the total business), the entitys maximum allowable debt will reflect a gearing level of between 3:1 and 20:1. The greater the proportion of on-lending activity the closer the overall gearing level will be to 20:1.

2.61 However, where the financial entity has assets that are zero-capital amounts , higher gearing levels than the 20:1 limit will be permitted. These amountsare effectively taken out of the safe harbour debt amount calculation and debt deductions are fully allowed in respect of these amounts. This recognises the relatively smaller gross margins at which this business falling within the zero-capital amount is conducted.

2.62 The on-lending rule does not apply to specialist in-house finance companies within non-financial groups unless those companies are registered under the Financial Corporations Act 1974 .

What is the safe harbour debt amount?

2.63 The safe harbour debt amount is the lesser of:

•

the total debt amount ; and

•

the adjusted on-lent amount .

2.64 The first of these is based on an overall 20:1 debt to equity ratio applying to the whole business with an allowance for assets falling within the zero-capital amount. The second incorporates the on-lending concession and applies the 3:1 limit to that part of the business which does not fall within that concession. The lesser amount is taken to ensure the debt to equity ratio is capped at 20:1, subject to the allowances for the zero-capital amount. [Schedule 1, item 1, subsection 820-200(1)]

What is the total debt amount?

2.65 The total debt amount is calculated by applying the following steps:

Step1: Work out the average value, for the income year, of all the assets of the entity.

Step 2: Reduce the result of step 1 by the average value, for that year, of all the associate entity debt of the entity.

Step 3: Reduce the result of step 2 by the average value, for that year, of all the associate entity equity of the entity.

Step 4: Reduce the result of step 3 by the average value, for that year, of all the non-debt liabilities of the entity.

Step 5: Reduce the result of step 4 by the value, for that year, of the entitys zero-capital amount .

Step 6: Multiply the result of step 5 by 20/21.

Step 7: Add to the result of step 6 the zero-capital amount.

Step 8: Add to the result of step 7 the average value of the entitys associate entity excess amount for that year.

The result of this step is the total debt amount.

[Schedule 1, item 1, subsection 820-200(2)]

What is the zero-capital amount?

2.66 The zero-capital amount provides a carve-out of certain assets from the thin capitalisation regime and as a consequence allows full debt funding for these qualifying assets. As explained in paragraph 2.61, these amounts will not be subject to the 20:1 ratio. The zero-capital amount is the sum of the following 4 amounts:

•

amounts received by the entity for the sale of securities (other than any fees associated with the sale) under the following arrangements where the securities have not been repurchased:

-

reciprocal purchase agreements;

-

sell-buyback arrangements; and

-

securities loan arrangements;

•

the total value of debt interests issued to the entity that remain on issue where:

-

the debt interests are loans of money for which no fees or charges other than interest is imposed; and

-

the long term foreign corporate credit rating of the issuer of the debt interest, at the time that it issued, was at least BBB (or equivalent) as rated by an internationally recognised credit agency. For ease of explanation these will be referred to as low margin loans;

•

the total value of the debt interests issued to the entity, that remain on issue at that time, where the debt interests have a risk-weighting of 0% or 20% under the prudential standards. For ease of explanation these will be referred to as low risk-weighted loans; and

•

the total value of an entitys securitised assets if the entity is a securitisation vehicle.

[Schedule 1, item 1, subsection 820-942(1); Schedule 2, item 74, definition of zero-capital amount in subsection 995-1(1)]

What are reciprocal purchase agreements, sell-buyback arrangements and securities loan arrangements?

2.67 These financial arrangements can be described as follows:

•

a REPO is a cash financing arrangement involving 2 transactions. Firstly, party A agrees to sell securities (e.g. government bonds) to party B in return for cash. Secondly, party B agrees to resell the securities to party A at a future date. The purchaser of the securities receives legal title to enable it to deal with the securities. Title returns when the securities are repurchased;

•

a sell-buyback arrangement is one where the parties enter into separate sell and buy transactions for securities. These transactions are entered into at the same time with settlement at some date in the future. The purchaser of the securities receives legal title until they are repurchased; and

•

a securities loan arrangement is an arrangement where one party lends securities to another on the payment of collateral. For example, party A agrees to lend securities (e.g. shares) to party B. In turn, party B agrees to return the securities to party A at a future date and provides collateral (e.g. cash or other securities) for the loan. Once again, the party acquiring the securities (in this case party B) obtains full title to the securities until they are repurchased by party A.

2.68 Typically, although the value of the assets which form part of these transactions is large, the gross profit margin is very small. If the thin capitalisation rules were applied to all the assets which form part of these arrangements, entities would need to hold a disproportionate amount of capital given the correspondingly small gross profit margin. In order to address this issue, the rules carve out any payments received for the sale of the securities (other than fees) under these arrangements. The effect is that entities will not be required to hold capital against assets which it holds at law and which form the basis of these arrangements.

What are low margin loans?

2.69 It is common for gross profit margins in financing arrangements to be determined by the difference between the interest rate at which the lender can itself borrow funds and the interest rate which the lender charges the borrower. These interest rates are usually determined by the credit rating of both the lender and the borrower. Generally, where the credit rating of the borrower is sufficiently high, the gross profit margin for the lender will be small.

2.70 As is the case with the securities transactions discussed in paragraph 2.67, these loans are typically large but the gross profit margin from this business is very small. As a result, lenders need to reduce the amount of capital held against these loans given the small gross profit margins, to earn a sufficient rate of return on the capital. An example of such loans are short-term bridging finance used by entities to fund corporate acquisitions.

2.71 In order to address this issue, lenders will not be required to hold capital against the loan assets. However, to ensure that only low margin lending falls within the concession and that the credit rating has been independently determined the legislation requires that:

•

the long term foreign corporate credit rating of the issuer of the debt interest (the borrower), at the time that it is issued, was at least BBB (or equivalent); and

•

the credit rating must have been provided by an internationally recognised credit rating agency.

2.72 Further, no fees or charges other than interest can be imposed on these loans. This requirement is designed to prevent high margin business being moved to arrangements which fall within the concession by substituting fee income for interest income.

What are low risk-weighted loans?

2.73 Under the capital adequacy regime ADIs are required to risk weight assets so that appropriate amounts of capital are held against their assets. The thin capitalisation rules which apply to ADIs are based on the capital adequacy regime, including the prudential standards. Chapters 4 and 5 discuss this in detail.

2.74 The prudential standards provide that certain assets of an ADI are to be risk weighted to 0% or 20%. For example, bonds issued by the Commonwealth government have a 0% risk weighting and claims guaranteed by Australian local governments have a 20% risk weighting. Including low risk-weighted loans within the zero-capital amount will give these loans by non-ADIs roughly similar treatment to that provided to ADIs under the ADI rules.

What is securitisation?

2.75 Securitisation is the pooling of assets in a special purposes vehicle in order to move assets (e.g. mortgages and leases) from the balance sheet of the owner (the originating entity) to the special purposes vehicle. The acquisition of the assets from the originating entity is fully funded by the issue of debt securities. The effect of securitisation is to enhance the cash flow of the originating entity by transferring non-liquid assets to the special purposes vehicle in exchange for a liquid asset such as cash.

2.76 An integral feature of securisation is that the special purposes vehicle is 100% debt funded on a stand alone basis. As a consequence, these vehicles would fail the thin capitalisation requirements because they would generally be geared in excess of the 20:1 limit. In recognition of the particular structure and commercial function of securitisation, certain assets held by special purpose vehicles will be included within the zero-capital amount. However, in order to qualify for the concession the vehicle must be a securitisation vehicle and the assets must be securitised assets .

Securitisation Vehicle

2.77 An entity will be a securitisation vehicle for thin capitalisation purposes if:

•

the entity has been established for the purpose of acquiring, funding and holding securitised assets;

•

the entity has acquired the securitised assets from another entity (the originator);

•

the acquisition of the securitised assets is wholly funded by the entity issuing debt interests;

•

in issuing those debt interests the entity has not received any guarantee, security or other form of credit support from any of its associate entities, the originator or an associate entity of the originator;

•

there are no debt interests issued to the entity by any of its associate entities, the originator or an associate entity of the originator; and

•

any arrangement that the entity has with its associate entities, the originator or an associate entity of the originator, is at arms length.

[Schedule 1, item 1, subsection 820-942(2)]

2.78 A securitisation vehicle is a financial entity for the purposes of the thin capitalisation regime. [Schedule 2, item 31, definition of financial entity in subsection 995-1(1)]

2.79 Note the term associate entity is explained in paragraphs 7.86 to 7.98.

Securitised Asset

2.80 An asset of an entity is a securitised asset if:

•

the entity is a securitisation vehicle;

•

the asset is either:

-

a debt interest issued by another entity other than the originating entity; or

-

a lease for the hire of goods falling within paragraph (b) of the definition of on-lent amount if the originating entity satisfies the requirements of that paragraph; and

•

the asset provides security for the issuing of a debt interest that funded the acquisition of the asset by the securitisation vehicle.

[Schedule 1, item 1, subsection 820-942(3)]

Why are the net assets of the entity multiplied by 20/21 in calculating the safe harbour debt amount?

2.81 The fraction 20/21 is best understood as arising from the 20:1 ratio in the same way as three-quarters corresponds to the 3:1 ratio. This amount represents the overall amount of debt that the entity can have to satisfy the debt to equity ratio of20:1 applied to its net assets as calculated in the method statement.

2.82 Example 2.7 illustrates the rationale behind the total debt amount calculation:

Example 2.7

The following average values have been extracted from Safefins balance sheet for the year ended 30 June 2002. The company is a foreign controlled financial entity during the whole income year.

Assets		Liabilities		Ratio
Loans provided	$90	Loan	$95	19 (debt)
Other assets	$10	Equity	$5	1 (equity)
	$100		$100

Safefin does not have any non-debt liabilities, any associate entity equity nor does it undertake any transactions which would fall under the zero-capital amount.

Under the total debt amount calculation Safefins average assets value of $100 is multiplied by 20/21 to arrive at the total debt amount (i.e. $100 20/21 = $95.24). At $95 Safefins debt satisfies this requirement.

2.83 It should be noted that the total debt amount is only one part of the safe harbour test for financial entities. A discussion of how the total debt amount and the adjusted on-lent amount interact is in paragraphs 2.63 and 2.64

What is the adjusted on-lent amount?

2.84 The adjusted on-lent amount is the second calculation required to calculate the safe harbour debt amount. The adjusted on-lent amount calculation operates to remove the assets which fall within the definition of on-lent amount so as to ensure that the entitys other assets are funded by a debt to equity ratio of not more than 3:1. The adjusted on-lent amount is calculated using the following steps:

Step 1: Work out the average value, for the income year, of all the assets of the entity.

Step 2: Reduce the result of step 1 by the average value, for that year, of all the associate entity equity of the entity.

Step 3: Reduce the result of step 2 by the average value, for that year, of all the non-debt liabilities of the entity.

Step 4: Reduce the result of step 3 by the average value, for that year, of the on-lent amount of the entity.

If the result of this step is negative, it is reset to zero.

Step 5: Multiply the result of step 4 by three-quarters.

Step 6: Add to the result of step 5 the average value, for that year, of the on-lent amount of the entity.

Step 7: Reduce the result of step 6 by the average value of all the associate entity debt of the entity.

Step 8: Add to the result of step 7 the entitys associate entity excess amount . The result is the adjusted on-lent amount.

[Schedule 1, item 1, subsection 820-200(3)]

2.85 Any associate entity debt is deducted at step 7 simply to avoid double counting. It is deducted from debt capital in calculating adjusted average debt and so should not be added back.

What is the on-lent amount?

2.86 The on-lent amount of an entity means:

•

the value of its assets that are comprised by:

-

debt interests issued to the entity by other entities; and

-

leases for the hire of goods which are not debt interests issued by other entities where:

•

the leases are for a term of 6 months or more;

•

the leases are part of the business of hiring goods carried on by the entity; and

•

the entitys business of hiring of goods is not carried on predominantly for the purpose of hiring goods to any of its associates (as defined in section 318 of the ITAA 1936); plus

•

the value of securities that were held by the entity that:

-

have been sold by the entity under a reciprocal purchase agreement, sell-buyback arrangement or securities loan arrangement; and

-

have not yet been repurchased by the entity under the agreement or arrangement.

[Schedule 2, item 50, definition of on-lent amount in subsection 995-1(1)]

2.87 The treatment of the on-lent amount is an acknowledgment that financial entities are in the business of borrowing funds in order to on-lend those funds to third parties, including associates. It recognises that these entities require higher gearing ratios in order to undertake their normal commercial activities. However, the inclusion of certain leases and securities lending and repurchase arrangements recognises that there are similarities between the lending of funds and these other activities.

Why are certain leases included within the on-lent amount?

2.88 Under the current law, the majority of leases are not treated as debt for tax purposes. Consistent with the current approach, the definition of debt interest will not include leases unless they are debt for the purposes of the existing income tax law. The definition of on-lent amount will ensure that certain leases which are not debt interests will nevertheless qualify for the on-lending concession because of the equivalence of this business to that of lending.

Why are certain securities included within the on-lent amount?

2.89 Payments received for the sale of the securities (other than fees) under reciprocal purchase agreements, sell-buyback arrangements and securities loan arrangements are included within the zero-capital amount. To ensure that securities under the abovementioned arrangements receive on-lending treatment these securities are included within the on-lent amount where they have not been repurchased under the arrangement. This is notwithstanding that, as the securities have been sold, they do not legally form part of the assets of the entity. However, this treatment recognises that the acquisition of the securities may have been funded through debt which has not been extinguished because the disposal of the securities is only a temporary disposal.

2.90 It should be noted that the other assets which come within the zero-capital amount (securitised assets, low margin loans and low risk-weighted loans) also fall within the definition of on-lent amount . Specifically, these assets are assets held by the entity that are comprised by debt interests issued by other entities.

Comparing the total debt amount and the adjusted on-lent amount

2.91 If the adjusted on-lent amount is equal to or greater than the total debt amount, the safe harbour debt amount is the total debt amount. This will ensure that the gearing is capped at 20:1 (subject to the carve-out of the zero-capital amount). If the adjusted on-lent amount is less than the total debt amount it is the safe harbour amount. [Schedule 1, item 1, subsection 820-200(1)]

2.92 Generally, depending on the proportion of on-lending activity undertaken by the financial entity, the actual safe harbour gearing ratio will be somewhere between 3:1 and 20:1. However, a safe harbour in excess of 20:1 will be possible where the entity has assets which fall within the zero-capital amount.

2.93 Example 2.8 illustrates the rationale behind the adjusted on-lent amount calculation.

Example 2.8

Following on from Example 2.7 Safefins balance sheet for the year ended 30 June 2002 is reproduced below.

Assets		Liabilities
Loans provided	$90	Loan	$95
Other assets	$10	Equity	$5
	$100		$100

Safefin does not have any non-debt liabilities, associate entity debt or associate entity equity. It does not hold any assets which fall within the zero-capital amount.

Safefins adjusted on-lent amount is calculated by adding the value of the loan assets of $90 and the value of the other assets (the non-lending assets) multiplied by three-quarters. This amount equals $97.50. That is, Safefins non-lending assets of $10 can be funded by no more than $7.50 of debt ($10 3/4 = $7.50) whereas the on-lent amounts ($90) can be funded totally by debt. This means that under the on-lending rule Safefin could effectively have $97.50 in debt to fund its Australian operations. This would reflect an overall gearing ratio of 40:1.

However, in Safefins case the safe harbour debt amount limits the overall gearing of the entity to a gearing level of 20:1 because it does not have assets which fall within the zero-capital amount. The safe harbour debt amount is the lesser of the total debt amount and the adjusted on-lent amount. Therefore, as the total debt amount is $95.24 ($100 20/21), which is the lesser of the 2 amounts, it is the safe harbour debt amount.

Thus, Safefin is limited to a gearing ratio of 20:1.

Example 2.9: Foreign controlled Australian financial entity

Forent (a foreign entity) owns 100% of AustFin1. AustFin1 is a financial entity that provides a range of financial services. It has provided loans to unrelated parties of $30 million. AustFin1 has invested $5 million into Assoc2 and holds a 75% interest in the company. Assoc2s primary business activity is land development. It is not a financial entity.

AustFin1s principle source of funds for carrying on its activities is debt financing.

The relevant transactions can be represented in the following diagram:

AustFin1s average assets are as follows:

Current assets	$2 million
Investment in Assoc2	$5 million
Loans to unrelated parties	$30 million
Other non-current assets	$4 million

AustFin1s total assets have an average value of $41 million (Chapter 8 discusses the methods used to calculate average values).

AustFin1 has non-debt liabilities of $1 million and average debt of $35 million.

AustFin1 is a foreign controlled company. Accordingly the entity will be subject to the thin capitalisation rules as a foreign controlled Australian financial entity.

Note (a): Austfin does not have any assets that come within the zero-capital amount. Example 3.2 demonstrates how the safe harbour debt amount is calculated for a financial entity which holds these types of assets. Please note that the example deals with an outward investing Australian financial entity.

Note (b): Assoc2 is also a foreign controlled company. It will be subject to the thin capitalisation rules for general foreign controlled Australian entities. Example 2.3 demonstrates how the thin capitalisation rules affect a foreign controlled Australian company that is not a financial entity. Austfin paid a premium of $1 million for its stake in Assoc2. Assoc2 has excess debt capacity of $0.5 million.

Calculations - safe harbour debt amount

AustFin1

Total debt amount

Step 1: The average value of all the assets of AustFin1 equals $41 million.

Step 2: The average value of AustFin1s associate entity debt is zero. Therefore, the result of step 2 is $41 million.

Step 3: The average value of AustFin1s associate entity equity is $5 million. Therefore, the result of step 3 is $36 million.

The $5 million invested in Assoc2 does not increase the maximum debt that AustFin1 may have unless there is excess debt capacity in Assoc2 or AustFin1 has paid a premium for its equity in Assoc2.

Step 4: The average value of AustFin1s non-debt liabilities is $1 million. Therefore, the result of step 4 is $35 million.

Step 5: AustFin1 does not have any zero-capital amount. Therefore, the result of step 5 is $35 million.

Step 6: Multiplying the result of step 5 by 2021 equals $33.33 million.

Step 7: As AustFin1 does not have any zero-capital amount, the result of step 7 is $33.33 million.

Step 8: The associate entity excess amount is $1.327 million. The total debt amount is $34.657 million.

The premium excess amount of Assoc2 is ($1 million multiplied by 20/21) $0.952 million. The attributable safe harbour excess amount of Assoc2 is ($0.5 million multiplied by AustFin1s equity holding of Assoc2, 75%) $0.375 million. The associate entity excess is the total of those 2 amounts which is $1.327 million.

Adjusted on-lent amount

Step 1: The average value of all of the assets of AustFin1 equals $41 million.

Step 2: The average value of AustFin1s average associate entity equity is $5 million. Therefore, the result of step 2 is $36 million.

Step 3: The average value of AustFin1s non-debt liabilities is $1 million. Therefore, the result of step 3 is $35 million.

Step 4: The average value of AustFin1s on-lent amount is $30 million. Therefore, the result of step 4 is $5 million.

Step 5: Multiplying the result of step 4 by three-quarters equals $3.75 million.

Step 6: Adding the average on-lent amount to the result of step 5 equals $33.75 million.

Step 7: The value of the associate entity debtof the entity is zero. Therefore, the result of step 7 is $33.75 million.

Step 8: The entitys associate entity excess amount is $1.125 million. Therefore, $34.875 million is the adjusted on-lent amount.

The premium excess amount of Assoc2 is ($1 million multiplied by 3/4) $0.75 million. The attributable safe harbour excess amount of Assoc2 is ($0.5 million multiplied by Austfins equity holding of Assoc 2: 75%) $0.375 million debt. The associate entity excess is the total of those 2 amounts which is $1.125 million.

As the total debt amount is less than the adjusted on-lent amount, the safe harbour debt amount is the total debt amount of $34.657 million.

The safe harbour debt amount of $34.657 million represents the maximum level of debt funding available to AustFin1 to fund its Australian operations. This amount is compared to AustFin1s average debt amount of $35 million. Hence, AustFin1 has not satisfied the safe harbour rule for financial entities.

An adjustment to disallow some of AustFin1s debt deduction will occur if it cannot demonstrate that its level of debt is acceptable under the arms length test.

Foreign general investor

2.94 The thin capitalisation rules will apply to non-residents who claim debt deductions in the course of deriving Australian assessable income. For example, the rule will apply to a non-resident company that operates in Australia through a permanent establishment (e.g. a branch) or to a non-resident partner in a partnership that derives Australian source income.

2.95 The safe harbour debt amount is calculated by applying the following method statement:

Step 1: Work out the average value, for the income year, of all of the Australian investments of the entity.

Step 2: Reduce the result of step 1 by the average value of all the associate entity debt of the entity from Australian investments.

Step 3: Reduce the result of step 2 by the average value, for that year, of all the associate entity equity of the entity from Australian investments.

Step 4: Reduce the result of step 3 by the average value of all the non-debt liabilities of the entity that have arisen because of those Australian investments. If the result is negative take it to be zero.

Step 5: Multiply the result of step 4 by three-quarters.

Step 6: Add to the result of step 5 the entitys associate entity excess amount . The result is the safe harbour debt amount.

[Schedule 1, item 1, section 820-205]

2.96 The safe harbour rule operates in the same manner as the rule for a general foreign controlled Australian entity, (see paragraphs 2.32 to 2.57) except that it deals only with amounts (e.g. assets and debt) attributable to the foreign entitys Australian investments .

What are Australian investments?

2.97 Australian investments are assets held by the entity that:

•

are attributable to any of its Australian permanent establishments whether the assets are located in Australia or not; or

•

are held for the purposes of producing the entitys assessable income.

[Schedule 1, item 1, section 820-205, step 1 of the method statement]

2.98 The record keeping requirements for foreign entities carrying on business through Australian permanent establishments are contained in Subdivision 820-L and are explained in Chapter 9.

Example 2.10: Foreign general investor

Mr Investor (a non-resident) owns several apartment blocks in Sydney and Melbourne. He derives assessable rental income from the letting of apartment units. In order to fund the acquisition of the apartment blocks he borrowed $50 million from an Australian bank and $30 million from an associate in the USA. He contributed the rest of the funds from his own savings. Mr Investors otherwise allowable debt deductions are $8 million per year. As this is greater than $250,000, the de minimis amount, Mr Investor is subject to Division 820.

The average value of the buildings and associated fixtures and fittings is $100 million. The assets are valued in accordance with Australian accounting standards.

Mr Investor is a foreign entity with Australian investments and hence the thin capitalisation rules apply to him. His safe harbour debt amount in respect of his Australian investment is calculated as follows:

afe harbour debt amount

Step 1: The average value of Mr Investors Australian investment is $100 million.

Step 2: Associate entity debt is zero. The result of step 2 is $100 million.

Steps 3 and 4: There is no associate entity equity or non-debt liabilities. Therefore, the result of step 4 is $100 million.

Step 5: Multiplying the result of step 4 by three-quarters equals $75 million.

Step 6: There is no associate entity excess. Therefore, $75 million is the safe harbour debt amount.

Mr Investors Australian investment has a safe harbour debt amount of $75 million. Thus, he has not satisfied the safe harbour rule because his total debt funding (i.e. debt capital) is $80 million which exceeds his safe harbour debt amount.

If Mr Investor is not able to demonstrate that the level of debt funding of the investment is acceptable on an arms length basis an adjustment to disallow part of his debt deductions against his Australian assessable income will be made for the relevant year.

Foreign financial investor

2.99 The safe harbour debt amount is the lesser of:

•

the total debt amount; and

•

the adjusted on-lent amount.

[Schedule 1, item 1, subsection 820-210(1)]

2.100 The calculation of these amounts is similar to that for a foreign controlled Australian financial entity (see paragraphs 2.58 to 2.93) but deals only with amounts attributable to its Australian investments. A total debt amount (calculated using the 20:1 ratio with an allowance for assets falling within the zero-capital amount) and an adjusted on-lent amount are calculated. In doing so, only the entitys Australian assets (comprising its Australian investments) and its Australian non-debt liabilities are taken into account. [Schedule 1, item 1, subsections 820-210(2) and (3)]

2.101 The same record keeping requirements apply to these foreign entities as apply to foreign general investors.

Arms length debt amount

2.102 The arms length debt amount can replace the safe harbour debt amount as an entitys maximum allowable debt for a period. An inward investing entity may choose to adopt an arms length debt amount as its maximum allowable debt amount where it can demonstrate that the amount satisfies the requirements set out in section 820-215.

2.103 The application of the arms length debt amount to inward investing entities is discussed in Chapter 10.

What is the amount of debt deduction disallowed under the thin capitalisation rules?

2.104 In circumstances where a foreign investor or foreign controlled Australian entity breaches the thin capitalisation rules an adjustment to disallow all or part of each debt deduction must be calculated [Schedule 1, item 1, subsection 820-185(1) and section 820-220] . The amount of debt deduction disallowed is calculated in the same way for all types of inward investing entities.

2.105 The amount of debt deduction disallowed is worked out using the following formula:

debt deduction * (excess debt / average debt)


Where:

average debt is the entitys average debt that gives rise to debt deductions for that year or part thereof.

debt deduction means each debt deduction for an income year, or part thereof.

excess debt equals the amount by which the adjusted average debt exceeds the maximum allowable debt.

For foreign investors, these are amounts attributable to their Australian investments.

2.106 Debt deductions are disallowed in direct proportion to the amount by which average debt exceeds the maximum allowable debt.

2.107 In effect, when applied across all deductions the formula applies an average cost of debt to the excess debt amount. The average cost is calculated from the entitys aggregate debt and debt deduction figures without any adjustments (e.g. no amounts of debt are excluded).

2.108 The legislation provides that the amount of debt deduction disallowed must be calculated separately for each deduction [Schedule 1, item 1, subsection 820-185(1) and section 820-220] . This is done in the event that taxable profits for particular activities or certain classes of income need to be calculated (e.g. where the tax rates vary for different pools of profits within an entity). However, in practice the entity will usually apply the formula to the total of its relevant debt deductions.

Example 2.11

Following on from Example 2.6 assume that Austcos total debt deduction for the income year in respect of the loan of $5 million is $600,000. If an adjustment to Austcos debt deduction is warranted under the thin capitalisation rules then the amount disallowed would be:

$600,000 * $125,000 / $5,000,000) = $15,000


Application to part year periods for inward investing entities

2.109 In relation to inward investing entities, the thin capitalisation rules will apply where, for a part of the year the entity was an inward investing entity and its adjusted average debt for that period exceeds its maximum allowable debt. [Schedule 1, item 1, subsection 820-225(1)]

2.110 The adjusted average debt of such an entity is the average value (for the period the entity was an inward investing entity) of its debt capital that gave rise to its debt deduction expenses incurred during that period less the average value of any associate entity debt outstanding during the period. [Schedule 1, item 1, subsections 820-225(2) and (3), item 4 in the table]

2.111 When calculating the maximum allowable debt and the amount of each debt deduction to be disallowed, the average values of all the elements that are used to calculate the respective amounts for the period are calculated by reference to the period for which the entity was an inward investing entity only, and not by reference to the entire income year [Schedule 1, item 1, subsection 820-225(3), item 1 in the table] . The debt deductions included are only those which are incurred during that same period [Schedule 1, item 1, subsection 820-225(3), items 2 and 3 in the table] . Debt deductions incurred outside that period in the income year are unaffected by the result of applying the rules to its deductions during the period.

2.112 Thus, for the period that the entity is a financial entity, the rules for foreign entities apply. For any period that the entity is not a financial entity the rules for general entities apply.

Example 2.12

As at 1 July 2002, a UK trading company carries on business via a permanent establishment in Australia. On 2 February 2003 it becomes a financial entity. Its balance day is 30 June 2003.

From 1 July 2002 to 1 February 2003 the rules for foreign general investors will apply to the UK trading company. From 2 February 2003 onwards, the rules for foreign financial investors will apply.

When calculating the average values of its assets, debt and equity the entity will separate the income year into the 2 periods, being 1 July 2002 to 1 February 2003 and 2 February 2003 to 30 June 2003, and calculate values for each period. Similarly, it will allocate its debt deductions so that only those debt deductions incurred in the first period are used for the foreign general investor calculations and only those debt deductions incurred in the second period are used for the foreign financial investor calculations.

If the entity exceeds its maximum allowable debt during the period that it was a foreign general investor, this will not affect the deductibility of its debt deductions incurred during the period it was a foreign financial investor. These latter debt deductions will only be disallowed if the maximum allowable debt applicable to foreign financial investors is exceeded for the period 2 February 2003 to 30 June 2003. Excess debt in one period cannot be reduced by not having excess debt in another period during the same or a different income year.

Diagram 2.1: When will an adjustment be made to disallow all or part of an inward investing (non-ADI) entitys debt deductions?

Application and transitional provisions

2.113 The application and transitional provisions for this measure are discussed in Chapter 1.

Consequential amendments

2.114 The consequential amendments for this measure are discussed in Chapter 1.