House of Representatives

Explanatory Memorandum

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

Chapter 4 - Inward investing entities (ADI)

Outline of chapter

4.1 This chapter explains how the thin capitalisation rules in Subdivision 820-E will apply to inward investing entities that are ADIs. These entities are foreign banks that operate their banking business in Australia at or through a permanent establishment. They are referred to as foreign bank branches throughout this chapter.

4.2 The thin capitalisation rules that apply to these entities ensure that they do not reduce their Australian tax liabilities by using an excessive amount of debt to finance their Australian operations. The rules do this by ensuring that the foreign bank allocates a minimum amount of equity capital to its Australian branch for the purposes of calculating its taxable income. The allocation of equity capital is an important aspect of the arms length attribution of profits to the branch because it bears on the amount of interest expense allocated to the branch and to other parts of the foreign bank. Where the foreign bank does not take an adequate amount of equity capital into account when calculating its Australian taxable income, its debt deductions (e.g. interest expense) will be reduced.

Context of reform

4.3 The current provisions dealing with the capitalisation of foreign bank branches are contained in Part IIIB of the ITAA 1936. Those rules impose a notional equity requirement that reduces the interest expense of a foreign bank branch by 4% (section 160ZZZB). The reduction is made to reflect that a part of the branchs funding is in the nature of capital rather than debt. Section 160ZZZB is to be repealed as part of the measures contained in this bill (see paragraphs 4.52 to 4.54). The notional equity rule will be replaced by the rules in Subdivision 820-E.

4.4 A foreign bank that is resident in a country with which Australia has a DTA can elect that Part IIIB does not apply in the calculation of its taxable income for an income year. Where this occurs, the taxable income is calculated by having regard to the business profits article of the relevant DTA. In the past, the rules for determining the appropriate capital funding of a branch in accordance with that article have not been specific about the method for calculating the level of capital required, although the OECD has made a commitment to clarify the position by providing guidance on the application of the article.

4.5 The current notional equity provisions are problematical for several reasons including that:

•

the rules operate arbitrarily in that the 4% reduction occurs regardless of whether the foreign bank branch has equity capital in its books of account;

•

it is arguable whether the definition of interest in the withholding tax provisions, which is used as the base for the notional equity requirement, is broad enough to capture all the finance expenses that are relevant to the funding of a foreign bank branch; and

•

the mechanism for imposing the notional equity requirement may not be accepted in foreign jurisdictions as being a suitable arms length approach for determining the capital or debt funding of a branch, which may result in double taxation. This is important in determining whether such an approach is consistent with the business profits articles of Australias DTAs.

4.6 The new thin capitalisation rules will:

•

remove the uncertainty that exists in the current law;

•

set out a minimum equity capital requirement for the branch (the safe harbour capital amount);

•

provide the branch with the option to demonstrate that a lower level of equity capital is justified using arms length principles (the arms length capital amount). The arms length capital amount is discussed in Chapter 10;

•

treat foreign bank branches more consistently with Australian banks; and

•

will be more consistent with the business profits articles of Australias DTAs.

4.7 Banks internationally are subject to prudential controls (by APRA in Australia, and prudential regulation authorities in other countries) requiring them to maintain minimum levels of capital to support the risk profile of their business operations. These capital adequacy requirements are aimed at ensuring security for creditors (including depositors) of the bank and providing stability to the financial markets.

4.8 The thin capitalisation rules applying to ADIs are broadly based on the methodology of the capital adequacy requirements prescribed by prudential regulators. Under the capital adequacy regime, an ADIs assets are risk weighted, so those assets that have higher risk (such as loans to corporate entities) require more capital than assets that have low risk (such as government bonds). Similarly, the thin capitalisation rules for ADIs will use risk-weighted asset values rather than book values of assets to calculate the safe harbour minimum capital amount.

4.9 Rules are not required for a foreign-controlled Australian bank (or bank group) that does not have any foreign operations itself, because APRAs prudential rules set capital levels that are considered to be adequate for calculating the taxable incomes of these purely Australian operations.

4.10 The rules described in this chapter may apply to groups that include a foreign bank branch. Chapter 6 provides details about groups for thin capitalisation purposes. Non-ADI subsidiaries of foreign banks that are not grouped will be subject to the thin capitalisation rules that apply to an inward investing entity (non-ADI). These rules are explained in Chapter 2.

Summary of new law

4.11 The thin capitalisation rules that apply to foreign bank branches treat the branch, for thin capitalisation purposes, as if it were a separate entity that requires a certain minimum level of capital in order to operate a banking business in Australia. This is necessary in order to determine interest and other finance expenses of the branch when calculating the banks Australian taxable income.

4.12 The thin capitalisation rules for ADIs will apply from the start of an ADIs first income year beginning on or after 1 July 2001. The rules are applied at the end of the entitys income year using average values of the entitys debt, equity capital and risk-adjusted assets throughout the year. However, in the first income year, special transitional rules provide that only the closing balances of those amounts need to be tested.

Detailed explanation of new law

Inward investing entities (ADI)

4.13 The thin capitalisation rules for ADIs are based on a minimum equity capital level and use risk-adjusted asset values, where they are relevant, rather than the unadjusted book value of assets. The framework for these rules is provided by the capital adequacy regime that ADIs must meet as part of the licensing regime that APRA and foreign prudential regulators administer.

4.14 The alignment with the capital adequacy regime recognises that risk-adjusted assets provide a more commercially realistic and appropriate basis for setting capital requirements. This is consistent with the arms length principle contained within the business profits articles of Australias DTAs. The use of information prepared for capital adequacy purposes also recognises that regulatory reporting information provides reliable data for determining capital requirements and that a globally consistent capital adequacy regime exists for banks. This should make it easier for host and home countries to agree on the appropriate allocation of capital and thereby greatly reduce the risk of double taxation.

4.15 In the thin capitalisation rules, the requirement to maintain a minimum capital amount ensures that foreign banks do not allocate a disproportionate share of their global debt funding to their Australian operations. The rules operate to disallow some or all of the debt deductions attributed to the Australian operations of a foreign bank where it does not book sufficient equity capital in the accounts of its Australian bank branch to satisfy the minimum requirement. [Schedule 1, item 1, subsection 820-395(1)]

What is an inward investing entity (ADI)?

4.16 The ADI rules apply to Australian and foreign entities that are ADIs for the purposes of the Banking Act 1959 . These entities include Australian banking entities and foreign bank branches.

4.17 An entity is an inward investing entity (ADI) if it is a foreign bank that carries on its banking business at or through permanent establishments in Australia. When a foreign bank has a branch in Australia, the rules for inward investing entities (ADI) apply. As mentioned in paragraph 4.3, these rules replace the notional equity requirement that is contained in section 160ZZZB of Part IIIB of the ITAA 1936. [Schedule 1, item 1, subsection 820-395(2); Schedule 2, item 39, definition of inward investing entity (ADI) in subsection 995-1(1)]

4.18 The rules also operate where the entity is an inward investing entity (ADI) for part of the year (see paragraphs 4.42 and 4.43). [Schedule 1, item 1, section 820-420]

What are the thin capitalisation rules for inward investing entities (ADIs)?

4.19 The thin capitalisation rules will operate to deny a proportion of a foreign bank branchs debt deductions where the equity capital of the foreign bank branch is less than the prescribed minimum. The legislation does this by requiring foreign bank branches to calculate their minimum capital amount either under a safe harbour formula or an arms length determination. The rules will disallow part or all of the banks debt deductions for the income year where the average value of the banks equity capital attributed to the branch is less than its minimum capital amount calculated under one of the alternatives. [Schedule 1, item 1, subsection 820-395(1)]

4.20 Although foreign bank branches will be required to calculate their minimum capital amount, they will not be required to calculate both the safe harbour and the arms length capital amounts. 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 banks average equity capital is less than the safe harbour amount. If the banks average equity capital is greater than the safe harbour amount there is no need to calculate the arms length amount.

4.21 Additionally, a foreign bank branch that has average equity capital less than the safe harbour amount could choose not to calculate the arms length capital amount and have debt deductions disallowed on the basis of the safe harbour capital amount.

4.22 Once a foreign bank branchs assets, debt and equity capital have been determined, the thin capitalisation rules can be applied. The rules will disallow some of a foreign bank branchs debt deductions where the branchs average equity capital is less than its minimum capital amount. However, debt deductions of an OBU which relate to its offshore banking business ( allowable OB deductions ) will not be disallowed. [Schedule 1, item 1, subsection 820-395(1)]

What is a foreign bank branchs average equity capital?

4.23 A foreign bank branchs average equity capital is made up of 2 components:

•

the average value of the equity capital of the entity that is attributable to the branch, for Australian tax purposes, other than equity capital that has been allocated to the offshore banking activities (OB activities) of the branch; and

•

the average value of interest-free funds made available to the branch by its head office or other branches. Chapter 8 explains how to work out average values.

[Schedule 1, item 1, subsection 820-395(3); Schedule 2, item 19, definition of average equity capital in subsection 995-1(1)]

What is equity capital?

4.24 The term equity capital is defined asthe total value of the entitys retained earnings, certain reserves and share capital (excluding any unpaid amounts and debt capital). It should be noted that the term equity capital is defined for the entity as a whole. However, the rules require an attribution in order to determine the equity capital for the branch. [Schedule 2, item 29, definition of equity capital in subsection 995-1(1)]

Why is equity capital allocated to the OB activities of an OBU deducted from a foreign bank branchs average equity capital?

4.25 The term offshore banking broadly refers to the intermediation by institutions operating in Australia in financial transactions between non-residents. It also includes the provision of financial services to non-residents in respect of transactions or businesses occurring outside Australia. Declaration as an OBU is confined to certain financial entities. Income derived by an OBU from OB activities is effectively taxed at a concessional rate of 10%. The meaning of an OB activity is set out in the current provisions of the ITAA 1936 dealing with OBUs. Allowable OB deductions are certain deductions which an OBU can claim, including interest expense, which relate to the OBUs assessable OB income (income derived from OB activities).

4.26 The current provisions dealing with foreign bank branches operate so that part of the debt funding of a foreign bank branch is treated as equity funding. This provision is explained in general terms in paragraph 4.3. In relation to OBUs, section 160ZZZB provides that interest deductions which are allowable OB deductions of an OBU are excluded in the calculation of the notional equity requirement. The effect is that there is no reduction in the interest expense which can be claimed by the branch where that interest expense is an allowable OB deduction.

4.27 Under the new thin capitalisation rules, foreign bank branches will retain the concession currently provided by section 160ZZZB. Foreign bank branches will not be required to hold capital against their Australian assets which are attributable to the OB activities of the branch. This is achieved by not including the risk-weighted assets that are attributable to the OB activities of the branch in calculating the safe harbour capital amount. [Schedule 1, item 1, section 820-405, step 1 in the method statement]

4.28 However, where a foreign bank branch does allocate equity capital to its OB activities in calculating its taxable income, that equity capital will not be available to the branch in calculating its average equity capital that it is required to have to fund its other business. This ensures that equity capital which has been allocated to the OBU business cannot also be used to increase the average equity capital of the branch available for funding its other business.

4.29 Consistent with the fact that capital will not be required for OB activities, debt deductions which are allowable OB deductions will not be disallowed if the Australian branch fails the safe harbour or the arms length tests. [Schedule 1, item 1, subsection 820-395(1) and section 820-415]

Why are interest-free loans included in a foreign bank branchs average equity capital?

4.30 Foreign bank branches are commonly provided with interest-free loans from other parts of the entity to use as working capital. These loans are sometimes referred to as dotation capital.

4.31 Where such loans do not give rise to debt deductions, they are included as part of the average equity capital. This recognises that although these loans are not equity in form, they provide capital to fund the branchs operations for which no debt deductions are claimed. However, loans that give rise to a notional amount of interest under the foreign bank branch provisions of the ITAA 1936 or for which a deduction is claimed in accordance with a DTA are not interest-free loans for the purposes of Division 820. Interest paid on these loans will comprise debt deductions for the branch and therefore the loans are not debt deduction free loans.

4.32 It is possible that interest-free loans to a foreign bank branch may not involve the issue of debt interests. It may be an informal agreement between the head office (or another part of the entity) and its foreign bank branch. Provided such arrangements do not give rise to debt deductions, they can be included as average equity capital [Schedule 1, item 1, subsection 820-395(3); Schedule 2, item 19, definition of average equity capital in subsection 995-1(1)] . Moreover, an item of dotation capital cannot also be an attributed amount in determining the equity capital amount (i.e. there should be no double counting of an amount).

What is a foreign bank branchs minimum capital amount?

4.33 A foreign bank branchs minimum capital amount is the lesser of its safe harbour capital amount and its arms length capital amount. [Schedule 1, item 1, section 820-400; Schedule 2, item 47, definition of minimum capital amount in subsection 995-1(1)]

The safe harbour capital amount

4.34 The safe harbour test for a foreign bank branch is similar to that for an inward investing entity (non-ADI), except that it is framed in terms of capital instead of debt. Furthermore, the safe harbour capital amount is based on risk-weighted Australian assets rather than on the unadjusted value of those assets. The safe harbour capital amount is 4% of the branchs risk-weighted assets. The safe harbour level of 4% is the level of Tier 1 capital agreed by bank regulatory authorities as the absolute minimum for capital adequacy purposes. As such, it should assist the international competitiveness of banks in Australia.

4.35 The safe harbour capital amount is determined by applying the method statement contained in section 820-405. That method statement starts with the risk-weighted assets that are attributable to the foreign banks Australian branch (excluding those which are attributable to the offshore banking activities of the branch). The result is multiplied by 4% to give the safe harbour capital amount. [Schedule 1, item 1, section 405; Schedule 2, item 59, definition of safe harbour capital amount in subsection 995-1(1)]

4.36 The method statement requires an allocation or attribution of risk-weighted assets of the foreign bank to its Australian branch(es). Hence, inter-branch assets shown in the books of the branch will not automatically be taken to be part of the risk-weighted assets of the branch unless they can be shown to reflect the attribution process. Moreover, inter-branch dealings undertaken for risk management purposes will not, of themselves, increase or decrease the risk-weighted assets attributable to the Australian branch.

4.37 For the purposes of the safe harbour capital amount, the risk-weighted assets of the entity means the sum of the assessed risk exposures associated with its business. The risk-weighting calculations are:

•

carried out in accordance with the prudential standards determined by the prudential regulator in the jurisdiction of the foreign bank or by APRA; and

•

encompass both on-balance sheet and off-balance sheet business.

[Schedule 2, item 57, definition of risk-weighted assets in subsection 995-1(1)]

4.38 The risk-weighted assets included in a report to the relevant prudential regulator will be accepted as supporting the branchs calculation of its risk-weighted assets to the extent that the report provides information on the risk-weighted assets attributed to the branch.

The arms length capital amount

4.39 The calculation of the arms length capital amount is discussed in Chapter 10.

Amount of debt deductions disallowed

4.40 Debt deductions are denied to the extent that the amount of equity capital funding (other than any allocated to its offshore banking business) of the foreign bank branch is less than the lower of the safe harbour and arms length capital amounts (the capital shortfall ). [Schedule 1, item 1, section 415]

4.41 The proportion of debt deductionsdisallowed is worked out by dividing the amount of the capital shortfall by the average value of the branchs debt for the period (other than debt used for offshore banking activities). [Schedule 1, item 1, section 820-415]

Example 4.1: Working out the amount of debt deduction disallowed

The Basel Bank, a foreign bank that carries on its banking business in Australia through an Australian permanent establishment, has assets (unadjusted for risk) of $200 million attributable to its Australian branch. The bank is not an OBU. According to the prudential standards of the prudential regulator in its home jurisdiction, the bank determines that the risk-weighted assets attributable to the Australian branch are $160 million for the income year.

The branch has debt deductions of $15 million and an average debt capital of $190 million.

The equity capital attributable to the branch is made up of $3 million in dotation capital that has been supplied to it and $2 million in retained earnings. Therefore, the foreign bank branchs average equity capital is $5 million.

Applying the method statement in section 820-405 to work out the safe harbour capital amount:

Step 1: Determine the average value of all the risk-weighted assets that are attributable to the branch:

= $160 million.

Step 2: The amount calculated under step 1 is multiplied by 4%. The result is the safe harbour capital amount:

= $160 million * 0.04 = $6.4 million

Since this amount is more than the branchs average equity capital, an amount of its debt deductions is disallowed, unless the branch can demonstrate that its arms length capital amount is equal to or less than its average equity capital.

Assuming that the bank cannot demonstrate that its arms length capital amount is less than its safe harbour capital amount, it has a capital shortfall of $1.4 million. That is the amount by which its average equity capital ($5 million) is less than its minimum capital amount ($6.4 million).

The amount of debt deduction that would be disallowed is determined under the formula in section 820-415:

debt deduction * (capital shortfall / average debt)


Accordingly, the amount of debt deduction disallowed is:

15,000,000 * ($1,400,000 / $190,000,000) = $100,526.32


Diagram 4.1: When will an adjustment be made to disallow all or part of the debt deductions of an inward investing entity (ADI)?

Application to part year periods

4.42 Where a foreign bank operates its banking business in Australia through a permanent establishment for only part of an income year, Subdivision 820-E only applies to that part year period. [Schedule 1, item 1, section 820-420]

4.43 For example, if a foreign bank is an inward investing entity for 6 months of the year, the banks average equity capital is the average of the equity capital attributable to the branch and any dotation capital provided to the branch for that 6 month period. Similarly, the foreign bank branchs safe harbour capital amount and arms length capital amount are determined for the 6 month period. Also, the amount of each debt deduction that is disallowed is calculated by reference to the average debt, capital shortfall and debt deductions that relate to that 6 month period only.

Application and transitional provisions

4.44 The thin capitalisation rules for ADIs apply from the first income year commencing on or after 1 July 2001 [Schedule 1, item 22, section 820-10] . The existing rules will continue to apply until the beginning of that income year. This means that a foreign bank branch with a substituted accounting period is required to calculate its notional equity requirement, or the amount of equity capital attributable to the branch under the relevant DTA, up until the first income year beginning on or after 1 July 2001 [Schedule 1, item 22, section 820-15] .

4.45 The rules will normally be applied at the end of the foreign bank branchs income year using an average of the quarterly values of its debt, capital and risk-adjusted assets throughout the year (see Chapter 8). In the first period of the rules operation, only the closing balances of those amounts at the end of the period need to be tested. [Schedule 1, item 22, section 820-25]

Consequential amendments

Section 128F

4.46 This bill contains 2 separate amendments to section 128F of the ITAA 1936. The first amendment will replace the current definition of the term associate used in section 128F and is discussed in paragraph 1.94 and 1.95. The second will broaden the scope of the interest withholding tax exemption provided by the provision and is discussed in paragraphs 4.47 to 4.51.

What is interest withholding tax?

4.47 The taxation of Australian sourced interest paid or credited to non-residents, and residents operating through offshore permanent establishments, is subject to the provisions contained in Division 11A of Part III of the ITAA 1936. These provisions provide, in conjunction with the Income Tax Dividends, Interest and Royalties Withholding Tax Act 1974 , that the recipient of Australian sourced interest is subject to withholding tax on the gross amount paid or credited. A rate of 10% of the gross amount of the interest is imposed.

What is the section 128F interest withholding tax exemption?

4.48 Section 128F of the ITAA 1936 provides an exemption from interest withholding tax where an Australian resident company issues debentures, the company is an Australian resident when the interest is paid and the issue satisfies requirements of the public offer test contained in subsection 128F(3) or (4). The purpose of the public offer test is to ensure that lenders on capital markets are aware that an Australian company is offering debentures for issue.

Extending the scope of section 128F

4.49 Under the current law, non-resident companies cannot issue debentures that can benefit from section 128F. However, these companies can avoid this restriction by establishing an Australian resident subsidiary which raises funds under section 128F and on-lends the funds to the non-resident parent (henceforth referred to as subsidiary borrowing arrangements). For example, a non-resident company carrying on business in Australia at or through a branch can establish a subsidiary in order to raise funds for use by the branch.

Diagram 4.2: Example of a subsidiary borrowing arrangement

4.50 Section 128F will be amended to allow non-resident companies (including foreign banks) carrying on business at or through permanent establishments in Australia to issue debentures under section 128F [Schedule 1, item 2] . However, the debentures must be issued through the Australian permanent establishment itself and not through the companys head office or a permanent establishment in another country. This will ensure that the activities associated with issuing of debentures are undertaken in Australia. This does not mean that the debentures must be issued in Australia.

4.51 This amendment will give these non-resident companies direct access to section 128F funding and thereby reduce compliance costs. The amendment will apply in relation to debentures issued on or after 1 July 2001. [Schedule 1, item 23]

Foreign bank branches

4.52 Section 160ZZZB of the ITAA 1936 presently operates so that a proportion of the debt funding of an Australian branch of a foreign bank is treated as equity funding. The result is that the deduction for interest on the debt funding is reduced by 4%. The 4% is referred to as the notional equity requirement .

4.53 The notional equity requirement is to be replaced by the provisions in the new thin capitalisation regime dealing with foreign bank branches in Australia. Hence, the notional equity requirement will be repealed. Other minor consequential amendments are made as a result of the repeal of the notional equity requirement. [Schedule 1, items 6 to 9]

4.54 These amendments apply to an amount of interest that is taken under section 160ZZZA to be paid during an income year that begins on or after 1 July 2001. If the interest is paid on or after 1 July 2001 during an income year that began before 1 July 2001, sections 160ZZZB and 160ZZZD continue to apply. [Schedule 1, item 25]