House of Representatives

Explanatory Memorandum

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

Chapter 5 - Outward investing entities (ADI)

Outline of chapter

5.1 This chapter explains Subdivision 820-D that contains the thin capitalisation rules for outward investing entities that are ADIs. These entities include Australian banks, and groups that contain an Australian bank, that have foreign subsidiaries and/or branches. These entities and groups are referred to as Australian banks throughout this chapter.

5.2 The thin capitalisation rules that apply to Australian banks 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 bank does not allocate a disproportionate portion of its equity capital to its foreign operations and accordingly, that it maintains a minimum amount of equity capital in its Australian operations for the purposes of calculating its taxable income. Where the bank does not maintain an adequate amount of equity capital in its Australian operations, its deductions that relate to its debt finance (e.g. interest) are reduced.

Context of reform

5.3 The current provisions that deal with the deductibility of interest expenses for outward investors (including Australian banks) are contained in sections 79D and 160AFD of the ITAA 1936 and section 8-1 of the ITAA 1997.

5.4 Section 79D prevents a foreign loss being deducted from domestic assessable income and section 8-1 denies deductions incurred in earning exempt (foreign) income. However, because all of these rules rely on tracing the use of borrowed funds, it is relatively easy to circumvent their operation by establishing a use of funds that guarantees deductibility. Another problem with the rules is that they apply on a single entity basis, and it is therefore possible to circumvent them by using interposed entities to separate the foreign income derivation from the expenditure occurrence.

5.5 Australias DTAs also require taxpayers with foreign branches to calculate the taxable (or exempt) income of those branches consistent with the business profits article of the relevant DTA. Chapter 4 outlines some of the problems with the rules for determining the appropriate capital funding of a branch in accordance with that article.

5.6 The new thin capitalisation regime will impose a limit on the extent to which the Australian operations of Australian banks can be funded by debt. Accordingly, the current limitations on interest deductions will be removed in so far as they apply to debt deductions that are regulated by the new thin capitalisation regime. Therefore, expenses relating to those deductions will be able to be deducted when incurred in earning exempt foreign income and will no longer be quarantined, subject to the limits imposed by the new thin capitalisation provisions.

5.7 The new thin capitalisation provisions will:

•

remove the inequity and uncertainty that exists in the current law;

•

set out a minimum equity capital requirement for an Australian bank;

•

provide the bank 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 detail in Chapter 10; and

•

treat Australian banks more consistently with foreign bank branches while recognising the differences between them.

5.8 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.

5.9 The thin capitalisation rules applying to ADIs are based on the methodology of the capital adequacy requirements prescribed by APRA. Under the capital adequacy regime, the 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). APRA may also require a specific amount of capital to be held for certain assets, such as goodwill and investments in life and general insurance subsidiaries.

5.10 Similarly, the thin capitalisation rules for ADIs will use risk-adjusted assets rather than book values of assets to calculate the safe harbour minimum capital amount and the worldwide capital amount, and will require additional capital to be held against certain Australian assets.

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

5.12 The rules described in this chapter will apply to bank groups. Chapter 6 provides details about groups for thin capitalisation purposes.

5.13 Non-ADI subsidiaries of an Australian bank that are not grouped with the bank will be subject to the thin capitalisation rules that apply to non-ADI entities if they directly or indirectly control foreign investments. These rules are explained in Chapter 3.

Summary of new law

5.14 The thin capitalisation rules that apply to Australian banks require a minimum capital amount to be used in calculating the taxable income of the banks Australian operations. The minimum capital required is determined as either a fixed safe harbour capital amount, a worldwide capital amount or an arms length capital amount. The safe harbour capital amount is similar to APRAs Tier 1 capital requirement for Australian operations.

5.15 The thin capitalisation rules for ADIs 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 tax 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

Outward investing entities (ADI)

5.16 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 administers.

5.17 The rules operate to disallow some or all of the debt deductions of an Australian bank where it does not maintain sufficient equity capital in respect of its Australian operations to satisfy the minimum requirement. [Schedule 1, item 1, subsection 820-300(1)]

What is an outward investing entity (ADI)?

5.18 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.

5.19 An entity is an outward investing entity (ADI) if it is an ADI that is an Australian entity and one of the following applies:

•

it carries on its business through a foreign branch;

•

it is an Australian controller of a foreign entity (e.g. it has a foreign subsidiary);

•

it has an associate entity that is an outward investing entity (ADI or non-ADI);

•

it is an associate entity of an outward investing entity (ADI or non-ADI).

[Schedule 1, item 1, subsection 820-300(2)]

5.20 Chapter 7 discusses what is meant by an Australian controller, a foreign entity and an associate entity.

5.21 The rules also operate where the entity is an outward investing entity (ADI) for part of the year (see paragraphs 5.47 to 5.50). [Schedule 1, item 1, section 820-330]

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

5.22 The thin capitalisation rules operate where the equity capital of the Australian bank for its Australian operations is less than the prescribed minimum. The minimum capital amount is determined by calculating a safe harbour amount, a worldwide capital amount or an arms length amount. The rules will disallow part or all of the entitys debt deductions for the income year, where the average value of the entitys equity capital attributed to its Australian operations (called its adjusted average equity capital) is less than its minimum capital amount calculated under one of the tests. [Schedule 1, item 1, subsection 820-300(1)]

5.23 Although Australian banks will be required to calculate their minimum capital amount, they will not be required to calculate the safe harbour, worldwide capital and arms length amounts. They will have the option to choose either of these amounts. However, the arms length capital amount will normally only be determined where the entitys equity capital is less than both the safe harbour and worldwide capital amounts. If the entitys average equity capital is greater than the safe harbour amount there is no need to calculate the arms length amount.

5.24 Additionally, an Australian bank that has average equity capital less than the safe harbour capital amount could choose not to calculate the arms length capital amount or worldwide capital amount and have debt deductions disallowed on the basis of the safe harbour capital amount.

What is the adjusted average equity capital?

5.25 The adjusted average equity capital of an Australian bank:

•

is the average value of the equity capital of the bank other than the equity capital attributed to its overseas branches; less

•

the average value of the controlled foreign entity equity other than the controlled foreign entity equity attributed to its foreign branches.

[Schedule 1, item 1, subsection 820-300(3)]

5.26 Equity capital attributable to the banks foreign branches will be the amount actually allocated to them (i.e. the value of capital shown in the banks book of accounts). However, where such an amount has been adjusted for foreign tax purposes or by the ATO for other tax purposes, the adjusted amount should be used.

5.27 The calculation of average values is explained in detail in Chapter 8 and the meaning of controlled foreign entity equity is explained in paragraphs 4.23 to 4.32. Broadly the latter is the value of its equity interests in foreign subsidiaries. To avoid double counting, any such equity held through a foreign branch and treated as an asset attributed to a foreign branch is not deducted in this calculation.

What is equity capital?

5.28 The equity capital of an Australian bank is the total value of its eligible Tier 1 capital less any instruments included in Tier 1 capital that are debt interests for tax purposes. [Schedule 2, item 29, definition of equity capital in subsection 995-1(1)]

5.29 Eligible Tier 1 capital is defined in the APRA prudential guideline PS111 Capital Adequacy: Measurement of Capital . Eligible Tier 1 capital includes:

•

paid up ordinary shares;

•

general reserves;

•

retained earnings;

•

current years earnings net of expected dividends and tax expenses;

•

minority interests in subsidiaries on consolidation;

•

non-cumulative irredeemable preference shares approved by APRA; and

•

other innovative capital instruments approved by APRA.

5.30 However, an instrument is not eligible for inclusion where its inclusion will result in the aggregate amounts of the latter 2 items exceeding 25% of the sum of all other Tier 1 components.

5.31 Eligible Tier 1 capital is net of goodwill, other intangibles assets, future income tax benefits, equity and other capital investments in associated lenders mortgage insurers. These are called Tier 1 prudential capital deductions.

5.32 For the purposes of the thin capitalisation legislation, any Tier 1 capital instrument that is defined as a debt interest under sections 974-15 to 974-65 of the New Business Tax System (Debt and Equity) Bill 2001 is not included in the definition of equity capital. See paragraph 5.53 for a transitional rule to deal with debt interests subject to elective treatment as equity interests under the new debt/equity legislation. [Schedule 1, item 1, subsection 820-300(3); Schedule 2, item 29, definition of equity capital in subsection 995-1(1)]

What is an Australian banks minimum capital amount?

5.33 An Australian banks minimum capital amount is the least of its safe harbour capital amount, its worldwide capital amount and its arms length capital amount. [Schedule 1, item 1, section 820-305; Schedule 2, item 47, definition of minimum capital amount in subsection 995-1(1)]

What is the safe harbour capital amount?

5.34 The safe harbour capital amount requires an Australian bank to have equity capital of at least 4% of its risk-weighted Australian assets, plus an additional amount for certain Australian assets that APRA requires capital to be held against. The safe harbour level of 4% is the absolute minimum level of Tier 1 capital agreed by bank regulatory authorities as sufficient, in the right circumstances. It should assist the competitiveness of Australian banks.

5.35 The safe harbour capital amount is determined by applying the method statement contained in section 820-310. That method statement starts with the risk-weighted assets of the Australian bank excluding those assets that are attributable to the banks foreign branches, equity interests in controlled foreign entities and prudential capital deductions. The result is multiplied by 4% and the average value of the Tier 1 prudential capital deductions is added to that amount to give the safe harbour capital amount. [Schedule 1, item 1, section 820-310; Schedule 2, item 59, definition of safe harbour capital amount in subsection 995-1(1)]

5.36 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 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)]

5.37 The risk-weighted assets included in a report to APRA will be accepted as supporting the banks calculation of its risk-weighted assets.

What are prudential capital deductions?

5.38 Prudential capital deductions include Tier 1 prudential capital deductions and deductions from total capital as defined in the prudential standard APS111 Capital Adequacy: Measurement of Capital . Deductions from total capital include investments in other ADIs outside the bank group, non-operating holding companies, non-consolidated subsidiaries and associates. In the calculation in the method statement, they do not include any prudential capital deductions attributable to the banks foreign branches because all the risk-weighted assets of those branches are already excluded. [Schedule 2, item 56, definition of prudential capital deduction in subsection 995-1(1)]

What are Tier 1 prudential capital deductions?

5.39 Tier 1 prudential capital deductions are amounts that must be deducted in calculating the eligible Tier 1 capital as defined in the prudential standards. These deductions include goodwill, other intangibles assets, future income tax benefits, equity and other capital investments in associated lenders mortgage insurers. In the final step of the method statement, any Tier 1 prudential capital deductions attributable to foreign branches or subsidiaries are not added on because they are not a part of the banks Australian operations. [Schedule 2, item 67, definition of Tier 1 prudential capital deduction in subsection 995-1(1)]

What is the worldwide capital amount for outward investing ADIs?

5.40 The outward investing entity (ADI) rules will allow the Australian operations to be capitalised at 80% of the capital ratio of the Australian entitys worldwide group. This allows the capitalisation of the banks Australian operations to differ from that of its foreign operations, which can occur because of differences in regulatory regimes. Where the entity is able to satisfy the worldwide capital amount test its deductions will not be reduced.

5.41 This is similar to the worldwide gearing debt rule provided for outward investing non-ADI entities. In the case of a bank that is foreign-owned for all or part of the year the worldwide test will not apply, for the same reasons as for non-ADIs (see Chapter 3). [Schedule 1, item 1, subsection 820-320(1)]

5.42 The worldwide capital amount is determined by applying the method statement contained in subsection 820-320(2). The method statement is similar to the safe harbour capital amount calculation but rather than multiply the adjusted risk-weighted assets of the bank by 4%, it uses 80% of the worldwide group capital ratio . [Schedule 1, item 1, subsection 820-320(2); Schedule 2, item 70, definition of worldwide capital amount in subsection 995-1(1)]

What is the worldwide group capital ratio?

5.43 The worldwide group capital ratio is determined by applying the method statement contained in subsection 820-320(3). That method statement starts with the average value of the eligible Tier 1 capital (not including any debt interests) of the consolidated group as defined by the APRA prudential standards. This amount is divided by the risk-weighted assets (as defined by the APRA prudential standards) of the same group. [Schedule 1, item 1, subsection 820-320(3)]

The arms length capital amount

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

Amount of debt deductions disallowed

5.45 Debt deductions are denied to the extent that the amount of equity funding of an Australian banks Australian operations is less than the least of the safe harbour amount, the worldwide capital amount and the arms length amounts (the capital shortfall).

5.46 The proportion of debt deductionsdisallowed is worked out by dividing the amount of the capital shortfall by the average value of the Australian banks debt for the period. Because debt deductions of the foreign branches of the bank are not subject to these rules, they are excluded from this calculation, as is the related debt capital. [Schedule 1, item 1, section 820-325]

Example 5.1: Working out the amount of debt deduction disallowed

Bank Oz is an Australian ADI that carries on an international banking business through Australian entities, foreign permanent establishments, and through foreign entities that it controls.

Bank Oz has total assets (unadjusted for risk) of $600 million, of which $100 million are attributable to its overseas permanent establishments and $7 million represents equity investments in controlled foreign entities.

Bank Oz has Tier 1 capital of $40 million of which $5 million are debt interests. Its total prudential capital deductions are $10 million of which $6 million is goodwill (i.e. a Tier 1 prudential capital deduction) and $4 million is an equity investment in a funds management subsidiary, which is not consolidated for capital adequacy purposes. Both assets relate to its Australian operations. It has controlled foreign entity equity of $7 million and equity attributable to its foreign branches of $4 million.

Work out the adjusted average equity capital

The calculation of average equity capitalis described in subsection 820-300(3). Bank Oz has eligible Tier 1 capital of $34 million less debt interests of $5 million less controlled foreign entity equity and permanent establishment Tier 1 capital of $11 million, which results in $18 million of adjusted average equity capital.

Work out safe harbour capital amount

Work through the method statement in section 820-310 to determine the safe harbour capital amount.

Step 1: Determine the average value of the risk-weighted assets after excluding those attributable to the foreign branches and the investment in controlled foreign entities. Assume the risk-weighted assets are $350 million.

Step 2: Multiply the amount calculated under step 1 by 4%, which results in $14 million.

Step 3: Add the Tier 1 prudential capital deductions of $6 million to the result of step 2, to give $20 million, which is the safe harbour capital amount.

Work out the worldwide capital amount

The calculation of the worldwide group capital ratio is described in subsection 820-320(3).

Step 1: Determine the eligible Tier 1 capital of the consolidated group as defined by APRA prudential standards (i.e. $40 million less Tier 1 prudential capital deductions of $6 million plus $4 million of retained earnings in controlled foreign entities) less debt interests ($5 million ) is $33 million.

Step 2: Divide step 1 by the risk-weighted assets of the group (e.g. $500 million) to give a worldwide group capital ratio of 6.6%.

The calculation of the worldwide capital amount is described in subsection 820-320(2).

Step 1: The risk-weighted assets of Australian operations are $350 million.

Step 2: Multiply the amount calculated under step 1 by 80% of the worldwide group capital ratio to give $18.48 million.

Step 3: Add the Tier 1 prudential capital deductions of $6 million to the result of step 2 to give $24.48 million, which is the worldwide capital amount.

The safe harbour amount of $20 millionis lower than the worldwide capital amount ($24.48 million). The safe harbour capital amount therefore becomes the minimum capital amount unless Bank Oz can demonstrate that its arms length capital amount is a lower amount.

Assuming that Bank Oz cannot demonstrate that its arms length capital amount is less than the safe harbour capital amount, it has a capital shortfall of $2 million. That is the amount by which its adjusted average equity capital ($18 million) is less than its minimum capital amount ($20 million). Consequently, an amount of Bank Ozs debt deductions will be disallowed.

Work out the amount of debt deduction disallowed

The amount of debt deduction that would be disallowed is determined under the formula in section 820-325. Assuming the average debt of Bank Ozs Australian operations is $450 million (net of debt attributable to its overseas permanent establishments) which gives rise to debt deductions of $30 million, the amount of debt deduction disallowed is:

debt deuction * (capital shortfall / average debt)


$30 million * ($2 million / $450 million) = $133,333


Diagram 5.1: When will an adjustment be made to disallow all or part of the debt deductions of an outward investing entity (ADI)?

Application to part year periods

5.47 Where an entity is an outward investing entity (ADI ) for only part of an income year, section 820-330 applies Subdivision 820-D to that part year period.

5.48 Where section 820-330 applies, its effect is to convert the application of the thin capitalisation rules from full income year application, to part year period application.

5.49 For example, if an entity is an outward investing entity (ADI) for 6 months of the year, then the entitys adjusted average equity capital is the average of the equity capital of the entity (other than that which is attributable to its overseas permanent establishments), minus the controlled foreign entity equity, for that 6 month period.

5.50 Similarly, the Australian banks safe harbour capital amount and arms length capital amounts are determined for the 6 month period only. 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. Any identified capital shortfall for that period has no direct effect on debt deductions arising in the rest of the income year.

Application and transitional provisions

5.51 The thin capitalisation rules for ADIs apply from the ADIs first income year beginning after 30 June 2001. The existing rules will continue to apply until that income year.

5.52 The rules are applied at the end of the ADIss income year using an average of the quarterly values of its debt, capital and risk-weighted assets throughout the year (see Chapter 8). An average of more frequent measurements may also be used. In the first period of the rules operation, only the closing balances of those amounts at the end of that period need to be tested. [Schedule 1, item 22, section 820-25]

Transitional hybrids

5.53 Under the rules in Subdivision 820-D, debt instruments that are Tier 1 capital are not included in the average equity capital amount. However, a transitional rule applies to Tier 1 capital instruments where they would be debt interests under the debt/equity borderline from 1 July 2001 but where an election is made to have the payments made on these instruments treated as payments on an equity interest until 1 July 2004. Under the transitional rule, such instruments are included in equity capital if they are Tier 1 capital until 30 June 2004. If, in Example 5.1, the debt interest of $5 million was a transition hybrid, the $5 million would not be deducted from the eligible Tier 1 capital amount of $34 million in the calculation of the banks adjusted average equity capital. This would result in adjusted average capital of $23 million and therefore, no deductions would be disallowed. [Schedule 1, item 22, section 820-35]

Consequential amendments

5.54 Consequential amendments are mentioned in Chapter 1. Of particular relevance to Australian banks would be the amendments to section 160AFD of the ITAA 1936 and the insertion of section 25-90 in the ITAA 1997. It should be noted that neither of these amendments relates to debt deductions attributable to the foreign branches of an Australian bank. [Schedule 1, item 5, subsection 160AFD(9) and item 16, section 25-90]