Senate

Revised Explanatory Memorandum

Circulated By the Authority of the Treasurer, the Hon Wayne Swan MP

Chapter 2 - Thin capitalisation - modification of the rules in relation to the application of accounting standards for authorised deposit-taking institutions

Outline of chapter

2.1 Schedule 2 to this Bill modifies the thin capitalisation rules contained within Division 820 of the Income Tax Assessment Act 1997 ( ITAA 1997) in relation to the use of accounting and prudential standards for valuing certain assets of authorised deposit-taking institutions (ADIs).

2.2 This measure aims to adjust for certain impacts from the 2005 adoption of the Australian equivalents to International Financial Reporting Standards on an ADI's thin capitalisation position. It does this by adjusting the application of accounting and prudential standard treatment of specified assets.

2.3 This chapter outlines the circumstances in which certain assets are to be recognised by particular entities for thin capitalisation purposes. The relevant assets are:

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treasury shares;

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one component of the business asset excess market value over net assets - the EMVONA asset. The relevant component is the value of business in force at the time of acquisition of the relevant subsidiaries; and

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capitalised software costs.

2.4 All references to legislative provisions in this chapter are references to the ITAA 1997 unless otherwise stated.

Context of amendments

2.5 The thin capitalisation rules in Division 820 are designed to ensure that Australian and foreign-owned multinational entities do not allocate an excessive amount of debt to their Australian operations thereby inappropriately reducing their Australian profits and tax. The thin capitalisation rules provide this by disallowing a proportion of otherwise deductible finance expenses (for example, interest) where the debt used to fund the Australian operations exceeds certain limits. The allowable level of debt for an ADI is calculated by reference to a minimum amount of equity capital.

2.6 Thin capitalisation rules use the accounting standards as the basis for the identification and valuation of assets, liabilities and equity capital. Prior to 2005, the relevant accounting standards were the Australian Generally Accepted Accounting Principles. However, from 1 January 2005 the Australian Generally Accepted Accounting Principles were replaced by the Australian equivalents to International Financial Reporting Standards. The adoption of Australian equivalents to International Financial Reporting Standards is regarded as having aligned Australia more closely with international accounting practice.

2.7 Transitional provisions were introduced to insulate affected entities, including ADIs, from potential adverse impacts on their thin capitalisation position from the 2005 adoption of the Australian equivalents to International Financial Reporting Standards. These transitional arrangements enabled entities to elect to apply the accounting standards as they existed immediately before 1 January 2005 (rather than the Australian equivalents to International Financial Reporting Standards) for a period of up to four income years from the first income year commencing on or after 1 January 2005. These arrangements are set out in section 820-45 of the Income Tax (Transitional Provisions) Act 1997.

2.8 Under subsection 820-45(4) of the Income Tax (Transitional Provisions) Act 1997, if an ADI makes a choice to use accounting standards that existed before 1 January 2005 (for an income year), the ADI must also choose to use the prudential standards in force under the Banking Act 1959 immediately before 1 January 2005 (rather than current prudential standards) for calculating amounts applicable to the ADI under Division 820.

2.9 The application of these transitional provisions began expiring from 1 January 2009.

2.10 The amendments in Schedule 2 implement the announcement in the 2009-10 Budget (Assistant Treasurer and Minister for Competition Policy and Consumer Affairs' Media Release No. 048 of 12 May 2009). In that media release, the Government announced it would introduce changes to the thin capitalisation regime for ADIs.

2.11 The amendments effectively establish the framework to apply on expiration of the current transitional arrangements and will apply to relevant entities whether or not an entity elected to use the transitional provisions.

2.12 At the time the Australian equivalents to International Financial Reporting Standards was adopted, certain impacts of the new standards for taxpayers subject to the thin capitalisation regime were expected, however other outcomes were unexpected and could not be considered at that time.

2.13 This measure does not reflect an intention to neutralise, for the purposes of the thin capitalisation rules, all differences in outcomes between the previous and current accounting standards. It is not intended to provide entities with scope to artificially inflate their asset base to support higher gearing levels inconsistent with the broader intent of this regime.

Summary of new law

2.14 For income years commencing on or after 1 January 2009, ADIs will be able to deviate from the accounting standard treatment of certain assets and liabilities when doing their thin capitalisation calculations.

Comparison of key features of new law and current law

Detailed explanation of new law

Treasury shares

2.15 Treasury shares are equity instruments that an entity acquires in itself (AASB 132 Financial Instruments Presentation). The amount of treasury shares held must be disclosed separately either on the face of the balance sheet or in the notes (AASB 101 Presentation of Financial Statements).

2.16 The circumstances in which an entity can hold shares in itself are strictly limited under the Corporations Act 2001. However, within these limits it is common business practice for the subsidiary of a bank to invest in the parent company. Two examples of an entity holding treasury shares are:

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life insurance company subsidiaries of the group holding equity in the parent bank as part of investment portfolios supporting policyholder liabilities; and

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employee share plan arrangements where entities hold parent company shares as part of the consolidated group's employee share plan arrangements.

2.17 Under AASB 1038 Life Insurance Business, issued 17 November 1998, direct investments in a particular bank's shares by that company's life insurance subsidiary's statutory funds are recognised in the group's balance sheet at market value (that is, recognised as investments relating to the life insurance business). Consequently, under this accounting standard, this amount was included in the calculation of adjusted average equity capital.

2.18 Section 820-300 is modified so that, for the purposes of calculating the adjusted average equity capital for an income year, certain treasury shares in the entity will be treated as included in the ADI's equity capital to the extent that those shares are part of the entity's eligible tier 1 capital [Schedule 2, item 1, subsection 820-300(4)]. These treasury shares are both shares held by a group member to support liabilities to third parties (that is, policy holders) and shares that offset the accrued expense of a share-based compensation scheme (as described in paragraphs 34 and 35 of Australian Prudential Standard 111 Capital Adequacy: Measurement of Capital issued January 2008).

2.19 Section 820-300 is amended to substantively retain the treatment, for thin capitalisation purposes, of a direct investment in a particular bank's shares by that company's life insurance subsidiary which existed immediately before 1 January 2005.

Value of business in force

2.20 An ADI group may include a life insurance subsidiary. Where this is the case, the accounting and prudential treatment of the assets of the life insurance company are relevant to the calculation of the safe harbour capital amount for the group.

2.21 Under Australian Generally Accepted Accounting Principles and AASB 1038 Life Insurance Business, a life insurer was able to recognise as a separate asset (in its consolidated financial statements) the excess of the market value of interests in subsidiaries over the net amount of the assets and liabilities of those subsidiaries as recognised in the consolidated financial statements. This was known as the 'EMVONA' asset.

2.22 EMVONA may be valued using various methodologies, including valuation as a composition of acquired goodwill arising from acquisitions of subsidiaries, comprising:

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the value of business in force at the time of acquisition, which includes the net present value of the expected distributable profits of business in force at that time;

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the value of new business, which is the net present value of the expected distributable profits of business expected to be written over future periods of time; and

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any changes in the value of business in force and value of new business since acquisition.

2.23 Prior to 1 January 2005, the value of business in force at the time of acquisition was treated as an asset for regulatory capital purposes and as such was deducted from total capital, but not from tier 1 capital. The value of new business was an intangible asset and a tier 1 prudential capital deduction. Consequently, the value of business in force did not increase safe harbour capital amount. The value of new business did.

2.24 The amendment to the safe harbour capital amount method statement reduces the minimum amount of equity capital that an ADI must hold to meet thin capitalisation requirements. The minimum amount is reduced by the amount of goodwill or intangible assets recorded in the financial accounts of an entity that are attributable to the acquisition of a life company's subsidiary which relates to the EMVONA asset and is referrable to the value of business in force at the time of acquisition. This represents a divergence from current accounting practice and a reinstatement of the treatment under the Australian Generally Accepted Accounting Principles. [Schedule 2, items 4 and 7, section 820-310 (step 3(d) in the method statement) and subsection 820-680(1)(note)]

2.25 That is, the value of business in force at acquisition that forms part of the EMVONA asset is the relevant amount for the purposes of step 3(c) in the method statement. Any changes in the value of business in force post acquisition are ignored. The adjusted amount of regulatory capital may be included in the value of business in force at the time of acquisition. However as it is not part of EMVONA it too falls outside the exclusion in step 3(c) of the safe harbour capital amount method statement . [Schedule 2, items 4, 6 and 8, section 820-310 (step 3(c) in the method statement), subsection 820-310(2) and the definition of value of business in force in subsection 995-1(1)]

2.26 The amount of goodwill or intangible asset that relates to the EMVONA asset must be adjusted to reflect any impairment of the class of assets comprising the life company business of the ADI group. In turn this impairment limits the amount of the goodwill or intangible asset that can relate to EMVONA or the value of business in force. [Schedule 2, item 4, section 820-310 (step 3(c) in the method statement)]

2.27 The value of business in force at acquisition is the amount calculated by an actuary according to Australian actuarial practice. If the prescribed actuarial calculation is not undertaken, the value of business in force will be nil . [Schedule 2, item 6, section 820-310]

Example 2.1 : Life company acquired on 1 July 2001

On 1 July 2001, Bank Group Ltd indirectly acquired through another of its life insurance company subsidiaries 100 per cent interest in Life Co Ltd, which carried on Australian life insurance business. At the time of the acquisition Bank Group Ltd prepared financial statements in accordance with Australian Generally Accepted Accounting Principles.

Under Australian Generally Accepted Accounting Principles, the consolidated accounts of Bank Group Ltd recognised an EMVONA asset.

Based on an actuarial assessment prepared at the time of acquisition by an Accredited Member of the Institute of Actuaries of Australia in accordance with Actuarial Guidance Notes 225 and 552, Life Co Ltd was valued as explained in Table 2.1.

Table 2.1 : Valuation of Life Co Ltd: 1 July 2001

The consolidated accounts of Bank Group Ltd therefore recognised EMVONA of $4,905 as at 30 June 2002, being the sum of the value of business in force and the value of new business at that date ($2,412 + $2,493 = $4,905).

On 1 July 2001 the value of business in force was $2,412.

Based on an actuarial assessment of the value of Life Co Ltd at 30 June 2002 by an Accredited Member of the Institute of Actuaries of Australia in accordance with Actuarial Guidance Notes 225 and 552, Life Co Ltd was valued as explained in Table 2.2.

Table 2.2 : Valuation of Life Co Ltd: 30 June 2002

The value of business in force at the time of acquisition at 30 June 2002 was $2,412. It does not include the $219 change in the value of the value of new business and the value of business in force.

For the year ending 30 June 2002, Bank Group Ltd, under the Australian Prudential Regulation Authority's (APRA's) regulatory regime that operated at that time, was required to treat the value of new business amount of $2,493 as a tier 1 prudential capital deduction. The value of business in force at acquisition amount of $2,412 was deducted from total capital. It was not a tier 1 prudential capital deduction.

For the year ending 30 June 2002, the safe harbour capital amount of Bank Group Ltd does not include the value of business in force amount of $2,412 in the safe harbour capital amount.

Example 2.2 : Life company acquired on 1 July 2011

On 1 July 2011 Savings Group Ltd indirectly acquires through another life insurance company subsidiary a 100 per cent interest in Insurance Co Ltd, which carries on Australian life insurance business. At the time of the acquisition, Savings Group Ltd prepares its accounts in accordance with the Australian equivalents to International Financial Reporting Standards.

Under the Australian equivalents to International Financial Reporting Standards, the consolidated accounts of Savings Group Ltd do not recognise an EMVONA asset in relation to the holding of Insurance Co Ltd. The value of business in force in relation to the acquisition of Insurance Co Ltd is not separately identified. However, this amount is included in the 'goodwill or intangible assets' of the group.

If, at the time of acquisition of Insurance Co Ltd, an actuarial valuation of the company was undertaken by an Accredited Member of the Institute of Actuaries of Australia in accordance with Actuarial Guidance Notes 225 and 552, then those values may be used for the purposes of Savings Group Ltd thin capitalisation calculations.

The valuation must identify the EMVONA component of Insurance Co Ltd and the value of business in force of Insurance Co Ltd at the time of the acquisition. Insurance Co Ltd was valued as explained in Table 2.3.

Table 2.3 : Valuation of Life Co Ltd: 1 July 2011

The value of business in force at 1 July 2011 is $5,911.

For the year ending 30 June 2012, Savings Group Ltd, will have a value of business in force at acquisition of $5,911. Under APRA's regulatory regime (assuming it remains unchanged), it will be a tier 1 prudential capital deduction

For the year ending 30 June 2012, the safe harbour capital amount of Savings Group Ltd excludes the value of business in force at acquisition of $5,911 from the safe harbour capital amount.

For the year ending 30 June 2013 the class of assets that includes the investment in Insurance Co Ltd (which in turn includes the value of business in force) is impaired by $3,000. This represents a 50 per cent reduction in that class of assets from the previous year. The goodwill or intangible assets recorded in the accounts of Savings Group Ltd are to be adjusted to reflect this impairment. Therefore on 30 June 2003 the value of business in force at acquisition, will be $2,955.50 (0.5 × $5,911).

Capitalised software expenses

2.28 Under Australian Generally Accepted Accounting Principles, capitalised software costs that were identified as 'other assets' and not intangible assets were treated as risk-weighted assets and increased the safe harbour capital amount required to be held by 4 per cent of their value.

2.29 Australian equivalents to International Financial Reporting Standards AASB 138 : Intangible Assets treats all capitalised software costs as intangible assets. Intangible assets are a tier 1 prudential capital deduction and as such, in the absence of this amendment, would reduce the safe harbour capital amount by 100 per cent of their value.

2.30 The safe harbour method statement in section 820-310 is amended to substantively retain the treatment of capitalised software costs under the accounting and prudential standards that existed immediately before the Australian equivalents to International Financial Reporting Standards were adopted.

2.31 That is, intangible assets referrable to capitalised software costs are not treated as a tier 1 prudential capital deduction as they are excluded from step 3 of the safe harbour capital amount method statement in section 820-310. Capitalised software costs retain risk-weighted asset treatment and increase the safe harbour capital amount required to be held by 4 per cent of their value by virtue of their inclusion at step 1 of that method statement . [Schedule 2, items 3 and 4, section 820-310 (step 1 in the method statement), section 820-310 (step 3(d) in the method statement)]

Requirement to use accounting standards

2.32 Subsection 820-680(1) requires an entity to comply with the accounting standards in identifying its assets and liabilities and in determining the value of its assets, liabilities and equity. The note following subsection 820-680(1) refers to provisions which modify this requirement. That note is amended to include the changes made by this Schedule to the treatment of the value of business in force component of the 'EMVONA' asset . [Schedule 2, item 7, subsection 820-680(1)(note)]

Application and transitional provisions

2.33 The transitional arrangements in the Income Tax (Transitional Provisions) Act 1997 cease to apply for income years commencing on or after 1 January 2009. The amendments made by this Schedule apply to assessments for each income year starting on or after 1 January 2009 . [Schedule 2, item 9]