Thin Capitalisation And Debt/Equity Borderline – Changes To Exposure Draft Legislation

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Thin Capitalisation And Debt/Equity Borderline – Changes To Exposure Draft Legislation


Thin Capitalisation And Debt/Equity Borderline – Changes To Exposure Draft


On 21 February 2001, the Government released an exposure draft of the New

Business Tax System (Thin Capitalisation and Other Measures) Bill 2001.

Submissions and consultations have identified a number of areas of the proposed

legislation that the Government considers require amendment.

Today I announce several measures which will be incorporated into the New

Business Tax System (Thin Capitalisation and Other Measures) Bill 2001. The

changes will provide greater certainty in relation to policy already announced

and improve the technical operation of the thin capitalisation rules and the

debt/equity borderline.

The measures ensure that the legislation is consistent with the Government’s

original intentions.

As outlined in Budget Paper No.2, the refinements to the thin

capitalisation measure will be at a cost to revenue of $70 million in 2001-02

and $45 million in 2002-03. The refinements to the debt/equity borderline have

no impact on the revenue estimates.

Attached is an outline of the main amendments to the Exposure Draft. Further

technical amendments will be incorporated in the final Bill.


22 May 2001


Contacts: Thin capitalisation

Contacts: Debt/equity borderline

Bob Jones (ATO) 02 6216 2390

Simon Matthews (ATO) 02 6216 1261

John Nagle (Treasury) 02 6263 4461

Richard Wood (Treasury) 02 6263 4406




Thin Capitalisation

Transitional measures

As a transitional assistance measure, in the first year the thin

capitalisation rules in the Exposure Draft require that debt, assets and other

matters be calculated at the end of the first year of a taxpayers accounting

period (for later years, it will apply to an average of values over a year).

The Government will provide additional transitional relief by applying the

new rules from the start of a taxpayers first income year beginning after 30

June 2001, rather than commencing on 1 July 2001 for all taxpayers. This will

remove the need for taxpayers with substituted accounting periods to apply the

old and new rules for parts of their 2000-01 year of income that includes 1 July

2001. It will also give all taxpayers broadly consistent treatment under the

transitional measure discussed in the preceding paragraph.

Further, under the reforms to the debt/equity borderline certain financial

instruments will change character for tax purposes. These instruments will be

subject to an election whereby a taxpayer can elect to have the current law

apply to them until 30 June 2004 (see below).

The Government will preserve the benefits of this transitional relief for the

new debt/equity borderline by providing in the thin capitalisation rules

comparable transitional relief for all instruments that change character as a

result of the debt/equity reforms (subject to the election).

De minimis rule

The Government will remove the need for smaller taxpayers to comply with the

thin capitalisation regime. Under this proposal, the new regime will not apply

to taxpayers or groups of taxpayers claiming annual debt deductions (eg interest

expenses) of less than $250,000.

Authorised Deposit-taking Institution safe harbour

The safe harbour test provides greater certainty to taxpayers in meeting the

thin capitalisation rules, without having to justify their individual

capitalisation levels.

After close consultation with both the domestic banks and international banks

operating in Australia, the Government will amend the safe harbour capital

amount as outlined in the Exposure Draft.

The safe harbour capital amount will be lowered from 7 per cent to 4 per cent

of Australian risk weighted assets, coupled with various technical adjustments

to how the safe harbour calculations are performed. Only prudential deductions

made in calculating Tier 1 capital will be included in the calculation of the

safe harbour capital amount. The definition of equity capital for the purposes

of the safe harbour will be more closely aligned to the Australian Prudential

Regulatory Authoritys (APRAs) calculation of Tier 1 capital, but will not

include instruments which are debt for tax purposes.

Including leases and other like financing arrangements in the on-lending rule

Under the current law, most (but not all) leases are treated as not being

debt. Leases (other than those treated as debt under existing law) are to be

excluded from debt for the purposes of the new debt test, pending a review of

the tax treatment of leases.

The Government will include leases and certain other like financing

arrangements which may be excluded from debt as being eligible for the on-lending

concession afforded to financial entities. This will ensure that the thin

capitalisation rules do not provide a tax-induced competitive disadvantage to

such financing arrangements.

Securities repurchase arrangements.

The financial industry has argued for an extension of the securities

repurchase arrangement (SRA) treatment in the Exposure Draft (essentially, the

allowance of full debt funding of certain assets) to cover assets which are

typically large in value but which would, if the entity were an Authorised

Deposit-taking Institution (ADI), require very low capital to be held against

them because of their low risk weighting.

In addition, industry has also argued for SRA treatment for loan assets which

are also large but which generate very small gross profit margins. The Exposure

Draft rules for financial institutions would require a disproportionate amount

of capital to cover these assets, notwithstanding the low risk weighting if the

institution were an ADI or the very low profit margins.

The Government will extend the SRA treatment or equivalent treatment, where

appropriate, to cover these assets.

Exclusion for securitised assets.

Securitisation vehicles are essentially conduit financing vehicles that can

be used to move assets (eg mortgages) off balance sheets. They are typically 100

per cent debt funded through debenture issues and generally operate under a

trust structure. Where banks operate or are associated with securitisation

vehicles, APRA assesses the credit risk to the bank and may adjust the capital

requirement accordingly.

The Government will provide SRA-like treatment to securitised assets. This

recognises that a high gearing level is commercially viable for entities that

hold securitised assets.

Definition of associates


Concerns have been raised that the definition of associates being used

in the thin capitalisation rules is too broad and could unintentionally bring

family members or other associates with little or no influence on a companys

funding decisions into the thin capitalisation test.

The Government will introduce a sufficient influence test within the

new rules. This will mean associates of an outward investor would only be

subject to the thin capitalisation rules where they are in a position to

sufficiently influence the associated outward investor, or vice-versa. This test

would also be used to narrow the application of the associate entity equity

deduction (outlined below).

Associate entity equity and debt.

Submissions have raised issues concerning the treatment of associate entity

equity in the Exposure Draft. This is an integrity measure to prevent excessive

debt gearing in a chain of entities.

The Government will amend the associate entity equity provisions to allow

taxpayers to carry up surplus debt capacity to the next corporate level on

a proportional basis. This will alleviate concerns that debt taken on by a

parent company in relation to the acquisition of a less than 100 per cent owned

subsidiary/entity will be counted for the purposes of the safe harbour test,

whilst the interest in the subsidiary funded by the investment will not.

The Government has also listened to concerns that double counting would occur

where intra-group loans are made to less than 100 per cent owned associates. If

not addressed, this could have very damaging effects on large existing

infrastructure projects.

The Government will symmetrically exclude certain intra-group loans from the

safe harbour calculations, subject to the associate receiving the loan funds

being itself subject to the thin capitalisation rules and any other necessary

integrity conditions.

A grouping rule in place of consolidation


The Government announced on 22 March 2001 that the consolidation regime would

be deferred to 1 July 2002. The deferral of consolidation has led to the need

for some form of grouping to be included in the thin capitalisation rules as an

interim measure.

The Government will include interim grouping provisions largely consistent

with the existing rules applying to loss transfers within wholly owned groups of

companies. This will reduce compliance costs.

The Government has decided that, for thin capitalisation purposes, foreign

banks should be able to group their Australian branches with their wholly owned

Australian subsidiaries, based on the existing law permitting foreign bank

branches to transfer losses between their Australian branches and subsidiaries.

The thin capitalisation rules for banks would apply to such a group.

In addition, the Government has decided that multiple entry point groups (ie

foreign owned Australian resident companies that do not have a common Australian

head entity) that are in existence at the date of introduction of the thin

capitalisation legislation to Parliament will be accommodated within the interim

thin capitalisation grouping rules.

80 per cent rule for ADIs


Under the proposed thin capitalisation rules, certain Australian non-ADI tax

groups are permitted to have a gearing ratio of up to 120 per cent of the

worldwide gearing of the group. The banking industry has argued that the lack of

such a rule for ADIs leaves them at a disadvantage compared to non-ADIs.

The Government will allow ADIs a capital ratio in Australia equal to 80 per

cent of their worldwide Tier 1 capital ratio if that would mean a lower minimum

capital amount than otherwise under the safe harbour. The 80 per cent figure

approximately mirrors the 120 per cent rule for non-ADIs.

Capital requirement for Offshore Banking Units (OBUs)


Present rules do not require foreign bank branches that operate OBUs to hold

capital in Australia associated with that OBU business. The Government will

retain this concession under the thin capitalisation regime.

Separate accounting statements for Australian branches of non-residents.

The Exposure Draft requires foreign entities (including international banks)

operating in Australia as branches to prepare branch financial statements. The

Government considers that more detailed work is required to determine which

accounting standards should be used and exactly which amounts should be included

in the financial statements. The functioning of the thin capitalisation rules is

not reliant on the preparation of these statements immediately.

The Government will defer commencement of this requirement for at least 12

months (ie it will not apply for income years starting before 1 July 2002)

pending completion of that work.

Debt/equity borderline

Reflecting the views put by taxpayers during the recent consultative process,

the exposure draft legislation will be amended to appropriately constrain its

impact, to improve its clarity and to address competitiveness concerns.

As mentioned above, the transitional relief foreshadowed in the exposure

draft legislation is to be extended. In particular, all interests issued before

release of the draft exposure legislation (21 February 2001) that change

character as a result of the debt/equity tax reform will be able to elect to

have the current law applied to returns paid on them on or before 30 June 2004.

Other changes include the following:

  • Foreign branches of APRA regulated ADIs will be permitted to issue

    unfranked non-share equity interests subject to the following safeguards.

    The foreign branches will need to be located in a broad exemption listed

    country, proceeds raised from the issuance of the unfranked equity interests

    will be required to be used to fund the operations of the foreign branch of

    the ADI and these interests will be subject to existing rules directed at

    countering dividend streaming (modified as appropriate).

  • The new debt/equity rules will apply to the taxation of dividends

    (including imputation), characterisation of payments from non-resident

    entities, thin capitalisation and the boundary between dividend and interest

    withholding tax (and related provisions).

  • The breadth of the debt/equity tests will be narrowed by applying the

    tests to ensure that they do not apply to certain leases, derivatives,

    service agreements and employment contracts.

Returns on Co-operative Capital Units will remain unfrankable and

non-deductible, leaving the current concessional status of co-operatives