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ADVANCED
TAXATION
4TH EDITION
MODULE 7
BE HEARD.
BE RECOGNISED.
Published by Deakin University, Geelong, Victoria 3217, on behalf of CPA Australia Ltd, ABN 64 008 392 452
First edition published January 2010, updated 2011, 2012, 2013, 2014, 2015
Second edition published July 2016
Third edition published July 2017
Fourth edition published June 2018
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Authors
Suzannah Andrews Consultant
Justin Dabner Associate Professor, Law School, James Cook University
Rami Hanegbi Lecturer (Tax Law), Deakin University
Monica Hope Teaching Scholar, Taxation, Deakin University
Jason MacDonald Director, White & Black Accountants
Dean Matchett Matchett Partners Pty Ltd
Dr David Morrison Reader in Law, The University of Queensland Law School
Wes Obst Consultant
Dr Sylvia Villios Senior Lecturer in Law, Adelaide Law School, University of Adelaide
2018 updates
Suzannah Andrews Consultant
Justin Dabner Associate Professor, Law School, James Cook University
Rami Hanegbi Lecturer (Tax Law), Deakin University
Monica Hope Teaching Scholar, Taxation, Deakin University
Jason MacDonald Director, White & Black Accountants
Dean Matchett Matchett Partners Pty Ltd
Dr David Morrison Reader in Law, The University of Queensland Law School
Wes Obst Consultant
Dr Sylvia Villios Senior Lecturer in Law, Adelaide Law School, University of Adelaide
Acknowledgments
Dr Ken Devos Senior Lecturer, Monash University
Mark Morris Professor of Practice, Taxation, College of Arts, Social Sciences and Commerce,
La Trobe Business School, La Trobe University
Denis Vinen Associate Professor, Faculty of Business and Enterprise,
Swinburne University of Technology
CPA Australia acknowledges the contribution of Tony Greco and Roger Timms to previous versions
of this Study guide.
Advisory panel
Ken Devos Senior Lecturer, Monash University
Dean Matchett Matchett Partners Pty Ltd
Joanna Roach Bristol-Myers Squibb Australia
Suzannah Andrews Consultant
Learning designer
Jan Williams DeakinCo.
Acknowledgments
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ADVANCED TAXATION
Module 7
CORPORATE FINANCING
462 | CORPORATE FINANCING
Contents
Preview 465
Introduction
Objectives
Review 523
References 529
MODULE 7
MODULE 7
Study guide | 465
Module 7:
Corporate financing
Study guide
Preview
Introduction
Corporate financing is a specific area of finance that relates to the financial activities of running
a corporation. The primary goal of a company is often the maximisation of profit. This may be
achieved through differing decisions regarding investment, financing and dividends.
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The area of corporate financing is highly regulated. This module discusses specific legislation
surrounding certain areas of corporate finance, most of which was implemented in response to
tax minimisation or shifting strategies.
Objectives
After completing this module, you should be able to:
• explain how the debt and equity rules apply to companies;
• identify arrangements subject to the value shifting rules;
• apply the thin capitalisation rules to calculate allowable deductions; and
• identify the treatment of gains and losses arising from various financial arrangements.
466 | CORPORATE FINANCING
Classifying an interest as either debt or equity is important because the shareholders and
creditors of a company are treated differently for tax law purposes. Company returns to
shareholders in the form of dividends:
may be franked (i.e. they may carry imputation credits representing underlying company tax which
may be used to reduce the shareholders’ tax) but … are not deductible to the company making the
dividend [(equity)] (Explanatory Memorandum, New Business Tax System (Debt and Equity) Bill 2001
(Cwlth), para. 1.5).
Conversely, creditors receive non-contingent returns on investment that cannot be franked but
are deductible (debt). The tiebreaker rule (discussed later in this module) provides that interests
that are debt interests will not be equity interests.
Therefore, the distinction between a debt and equity interest may determine whether a return
is frankable and non-deductible, or deductible and non-frankable.
The correct classification of an interest as a debt or equity interest is also relevant when
considering other tax purposes, such as:
• the identification of debt for thin capitalisation purposes (discussed in Part C of this module)
• the identification of debt for the consolidation regime (discussed in Module 5)
• whether interest withholding tax or dividend withholding tax is necessary.
Division 974 of ITAA97 outlines the tests for determining when an interest is a debt or an equity
interest. Note 1 to s. 974-10(2) provides a succinct summary:
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The basic indicator of the economic character of a debt interest is the non-contingent nature of
the returns. The basic indicator of the economic character of an equity interest, on the other hand,
is the contingent nature of the returns (or convertibility into an interest of that nature) (ITAA97,
s. 974-10(2), Note 1).
To ensure the correct characterisation of schemes, the approach taken to classification is one of
substance over form. We look to the underlying rights and obligations of an interest, as opposed
to its legal form, to determine whether such an interest is to be treated as debt or equity.
A scheme will satisfy the debt test in s. 974-20(1) if the elements outlined in Figure 7.1
are satisfied.
Study guide | 467
Element 4: It is substantially more likely than not that the value of the financial
benefit provided will be at least equal to the value received.
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This term has broad application and is intended to ‘include formal and informal agreements,
arrangements and understandings that are not legally binding’ (Explanatory Memorandum,
New Business Tax System (Debt and Equity) Bill, para. 2.159).
Certain provisions regarding related schemes are contained in s. 974-155. While two or
more related schemes together may give rise to a debt interest in an entity, separate schemes
that individually give rise to a debt interest will not be combined into one debt interest
(ITAA97, s. 974-15).
The scheme must be a financing arrangement. Section 974-130(1)(a) of ITAA97 provides that:
a scheme is a financing arrangement for an entity if it is entered into or undertaken … to raise
finance for the entity (or a connected entity of the entity) (ITAA97, s. 974-130(1)).
468 | CORPORATE FINANCING
This provision is extended to apply where the arrangement is to fund another scheme or return,
or part of a scheme or return, that is a financing arrangement (s. 974-130(1)(b)–(c)). Examples of
schemes that may be entered into or undertaken to raise finance are bills of exchange, income
securities and convertible interests (that will convert into equity interests) (ITAA97, s. 974-130(2)).
Some arrangements and schemes are specifically excluded from the definition of financing
arrangement in s. 974-130(4) of ITAA97, for example certain leases or bailments, and ‘life
insurance and general insurance contracts undertaken as part of the issuer’s ordinary course
of business’ (Explanatory Memorandum, New Business Tax System (Debt and Equity) Bill,
para. 2.125).
The financial benefit is usually straightforward and is the amount paid to enter into or acquire
the financial interest. This is ordinarily the amount of money that the issuing entity receives,
and is obliged to pay back to the lender, with interest. A present obligation to provide a
financial benefit in the future also constitutes a financial benefit (ITAA97, s. 974-30(3)).
The debt test requires the entity (or a connected entity) to have an effectively non-contingent
obligation under the scheme to provide a financial benefit or benefits to one or more entities
(ITAA97, s. 974-20(c)). The pricing, terms and conditions of the scheme must be looked into
‘in determining whether there is in substance or effect a non-contingent obligation to take
[an] action’ (ITAA97, s. 974-135(6)).
In this case, the CPSs are not debt. The value returned to AdamCo will likely at least equal the issue
price, but there is no effectively non-contingent obligation to provide a financial benefit. It should also
be noted that the issue of an equity interest does not constitute the provision of a financial benefit
(ITAA97, s. 974-30).
Source: Based on Explanatory Memorandum, New Business Tax System (Debt and Equity) Bill 2001
(Cwlth), para. 2.188, Federal Register of Legislation, accessed February 2018, https://www.legislation.
gov.au/Details/C2004B00920/Explanatory%20Memorandum/Text.
The financial benefit provided relates to the non-contingent obligations identified in the
preceding step, being the amount that the issuer is to provide the investor in relation to the
interest (ATO 2017b, p. 5). This may be the return of the initial investment amount, and any other
interest or amounts paid.
Section 974-35(1)(a) of ITAA97 provides that in calculating the benefit, its value may be calculated:
(i) in nominal terms if the performance period … must end no later than 10 years after the interest
arising from the scheme is issued; or
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(ii) in present value terms (see section 974-50) if the performance period must or may end more
than 10 years after the interest arising from the scheme is issued (ITAA97, s. 974-35(1)(a)).
The performance period is the period within which, under the terms on which the interest is
issued, the effectively non-contingent obligations of the issuer to provide a financial benefit in
relation to the interest have to be met (ITAA97, s. 974-35(3)).
In applying elements 1–4, we see that there is a scheme that is a financing arrangement between
Money and Cash, being the loan of $300 000 between them. The issuing entity (Cash) will receive a
financial benefit, and there is ‘an effectively non-contingent obligation under the scheme to provide
a [future] financial benefit’ (ITAA97, s. 974-20). The term of the loan is less than 10 years so the value
of the financial benefit will be calculated in nominal terms. There is an effectively non-contingent
obligation totalling $405 000 (being $300 000 principal loan repayment + $15 000 interest p.a. ×
5 years). This interest is therefore likely to be treated as a debt interest. The annual interest payments
will generally be deductible under s. 8-1 of ITAA97 but are not frankable.
470 | CORPORATE FINANCING
Equity test
(satisfied by one of four items
from s. 974-75 of Income
Tax Assessment Act 1997 (Cwlth))
A scheme (or a number of related schemes) gives rise to an equity interest in a company if it
meets one of the items outlined in Figure 7.2, and is not characterised as, and does not form part
of, a larger interest that is characterised as a debt interest (ITAA97, s. 974-70(1)). The concept of
‘scheme’ was discussed earlier under element 1 of the debt test. With regard to equity interests
the relevant scheme may be a single instrument (e.g. a share) or be part of a larger interest or
MODULE 7
arrangement. A scheme that gives rise to any one of items 2–4 (inclusive) must also be a financing
arrangement to give rise to an equity interest (ITAA97, s. 974-75(2)).
In addition to this, s. 974-85(2) provides that ‘the regulations may specify circumstances in
which a right or return is to be taken to be contingent, or not contingent’.
With respect to the scope of economic performance, a link is required between the economic
performance of the entity issuing the interest and the return to the investor (the interest holder).
That is, ‘the company in which an equity interest exists is taken to be the issuer of the interest’
(ITAA97, s. 974-95(5)), and ‘an interest whose returns are contingent on something other than
the economic performance of the issuer or a connected entity’ (Explanatory Memorandum,
New Business Tax System (Debt and Equity) Bill, para. 2.28) does not satisfy the requirements
of Item 2.
Similarly, if Brown issues an interest that carries the right to an annual payment of $500 for each financial
year that Brown records a profit, the right to a return will be contingent on such profit being made
and will therefore also satisfy Item 2 and be an equity interest.
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In contrast, if Brown issued an interest with a right to return of $50 per interest held, payable annually at
the discretion of the directors based on an assessment of Brown’s annual turnover (not profit), then the
return will not be contingent on economic performance and will fail Item 2.
Brown does not have an effectively non-contingent obligation to provide Jason with a financial benefit,
even though it is likely to do so. The return is still at the discretion of the company and therefore the
interest is an equity interest.
Converting or convertible interests are further defined in s. 974-165 of ITAA97, which states that
an interest will or may convert into a second interest if:
(a) the first interest, or a part of the first interest, must be or may be converted into the second
interest; or
(b) the first interest, or a part of the first interest, must be or may be redeemed, repaid or satisfied by:
(i) the issue or transfer of the second interest (whether to the holder of the first interest or to
some other person); or
(ii) the acquisition of the second interest (whether by the holder of the first interest or by some
other person); or
(iii) the application in or towards paying-up (in whole or in part) the balance unpaid on the
second interest (whether the second interest is to be issued to the holder of the first
interest or to some other person) (ITAA97, s. 974-165).
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‘At-call’ loans (or related party at-call loans) may be classified as giving rise to either debt or
equity interests. However, where a company satisfies the exemption for at-call loans, the at-call
loan will be treated as a debt interest rather than an equity interest. This exemption applies for
companies that have a turnover of less than $20 million.
Study guide | 473
An at-call loan that does not satisfy the debt test (ITAA97, s. 974-20) and is not carved out by
the turnover test will likely constitute an equity interest.
Equity interests are treated the same for tax law purposes, and as such, many of the rules
(e.g. regarding imputation and dividends) apply to non-share equity holders and shareholders
in the same manner. Subdivision 974-E of ITAA97 defines a distribution from a company to a
non-share equity holder as a non-share distribution (s. 974-115). A non-share distribution will
usually be a non-share dividend, and the treatment of this will be similar to a normal dividend on
a share (e.g. frankable under the imputation system) (s. 974-120). The exception to this is where
a distribution is debited to the non-share capital account of the company. Non-share capital
MODULE 7
returns are taxed as returns of capital and not as dividends (ss. 974-120, 974-125).
Where a non-share equity is issued, capital raised is credited to a non-share capital account
(ITAA97, s. 164-10)). A non-share capital account is used by the company to record ‘contributions
made to it in respect of non-share equity interests and returns’ (ITAA97, s.164-5(1)).
Tiebreaker rule
If an interest satisfies both the debt test and the equity test, the tiebreaker rule provides that the
interest will be treated as a debt interest and not an equity interest (ITAA97, s. 974-5(4)).
➤➤Question 7.1
Snow Co issues redeemable preference shares with a face value of $2 each. The terms of issue
are that:
• The shares must be redeemed at their face value after eight years.
• The shares must be redeemed for face value if a takeover offer is made before the expiration
of eight years.
• Dividends will be paid annually at 7 per cent at the discretion of the board of directors.
Source: Based on ATO (Australian Taxation Office) 2017, ‘Redeemable preference shares’, accessed
February 2018, https://www.ato.gov.au/Business/Debt-and-equity-tests/In-detail/Guides/Debt-and-
equity-tests--guide-to-the-debt-and-equity-tests/?page=15.
Check your work against the suggested answer at the end of the module.
Study guide | 475
In simple terms, value shifting is the creation of an artificial value between two assets—that
is, an arrangement that distorts the value of assets when the dealings are not at arm’s length.
This in turn may create artificial losses and defer gains. The provisions operate to address these
arrangements that shift value out of assets. Specifically, Part 3-95 of ITAA97 seeks to redress the
issues associated with value shifting by preventing inappropriate losses and gains from being
realised by ensuring consistent treatment across entities.
The general value shifting rules can be separated into three categories of value shifting:
1. direct value shifting rules for entity interests (Division 725)
2. direct value shifting rules for created rights (Division 723)
3. indirect value shifting rules (Division 727).
The general value shifting rules are intended to broadly apply to substantial value shifts. As such,
there are certain transactions and businesses (small value exclusions) to which the value shifting
rules will not apply. These are categorised as follows:
• entity interest direct value shifting rules – total value shifts under a scheme are less than
$150,000
• created rights direct value shifting rules – the market value of the right granted exceeds the
proceeds for the grant by $50,000 or less, and
• indirect value shifting rules – total value shifted is equal to or less than $50,000 (ATO 2006, p. 1).
The general value shifting rules and their interaction with tax consolidation are discussed briefly
in Module 5.
MODULE 7
For further reading on the value shifting rules, please see the ATO’s Guide to the General Value
Shifting Regime, available at: https://www.ato.gov.au/Business/Consolidation/In-detail/General-value-
shifting-regime/Guide-to-the-general-value-shifting-regime/.
This will therefore either adjust the cost base in relation to the assets that are involved in the
value shifting transaction, or produce a taxable event in relation to the value shifting transaction.
In relation to the character of an interest, this refers to whether the interest is a capital gains tax
(CGT) asset, trading stock or a revenue asset.
For Division 725 to be triggered, the following requirements must be met (ITAA97, s. 725-50):
• There is an impact on the market value of interests in the target entity (being a company or
trust) so there is an up interest and a down interest.
• The entity interest direct value shift is under a scheme.
• The threshold conditions are met.
The two directors of the company, John and Paul, hold all of the A and B class shares respectively.
MODULE 7
John and Paul decide to vary the rights attaching to both classes of shares. This means that the A class
shares have a new market value of $1500 each, and the B class shares have a new market value of
$3000 each.
While an up increase is the increase in the market value of one or more equity or loan interests,
it will also occur when such interests are issued at a discount.
An equity or loan interest is issued at a discount if, and only if, the market value of the interest
when issued exceeds the amount of the payment that the issuing entity receives. The excess is the
amount of the discount (ITAA97, s. 725-150(1)).
For example, if Lotus Pty Ltd from Example 7.7 issues shares for $2000 when their market value
at the time of issue was $4000, there will be a discount of $2000 (i.e. an up interest).
Scheme
The entity interest direct value shift needs to occur under a scheme involving equity or loan
interests in the target entity. Such value shifting will occur under a scheme if the decrease and
the increase in value are reasonably attributable to a thing or things done under that scheme,
and happen at or after the time when the first of those things happens under the scheme
(ITAA97, s. 725-145). This is to be determined as a question of fact.
Threshold conditions
For the general value shifting rules to apply, further tests need to be met. These tests ensure
that the value shifting rules operate to target large and significant value shifts. Section 725-50
of ITAA97 provides that a direct value shift will have consequences if:
• The controlling entity test is satisfied (ITAA97, s. 725-55).
• The participants in the scheme test is satisfied (ITAA97, s. 725-65).
• There are affected owners of interests in the target entity (ITAA97, ss. 725-80, 725-85).
• Neither the ‘de minimis exception’ nor the ‘reversal exception’ applies.
MODULE 7
during the period starting when the scheme is entered into and ending when it has been carried
out (ITAA97, s. 725-55).
An entity will control a company if one of the three tests in s. 727-355 of ITAA97 are satisfied.
An entity controls a company if it (or the entity and its associates between them):
• holds at least a 50 per cent interest in either the voting power, right to distribution of
dividends, or right to distribution of capital in the company (s. 727-355(1))
• holds at least 40 per cent of the voting power, right to distribution of dividends, or right
to distribution of capital in the company, and it can be shown that no other entity actually
controls the company (s. 727-355(2))
• in fact, controls the company (i.e. has actual control of the company) (s. 727-355(3)).
In relation to trusts, the control tests applied will depend on whether the trust is a fixed trust
or otherwise. The tests that determine whether an entity controls a fixed trust are in s. 727-360
of ITAA97. An entity will control a fixed trust for value shifting purposes if the entity:
either alone or together with its associates, has the right to receive (directly or indirectly) at least
40% of any distribution of income or capital of the trust (ATO 2006, p. 134).
478 | CORPORATE FINANCING
An entity will also control, for value shifting purposes, a fixed trust if one of the further tests
in s. 727-360(2) are met:
(a) the entity, or an associate of the entity, whether alone or with other associates (the relevant
entity), has the power to obtain the beneficial enjoyment of the trust’s capital or income
(whether or not by exercising its power of appointment or revocation, and whether with or
without another entity’s consent); or
(b) the relevant entity is able to control the application of the trust’s capital or income in any
manner (whether directly or indirectly); or
(c) the relevant entity is able to do a thing mentioned in paragraph (a) or (b) under a scheme; or
(d) a trustee of the trust is accustomed or is under an obligation (whether formally or informally),
or might reasonably be expected, to act in accordance with the relevant entity’s directions,
instructions or wishes; or
(e) the relevant entity is able to remove or appoint a trustee of the trust (ITAA97, s. 727-360(2)).
For non-fixed trusts, the ‘trustee test’ set out in s. 727-365 of ITAA97 provides that:
an entity controls [for value-shifting purposes] a non-fixed trust … if:
• that entity, or an associate, is the trustee of the trust, or
• that entity, either alone or together with its associates, has the power to appoint or remove
the trustee of the trust.
An entity will also control a non-fixed trust if the trustee is accustomed to act, is under some formal
or informal obligation to act or might reasonably be expected to act in accordance with their
directions, instructions or wishes. It does not matter if the directions, instructions or wishes are
those of the entity or its associate alone, or together with any other entities (ATO 2006, p. 134).
In addition, under the tests known as the ‘control of trust income or capital tests’:
an entity controls a non-fixed trust … if the entity, either alone or with its associates, has:
• the power to obtain the beneficial enjoyment of trust income or capital
• the power to control in any way the application of trust income or capital
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• the ability, under a scheme, to gain the beneficial enjoyment, or control the application, of trust
income or capital (ATO 2006, p. 134).
Finally, an entity can be said to control a non-fixed trust ‘if that entity, or any of its associates,
can benefit under the trust otherwise than because of a fixed entitlement’ (ATO 2006, p. 135)
to a share of the income or capital of the trust, or if the entity and any of its associates have
between them:
the right to receive (either directly, or indirectly through one or more interposed entities) at least
40 per cent of any distribution of trust income, or trust capital (ATO 2006, p. 134).
An entity will be an active participant if the target entity is a closely held entity (i.e. an entity with
fewer than 300 members, or beneficiaries, in the case of a trust) and:
owned either a down interest or an up interest in the target entity or had an up interest issued to it
at a discount in the target entity (ATO 2006, p. 15; see ITAA97, s. 725-65(2)).
Study guide | 479
If an entity has 300 or more members or beneficiaries, special rules may apply ‘under which
certain companies and trusts are not regarded as having 300 or more members or beneficiaries’
(ITAA97, s. 725-65(3); see s. 124-810). Additionally, s. 725-65(4) of ITAA97 states that Division 725
‘applies to a non-fixed trust as if it did not have 300 or more beneficiaries’.
No exceptions apply
There will be no entity interest direct value shift consequences if either the ‘de minimis exception’
or the ‘reversal exception’ are met.
Under the de minimis exception (ITAA97, s. 725-70(1)), there will only be consequences if the
sum of the decreases in the market value of all down interests in the target entity because of
direct value shifts under the scheme are at least $150 000. If it can be concluded that value shifts
happened under different schemes in order to access this exemption, the exception will not
apply (s. 725-70(2)).
MODULE 7
arrangement of $100 000. The decrease is less than $150 000, so the de minimis rule will apply and
there will be no consequences under the entity interest direct value shifting provisions.
Source: Based on ATO (Australian Taxation Office) 2006, Guide to the General Value Shifting Regime,
p. 18, accessed February 2018, https://www.ato.gov.au/Business/Consolidation/In-detail/General-value-
shifting-regime/Guide-to-the-general-value-shifting-regime/.
Under the reversal exception (ITAA97, s. 725-90), there will be no entity direct value shift
consequences if it is more likely than not that, because of the scheme, ‘the cause of the value
shift will reverse within four years under the terms of the same scheme’ (ATO 2006, p. 19)
from when it first happened.
The exception will stop applying if the value shifting terms or scheme is not reversed at the
end of those four years or when a realisation event happens (s. 725-90(2)). If the exception no
longer applies then it is taken never to have applied to the direct value shift, the consequence
of which may be that an assessment is made for an earlier tax year (s. 725-90(3)).
480 | CORPORATE FINANCING
This year, under a scheme, Blue changes certain rights relating to voting for the A class shares.
As a result, the market value of the A class shares decreases, and the value of the B class shares
proportionately increases. Blue’s constitution provides that the change in voting rights attaching to
the shares is to last for a maximum of three years, before it reverts to the original rights attaching
to the shares when issued.
As such, if the reversal does happen within three years, the direct value shift will not have consequences
(ITAA97, s. 725-90(1)). The exception will cease to apply if, before the reversal happens, the four-year
period expires or an affected owner of the shares sells their interest.
Source: Adapted from Income Tax Assessment Act 1997 (Cwlth), s. 725-90, Federal Register of
Legislation, accessed February 2018, https://www.legislation.gov.au/Details/C2017C00336.
However:
a different assumption applies where a value shift is neutral for a particular affected owner (that is,
where the total of the market value decreases for their down interests is equal to the sum of the
increases in market value and discounts received for their up interests). The consequences for that
affected owner are worked out as if the value shifted from their down interests to their up interests
(ATO 2006, p. 21; see ITAA97, s. 725-220).
Treatment of interests
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The consequences of Division 725 of ITAA97 will vary depending on the owner of the interests
and whether assets are held on capital account, trading stock or are a revenue asset. Generally,
rollover treatment will apply to interests with the same affected owner and similar character.
Disposal treatment will apply in other cases.
Relating to disposal treatment for an affected owner of a down interest, the CGT consequences
of a value shift may be the triggering of one or more taxing events generating a gain (gain
treatment) and/or a reduction in the cost base or reduced cost base of the interest (changes to
adjustable values). The consequences of the direct value shift from a down interest that triggers
a taxing event is contained in s. 725-245 of ITAA97. This section provides a table of taxing events
generating a gain for interests as CGT assets. The gain is then calculated under s. 725-365 of
ITAA97.
For an affected owner of an up interest, the CGT consequences of a value shift may be the
uplifting of the cost base or reduced cost base of the interest (changes to adjustable values).
‘For up interests, adjustments are made when they increase in value or are issued at a discount
under a scheme’ (ATO 2006, p. 35).
Rollover treatment may apply where the same affected owner holds interests of the same
character, and value is shifted between those interests. Rollover treatment provides there are
only changes to adjustable values. The consequences for adjustable value are worked out
according to the table in s. 725-250(2) of ITAA97. In relation to trading stock and revenue assets,
adjustable values are worked out under s. 725-335(3) of ITAA97.
Study guide | 481
The rules in this Division operate to stop artificial losses being created ‘when an entity creates
in an associate a right out of, or over, an existing asset … for less than market value’ (ATO 2006,
p. 44). The effect of this is that the market value of the existing asset (known as the ‘underlying
asset’) decreases and losses can be created through the disposal or realisation of that asset at a
reduced value (ITAA97, s. 723-1).
To redress this, the created rights direct value shifting rules operate to reduce the loss that would
have been made in relation to the underlying asset.
An underlying asset can be any asset except for a depreciating asset. The consequences for
value shifting are worked out according to s. 723-10 of ITAA97, where there is a reduction in loss
from realising a non-depreciating asset over which a right has been created. Section 723-15 is
used where there is a reduction in loss from realising a non-depreciating asset at the same time
as a right is created over it.
In substance, these provisions are similar. They require that (see, for example, ITAA97, s. 723-10):
• ‘The owner of an asset [created] a right out of, or over it, in their associate’ (ATO 2006, p. 45).
• ‘The market value of the right created [exceeded] the consideration … received by the owner
by more than $50 000’ (ATO 2006, p. 45).
• ‘The right [is] in existence … when a realisation event happens to a relevant asset’ (ATO 2006,
p. 45).
• ‘The market value of the underlying asset [is] less than it would have been if the right did not
exist when the realisation event [happened]’ (ATO 2006, p. 45).
• There is ‘a loss realised for tax purposes when the realisation event happens to the relevant
asset’ (ATO 2006, p. 45).
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• Creating the right involves a CGT event that meets special conditions (ITAA97, ss. 723-10(1)
(e), 723-15(1)(c)).
The right that is created then needs to be identified. The provisions will apply to any type of
right, but not to:
• a conservation covenant over land (where the underlying asset is land) (ITAA97, s. 723-20(1))
• a right created on the death of an owner (e.g. through a Will or codicil) (ITAA97, s. 723-20(2)).
The right then needs to be created over the underlying asset, in the asset owner’s associate
(i.e. related party) (Income Tax Assessment Act 1936 (Cwlth) (ITAA36), s. 318).
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A shortfall is calculated as the difference between capital proceeds and market value on creation
of the right. A shortfall exists if ‘creating the right involved a CGT event … whose capital proceeds
are less than the market value of the right when created’ (ITAA97, s. 723-10(1)(e)). When considering
the capital proceeds (ITAA97, s. 116-20) that amount may differ from any actual consideration
received, particularly if the market value substitution rule applies (ITAA97, Division 116). If the:
market value substitution rule applies for tax purposes, the created rights direct value shifting rules
will not apply as no shortfall will exist on the creation of the right (ATO 2006, p. 160).
The creation of the right triggers CGT event D1 (for Matt) and there are no capital proceeds (ITAA97,
s. 116-20). Market value substitution does not apply (ITAA97, s. 116-30(3)). ‘Creating the right involved
a CGT event … whose capital proceeds are less than the market value of the right when created’
(ITAA97, s. 723-10(1)(e)) and a shortfall of $200 000 exists.
For there to be consequences under Division 723 of ITAA97, the de minimis rule requires that
the difference between the consideration for tax purposes and the market value of the right
when created must exceed $50 000 (ss. 723-10(1)(f), 723-15(1)(d)). However, where multiple rights
are created as to be under the threshold, the exemption will not apply (s. 723-35).
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Section 977-5 of ITAA97 states that ‘for a CGT asset, a realisation event is a CGT event (except
CGT event E4, CGT event E10 and CGT event G1)’, while s. 977-20 provides that ‘for an item
of trading stock, a realisation event is a disposal of the item or the ending of an income year’.
For a revenue asset, there is a realisation event where an entity disposes of or ceases to own,
or otherwise realises, the asset (ITAA97, s. 977-55). A realisation event can be a partial realisation
(ITAA97, s. 723-25).
The relevant asset and the realisation event that happens to it needs to be identified so that the
consequences for the realisation event can be determined.
If the right did not exist when the realisation event (sale) happened, the market value would have been
$2 million. Thus, there is a deficit on realisation of $500 000.
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Method used to make a reduction
Both the basic case and same asset rollover case use ‘reduction methodology’, whereas
replacement asset rollover may see the use of different methods to make a reduction. The basic
case and same asset rollover case occur where the loss on the asset is reduced directly, the basic
case being a realisation of the underlying asset by the creator of the right.
For a replacement asset rollover case, the created rights direct value shifting rules apply when
a realisation event happens to a replacement interest and a loss is realised for tax purposes
(ATO 2006, p. 53).
The ATO explains that ‘a direct replacement asset rollover is one where a CGT replacement asset
rollover applies directly to a transfer of the underlying asset’ (ATO 2006, p. 151), whereas:
an indirect replacement asset rollover is one where a CGT replacement asset rollover applies when
a CGT event happens to a replacement interest that has been obtained under a prior replacement
asset rollover (ATO 2006, p. 53; see ITAA97, s. 723-110).
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Further, ‘losses made on the realisation of the replacement interests received may be subject
to reduction’ (ATO 2006, p. 53).
If the right created in respect of an underlying asset is also trading stock or a revenue asset, and a
gain is realised on the right within four years of the realisation of the underlying asset, then the gain
taken into account in the reduction formula is:
• if the right is trading stock – the gain on realisation of the item of trading stock, and
• if the right is a revenue asset – the gain on realisation of the right as a revenue asset or as a
CGT asset, whichever is the greater (ATO 2006, p. 51; see ITAA97, s. 723-50).
If, prior to the sale of the asset, Nic had sold the right to Stephanie for market value ($180 000),
there would be a capital gain realised of $180 000.
The maximum reduction under the created rights direct value shifting regime for Matt’s loss on the
sale of the asset will be $20 000.
This is worked out with the maximum reduction for a loss being $200 000 (the lesser of the deficit
on realisation ($500 000) and shortfall on granting the right ($200 000)) less the gain made on the
realisation ($180 000).
Using the equation $200 000 – $180 000 = $20 000 shows a maximum reduction of $20 000 under the
created rights direct value shifting regime.
Source: Based on ATO (Australian Taxation Office) 2006, Guide to the General Value Shifting Regime,
p. 51, accessed February 2018, https://www.ato.gov.au/Business/Consolidation/In-detail/General-value-
shifting-regime/Guide-to-the-general-value-shifting-regime/.
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➤➤Question 7.2
Continuing the facts from Example 7.12, Matt granted a right to Nic for the exclusive use of the
asset for five years. No consideration was paid. As a result, there was a shortfall on creating the
right of $200 000. Matt then sold the asset, resulting in a loss and deficit on realisation of $500 000.
Prior to the sale, instead of selling the right to Stephanie for $180 000 (being the market value),
Nic sold the right to Lucinda for $210 000 (being $30 000 more than market value). The right
was held by Nic as a revenue asset.
What would the consequences be for Matt on the sale of the underlying asset?
Check your work against the suggested answer at the end of the module.
Study guide | 485
The reduction methodology may also apply for partial rollover cases, where only part of the
underlying asset is realised. In this case, the reduction methodology applies slightly differently to
that in s. 723-10 or s. 723-15 of ITAA97, and a fractional approach is used (ITAA97, s. 723‑25(1)).
Section 723-25(2) of ITAA97 provides that ‘the shortfall on creating the right and deficit on
realisation are each multiplied by the fraction’ (ATO 2006, p. 52):
Shortly after this happens, Frankie transfers all of the business assets to Acquire Co in exchange for all
of the rights in Acquire Co. The large asset is transferred as part of this arrangement. This constitutes
a direct replacement asset rollover. If Frankie later exchanges his shares in Acquire Co for shares
in another company (ITAA97, Subdivision 124-M scrip-for-scrip rollover), there will be an indirect
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replacement asset rollover.
In both cases, the cost base and reduced cost base of the replacement interest are or could be derived
in part from the cost base and reduced cost base of the large asset. The created rights direct value
shifting rules may apply if the replacement interest is realised at a loss.
Source: Based on ATO (Australian Taxation Office) 2006, Guide to the General Value Shifting Regime,
p. 54, accessed February 2018, https://www.ato.gov.au/Business/Consolidation/In-detail/General-value-
shifting-regime/Guide-to-the-general-value-shifting-regime/.
An indirect value shift will arise where there has been a shift of value from one entity to a
related entity and, as such, involves a reduction in value of debt (loan) or equity interests in
one entity (the losing entity) and a corresponding increase in the value of interests in another
entity (the gaining entity). Examples of indirect value shifts include the provision of services or
transfer of assets for less or more than market value.
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The rules operate to prevent inappropriate gains and losses arising when entity interests are
later realised. For there to be consequences under the indirect value shifting rules, it must be
established that:
• There is an indirect value shift.
• The threshold conditions are met.
• The entity is one affected by the rules.
Under the basic case, there will be an indirect value shift if there is a scheme that results in
economic benefits being shifted from one entity (the losing entity) to another entity (the gaining
entity) and those economic benefits are of greater market value than the economic benefits
provided by the gaining entity to the losing entity in return (ITAA97, s. 727-150). The definition
of ‘scheme’ was discussed earlier. Market value is determined as a question of objective fact.
An economic benefit is provided in connection with a scheme if it is provided under the scheme
or is reasonably attributable to something done (or omitted to be done) under the scheme by
the provider or recipient, or by a third party (ITAA97, s. 727-160).
Section 727-155(1) of ITAA97 lists some examples of an entity providing an economic benefit
to another entity:
(a) the first entity pays an amount to the other entity (in this case the market value of the benefit
is the amount of the payment);
(b) the first entity provides an asset or services to the other entity;
(c) the first entity does something that creates an asset in the hands of the other entity
(for example, a company issues shares to its members);
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(d) the first entity incurs a liability to the other entity, or increases a liability it already owes
to the other entity;
(e) the first entity terminates all or part of a liability owed by the other entity;
(f) the first entity does something that increases the market value of an asset that the other entity
holds (ITAA97, s. 727-155(1).
There are two further cases that may have consequences: a ‘presumed indirect value shift’ and
an ‘indirect value shift resulting from an entity interest direct value shift’. These are less common
cases and, as such, are not covered in this module.
The ‘presumed indirect value shift’ and the ‘indirect value shift resulting from an entity interest direct
value shift’ are not examinable. For further information regarding the consequences of these types
of value shift, see ‘Indirect value shifting rules’ in the ATO’s Guide to the General Value Shifting
Regime, available at: https://www.ato.gov.au/assets/0/104/1083/1160/65c68c14-2407-475c-a289-
dcb12d7066c1.pdf.
The provision of the services for no charge creates an indirect value shift from Bubble (losing entity)
to Squeak (gaining entity). The amount of the indirect value shift is $1.5 million.
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Threshold conditions
An indirect value shift has consequences under Division 727 of ITAA97 if:
(a) the losing entity is at the time of the indirect value shift a company or trust (except one
listed in section 727‑125 (about superannuation entities)); and
(b) in relation to either or both of the following:
(i) the losing entity providing one or more economic benefits to the gaining entity in
connection with the scheme from which the indirect value shift results;
(ii) the gaining entity providing one or more economic benefits to the losing entity
in connection with the scheme;
the 2 entities are not dealing with each other at arm’s length; and
(c) either or both of sections 727‑105 and 727‑110 are satisfied; and
(d) no exclusion in Subdivision 727‑C applies (ITAA97, s. 727-100).
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Section 727-105 of ITAA97 provides that at some time during the indirect value shifting period,
one of the following must be the case:
(a) the losing entity and the gaining entity have the same ultimate controller; or
(b) the ultimate controller of the losing entity is the same entity that was the ultimate controller
of the gaining entity at a different time during that period; or
(c) the gaining entity is the ultimate controller of the losing entity; or
(d) the losing entity is the ultimate controller of the gaining entity (ITAA97, s. 727-105).
The tests for determining the controller are discussed under the entity interest direct value
shifting rules.
In the alternative, if the entities have fewer than 300 members (i.e. are closely held), the provisions
can be triggered if there is a common ownership nexus between the entities (ITAA97, s. 727-110).
Two entities have a common-ownership nexus within a period if they satisfy one of the items in
s. 727-400(1) of ITAA97.
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General exclusions
The exclusions are separated into: general exclusions and ‘realisation time method exclusions’.
Value shifts between members of consolidated groups or multiple entry consolidated (MEC)
groups (see Module 5) will also be excluded.
In addition to the general exclusions, there are realisation time method exclusions, which apply
to the realisation of certain interests to which the realisation time method (discussed later)
applies. If this method applies, there will be no consequences where:
• ‘the indirect value shift happens at least four years before that affected interest in the losing
entity is realised, and the amount of the value shift is less than $500 000’ (ATO 2006, p. 84;
see ITAA97, s. 727-610(2))
• ‘the indirect value shift is a 95% services indirect value shift’ (ITAA97, s. 727-700).
According to s. 727-700(2):
an indirect value shift is a 95% services indirect value shift if, and only if, to the extent of at least 95%
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of their total market value, the greater benefits consist entirely of:
(a) a right to have services that are covered by section 727‑240 provided directly by the losing
entity to the gaining entity; or
(b) services that are covered by section 727‑240 and have been, are being, or are to be,
so provided;
or both (ITAA97, s. 727-700(2)).
‘Greater benefits’ means the total market value of the one or more economic benefits that the
losing entity has provided to the gaining entity. The ‘lesser benefits’ would be the total market
value of the one or more economic benefits that the gaining entity has provided to the losing
entity in connection with the scheme (ITAA97, s. 727-150).
Affected interests
Indirect value shifting provisions apply only to ‘affected interests’. Under s. 727-460 of ITAA97,
the affected interests in the losing entity are:
(a) each equity or loan interest that an affected owner owns in the losing entity immediately before
the [indirect value shift] time; and
(b) each equity or loan interest that:
(i) an affected owner owns in another affected owner immediately before the [indirect value
shift] time; and
(ii) is an indirect equity or loan interest in the losing entity (ITAA97, s. 727-460).
Study guide | 489
The ‘affected owners’ for the purposes of these provisions (and an indirect value shift) are set
out in the table in s. 727-530 of ITAA97.
The two methods that may be applied to work out if any adjustments required are the:
1. realisation time method (Subdivision 727-G)
2. adjustable value method (Subdivision 727-H).
With respect to the losing entity, s. 727-615 of ITAA97 provides that, where a realisation event
happens to an affected interest in the losing entity, any resulting loss is reduced by an amount
that is reasonable having regard to ‘a reasonable estimate of the amount (if any) by which the
indirect value shift has reduced the interest’s market value’ (ITAA97, s. 727.615(a)).
Where an interest is also an interest in the gaining entity, the adjustment will need to be worked
out on a net basis taking into account the extent to which any increase in the market value of
the interest relating to the value shift is still reflected in the market value at the time at which the
interest is realised (ATO 2006, p. 96).
The same approach is applied regarding reasonable estimates to the reduction of a gain on a
realisation event for the affected interest in the gaining entity (ITAA97, s. 727-620). An adjustment
will also take into account (when the affected interest is later realised) whether the value that is
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shifted is still reflected at that time.
The amount of the adjustments that may be made in respect of an interest in the gaining entity
is limited by reference to the adjustments that have been made on realisation of interests in the
losing entity (ATO 2006, p. 98).
That is, there is a cap (ITAA97, s. 727-625). This may mean that where the losing entity is yet to
realise an interest, there cannot be an adjustment made for the gaining entity.
BCo then provides services to an associate company on a non-arm’s length basis. The associate
company pays BCo $1 million for the services, but a commercial charge would have been $1.5 million.
This constitutes an indirect value shift for which there will be consequences.
Following this transaction, the market value of ACo’s shares in BCo reduces to $0.60 and ACo decides
to sell half the shares in BCo.
ACo sells 500 000 shares in BCo for $0.55 a share, realising a loss (of $0.45 per share). Of this loss, it is
reasonable to suggest that $0.40 is attributable to the indirect value shift.
ACo’s loss will be reduced to $0.05 a share under the realisation time method.
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The calculation of the adjustments required under the realisation time method or adjustable value
method is not examinable.
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Study guide | 491
The term ‘thin capitalisation’ broadly refers to the situation where a company is financed
primarily by (multinational) debt capital, as opposed to equity capital. It arises in the context
of international investment and is concerned with the debt to equity funding ratio of
corporations. If an entity is funded by excess debt (when looking at a debt to equity ratio)
then it can be said to be thinly capitalised.
The way a company is funded can have a significant impact on profitability and the tax paid
in certain countries. The different tax treatments of debt and equity (discussed earlier in this
module) are relevant in understanding why companies would want to be thinly capitalised for
tax purposes.
A company may fund its subsidiary by a significant amount of debt because the subsidiary’s
taxable profits are reduced by the significant interest payments made to the head company
(on the debt), and which the subsidiary will in turn take as a deduction. The thin capitalisation
provisions seek to limit this deduction.
The interaction of the thin capitalisation rules with the transfer pricing regime is discussed in
Module 8.
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Thinly capitalised entities
The thin capitalisation rules operate to disallow certain interest deductions to thinly capitalised
entities. A thinly capitalised entity is one that has a high level of debt compared to relatively
little equity. An entity’s ratio of debt to equity is examined, to determine whether it is
thinly capitalised.
Figure 7.3 provides a series of questions that need to be asked in making an assessment as to
whether, and how, the thin capitalisation provisions apply to an entity.
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Figure 7.3: Assessing whether and how the thin capitalisation provisions apply
No
Yes
ADI Non-ADI
Is the entity a
financial entity?
No Yes
Each of the areas outlined in Figure 7.3 are discussed later in this module.
Application of regime
Broadly, the object of the regime is:
to ensure that the following entities do not reduce their tax liabilities by using an excessive
amount of debt capital to finance their Australian operations:
(a) Australian entities that operate internationally;
(b) Australian entities that are foreign controlled;
(c) foreign entities that operate in Australia (ITAA97, s. 820-30).
Study guide | 493
The meaning of a debt deduction for the purposes of the thin capitalisation rules is a cost
incurred by the entity in relation to a debt interest issued by the entity, to the extent to which
the cost is, in the most general sense, interest which the entity could, apart from Division 820
of ITAA97, deduct from its assessable income for that year (ITAA97, s. 820-40). (A debt interest
was defined in Part A of this module.)
The thin capitalisation regime does not apply to private or domestic assets or to a non-debt
liability that is for private use (ITAA97, s. 820-32). Nor does the regime apply to an outward
investing entity that is not also an inward investing entity if the average Australian assets of the
entity and its associates comprise 90 per cent or more of their average total assets (ITAA97,
s. 820-37). Some special purpose entities may also be exempt (ITAA97, s. 820-39).
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• foreign entities with operations or investments in Australia that are claiming debt
deductions (inward investors) (ATO 2016b).
An outward investing entity is the opposite of an inward investing entity, being an Australian
resident entity that:
• is an Australian controller of at least one Australian controlled foreign entity
• carries on business overseas at or through one or more permanent establishments, or
• is an associate entity of either of the above two entities (ATO 2016a, p. 269).
If an entity is neither an inward nor an outward investing entity, Division 820 does not apply.
Aus Co is an Australian company that has a 51 per cent shareholding in an overseas company. Aus Co is
an outward investor.
Control of entity
An assessment also needs to be made as to whether an entity is:
• an Australian controller—that is, an outward investor, or
• a foreign controlled Australian entity—that is, an inward investment vehicle.
Entities that are Australian controllers of Australian controlled foreign entities are subject to the
thin capitalisation rules.
An Australian controlled foreign entity for the purposes of the thin capitalisation regime is,
under s. 820-745 of ITAA97:
• a controlled foreign company (CFC) (except a corporate limited partnership) (as defined in
Module 8)
• a controlled foreign trust, or
• a controlled foreign corporate limited partnership.
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An Australian controlled foreign entity is also a foreign trust that satisfies the test in s. 342 of
ITAA36 or a foreign corporate limited partnership that meets the test in s. 820-760 of ITAA97.
Once it has been established that there is an Australian controlled foreign entity, it needs to be
determined which Australian entities are Australian controllers of those Australian controlled
foreign entities (ATO 2016a).
The thin capitalisation rules will also apply to a foreign controlled entity, namely (ITAA97,
s. 820‑780):
• a foreign controlled Australian company
• a foreign controlled Australian trust
• a foreign controlled Australian partnership.
A foreign controlled Australian company is an Australian entity to which at least one of the
following paragraphs applies:
(a) not more than 5 foreign entities (each of which holds a [thin capitalisation] control interest
in the company that is at least 1%) hold a total of [thin capitalisation] control interests in the
company that is 50% or more;
Study guide | 495
(b) a foreign entity holds a [thin capitalisation] control interest in the company that is 40% or
more, and no other entity or entities (except an associate entity of the foreign entity or entities
including the foreign entity or its associate entities) control the company;
(c) not more than 5 foreign entities control the company (whether or not with associate entities
and whether or not any associate entity is a foreign entity) (ITAA97, s. 820-785(1)).
The thin capitalisation provisions will also apply to a foreign controlled Australian trust that
satisfies the test in s. 820-790 of ITAA97, and to foreign controlled Australian partnerships
that meet the test in s. 820-795 of ITAA97.
If it is established that the entity is a foreign controlled Australian entity then the thin
capitalisation rules will apply.
In certain circumstances, an Australian entity may not be a foreign controlled Australian
entity … [if] the actual control interest is less than 20% (ATO 2016a, p. 18; see ITAA97,
ss. 820‑785(2), 820‑790(3), 820-795(3).
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(d) the [thin capitalisation] indirect control interests (if any) held by the entity’s associate entities
in the company, trust or partnership at that time (ITAA97, s. 820-815 (1)).
With respect to direct control interests, these relate to interests that the entity directly holds
(or is entitled to acquire) in the company at that time (e.g. share capital or voting rights) (ITAA97,
s. 820-855). For trusts, ‘the thin capitalisation direct control interests are those interests in the
income or corpus of trusts held by beneficiaries’ (ATO 2016a, p. 20; see ITAA97, s. 820-860).
For partnerships:
(a) in the case of a corporate limited partnership—100% if the entity is a general partner of
the partnership;
(b) in the case of a partnership that is not a corporate limited partnership—the percentage of the
control of voting power in the partnership that the entity has at that time (ITAA97, s. 820-865).
‘If an entity holds more than one type of thin capitalisation direct control interest’, then ‘the
greatest percentage is taken to be the thin capitalisation direct control interest’ (ATO 2016a,
p. 21; see Explanatory Memorandum, New Business Tax System (Thin Capitalisation) Bill 2001
(Cwlth), para. 7.65).
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Australia Co
Foreign Co
Australia Co is an Australian entity owning 65 per cent of the capital on issue, and 60 per cent of the
voting rights in Foreign Co. The thin capitalisation direct control interest of Australia Co would be 65
per cent (because the greatest percentage is taken).
A control interest can also be an indirect control interest, being ‘interests an entity holds in
another entity via direct interests held in an interposed entity’ (ATO 2016a, p. 21; see ITAA97,
s. 820-870). ‘Interest can be traced through an interposed entity only if the interposed entity is
itself a foreign controlled Australian entity’ (ATO 2016a, p. 22; see ITAA97, s. 820-825).
➤➤Question 7.3
Australia Co has 100 per cent of the share capital on issue of US Co. US Co in turn owns 75 per cent
of the issued share capital, and 60 per cent of the voting rights, in French Co.
What are Australia Co’s thin capitalisation control interests in US Co and French Co?
MODULE 7
Check your work against the suggested answer at the end of the module.
An ADI is ‘a body corporate that is an authorised deposit-taking institution for the purposes
of the Banking Act 1959’ (ITAA97, s. 995-1). ADIs (e.g. banks) are regulated by the Australian
Prudential Regulation Authority (APRA) and may be subject to certain capital requirement
measures. The consequences under the thin capitalisation regime for a non-ADI may be
different to those for an ADI.
Study guide | 497
An entity’s adjusted average debt is calculated according to the method statement in s. 820-85(3)
of ITAA97 for a non-ADI outward investing entity. For an income year, this amount is:
• the average value of its debt capital that gives rise to its debt deductions (other than debt
capital attributable to its foreign permanent establishments); less
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• the average value of its loans to associate entities (other than any loans to its controlled foreign
entities); less
• the average value of any loans to its controlled foreign entities (Explanatory Memorandum,
New Business Tax System (Thin Capitalisation) Bill, para. 3.29).
Storage Co will seek to take debt deductions equal to 10 per cent per annum on the bank loan of
$2.1 million. Storage Co’s adjusted average debt will be $2.1 million. This is the amount giving rise to
its debt deductions, and it does not have any loans to associated entities or controlled foreign entities.
Provided that the entity is not also an inward investment vehicle, the maximum allowable debt
amount is then calculated on the basis of the greatest of the three amounts under:
• the safe harbour debt test
• the arm’s length debt test
• the worldwide gearing debt test (ITAA97, s. 820-90).
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Figure 7.4 outlines the steps that are taken by a non-ADI outward investing entity when analysing
whether the thin capitalisation rules have been met.
Step 1: The entity’s adjusted average debt for a tax year is the result of
Calculate the applying the method statement in s. 820-85(3) of the Income Tax
adjusted average debt. Assessment Act 1997 (Cwlth) (ITAA97).
If the entity’s adjusted average debt is equal to or less than the safe
harbour debt amount, the entity is allowed debt deductions and
the thin capitalisation rules do not operate to prevent the entity
from taking a deduction. If an entity’s debt funding exceeds the
Step 2: ‘safe harbour limit’, an adjustment to reduce the debt deductions
Calculate the safe will ordinarily occur. This is unless the entity demonstrates debt to
harbour debt amount. be acceptable under arm’s length principles (ITAA97, s. 820-105).
If the entity’s adjusted average debt capital is less than the safe
harbour amount, there is no need to calculate the worldwide debt
amount or arm’s length debt amount (Explanatory Memorandum,
New Business Tax System (Thin Capitalisation) Bill 2001 (Cwlth),
para. 3.42).
Calculate the arm’s that the entity would reasonably be expected to have throughout
length debt amount. the tax years (ITAA97, s. 820-105; see Taxation Ruling TR 2003/1).
The entity will not be able to take a deduction for amounts exceeding the maximum allowable
debt amount.
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Step 1
Work out the average value, for the income year, of all the assets of the entity.
Step 1a
Reduce the result of step 1 by the average value, for that year, of all the excluded equity interests in the
entity—some interests are excluded for integrity reasons. By way of brief overview, excluded equity
interest is an entity’s equity capital that has been on issue for a period of less than 180 days and has
certain features that make it possible to manipulate debt and asset values.
Step 2
Reduce the result of step 1a by the average value, for that year, of all the associate entity debt of the
entity. Associate entity debt is a loan asset of the lending entity representing (broadly) the debt interest
issued to the lender by its associate 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. Associate entity equity is generally the sum of the equity invested in, and interest-free loans
granted to, associate entities (it is an asset of the investing entity).
Step 4
Reduce the result of step 3 by the average value, for that year, of all the controlled foreign entity debt
of the entity. Controlled foreign entity debt is a loan asset of the lender—this represents the debt
interests issued to the lender by the controlled foreign entity.
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Step 5
Reduce the result of step 4 by the average value, for that year, of all the controlled foreign entity equity
of the entity. Controlled foreign entity equity is an asset of the investing entity.
Step 6
Reduce the result of step 5 by the average value, for that year, of all the non-debt liabilities of
the entity. If the result of this step is a negative amount, it is taken to be nil.
Step 7
Multiply the result of step 6 by 3 / 5—this reflects the debt to equity ratio of 1.5:1.
Step 8
Add to the result of step 7 the average value, for that year, of the entity’s associate entity excess amount.
The average associate entity excess amount is (broadly) the excess borrowing capacity of any associate
entities. If the entity has no associate entities that are non-authorised deposit-taking institution outward
or inward investors, this amount will be zero. The result of this step is the safe harbour debt amount.
Source: Based on Income Tax Assessment Act 1997 (Cwlth), s. 820-95, Federal Register of Legislation,
accessed February 2018, https://www.legislation.gov.au/Details/C2018C00068.
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➤➤Question 7.4
OztralCo is an Australian company with a wholly owned subsidiary in the United States called
OztralUS. At the end of the financial year, OztralCo records on its balance sheet:
Assets
$
• Investments in OztralUS 2 million
• Land 3 million
• Other assets 1 million
Liabilities/Equity
• Shares on issue 1.8 million
• Loans (@10%) 2.8 million
• Other liabilities (non-debt) 1.4 million
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Check your work against the suggested answer at the end of the module.
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Once the entity’s arm’s length debt amount has been calculated, it can be compared to the
adjusted average debt.
If the entity’s adjusted average debt is equal to or less than the arm’s length debt amount,
the entity is not disallowed any debt deductions under the thin capitalisation rules (ATO 2016a,
p. 80).
If this is not the case, you need to continue to calculate whether deductions are disallowed.
Steps 1 and 2
Divide the average value of all the entity’s worldwide debt for the
income year by the average value of the entity’s worldwide equity.
Step 3
Step 4
Divide the result of step 1 by the result of step 3. That is, dividing the worldwide debt by the
worldwide equity provides the worldwide gearing ratio.
Step 5
Multiply the result of step 4 in this method statement by the result of step 6
in the method statement in s. 820-95 of Income Tax Assessment Act 1997 (Cwlth) (ITAA97).
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Step 6
Add to the result of step 5 the average value, for that year, of the entity’s associate entity excess
amount. The result of this step is the worldwide gearing debt amount.
Source: Adapted from Income Tax Assessment Act 1997 (Cwlth), s. 820-110, Federal Register
of Legislation, accessed February 2018, https://www.legislation.gov.au/Details/C2018C00068.
‘Excess debt’ is the amount by which an entity’s adjusted average debt is more than its maximum
allowable debt and the ‘average debt’ is the average value of an entity’s debt capital that gives
rise to debt deductions (ATO 2016a, pp. 252, 261).
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The safe harbour debt amount for Sydney Co can now be calculated (s. 820-95; see steps discussed
earlier):
$12 000 000 – $4 000 000 – $2 800 000 = $5 200 000 × 60% = $3 120 000
We have been told that Sydney Co’s arm’s length debt amount is $2.5 million and the worldwide
gearing debt amount is $3 million.
We need to compare Sydney Co’s adjusted average debt ($5.6 million) with the maximum allowable
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debt ($3.12 million). If the adjusted average debt exceeds the maximum allowable debt then any excess
will be disallowed. The debt deduction for Sydney Co is $672 000 (i.e. $5 600 000 × 12%).
The excess debt is an amount of $2.48 million, being the adjusted average debt of $5.6 million less
the maximum allowable debt of $3.12 million. The average debt is an amount of $5.6 million, being the
loan amount giving rise to the deductions. To calculate the disallowed amount:
The amount of $297 600 will be disallowed. Therefore, Sydney Co will be allowed a deduction of
$374 400 (i.e. $672 000 – $297 600).
Source: Based on ATO (Australian Taxation Office) 2016, ‘Non-ADI general outward investor’, accessed
February 2018, https://www.ato.gov.au/Business/Thin-capitalisation/Non-ADI-general-outward-investor/.
Each of these steps is accompanied by method statements in the legislation. There is a safe
harbour level of 1.5:1 debt to equity ratio (ITAA97, s. 820-195). For an inward investor, this is
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contained in s. 820-205 of ITAA97. That is, for every $3 of debt, the entity is funded by $2
of equity. For an inward investing vehicle that is financial, this amount changes to 15:1 debt
to equity ratio (ITAA97, s. 820-200).
As can be seen:
there are a number of different methods for calculating the maximum debt allowed, including the
‘safe harbour debt amount’, the ‘arm’s length debt amount’ and the ‘worldwide gearing debt
amount’ (PwC 2014, p. 1).
The worldwide gearing test is available to non-ADI general outward investors that are not also
inward investment vehicles. Amounts in excess of this amount will not be deductible.
Step 1
Step 1a
Reduce the result of step 1 by the average value, for that year,
of all the excluded equity interests in the entity.
Step 2
Reduce the result of step 1a by the average value, for that year, of all the associate entity debt
of the entity that has arisen because of the 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 that has arisen because of the Australian investments.
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Step 4
Reduce the result of step 3 by the average value, for that year, of all the non-debt
liabilities of the entity that have arisen because of the Australian investments.
If the result of this step is a negative amount, it is taken to be nil.
Step 5
Step 6
Add to the result of step 5 the average value, for that year, of the entity’s associate entity excess
amount. The result of this step is the safe harbour debt amount.
Source: Adapted from Income Tax Assessment Act 1997 (Cwlth), s. 820-205, Federal Register
of Legislation, accessed February 2018, https://www.legislation.gov.au/Details/C2018C00068.
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Step 1
Divide the entity’s statement worldwide debt for the income year by the entity’s
statement worldwide equity for that year.
Step 2
Step 3
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Step 4
Multiply the result of step 3 in this method statement by the result of step 4
in the method statement in s. 820-205 of Income Tax Assessment Act 1997 (Cwlth).
Step 5
Add to the result of step 4 the average value, for that year, of the entity’s associate entity excess
amount. The result of this step is the worldwide gearing debt amount.
Source: Adapted from Income Tax Assessment Act 1997 (Cwlth), s. 820-218, Federal Register
of Legislation, accessed February 2018, https://www.legislation.gov.au/Details/C2018C00068.
Example 7.20 shows the process for working out the worldwide gearing debt amount for inward
investor (general).
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Source: Income Tax Assessment Act 1997 (Cwlth), s. 820-218, Federal Register of Legislation,
accessed February 2018, https://www.legislation.gov.au/Details/C2018C00068.
As noted earlier, the relevant entity can use different methods and then pick the one giving the
highest maximum deduction amount. The ATO explains that ‘the proportion of debt deductions
disallowed depends on the amount by which the entity’s adjusted average debt … exceeds its
maximum allowable debt’ (ATO 2016a, p. 164).
Melbourne Co’s excess debt amount is calculated as $2 762 500, which is worked out as the adjusted
average debt of $58 million less the maximum allowable debt of $55 237 500. This amount can then
be divided by the average debt of $59 million, as follows:
This is the proportion that can be applied to Melbourne Co’s debt deductions. The debt deductions
are $2.7 million.
➤➤Question 7.5
Hope Co is an Australian company seeking to calculate its disallowable debt deductions in
accordance with the thin capitalisation rules. The maximum allowable debt for Hope Co is the
greatest of the safe harbour debt amount, the arm’s length debt amount and the worldwide
gearing debt amount. Hope Co calculates all three amounts and decides to use the safe harbour
debt amount.
Hope Co has the following:
• safe harbour debt amount—$45 million
• adjusted average debt—$50 million
• average debt capital—$55 million
• debt deductions for tax year—$5 million.
Check your work against the suggested answer at the end of the module.
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Authorised deposit-taking institution entities
Outward investing entities
The rules for outward investing entities that are ADIs operate to affect institutions such as
Australian banks that may have foreign subsidiaries. The individual method statements to
calculate any disallowed deduction for an ADI have not been included in this module; only a
brief overview of ADI entities is provided here.
The five steps that an ADI outward investing entity takes to calculate whether it has met the thin
capitalisation rules are outlined in Figure 7.10.
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Source: Adapted from ATO (Australian Taxation Office) 2016, ‘ADI outward investing entity’, accessed
February 2018, https://www.ato.gov.au/Business/Thin-capitalisation/ADI-outward-investing-entity/.
The thin capitalisation rule for these entities is contained in s. 820-300 of ITAA97.
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The minimum amount of equity capital for outward investing ADIs is the least of:
• the safe harbour capital amount (ITAA97, s. 820-310)
• the arm’s length capital amount; this is a notional amount (ITAA97, s. 820-315)
• the worldwide capital amount (ITAA97, s. 820-320).
The amount of debt deduction disallowed is worked out according to s. 820-415 of ITAA97
and is similar to the non-ADI debt deduction calculation.
In effect, the provisions operate to disallow a portion of a foreign bank branch’s debt deductions
where the equity capital is less than a certain minimum amount. The thin capitalisation rule for
inward investing ADI entities is contained in s. 820-395 of ITAA97.
The four steps an inward investing ADI entity takes to calculate whether it has met the thin
capitalisation rules are outlined in Figure 7.11.
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Source: Based on ATO (Australian Taxation Office) 2016, ‘ADI inward investing entity’, accessed
February 2018, https://www.ato.gov.au/Business/Thin-capitalisation/ADI-inward-investing-entity/.
For inward investing ADIs, the minimum amount of equity capital is the lesser of:
• the safe harbour capital amount (ITAA97, s. 820-405)
• the arm’s length capital amount, determined in a similar manner to the arm’s length debt
amount for non-ADIs (ITAA97, s. 820-410).
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The TOFA provisions aim to better align the timing of deductions for payments on instruments
and the timing of the assessability of gains made in relation to financial arrangements (ITAA97,
s. 230-15). The objectives of the provisions are greater tax efficiency and the lowering of
compliance costs.
However, the TOFA provisions are particularly complex, with many concerns being raised
regarding the compliance costs associated with the provisions. In the 2016–17 Federal Budget,
the government announced that it would reform the TOFA rules to reduce their scope, decrease
compliance costs and increase certainty for tax years commencing on or after 1 January 2018.
The budget stated that the new measures will have four components:
• A ‘closer link to accounting’ which will strengthen and simplify the existing link between tax and
accounting in the TOFA rules.
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• Simplified accruals and realisation rules, which will significantly reduce the number of taxpayers
in the TOFA rules, reduce the arrangements where spreading of gains and losses is required
under TOFA and simplify the required calculations.
• A new tax hedging regime which is easier to access, encompasses more types of risk
management arrangements (including risk management of a portfolio of assets) and removes
the direct link to financial accounting.
• Simplified rules for the taxation of gains and losses on foreign currency to preserve the current
tax outcomes but streamline the legislation (ATO 2017c).
At the time of writing, the commencement of these changes has been deferred, and there has been
no legislation implementing these changes released.
The following entities are subject to TOFA on a mandatory basis (see exceptions in ITAA97,
s. 230-5):
• an ADI, a securitisation vehicle or a financial sector entity with an aggregated turnover
of $20 million or more
• a superannuation entity, a managed investment scheme or a similar scheme under a foreign
law if the value of the entity’s assets is $100 million or more
• any other entity (except an individual) that has an aggregated turnover of $100 million or
more, or assets of $300 million or more, or financial assets of $100 million or more.
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Division 230 of ITAA97 taxes net gains and losses arising from financial arrangements entered
into by entities who meet certain asset and turnover threshold tests. The division does not apply
to all financial arrangements, with the main exemptions being contained in s. 230-5(2) of ITAA97.
An entity that is not mandatorily subject to TOFA can make an election to apply TOFA to its
financial arrangements.
In determining whether the turnover or asset thresholds are met by a tax consolidated group,
the entity being tested is the head company, which includes all its subsidiary members.
Details of the interaction of TOFA and the tax consolidation regime are not examinable.
There is a financial arrangement if there is, under an arrangement, a cash settlable (with money
or equivalent) legal or equitable right to receive or provide a financial benefit (ITAA97, s. 230‑45)
or a combination of such rights and/or obligations. However, an arrangement will not be
a Division 230 of ITAA97 financial arrangement if the cash settlable rights and obligations
are insignificant compared to other rights and obligations under the arrangement (ITAA97,
s. 230‑45)(1)(d)–(f)).
The term ‘arrangement’ is broad in scope and encompasses most financial arrangements.
Certain equity interests may constitute a financial arrangement (ITAA97, s. 230-50). Where an
arrangement is both cash settlable and an equity interest, it will be treated as an equity interest
for the purposes of applying Division 230 (Taxation Determination TD 2011/12).
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sets out the factors to be considered when determining what rights or obligations comprise
an arrangement or two or more separate arrangements (Explanatory Memorandum, Tax Laws
Amendment (Taxation of Financial Arrangements) Bill 2008 (Cwlth), para. 1.41).
Some financial arrangements are excluded from Division 230. Excluded arrangements include,
but are not limited to:
• ‘financial arrangements held by individuals that are not qualifying securities, and qualifying
securities held by individuals which have a remaining life at the time of acquisition of
12 months or less’ (Explanatory Memorandum, Tax Laws Amendment (Taxation of Financial
Arrangements) Bill, para. 1.49; see ITAA97, s. 230-455)
• ‘short-term financial arrangements where a non-monetary amount (property, goods or
services) is involved’ (Explanatory Memorandum, Tax Laws Amendment (Taxation of Financial
Arrangements) Bill, para. 1.49; see ITAA97, s. 230-450)
• various leasing and property arrangements, interests in a partnership or trust, insurance
policies and superannuation benefits (ITAA97, s. 230-460)
• certain arrangements for the forgiveness of commercial debts (ITAA97, s. 230-470).
The financial arrangement will come into existence when it starts to be held, and the entity holds
relevant rights, obligations or assets under the arrangement.
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At the time of the agreement, Light has a right to receive a monetary financial benefit ($300 000) but it
also has an obligation to provide something that is not cash settlable (furniture). As this obligation to
provide furniture is not insignificant when compared to the right to receive payment, the arrangement
is not a financial arrangement when entered into in June 2017 (ITAA97, s. 230-45(1)).
Source: Based on ATO (Australian Taxation Office) 2016, ‘Section 230-45 financial arrangements’,
accessed February 2018, https://www.ato.gov.au/Business/Taxation-of-financial-arrangements-
%28TOFA%29/In-detail/Guide-to-the-taxation-of-financial-arrangements-%28TOFA%29/?page=5.
In identifying a financial arrangement, it may be that several arrangements form one arrangement.
An assessment then needs to be made as a question of fact and degree, which is determined
having regard to the matters referred to in s. 230-55(4) of ITAA97 (Taxation Ruling TR 2012/4).
not insignificant in comparison to the cash settlable right (the right to receive $50,000).
A financial arrangement arises when there is no longer a non-cash settlable non-insignificant
obligation – that is, when the obligation to provide the truck is satisfied, which is on
1 September [2017].
Jam Co makes a sufficiently certain gain of $10,000 under the financial arrangement because it:
• receives a financial benefit of $50,000
• provides a financial benefit of $40,000 – the value of the truck on the date of delivery,
not the contract date.
Source: ATO (Australian Taxation Office) 2016, ‘Calculating gains or losses’, accessed February 2018,
https://www.ato.gov.au/Business/Taxation-of-financial-arrangements-(TOFA)/In-detail/Guide-to-the-
taxation-of-financial-arrangements-(TOFA)/?page=10#Calculating_gains_or_losse/.
A gain or loss for TOFA is then recognised by using one of the timing methods detailed in the
following section. There are six tax timing methods (two default methods and four elective
methods) that detail when a gain or loss should be brought to account for tax purposes
(ITAA97, s. 230-40). A taxpayer can elect to use an elective tax timing method by completing
and submitting a form. In the case where no election is made, one of the non-elective methods
will apply.
Study guide | 515
One or more of the following tax methods applies to every financial arrangement that is subject
to Division 230 of ITAA97:
• non-elective methods:
–– accruals (Subdivision 230-B)
–– realisation (Subdivision 230-B)
• elective methods:
–– fair value (Subdivision 230-C)
–– foreign exchange retranslation (Subdivision 230-D)
–– hedging (Subdivision 230-E)
–– financial reports (Subdivision 230-F).
Elective hedging
Elective methods
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Elective retranslation
Accruals
Non-elective methods
Realisation
Source: Explanatory Memorandum, Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008
(Cwlth), para. 1.54, accessed February 2018, http://parlinfo.aph.gov.au/parlInfo/download/legislation/
ems/r4029_ems_e8895467-71c4-4ea7-9e03-fdd89ea74297/upload_pdf/321508.pdf.
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The core method for spreading sufficiently certain gains or losses uses compounding accruals;
although it is possible to use another type of accruals method for sufficiently certain gains or
losses, the outcome must approximate the outcome under the compounding accruals method.
InvestCo will receive two financial benefits, being the interest return and $130 000 at maturity.
The interest payment cannot be said to be sufficiently certain; however, it can be reasonably expected
that the $130 000 payment at maturity will be received by InvestCo. As such, this amount is sufficiently
certain (s. 230-115).
Applying the compounding accruals method, the overall sufficiently certain gain of $30 000 will be
brought to account over the life of the bond (s. 230-130).
This method is conceptually identical to the ‘effective interest rate’ method required by Australian
Accounting Standard AASB 139 Financial Instruments: Recognition and Measurement as they reflect
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‘interest on interest’.
Sections 230-70 and 230-75 of ITAA97 allow financial benefits provided and financial benefits
received to be apportioned in calculating the amount of the gain or loss.
➤➤Question 7.6
On 1 July 2016 InvestCo decides to acquire shares in SellCo for $60 million and subsequently
makes a fair value method election regarding its financial arrangements. On 30 June 2017,
the market value of the SellCo shares has risen to $75 million. In the same year, InvestCo also
receives $2 million in dividend payments.
Source: Based on content from Australian Taxation Office, www.ato.gov.au.
What amount will be assessed as the fair value gain under Division 230 of ITAA97?
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Check your work against the suggested answer at the end of the module.
Subdivision 230-D requires that the election is irrevocable, with the election ceasing to apply
when the arrangement ceases, or the conditions for the election are no longer satisfied.
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Source: ATO (Australian Taxation Office) 2016, ‘Foreign exchange retranslation method’,
accessed February 2018, https://www.ato.gov.au/Business/Taxation-of-financial-arrangements-(TOFA)/
In-detail/Guide-to-the-taxation-of-financial-arrangements-(TOFA)/?page=17#Foreign_exchange_
retranslation_method.
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Balancing adjustments
On the cessation of an arrangement (i.e. where rights or obligations are transferred under an
arrangement or those rights or obligations cease), a balancing adjustment may be required
(ITAA97, s. 230-435). A method statement for the calculation of any adjustment upon complete
cessation or transfer is contained in s. 230-445 of ITAA97.
The return on this is brought to account on a compounding accruals basis. That is, Division 16E
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operates to assess the holder of a qualifying security on the eligible return over the life of the
security, rather than when the amount is actually paid (the same applying to deductions).
Section 240-112 of ITAA97 removes the potential for double taxation that would otherwise exist
by stating that Division 16E will apply to certain arrangements. Section 240-112 provides:
Division 16E of Part III of the Income Tax Assessment Act 1936 applies in relation to an arrangement
(the assignment arrangement) between the notional seller and another person (the holder) to
transfer the right to payments (the Division 240 payments) under an arrangement that is treated
as a sale and loan by this Division (the sale and loan arrangement) (ITAA97, s. 240-112(1)).
Regardless of the TOFA thresholds, the regime applies to the qualifying securities of ‘all entities
(including individuals) that end more than 12 months after the entity starts to have the qualifying
security’ (ATO 2016c).
As a result, Division 230 will provide the tax treatment for most of the gains and losses on
securities that would otherwise have been taxed under Division 16E.
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Division 240 was implemented to give effect to the administrative practice of treating hire
purchase transactions as a means of finance. Hire purchase arrangements are subject to
specific rules in this division. The TOFA regime in Division 230 of ITAA97 does not apply
to these arrangements.
The potential for double taxation does not exist if the assignment arrangement causes the
sale and loan arrangement to terminate, so that Division 240 no longer applies, providing that
Division 16E of ITAA36 applies to the assignment arrangement as if it were a qualifying security
issued by the notional seller to the assignee.
A hire purchase arrangement will also arise where there is an agreement for the purchase of
goods by instalments where title in the goods does not pass until the final instalment is paid.
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Under Division 240, hire purchase transactions are effectively treated as a notional sale and
notional loan (ITAA97, s. 240-10).
The notional seller is taken to have disposed of the property by way of sale to the notional buyer,
and the notional buyer is taken to have acquired it, at the start of the arrangement … The notional
buyer is taken to own the property until … the arrangement ends (ITAA97, s. 240-20).
This has consequences for the notional seller and notional buyer.
As provided for in s. 240-3(1) of ITAA97, the characterisation means (for the seller) that ‘the
consideration for the notional sale is either the price stated as the cost or value of the property
or its arm’s length value’. The notional seller will be assessed on the sale price. (If the property is
being disposed of as trading stock then normal trading stock disposal consequences follow.)
Section 240-3(3) states that ‘the notional seller’s assessable income will include notional interest
over the period of the loan’. This in effect displaces:
the income tax consequences that would otherwise arise from the arrangement. For example, the
actual payments to the notional seller are not included in its assessable income. Also, the notional
seller loses the right to deduct amounts under Division 40 (ITAA97, s. 240-3(4)).
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The effect for the purchaser under s. 240-7 of ITAA97 is that the cost of the acquisition is either
the price stated as the cost or value of the property or its arm’s length value (if it is trading stock,
again normal rules apply). The notional buyer can usually deduct the purchase price if the item
is trading stock. If the property is not trading stock, the notional buyer may be able to deduct
amounts for the expenditure under Division 40 of ITAA97 (see Taxation Ruling TR 2005/20).
The buyer may also be able to deduct interest.
Farm has a right, obligation or contingent obligation to buy the goods; the charge exceeds the
price of the goods; and title in the goods does not pass to the hirer until the goods are purchased.
The requirements of s. 995-1 of ITAA97 are satisfied. The arrangement is a hire purchase agreement
under Division 240 of ITAA97.
Farm will be taken to be the notional owner and will be able to claim a tax deduction for the interest
component on repayments. It may also be able to depreciate the item of machinery under Division 40.
The taxation consequences of sale and leaseback financing arrangements that involve
depreciating assets are detailed in Taxation Ruling 2006/13, which provides generally that:
• When the depreciating asset is sold, balancing adjustments may apply. Market value at
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the time of sale is accepted as a sale price.
• Deductions for the decline in value of the asset are available to the lessor. These will be
based on the cost of the asset to the lessor (ordinarily, the price paid under the sale, not the
cost to the lessee).
• Periodic lease payments by the lessee to the lessor are deductible to the lessee and
assessable to the lessor
In summary, Division 243 operates to limit the deductions that a taxpayer may claim in respect
of property acquired using limited recourse debt. The division will apply where:
(a) limited recourse debt has been used to wholly or partly finance or refinance expenditure; and
(b) at the time that the debt arrangement is terminated, the debt has not been paid in full by the
debtor; and
(c) the debtor can deduct an amount as a capital allowance for the income year in which the
termination occurs, or has deducted or can deduct an amount for an earlier income year, in
respect of the expenditure or the financed property (ITAA97, s. 243-15(1)).
Excessive deductions are then calculated under s. 243-35 of ITAA97. Only the amount of capital
allowance deductions equal to the amount actually paid under the arrangement can be obtained.
This is worked out in consideration of the deductions that would be allowable if the expenditure
were reduced by the unpaid amount of debt and the ‘actual deductions’. Any excess deductions
may be brought back in as being assessable (i.e. where actual deductions exceed the limit,
the excess is assessable).
The purchase of the property is financed by a limited recourse loan of $100 000. The term of the
arrangement is three years, after which time $70 000 will remain unpaid to HireCo. The market value
of the property on that date is $50 000.
After three years, the property declines in value by $60 000. On 30 June 2017, the adjustable value of
the property is $40 000. The termination value of the property is $50 000 (the market value as stated),
so there is an assessable balancing adjustment for BuildCo of $10 000 (i.e. $50 000 – $40 000). It follows
that actual deductions are $50 000 (the total capital allowance deductions of $60 000 less the assessable
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The deduction limit is $30 000. This assumes that the original expenditure ($100 000) was reduced by
the unpaid loan amount ($70 000), and that deductions continued for the effective life of the property.
As the actual deductions ($50 000) exceed the deduction limit ($30 000), the excess ($20 000) is
assessable for BuildCo.
Source: Based on CCH Australia 2017, Australian Master Tax Guide 2017,
60th edn, CCH Australia, Sydney, para. 23-260.
Study guide | 523
Review
The aim of this module was to provide an understanding of four distinct areas of corporate
financing.
Part A considered the debt to equity rules and how to apply the tests to determine whether
an interest is a debt interest or an equity interest for tax purposes. This is important because
it determines which interests may be frankable (and non-deductible) and which interests are
deductible (and non-frankable).
Part B considered the value shifting regime, which operates to prevent value being shifted
between entities. Value shifting was considered in three broad categories:
1. entity interest direct value shifting
2. created rights direct value shifting
3. indirect value shifting.
They all operate to prevent contrived values being allocated to company assets and interests.
Part C considered the thin capitalisation provisions. The thin capitalisation regime operates to
deny certain deductions for companies who are ‘thinly capitalised’, meaning they are heavily
funded by debt. The application and calculation of the debt amounts denied was explained in
this part.
Part D considered the TOFA regime, which aims to better align the timing of deductions for
payments on instruments and the timing of the assessability of gains made in relation to financial
arrangements. This part also considered financial instruments excluded from the TOFA regime.
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MODULE 7
Suggested answers | 525
Suggested answers
Suggested answers
Question 7.1
(a) Is the interest a debt or equity interest? Debt
Debt test
The interest is a debt interest because it meets the four
elements of the debt test set out in Figure 7.1:
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1. The arrangement between Snow Co (Snow) and the
holder is a scheme, and the scheme is a financing
arrangement because it was entered into to raise
finance for Snow.
2. Snow receives a financial benefit of $2.
3. The payment of annual dividends is not an
effectively non-contingent obligation because
it depends on the board’s approval. However,
Snow has an effectively non-contingent obligation
to repay the issue price of $2 on redemption.
4. The performance period is within 10 years because
the shares must be redeemed at face value after
eight years. This means the valuation of the benefits
will be in nominal terms.
Tiebreaker rule
The interest meets both the equity test and the debt
test. The tiebreaker rule means that it is considered a
debt interest.
Source: Based on ATO (Australian Taxation Office) 2017, ‘Redeemable preference shares’, accessed
February 2018, https://www.ato.gov.au/Business/Debt-and-equity-tests/In-detail/Guides/Debt-and-
equity-tests--guide-to-the-debt-and-equity-tests/?page=15.
Question 7.2
Prior to the sale, instead of selling the right to Stephanie for $180 000 (being the market value),
Nic sold the right to Lucinda for $210 000 (being $30 000 more than market value).
In this case, Nic will include the amount of $210 000 as a revenue amount in working out net
income. This amount ($210 000) is applied to the reduction formula as it is a revenue asset
(ITAA97, s. 723-50).
As per the formula, the shortfall on creating the right ($200 000) less the amount of any gain
made on the realisation of the right ($210 000) is calculated.
Therefore, there will be no consequences for the loss Matt makes on sale of the asset.
Source: Based on ATO (Australian Taxation Office) 2006, Guide to the General Value Shifting Regime,
p. 52, accessed February 2018, https://www.ato.gov.au/Business/Consolidation/In-detail/General-value-
shifting-regime/Guide-to-the-general-value-shifting-regime/.
Question 7.3
Australia Co has 100 per cent of the share capital on issue of US Co. US Co in turn owns
75 per cent of the issued share capital, and 60 per cent of the voting rights, in French Co.
Australia Co will have a thin capitalisation direct control interest in US Co of 100 per cent.
Australia Co will have a thin capitalisation indirect control interest in French Co of 75 per cent,
measured by tracing through the interests held in US Co.
Question 7.4
(a) What is the safe harbour amount for $1.56 million
OztralCo?
(b) Show how you obtained your answer. OztralCo is an outward investor (general; non-ADI).
Step 1. Work out the average value, for the tax year, of all the
assets of the entity.
Step 8. Add to the result of step 7 the average value, for that
year, of the entity’s associate entity excess amount. The result of
this step is the safe harbour debt amount.
Source: Based on Income Tax Assessment Act 1997 (Cwlth), s. 820-95, Federal Register of Legislation,
accessed February 2018, https://www.legislation.gov.au/Details/C2018C00068.
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Return to Question 7.4 to continue reading.
Question 7.5
(a) What amount, if any, of the debt deductions Hope Co is disallowed $454 545 of its debt deductions.
is disallowed for Hope Co?
(b) Show how you obtained your answer. The first step is to work out the excess debt, being the
average debt divided by the safe harbour debt amount:
Question 7.6
InvestCo’s taxable income for that financial year will include the fair value gain of $15 million
(being $75 000 000 – $60 000 000) and the dividend received of $2 million. However, the dividend
will be assessed according to s. 44 of ITAA36, and Division 230 of ITAA97 will only assess the fair
value gain of $15 million.
References
References
ATO (Australian Taxation Office) 2006, Guide to the General Value Shifting Regime, accessed
February 2018, https://www.ato.gov.au/Business/Consolidation/In-detail/General-value-shifting-
regime/Guide-to-the-general-value-shifting-regime/.
ATO (Australian Taxation Office) 2016a, Thin Capitalisation, accessed February 2018, https://www.
ato.gov.au/misc/downloads/pdf/qc17057.pdf.
ATO (Australian Taxation Office) 2016b, ‘Who is affected’, accessed February 2018, https://www.
ato.gov.au/Business/Thin-capitalisation/Understanding-thin-capitalisation/Thinly-capitalised-
entities/Who-is-affected/.
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ATO (Australian Taxation Office) 2016c, ‘Who the rules apply to’, accessed February 2018,
https://www.ato.gov.au/Business/Taxation-of-financial-arrangements-%28TOFA%29/In-detail/
Guide-to-the-taxation-of-financial-arrangements-%28TOFA%29/?page=2.
ATO (Australian Taxation Office) 2017a, Debt and Equity Tests: Guide to ‘At Call’ Loans,
accessed February 2018, https://www.ato.gov.au/misc/downloads/pdf/qc18207.pdf.
ATO (Australian Taxation Office) 2017b, Debt and Equity Tests: Guide to the Debt and Equity
Tests, accessed February 2018, https://www.ato.gov.au/misc/downloads/pdf/qc36047.pdf.
ATO (Australian Taxation Office) 2017c, ‘Taxation of financial arrangements: Regulation reform’,
accessed February 2018, https://www.ato.gov.au/General/New-legislation/In-detail/Direct-taxes/
Income-tax-for-businesses/Taxation-of-financial-arrangements---regulation-reform/.
PwC 2014, First Look at Proposed Thin Cap and Foreign Dividend Amendments, accessed
February 2018, https://www.pwc.com.au/tax/taxtalk/assets/alerts/taxtalk-alert-thin-cap-foreign-
dividend-may14.pdf.
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