Thin capitalisation rules: risk-weighted assets - non-banking members

Does the head company of a consolidated group classified as an 'outward investing entity (ADI)' have to include the assets and other risk exposures of the non-banking members of the group in determining the amount of its 'risk-weighted assets' for Step 1 of section 820-310 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes. The head company of a consolidated group classified as an 'outward investing entity (ADI)' has to include the assets and other risk exposures of the non-banking members of the group in determining the amount of its 'risk-weighted assets' for Step 1 of section 820-310 of the ITAA 1997.

A company is the head company of an income tax consolidated group.

The consolidated group includes an Australian Authorised Deposit-Taking Institution (ADI) for the purposes of the Banking Act 1959 .

The head company is classified under subsection 820-583(7) of the ITAA 1997 as an 'outward investing entity (ADI)' for the purposes of applying Division 820 of the ITAA 1997.

The head company's consolidated group includes non-banking members that are excluded from the 'Level 2' group of the ADI that are subject to Tier 1 capital requirements under the prudential standards determined by the Australian Prudential Regulation Authority ( APRA ) under section 11AF of the Banking Act 1959 .

The head company of a consolidated group or MEC group is subject to the thin capitalisation rules in Subdivision 820-D of the ITAA 1997 if it is classified as an 'outward investing entity (ADI)' under subdivisions 820-EA, 820-FA or 820-FB of the ITAA 1997 (as applicable).

The application of relevant provisions in Division 820 of the ITAA 1997 is for a 'head company core purpose', within the meaning of section 701-1 of the ITAA 1997, since it is necessary to determine a taxpayer's allowable deductions in order to determine its liability for income tax (see sections 4-10 and 4-15 of the ITAA 1997).

Accordingly, all the subsidiary members of a consolidated group are 'taken ... to be parts of the head company' for the purpose of determining the amount of 'the average value ... of all the risk-weighted assets of [the head company]' in Step 1 of the 'Method statement' in section 820-310 of the ITAA 1997.

'Risk-weighted assets' is defined in subsection 995-1(1) of the ITAA 1997 as: the sum of the entity's risk exposures that the entity has at that time, as is determined in accordance with: (a) if the entity is [an Australian resident that is not foreign controlled] - the *prudential standards.

'Prudential standards' is defined in subsection 995-1(1) of the ITAA 1997 as: the prudential standards determined by *APRA and in force under section 11AF of the Banking Act 1959 .

Australian Prudential Standard (APS) 110 is a prudential standard determined by APRA and in force under section 11AF of the Banking Act 1959 . Paragraph 14 of APS 110 states: An ADI [as defined in paragraph 4 to be the Level 2 ADI group] is subject to a prudential capital ratio ( PCR ) as determined by APRA. Subject to paragraphs 15 and 16, an ADI's PCR is eight percent of its total risk-weighted assets, half of which must be held in the form of Tier 1 capital. An ADI must, at all times, maintain a risk-based capital ratio, in excess of its PCR. For the definition of total risk-weighted assets and risk-based capital ratio, refer to Attachment D. [bolding not added]

Paragraph 3 of Attachment D to APS 110 states: Under the risk-based capital adequacy framework, an ADI's capital adequacy is measured by means of a risk-based capital ratio calculated by dividing its capital base by its total risk-weighted assets. That is: Risk-based capital ratio = capital base / total risk-weighted assets [bolding not added].

Paragraph 6 of Attachment D to APS 110 states: An ADI's total risk-weighted assets is calculated as the sum of: (a) risk-weighted on-balance sheet and off-balance sheet assets determined in accordance with Prudential Standard APS 112 Capital Adequacy : Standardised Approach to Credit Risk ; (b) risk-weighted assets determined under APS 113 Capital Adequacy : Internal Ratings-based Approach to Credit Risk ; (c) 12.5 times the sum of the capital charges determined under Prudential Standards APS 114 Capital Adequacy : Standardised Approach to Operational Risk, APS 115 Capital Adequacy : Advanced Measurement Approaches to Operational Risk and APS 116 Capital Adequacy : Market Risk and APS 117; and (d) risk-weighted assets determined under APS 120. [bolding not added]

Accordingly, the risk-weighted assets amount for assets held by a head company and its subsidiary members are determined in accordance with the method in APS 112, except only for the following assets: - 'trading book' and 'securitisation' assets covered by APS 116 or APS 120 - the applicable method under APS 116 or APS 120, respectively, instead applies; - assets of the members of the consolidated group that are subject to Tier 1 capital requirements for which APRA has granted its approval to use APS 113 - the method(s) as approved by APRA under APS 113 for those assets.

Paragraphs 11 and 12 of APS 112 state: 11. An ADI's total risk-weighted on-balance sheet assets (for the purpose of assessing its credit risk capital requirement) must equal the sum of the risk-weighted amounts of each on-balance sheet asset. 12. The risk-weighted amount of an on-balance sheet asset is determined by multiplying its current book value (including accrued interest or revaluations, and net of any specific provision or associated depreciation) by the relevant risk-weight in Attachment A. ...

Items 18 to 23 of Attachment A to APS 112 state that the risk weighting to be assigned to the classes of assets (that are not monetary claims covered by the previous items) are: Claim Risk-weight (%) 18. Investments in premises, plant and equipment and all other fixed assets. 100 19. Claims on all fixed assets under operating leases. 100 20. Equity exposures (as defined in paragraphs 47 to 50 of APS 113) that are not deducted from capital and that are listed on a recognised exchange. 300 21. Equity exposures (as defined in paragraphs 47 to 50 of APS 113) that are not deducted from capital and that are not listed on a recognised exchange. 400 22.Margin lending against listed instruments on recognised exchanges. 20 23. All other assets and claims not specified elsewhere. 100"

Claim | Risk-weight (%)

18. Investments in premises, plant and equipment and all other fixed assets. | 100

19. Claims on all fixed assets under operating leases. | 100

20. Equity exposures (as defined in paragraphs 47 to 50 of APS 113) that are not deducted from capital and that are listed on a recognised exchange. | 300

21. Equity exposures (as defined in paragraphs 47 to 50 of APS 113) that are not deducted from capital and that are not listed on a recognised exchange. | 400

22.Margin lending against listed instruments on recognised exchanges. | 20

23. All other assets and claims not specified elsewhere. | 100"

The relevant legislative context to section 820-310 of the ITAA 1997 discloses that it is expressly contemplated, and intended, that the amount of 'risk-weighted assets' can be determined for any, and all, of the assets of a taxpayer which is treated as an 'outward investing entity (ADI)', irrespective of whether the taxpayer is subject to Tier 1 capital adequacy regulation by APRA under APS 110 and the Banking Act 1959 . That relevant legislative context includes: • the application of the ADI rules in Subdivisions 820-D and 820-E of the ITAA 1997 (as the case may be) to a taxpayer that has made an election under section 820-430 of the ITAA 1997 to be treated as an ADI under Division 820. The election in Subdivision 820-EA of the ITAA 1997 is expressly premised on a taxpayer which is not a regulated bank (including a consolidated or MEC group that does not include a regulated bank) being able to determine the amount of its 'risk-weighted assets' in determining its 'safe harbour capital amount' under section 820-310 of the ITAA 1997. • the classification of a taxpayer as an 'outward investing entity (ADI)', even if the taxpayer is otherwise not an ADI under the Banking Act 1959 , if the taxpayer includes: • a single subsidiary member which is an ADI - refer to subsection 820-583(7) of the ITAA 1997; or • qualifying Australian branch operations (of its foreign owners) pursuant to an election under section 820-597 or 820-599 of the ITAA 1997 - refer to subsection 820-609(1) of the ITAA 1997. • section 820-588 of the ITAA 1997. The enactment of section 820-588 for specialist credit card institutions is based on the premise that a taxpayer's consolidated group which does not have any member subject to Tier 1 capital adequacy regulation by APRA (for which its 'risk weighted assets' has to be determined under Attachment D to APS 110) is nevertheless able to determine the amount of its 'risk-weighted assets' in calculating its 'safe harbour capital amount' under section 820-310 of the ITAA 1997.

Accordingly, the amount of 'risk-weighted assets' for the purpose of Step 1 of the Method statement in section 820-310 of the ITAA 1997 is the sum of the amounts determined in accordance with APRA's method (in paragraph 6 of Attachment D to APS 110) for determining an ADI's 'total risk-weighted assets'. This interpretation of 'risk-weighted assets' in section 820-310 not only accords with the express intent of the legislature discerned from the relevant legislative context of section 820-310, as referred to above, it also reflects a natural reading of the words of the definition in subsection 995-1(1) of the ITAA 1997, namely: the sum of the entity's risk exposures ...at that time, as is determined in accordance with [APRA's prudential standards].

This interpretation is also consistent with the relevant statements in the Explanatory Memorandum to New Business Tax System (Thin Capitalisation) Act 2001 : 5.9 The thin capitalisation rules applying to ADIs are based on the methodology of the capital adequacy requirements prescribed by APRA. Under the capital adequacy regime, the ADIs assets are risk weighted, so those assets that have higher risk (such as loans to corporate entities) require more capital than assets that have low risk (such as government bonds). APRA may also require a specific amount of capital to be held for certain assets, such as goodwill and investments in life and general insurance subsidiaries. 5.10 Similarly, the thin capitalisation rules for ADIs will use risk-adjusted assets rather than book values of assets to calculate the safe harbour minimum capital amount and the worldwide capital amount, and will require additional capital to be held against certain Australian assets.

It is noted that, if the amount of 'risk-weighted assets' in Step 1 of the Method statement in section 820-310 of the ITAA 1997 only included the amount determined under paragraph 6 of Attachment D to APS 110 in the course of meeting the taxpayer's (or the taxpayer's subsidiary members') Tier 1 capital requirements under the Banking Act 1959 , this would result in the unintended consequence that the operations of the non-banking members of the consolidated group are effectively exempted from any thin capitalisation limit under Division 820 of the ITAA 1997.