AT Module-7 4th-Edn

CPA PROGRAM
ADVANCED
TAXATION
4TH EDITION
MODULE 7
BE HEARD.
BE RECOGNISED.
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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
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
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.
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Ken Devos Senior Lecturer, Monash University
Joanna Roach Bristol-Myers Squibb Australia
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ADVANCED TAXATION
Module 7
CORPORATE FINANCING
462 | CORPORATE FINANCING
Contents
Preview 465
Introduction
Objectives
Part A: Debt and equity rules 466

Test that identifies a debt interest 466
Element 1: Scheme that is a financing arrangement
Element 2: Financial benefit received
Element 3: Effectively non-contingent obligation to provide a future financial benefit
Element 4: Value of financial benefit provided at least equal to value received
Test that determines whether an interest is an equity interest 470
Item 1: Interest as member or stockholder of company
Item 2: Interest carrying a right to return that is effectively contingent on
economic performance
Item 3: Interest carrying a right to a return that is at the discretion of the company
Item 4: Interest issued by the company that will or may convert to an equity interest
Non-share equity interests and non-share capital account 473
Tiebreaker rule 474
Part B: Value shifting 475

Direct value shifting rules: Entity interests 475
Entity interest direct value shift
Scheme
Threshold conditions
Consequences of direct value shifting rules applying
Direct value shifting rules: Created rights 481
Owner of asset creating a right in their associate
Market value of right and consideration received
Realisation event and existence of right
Market value of underlying asset and realisation event
Loss realised for tax purposes
Method used to make a reduction 483
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Reduction methodology: Basic case and same asset rollover

Reduction methodology: Replacement asset rollover
Indirect value shifting rules 485
Indirect value shift
Affected interests
Consequences of indirect value shifting rules applying
Part C: Thin capitalisation 491

Thinly capitalised entities 491
Application of regime
Assets and entities not affected
Types of entities and control 493
Australian or foreign multinational entity
Authorised deposit-taking institution or non-authorised deposit-taking institution
General entity or financial entity
Disallowance of certain deduction amounts
Non-authorised deposit-taking institution: Outward investing entities 497
Safe harbour debt amount
Arm’s length debt amount
Worldwide gearing debt amount
Amount of debt deduction disallowed
Non-authorised deposit-taking institution: Inward investing entities 504
CONTENTS | 463
Authorised deposit-taking institution entities 509

Outward investing entities
Inward investing entities
Part D: Financial arrangements and financial instruments 512

Taxation of financial arrangements regime 512
Entities and financial arrangements subject to the regime
Application of the rules
Calculating gains or losses
Outside the taxation of financial arrangements regime 519
Accruals regime: Qualifying securities
Asset and project financing arrangements 520
Hire purchase arrangements
Sale and leaseback arrangements
Large project financing: Limited recourse debt
Review 523
Suggested answers 525
References 529
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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.
Part A: Debt and equity rules

The rules that determine whether an interest is a debt or equity interest are contained in
Division 974 of the Income Tax Assessment Act 1997 (Cwlth) (ITAA97). In its simplest form,
the distinction between debt and equity is that debt provides a non-contingent return on
investment, while equity returns are contingent (e.g. on company performance).
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.
Test that identifies a debt interest

The debt test is contained in Subdivision 974-B of ITAA97. A debt interest is an interest in
respect of which distributions will not be frankable, but which may be deductible to the company.
A single scheme will give rise to a debt interest in an entity if the debt test in s. 974‑20(1)
is satisfied. Two or more related schemes can also operate together to give rise to a debt
interest in an entity.
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
Figure 7.1: Elements of the debt test
Element 1: There is a scheme that is a financing arrangement.
Element 2: A financial benefit is received, or will be received, under the scheme.
Element 3: There is an effectively non-contingent obligation under the scheme

to provide a future financial benefit.
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.
Source: CPA Australia 2018.
Element 1: Scheme that is a financing arrangement

The first requirement of the test for a debt interest is that there is a scheme that is a financing
arrangement for the entity (ITAA97, s. 974-20(1)(a)). A scheme is defined as:
(a) any arrangement; or
(b) any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral
or otherwise (ITAA97, s. 995-1).
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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).
Section 974-150 of ITAA97 states that:

The Commissioner:
(a) may determine that what would otherwise be a single scheme is to be treated for the purposes
of [Division 974] as 2 or more separate schemes; and
(b) may determine that the schemes are to be taken … to not be related schemes (ITAA97,
s. 974‑150).
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)).
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).
Element 2: Financial benefit received

When a scheme that is a financing arrangement has been identified, it is necessary to then
establish that the issuing ‘entity, or a connected entity of the entity, receives, or will receive,
a financial benefit or benefits under the scheme’ (ITAA97, s. 974-20(1)(b)). Financial benefit is
defined broadly to mean anything of economic value (ITAA97, s. 974-160(1)), including property
and services. A financial benefit will also be provided to an entity if it is provided on the entity’s
behalf or for the entity’s benefit (ITAA97, s. 974-30(2)).
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)).
Example 7.1: Financial benefit received

Company M Pty Ltd issues an instrument with an issue price of $300 payable in instalments (over two
consecutive years). The first instalment payment of $150 is to be paid on issue and the second,
one year later. The full issue amount will constitute the financial benefit received, even though it is
received over time.
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Element 3: Effectively non-contingent obligation to provide

a future financial benefit
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)).
An obligation is ‘non-contingent’ if it is not reliant on any event, condition or situation

happening in order for the entity to meet its obligations (ITAA97, s. 974-135(3)). In that sense,
the requirement that the benefit is non-contingent can be contrasted with a return on equity,
where payments are contingent on the economic performance of the entity.
Study guide | 469
Example 7.2: Convertible preference shares

AdamCo issues convertible preference shares (CPSs). At the end of their term, these shares become
ordinary shares. There is a real likelihood of making a gain on conversion as the terms of issue mean
that the value of an ordinary share may exceed the issue price.
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.
Element 4: Value of financial benefit provided at least equal

to value received
Once it has been established that:
the issuer has an effectively non-contingent obligation, the [final] element of the debt test requires
that it be substantially more likely than not that the financial benefit to be provided by the issuer
will be at least equal to the value of the financial benefit received (ATO 2017b, p. 5; see ITAA97,
s. 974-20(1)(d)).
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)).
Example 7.3: Loan amount

Money Pty Ltd (Money)—as lender—enters into a loan agreement with Cash Pty Ltd (Cash). The loan
amount is $300 000 and the term of the loan is seven years with interest payable at 5 per cent per
annum. No capital repayments are to be made during the term of the loan.
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.
Test that determines whether an interest

is an equity interest
The equity test is contained in Subdivision 974-C of ITAA97. An equity interest is one that may
have frankable distributions that are not deductible. A scheme will give rise to an equity interest
if it gives rise to one of the items in s. 974-75 of ITAA97 as outlined in Figure 7.2.
Figure 7.2: The equity test
Equity test
(satisfied by one of four items
from s. 974-75 of Income
Tax Assessment Act 1997 (Cwlth))
Item 1: Item 2: Item 3: Item 4:

An interest in the An interest carrying An interest carrying An interest that will or
company as a a right to return a right to return may convert to an
member or that is effectively that is at the equity interest in
stockholder of contingent on the discretion the company
the company company’s economic of the company
performance
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)).
Item 1: Interest as member or stockholder of company

A scheme satisfies the equity test in relation to a company if it gives rise to an interest in the
company as a member or stockholder of the company (ITAA97, s. 974-75(1) Item 1). This includes
ordinary and preference shares in companies limited by shares or guarantee. Item 1 operates,
in simple terms, to identify and apply to equity interests in a company, being shares and stock.
Item 2: Interest carrying a right to return that is effectively

contingent on economic performance
Item 2 in s. 974-75(1) of ITAA97 provides that a scheme satisfies the equity test in relation to
a company if it gives rise to:
an interest that carries a right to a variable or fixed return from the company if either the right
itself, or the amount of the return, is in substance or effect contingent on aspects of the economic
performance (whether past, current or future) of:
(a) the company; or
(b) a part of the company’s activities; or
(c) a connected entity of the company or a part of the activities of a connected entity of the
company (ITAA97, s. 974-75(1), Item 2).
Study guide | 471
Economic performance can be broadly considered as profit.
‘A right, or the amount of a return, is contingent on aspects of the economic performance

of an entity’ (ITAA97, s. 974-85(1)) where there is an actual contingency relating to economic
performance. This contingency cannot be solely because of:
(a) the ability or willingness of an entity to meet the obligation to satisfy the right to the return;
(b) the receipts or turnover of the entity or the turnover generated by those activities
(ITAA97, s. 974-85(1)).
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.
Example 7.4: Return contingent on economic performance

Brown Pty Ltd (Brown) issues an interest that carries a right to return of 0.5 per cent of company profits,
payable annually to the holder. As the right to a return and the amount of the return are contingent
on the economic performance of the company (i.e. that a profit is made), Item 2 (ITAA97, s. 974-75(1))
is satisfied and the interest will be an equity interest.
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.
Item 3: Interest carrying a right to a return that is at the

discretion of the company
Item 3 in s. 974-75(1) of ITAA97 provides that a scheme satisfies the equity test if it gives rise to:
an interest that carries a right to a variable or fixed return from the company if either the right itself,
or the amount of the return, is at the discretion of:
(a) the company; or
(b) a connected entity of the company (ITAA97, s. 974-75(1), Item 3).
Section 974-90 further states:

The regulations may specify circumstances in which a right, or the amount of a return, is to be taken
to be at the discretion of a company (ITAA97, s. 974-90).
Example 7.5: Discretionary return

Brown Pty Ltd (Brown) issues an interest with a right to a share in 1 per cent of the annual return of
profits, payable at the company’s discretion, to the interest holder. Jason purchases 1000 of these
interests after a discussion with one of the directors of Brown. The director told Jason that because
the annual return threshold was so low, he was almost certain that it would be paid.
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.
Item 4: Interest issued by the company that will or may convert

to an equity interest
Item 4 in s. 974-75(1) of ITAA97 provides that a scheme satisfies the equity test if an interest
issued either gives its holder a right to be issued with or may convert to an equity interest in the
company or a connected entity of the company in the future.
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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In relation to connected entities, or a series of related transactions, it is necessary to look at the

holder of the related arrangements to see whether their combined effect will result in the interest
held being an equity interest. Under s. 974-80 of ITAA97, debt interests may be reclassified as
equity interests where interposed debt interests are used to create ‘de facto’ equity interests
(Taxation Determination TD 2015/3). That is, where there is a debt interest issued by a company
to a connected entity and the transactions operate to provide that any return to the connected
entity is used to fund the return on an equity interest held by another entity (being the ultimate
recipient in a series of transactions), s. 974-80 may be triggered to reclassify the debt interest as
an equity interest. Conversely, an exception will exist if the interest held by the ultimate recipient
forms part of a larger scheme that is a debt interest.
‘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 will satisfy the debt where:

• If the ‘at call’ loan has a maximum term of 10 years or less, and there is an effectively non-
contingent obligation to repay (at least) the amount that was borrowed, the ‘at call’ loan will be
a debt interest, irrespective of whether it pays interest.
• If the loan is repayable ‘at call’ and has no fixed term, in order for it to be a debt interest there
needs to be an effectively non-contingent obligation to pay an interest rate that is high enough
to pass the debt test on a present value basis (an arm’s length interest rate will achieve this)
(ATO 2017a, p. 2).
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.
Non-share equity interests and non-share

capital account
There are equity interests that are not solely in the (legal) form of a share, and these are called
‘non-share equity interests’, a concept that was created in the New Business Tax System (Debt
and Equity) Bill 2001 (Cwlth). Section 995-1(1) of ITAA97 defines a non-share equity interest as an
equity interest in the company that is not solely a share (a share meaning a share in the capital
of the company). This means that it is necessary that the whole or part of an interest not be a
share to be a non-share 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
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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)).
Example 7.6: Non-share capital account

Brown Pty Ltd (Brown) issues certain income and stapled securities that are non-share equity interests
and raises $50 000 capital from their issue. Capital raised by Brown from the issue of these non-share
equity interests is to be recorded (credited) to a non-share capital account. If, in relation to one of
the securities issued, Brown pays a shareholder $10 000, this will also be recorded (debited) on the
non-share capital account.
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.
(a) Is the interest a debt or equity interest? Debt

Equity
(b) Show how you arrived at your answer.

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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.
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Part B: Value shifting

The current general value shifting rules came into effect on 1 July 2002 and applied to entities from
that date. The general value shifting rules have replaced previous rules contained in Divisions 138,
139 and 140 of ITAA97. The new rules are found in Part 3-95 of ITAA97, specifically Divisions 723,
725 and 727.
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.
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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/.
Direct value shifting rules: Entity interests

The direct value shifting rules apply when material value is shifted between equity or loan
interests held in a company or trust. Division 725 of ITAA97 operates to prevent inappropriate
gains or losses from arising on the realisation of equity or loan interests, if value is shifted from
equity or loan interests in a company or trust that is controlled by another entity.
This is done by:
(a) adjusting the value of those interests for income tax purposes to take account of changes in
market value that are attributable to the value shift; and
(b) treating the value shift as a partial realisation to the extent that value is shifted:
(i) between interests held by different owners; or
(ii) in the case of interests in their character as CGT assets—from post-CGT assets to pre-CGT
assets; or
(iii) between interests of different characters (ITAA97, s. 725-45(2)).
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.
Entity interest direct value shift

The general value shifting rules apply to arrangements where value is shifted from an equity or
loan interest held directly in a company or trust (the target entity) leading to a decrease in market
value, and consequentially, a direct interest in the same entity increases in market value (ITAA97,
ss. 725-145, 725-160(2)). Therefore, for there to be an entity interest value shift, there needs to
be both:
• a down interest—‘a decrease in the market value of one or more equity or loan interests in a
target entity’ (ATO 2006, p. 11)
• an up interest—‘an increase in the market value of one or more equity or loan interests,
or the issue at a discount of one or more equity or loan interests in the same target entity’
(ATO 2006, p. 11).
Example 7.7: Decrease and corresponding increase in value

Lotus Pty Ltd has on issue:
• 100 A class shares with market value of $3000 each.
• 100 B class shares with market value of $1500 each.
The two directors of the company, John and Paul, hold all of the A and B class shares respectively.
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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.
Lotus Pty Ltd
A class shares: B class shares:

Decrease in market value from Increase in market value from
$300 000 to $150 000 $150 000 to $300 000
Direct value shift between John

(as holder of the A class shares) and Paul
(as holder of the B class shares)
in the amount of $150 000

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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.
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.
Control of target entity test

an entity (the controller) must control (for value shifting purposes) the target entity at some time
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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).
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).
Participants in scheme test and cause of the value shift

Under s. 725-65(1) of ITAA97, for the value shifting rules to apply, the target entity, the controller,
an associate of the controller or an active participant in the scheme must have done one or more
things under the scheme to which the decrease in market value of the down interest, and the
increase in market value of the up interest, are reasonably attributable.
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)).
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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’.
Affected owners of interest in target entity

There will only be direct value shifting consequences under a scheme if there is an affected
owner of a down interest (ITAA97, s. 725-80) or an up interest (ITAA97, s. 725-85). This will be the
case if one of the following owned the interest at the time it decreased or increased in value
under the scheme:
• the controller
• an associate of the controller
• an active participant in the scheme.
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)).
Example 7.8: De minimis exception

Chris owns 15 of 20 shares on issue in Edward Co. The market value of each of these shares is $15 000.
Chris causes 10 shares to be issued to her daughter for no consideration. The market value of the
20 shares on issue decreases by $5000 per share, which leads to a total decrease as a result of the
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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-
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)).
Example 7.9: Direct value shift that will be reversed

Blue Pty Ltd (Blue) has 100 A class and 100 B class shares on issue.
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.
Consequences of direct value shifting rules applying

Once it has been satisfied that there is an entity direct value shift, and the threshold conditions
have been met, the consequences of the value shifting provisions can be considered. The value
shifting rules assume that the value shift is from each of the down interests to each of the up
interests for the purposes of Division 725 (ITAA97, s. 725-160(3)).
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.
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Direct value shifting rules: Created rights

The created rights direct value shifting rules are located in Division 723 of ITAA97 and apply when
there has been the creation of a right out of, or over, an asset, and the subsequent realisation of
that asset occurring after 1 July 2002.
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)).
Owner of asset creating a right in their associate

The asset over which the right is created can be any asset other than a depreciating asset.
The provisions therefore relate to:
• CGT assets (non-depreciable)
• trading stock, or
• revenue assets (ITAA97, ss. 723-10(1), 723-15(1)).
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).
Market value of right and consideration received

It needs to be established that the market value of the right created both exceeds the
consideration (or capital proceeds from creation of the right), and that this amount is more
than the minimum of $50 000. That is, a shortfall needs to exist on the creation of the right.
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).
Example 7.10: Market value exceeds consideration

Matt Pty Ltd (Matt) owns a non-depreciable asset and decides to grant the exclusive right to use of
the asset (for five years) to an associate, Nic Pty Ltd (Nic). Nic does not pay any consideration and,
as such, Matt receives no capital proceeds from the creation of the right. The market value of the
right at the time is $200 000.
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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Realisation event and existence of right

It must next be established that there is a right in existence being held by an associate when a
realisation event happens to the asset.
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.
Market value of underlying asset and realisation event

It also needs to be established whether ‘the market value of the underlying asset at the time
when it is realised is less than it would have been if the right no longer existed at that time’
(ATO 2006, p. 49). Division 723 of ITAA97 states that ‘a loss that would, apart from this Division,
be realised for income tax purposes by a realisation event is reduced’ (s. 723-10(1)) if ‘the market
value of the underlying asset at the realisation time is less than it would have been if the right no
longer existed at that time’ (s. 723-10(1)(g)).
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This difference is called the ‘deficit on realisation’.
Example 7.11: Deficit on realisation

Continuing the facts from Example 7.10, this year Matt sells the asset and at the time of sale its market
value was $1.5 million.
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.
Loss realised for tax purposes

Finally, it must be established that a loss occurred for tax purposes when the realisation event
happened to the asset. Realisation events and subsequent losses are contained in Division 977
of ITAA97.
There will be a loss realised for tax purposes as follows:

• CGT asset—where the underlying asset is a CGT asset, a loss is realised ‘by a realisation
event that happens to a CGT asset if … an entity makes a capital loss from the event’
(s. 977‑10(1)).
• Trading stock—a loss will be realised in three circumstances:
(a) if trading stock ‘is disposed of, for less than its cost, in the same income year in which
it became part of the trading stock on hand of the entity disposing of it’ (s. 977-25(1)(a))
(b) if ‘the item is disposed of in a later income year for less than its value as trading stock of
the entity on hand at the start of the later income year’ (s. 977-25(1)(b))
(c) if the tax year ends, and the closing value of the item is less than its opening value for
the start of the tax year or, if none, its cost (s. 977-30).
• Revenue asset—a loss is realised for income tax purposes by the realisation event if, and only
if, there is a loss on the event (for income tax purposes) (s. 977-55).
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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).
Reduction methodology: Basic case and same asset rollover

‘The amount by which this section reduces the loss is the lesser of the shortfall on creating the
right and the deficit on realisation’ (ITAA97, ss. 723-10(3), 723-15(2)). However, that amount is
reduced by each gain (other than a gain that is disregarded) that:
is realised for income tax purposes by a realisation event that happens to the right within 4 years
after the realisation time for the underlying asset (ITAA97, ss. 723-10(4), 723-15(3)).
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).
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).
Example 7.12: Reduction methodology

In Examples 7.10 and 7.11, 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.
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.
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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?
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):
Market value of part

Market value of underlying asset

In calculating this fraction:

market value of part means the market value, at the time of the realisation event, of the part [of the
underlying asset] … Market value of underlying asset means the market value, immediately before
the realisation event, of the underlying asset (ITAA97, s. 723-25(3)).
Reduction methodology: Replacement asset rollover

If the interest was a direct rollover replacement, its reduced cost base is reduced by the amount
worked out using a different formula (ITAA97, s. 723-105(2)). This formula results in the reduced
cost base of an interest being reduced when an interest is realised at a loss.
Example 7.13: Direct and indirect rollover replacement

The assets of a business carried on by Frankie include a large asset, over which he has created a right
in favour of his associate. On creating the right, Frankie did not charge the associate and received no
money, and as such, a shortfall exists. The value of the asset before the created right was $10 million,
and the creation of the right reduces the value by $6 million to $4 million.
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.
Indirect value shifting rules

The indirect value shifting rules are contained in Division 727 of ITAA97 and apply to schemes
entered into on or after 1 July 2002.
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.
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.
Indirect value shift

Basic case
The most common type of indirect value shift for the purposes of the indirect value shifting rules
is called the ‘basic case’, which is where there are non-arm’s length dealings between entities
and an unequal provision of economic benefits.
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.
Example 7.14: Indirect value shift

Bubble Pty Ltd (Bubble) and Squeak Pty Ltd (Squeak) are wholly owned subsidiaries of Menu Pty Ltd
(Menu) (head company), a distributor of fresh fruit and vegetables to restaurants. The companies are
not consolidated. Bubble agrees to provide services to Squeak for no charge; as such, the parties are
not dealing at arm’s length. The market value of the right to have the services performed is $1.5 million.
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.
Study guide | 487
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).
Losing entity is a company or trust at time of shift

For the indirect value shifting rules to apply, the losing entity (from whom economic benefits
are being shifted) must be a company or a trust, except one listed in s. 727-125 of ITAA97
(superannuation entities) (ITAA97, s. 727-100(a)). The gaining entity can be any type of entity
including an individual or superannuation fund.
Not at arm’s length

If the entities are not dealing at arm’s length, there may be consequences under the indirect
value shifting rules. Conversely, where parties are dealing at arm’s length, the rules will not apply.
Section 995-1 of ITAA97 provides that in ‘determining whether parties deal at arm’s length,
consider any connection between them and any other relevant circumstance’.
Control and common ownership tests
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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).

An entity is an ultimate controller of another entity if, and only if:
(a) the first entity controls (for value shifting purposes) the other entity; and
(b) there is no entity that controls (for value shifting purposes) both the first entity and the other
entity (ITAA97, s. 727-350).
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.
General exclusions
The exclusions are separated into: general exclusions and ‘realisation time method exclusions’.
The general exclusions include:

• the de minimis exclusion where the amount of the value shift does not exceed $50 000
(ITAA97, s. 727-215)
• ‘the transfer by the losing entity of an asset for at least the greatest of its cost base, its cost,
or its market value just before an affected owner last acquired a direct or indirect equity
interest in the losing entity’ (ATO 2006, p. 70; see ITAA97, s. 727-220). This is because the
aim of the indirect value shifting regime is to remove inappropriate losses arising as a result
of a value shift. Where the transfer is made by the losing entity for an amount that is at least
the greatest of its cost, cost base or market value, there is little opportunity for inappropriate
losses to be made
• ‘services provided by losing entity to gaining entity for at least their direct cost’ (ITAA97,
s. 727-230) (and not less than a commercially realistic price) (ITAA97, s. 727-235)
• ‘distribution by an entity to a member or beneficiary’ (ITAA97, s. 727-250)
• ‘gaining entity is a wholly-owned subsidiary of the losing entity’ (ITAA97, s. 727-260).
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.
Consequences of indirect value shifting rules applying

If the indirect value shifting provisions apply, there will be a resulting adjustment to the cost
bases of interests in both the losing entity and the gaining entity. The consequences apply to
the affected interests of affected owners.
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).
Realisation time method

‘The realisation time method will apply if a choice has not been made to apply the adjustable
value method’ (ATO 2006, p. 82). If a choice is made to apply the adjustable value method,
that choice will bind all owners for the indirect value shift (ITAA97, s. 727-550).
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.
Example 7.15: Realisation time method—reduction of loss

ACo Pty Ltd (ACo) is the parent company of a wholly owned subsidiary, BCo Pty Ltd (BCo). ACo owns
one million shares in BCo. The group is not consolidated. The value of the shares at the time they
were purchased by ACo was $1, which is the same as their current market value.
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.
Adjustable value method

An election can be made to apply the adjustable value method; this method adjusts the affected
interest immediately before the time of the indirect value shift (ITAA97, ss. 727-550, 727-770).
The adjustment may depend on whether:
a loss would have arisen had the interest been realised at the indirect value shifting time.
On a non loss focused basis, adjustments are made in every case reflecting the effect of the
indirect value shift on the market value of affected interests (ATO 2006, p. 103).
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
Part C: Thin capitalisation

The thin capitalisation rules are contained in Division 820 of ITAA97 and operate to limit
allowable interest deductions to entities that have an excess overseas debt to equity ratio.
The thin capitalisation regime applies to Australian entities investing overseas (and their
associate entities) and to foreign entities investing in Australia.
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.
Some of the important features of Division 820 are that it:

• it applies to inbound and outbound investing entities
• can disallow or limit the deduction of financing expenses
• takes into account total debt, not just related party debt.
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.
Figure 7.3: Assessing whether and how the thin capitalisation provisions apply
The entity will not be

Does the de minimis test Yes
subject to the thin
apply to the entity?
capitalisation regime.
No
Is the entity either an

The entity will not be No outward investing entity or
subject to the thin an inward investing entity
capitalisation regime. (Australian or foreign
multinational entity)?
Yes
Is the entity an authorised

deposit-taking institution
(ADI) or non-ADI?
ADI Non-ADI
• An outward investing entity that • An outward investing entity that

is an ADI will be subject to the is a non-ADI will be subject to
Income Tax Assessment Act ITAA97, Subdivision 820-B.
1997 (Cwlth) (ITAA97), • An inward investing entity that
Subdivision 820-D. is a non-ADI will be subject to
• An inward investing entity that ITAA97, Subdivision 820-C.
is an ADI will be subject to
ITAA97, Subdivision 820-E.
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Is the entity a
financial entity?
No Yes
No further Further special

rules apply. rules may apply.
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.)
Assets and entities not affected

If the de minimis exemption applies, an entity will not be subject to the thin capitalisation
rules. The de minimis rule for thin capitalisation provides particular entities with the ability to
eliminate the need to comply with Division 820 of ITAA97, if they claim under the threshold
amount for debt deductions. Up to 30 June 2014, all entities were able to claim up to an
aggregated $250 000 in interest deductions per year without triggering the application of
the thin capitalisation rules. From 1 July 2014, the de minimis threshold has been increased
to $2 million of debt deductions (ITAA97, s. 820-35). Associate entities must be included in
determining whether de minimis test is satisfied.
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).
Types of entities and control

According to the ATO, the following will be affected by the thin capitalisation rules:
• Australian entities with certain overseas operations, and their associate entities
(outward investors)
• Australian entities that are foreign controlled (inward investors)
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• foreign entities with operations or investments in Australia that are claiming debt
deductions (inward investors) (ATO 2016b).
Australian or foreign multinational entity

Australian entities that either are controlled by foreign entities, or control foreign entities, will be
subject to the provisions in Division 820 of ITAA97. It is also important to determine whether an
entity is an inward or outward investing entity for the operation of this Division.
Inward or outward investing entities

Entities are considered to be either ‘inward investing entities’ or ‘outward investing entities’;
the distinction between the two is relevant when the consequences of the regime are considered.
The ATO defines an inward investing entity as either of the following:

• an Australian entity controlled by a foreign entity
• a foreign entity that derives Australian assessable income through an Australian permanent
establishment or direct Australian investment; for example, an Australian rental property
(ATO 2016a, p. 265).
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.
Example 7.16: Inward and outward investors

Alice Co is an Australian company that is a subsidiary of a parent company in the United Kingdom.
Alice Co is an inward investing entity.
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).
Control interests in a company, trust or partnership

An entity is an Australian controller of an Australian controlled foreign entity when it holds
a control interest in that entity. Similarly, when a foreign entity holds a control interest in an
Australian entity, the Australian entity is considered to be foreign controlled. The meaning
of the term ‘thin capitalisation control interest’ is found in s. 820-815 of ITAA97:
The thin capitalisation control interest … that an entity holds in a company, trust or partnership
at a particular time is the total of the following interests:
(a) the [thin capitalisation] direct control interest (if any) held by the entity in the company, trust or
partnership at that time;
(b) the [thin capitalisation] indirect control interest (if any) held by the entity in the company,
trust or partnership at that time;
(c) the [thin capitalisation] direct control interests (if any) held by the entity’s associate entities in
the company, trust or partnership at that time;
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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).
Example 7.17: Direct control interest
Australia Co
65% capital on issue

60% voting rights
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
Authorised deposit-taking institution or non-authorised deposit-

taking institution
Once it is determined that an entity is either an inward or outward investing entity, and therefore
subject to Division 820 of ITAA97, it is also necessary to determine whether the entity is an
authorised deposit-taking institution (ADI).
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
General entity or financial entity

A non-ADI entity is further classified as a general entity or a financial entity. A general entity
is an entity that is neither a financial entity nor an ADI. A financial entity is defined in s. 995-1
of ITAA97.
Disallowance of certain deduction amounts

The maximum allowable debt amount, and the disallowance of deductions under the thin
capitalisation rules, will differ depending on the type of entity to which the rules relate. There are
different ways to calculate the amount of debt deduction that will be disallowed. Some of these
are discussed in further detail in the following section. In summary, the relevant provisions in
ITAA97 dealing with the disallowance of a debt deduction are:
• for outward investing entities (non-ADI), s. 820-115
• for inward investing entities (non-ADI), s. 820-220
• for outward investing entities (ADI), s. 820-325
• for inward investing entities (ADI), s. 820-415.
Non-authorised deposit-taking institution:

Part of a debt deduction for a tax year is disallowed if the entity is an outward investing
entity (non-ADI) and the entity’s adjusted average debt exceeds its maximum allowable debt
(ITAA97, s. 820-85).
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
MODULE 7
• 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).
Example 7.18: Adjusted average debt amount

Storage Co is an Australian company with a wholly owned subsidiary in the United States. Storage Co
is also the controller of an Australian controlled foreign entity that has the following liabilities showing
on its balance sheet:
$
Issued capital 1.5 million
Bank loan (10% per annum) 2.1 million
Other (non-debt) liabilities 4 million
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).
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.
Figure 7.4: Non-authorised deposit-taking institution outward investing entity—

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).
Apply method statement in s. 820-95 of ITAA97. From 1 July 2014

the safe harbour debt to asset ratio test has been reduced to 1.5:1
and 15:1 for financial entities (debt to equity ratio).
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 outward investor is a financial entity, see s. 820-100 of ITAA97.
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).
Step 3: This is an amount that represents a notional amount of debt capital

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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).
Step 4: Apply method statement in s. 820-110 of ITAA97 (see s. 820-111).

This test allows the Australian operations of an entity, in certain
Calculate the worldwide
circumstances, to be geared up to 100 per cent of the gearing of
gearing debt amount.
the Australian entity’s worldwide group.
The maximum allowable debt for an entity is the greatest of

the safe harbour debt amount, arm’s length debt amount and
Step 5: worldwide gearing debt amount. The amount of debt deduction
Calculate the debt disallowed under s. 820-85(1) of ITAA97, is worked out using the
deductions disallowed. following formula (ITAA97, s. 820-115):
Debt deduction × (Excess debt / Average debt)

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The entity will not be able to take a deduction for amounts exceeding the maximum allowable
debt amount.

In calculating the allowable deductions, the ‘safe harbour’ debt amount for an outward investor
(general) is calculated according to the method statement in s. 820-95 of ITAA97, as shown in
Figure 7.5. The safe harbour debt amount for an outward investor (financial) is contained
in s. 820-100 of ITAA97.
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Figure 7.5: Safe harbour debt amount—outward investor (general)
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
OztralCo has an adjusted average debt amount of $2.8 million.
(a) What is the safe harbour amount

for OztralCo?
(b) Show how you obtained

your answer.
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The arm’s length debt amount is a notional amount having regard to the factual assumptions
and other relevant factors set out in s. 820-105 of ITAA97. Broadly, this amount represents the
tax-deductible debt (maximum) that the entity could have borrowed from commercial lending
institutions that were not associates of the entity.
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.

‘The gearing of the entity’s worldwide group is determined by reference to method statements
contained in’ s. 820-110 of ITAA97 (ATO 2016a, p. 72; see Figure 7.6).
If the worldwide equity amount … is a negative amount, the worldwide gearing debt amount
cannot be used by the entity as a measure of its maximum allowable debt for the income year
(ATO 2016a, p. 72).
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Figure 7.6: Worldwide gearing debt amount—outward investor (general) that is

not also an inward investment vehicle
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
Add 1 to the result of step 1.
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.

‘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. 81). The amount
of debt deduction disallowed is worked out using the formula in s. 820-115 of ITAA97:
Debt deductions × (Excess debt / Average debt)
‘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).
Example 7.19: Outward investing entity (general; non-

authorised deposit-taking)
Sydney Co is an Australian company with a wholly owned subsidiary in the United States called
Chicago Co. Sydney Co is also the controller of Chicago Co, which is an Australian controlled foreign
entity. Sydney Co. is neither a financial entity nor an ADI. Sydney Co has an adjusted average debt
of $5.6 million in the form of a bank loan (assuming the amount of the bank loan is stable throughout
the income year). Sydney Co’s arm’s length debt amount is $2.5 million and its worldwide gearing
debt amount is $3 million.
The balance sheet as at 30 June 2017 shows:
Sydney Co Assets (AUD) $

• Investments in Chicago Co 4 000 000
• Land/buildings 6 000 000
• Other assets in Australia 2 000 000
Sydney Co Liabilities (AUD)

• Issued capital 3 600 000
• Bank loan (12% interest) 5 600 000
Other liabilities (non-debt) 2 800 000
Chicago Co bank debt (AUD) 2 000 000
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:
$672 000 × ($2 480 000 / $5 600 000) = $297 600
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).
Non-authorised deposit-taking institution:

Similar steps are taken in Subdivision 820-C of ITAA97 when considering the application of
the thin capitalisation rules to an inward investing entity. The legislation differs depending on
whether the entity is an investor or an investment vehicle. The steps to take in calculating any
debt deductions allowed for the purposes of an inward investing entity are broadly outlined in
Figure 7.7.
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Figure 7.7: Calculating for the purposes of an inward investor non-authorised

deposit-taking institution
Step 1: Calculate the adjusted average debt.
Step 2: Calculate the safe harbour debt amount.
Step 3: Calculate the arm’s length debt amount.
Step 4: Calculate the worldwide gearing debt amount.
Step 5: Calculate the debt deductions disallowed.
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.

The safe harbour amount is calculated in accordance with the method statement in s. 820-205 of
ITAA97. If an entity’s debt funding exceeds this safe harbour limit, an adjustment will be made
to reduce the debt deductions unless the funding would be acceptable under the arm’s length
principles (ITAA97, s. 820-215). This is shown in Figure 7.8. Note that for financial entities the
method statement will differ (ITAA97, Subdivision 820-C).
Figure 7.8: Safe harbour debt amount—inward investor (general)
Step 1
Work out the average value, for the income year,

of all of the following assets of the entity (the Australian investments):
• assets that are attributable to the entity’s Australian permanent establishments
• other assets that are held for the purposes of producing the entity’s assessable income.
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
Multiply the result of step 4 by 3 / 5.
Step 6
amount. The result of this step is the safe harbour debt amount.
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As explained earlier, for outward investing entities the arm’s length debt amount is a notional
amount having regard to the factual assumptions set out in s. 820-215 of ITAA97. The same
principles discussed earlier apply here.

The worldwide gearing ratio is determined under s. 820-218 of ITAA97, which is extracted in
Figure 7.9.
Figure 7.9: Worldwide gearing debt amount—inward investor (general)
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
Add 1 to the result of step 1.
Step 3
Divide the result of step 1 by the result of step 2.
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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
amount. The result of this step is the worldwide gearing debt amount.
Example 7.20 shows the process for working out the worldwide gearing debt amount for inward
investor (general).
Example 7.20: Worldwide gearing debt amount

MLO Limited, a company that is not an Australian entity, has investments in Australia.
MLO Limited has statement worldwide debt of $120 million and statement worldwide equity
of $40 million.
The result of applying step 1 [of Figure 7.9] is therefore 3. Dividing 3 by 4 (through applying
steps 2 and 3) and multiplying the result by $75 million (which is the result of step 4 of the
method statement in section 820- 205) equals $56.25 million. As the average value of
the company’s associate entity excess amount is $4 million, the worldwide gearing debt
amount is therefore $60.25 million.
Source: Income Tax Assessment Act 1997 (Cwlth), s. 820-218, Federal Register of Legislation,

The amount of debt deduction disallowed is worked out using the formula in s. 820-220 of
ITAA97:
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).
Example 7.21: Debt deductions disallowed

Melbourne Co has an adjusted average debt of $58 million and its maximum allowable debt is
$55 237 500. Melbourne Co’s average debt capital is $59 million. Melbourne Co’s debt deductions
are $2.7 million.
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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:
$2 762 500 / $59 000 000 = 0.04682
This is the proportion that can be applied to Melbourne Co’s debt deductions. The debt deductions
are $2.7 million.
Therefore, the proportion disallowed is calculated as follows:
$2 700 000 × 0.04682 = $126 419
Melbourne Co is disallowed $126 419 of its debt deductions.
Source: Based on ATO (Australian Taxation Office) 2016a, Thin Capitalisation,

accessed February 2018, https://www.ato.gov.au/misc/downloads/pdf/qc17057.pdf.
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➤➤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.
(a) What amount, if any, of the debt

deductions is disallowed for Hope Co?
(b) Show how you obtained your answer.
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Authorised deposit-taking institution 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.
Figure 7.10: Calculating for the purposes of an authorised deposit-taking

institution outward investing entity
Step 1: Calculate the adjusted average equity capital.
Step 2: Calculate the safe harbour capital amount.
Step 3: Calculate the worldwide capital amount.
Step 4: Calculate the arm's length capital amount.
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.

Subdivision 820-E of ITAA97 contains the rules for inward investing ADI entities. These ADIs
are foreign banks that operate their banking business in Australia at or through a permanent
establishment. This means they are foreign ADIs with Australian permanent establishments.
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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Figure 7.11: Calculating for the purposes of an authorised deposit-taking

institution inward investing entity
Step 1: Calculate the average equity capital.
Step 2: Calculate the safe harbour capital amount.
Step 3: Calculate the arm's length capital amount.
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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Part D: Financial arrangements and

financial instruments
Various legislative reforms have been implemented in response to corporations’ use of financial
agreements and instruments. This part of the module considers the taxation of financial
arrangements (TOFA) rules, and some of the financial instruments that sit outside those rules.
Taxation of financial arrangements regime

The TOFA reforms were introduced to provide a framework for the taxation of gains and losses
from financial arrangements. The relevant provisions are contained in Division 230 of ITAA97,
which was introduced by the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009
(TOFA Act) applying from 1 July 2010.
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.
Entities and financial arrangements subject to the regime

The TOFA rules apply to financial arrangements. However, they do not apply to all financial
arrangements, with some being excepted under Subdivision 230-H of ITAA97.
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.
Application of the rules

Financial arrangement
In addition to the entities listed in the previous section, the TOFA rules apply to ‘financial
arrangements’. Sections 230-45 and 230-50 of ITAA97 provide tests that determine whether there
is a financial arrangement.
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).
Section 230-55 of ITAA97:
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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.
Example 7.22: Purchase of goods

Heavy Pty Ltd (Heavy) enters into an arrangement with Light Pty Ltd (Light) in June 2017 for the supply
of office furniture. The furniture is to be supplied by Light to Heavy in November 2017 for $300 000.
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).
Calculating gains or losses

A gain or loss under the TOFA rules is calculated on a net basis, meaning that costs (financial
benefits provided) are offset against proceeds (financial benefits received). The usual income
rules apply insofar as gains are assessable and losses are deductible (ITAA97, s. 230-15) and will
sit on revenue account (this is with the exception of hedging financial arrangements).
Example 7.23: Gains and losses—a net concept

Jam Co enters into a contract to sell a truck to Straw Co on 1 July [2017]. Under the contract,
Jam Co must deliver the truck to Straw Co on 1 September [2017] and Straw Co must make
payment of $50,000 on 30 June [2019]. The value of the truck is $40,000 on 1 September [2017].
Jam Co starts to have a financial arrangement from 1 September [2017]. Before this date,
Jam Co had a non-cash settlable obligation (the obligation to provide the truck), which was
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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).
As well as these tax methods, ‘a balancing adjustment is generally required to be calculated

when a taxpayer ceases to have a financial arrangement’ (Explanatory Memorandum, Tax Laws
Amendment (Taxation of Financial Arrangements) Bill, para. 1.55). The methods are discussed
in brief in the following section. In practice, the application of tax treatments for the methods
(outlined in Figure 7.12) is particularly complex.
Figure 7.12: Hierarchy of tax treatments
Elective hedging
Elective methods
Elective financial reports
Elective fair value
MODULE 7
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.
Accruals method (Subdivision 230-B)

This method applies where a gain or loss is sufficiently certain. In simple terms, this gain or loss is
then spread over the term of the arrangement to which the gain or loss relates. Section 230‑125
provides an overview of the method, and the way in which the gain or loss is spread over the
arrangement is worked out according to ss. 230-130 and 230-135. If a gain or loss amount is
sufficiently certain at the time the arrangement is entered into (or at a particular time), then this
amount can be spread over the life of the arrangement under this method. In considering
whether a gain or loss, or financial benefit, is sufficiently certain, regard must be had to
(among other things) a reasonable expectation of whether an entity will provide the benefit,
and the terms and conditions of any arrangement (ss. 230-110, 230-115).
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.
Example 7.24: Compounding accruals

InvestCo acquires a six-year bond that makes annual interest payments of 7 per cent subject to the
issuer deciding to make such payments. In addition to the 7 per cent return, InvestCo will receive
130 per cent of the investment amount at maturity from the issuer. InvestCo originally acquired the
bond for $100 000.
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
MODULE 7
‘interest on interest’.
Realisation method (Subdivision 230-B)

The realisation method brings to account gains or losses in the income year in which the gain
or loss occurs. Generally, a gain or loss occurs when the last of the financial benefits is provided
or is to be provided (Explanatory Memorandum, Tax Laws Amendment (Taxation of Financial
Arrangements) Bill, para. 4.14; see ITAA97, s. 230-180).
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.
Example 7.25: Realisation method

InvestCo lends $100 to BorrowCo and is to receive $10 interest each year (for three years) subject to a
contingency. The contingency has been met, and InvestCo receives the amounts each year. Under the
realisation method, InvestCo will make a gain of $10 in each year that the interest is paid. The initial
$100 lent is not a realised loss when it is paid. Instead, the entity must wait until the last reasonably
attributable financial benefit is received or provided in relation to the loan amount, which happens
when the principal is repaid. This will be at the end of the arrangement.
Study guide | 517
Fair value method (Subdivision 230-C)

The gain or loss for a particular period is taken to account under this method if a fair value
election has been made (s. 230-210). This means that the increase or decrease in the financial
arrangement’s fair value between the beginning and end of the period, adjusted for amounts
paid or received during the period, is realised. The term ‘fair value’ is defined in AASB 139.
Example 7.26: Fair value method

A taxpayer enters into a financial arrangement with a value of $100 000 as at 30 June 2016. The value
of that financial arrangement increases to $130 000 as at 30 June 2017. As such, it can be said that
there is a fair value gain to be accounted for, equal to $30 000 over that period.
➤➤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?
MODULE 7
Foreign exchange retranslation method (Subdivision 230-D)

Similar to the fair value method, the foreign exchange retranslation method recognises
unrealised gains and losses. When this method is chosen:
Currency exchange rates will be generally determined by the amount which is required under
Australian Accounting Standard AASB 121 The Effects of Changes in Foreign Exchange Rates
… [A]ll gains and losses attributable to changes in currency exchange rates arising from financial
arrangements will be brought to account under Subdivision 230-D [of ITAA97] (Explanatory
Memorandum, Tax Laws Amendment (Taxation of Financial Arrangements) Bill, paras 7.4–5).
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.
Example 7.27: Applying the general retranslation election

to a USD loan
Yee Imports Co (Yee) is a large Australian company that is eligible and makes the foreign
exchange retranslation method – general election. Yee has a loan of US$1,000 for which gains
and losses attributable to changes in foreign exchange rates must be recognised in profit or
loss in accordance with AASB 121. Under the loan agreement, Yee does not have to repay
any principal until the end of year four.
When Yee entered into the loan, it had a liability in Australian dollars (A$) of $2,000 (A$1 =
US$0.50). By the end of year one, the Australian dollar had appreciated against the US dollar,
such that the A$ value of the loan decreased to $1,333. For accounting purposes, a profit of
$667 is recognised. This means for tax purposes, a $667 gain is recognised.
In year two, a gain of $83 is recognised as the Australian dollar value of the loan has decreased
from $1,333 to $1,250. In year three, the Australian dollar value of the loan has increased to
$1,428 and a loss of $178 is recognised.
At the end of year four, when the loan is repaid, Yee performs a balancing adjustment
calculation under Subdivision 230-G and works out that it makes a $110 loss.
Year 0 Year 1 Year 2 Year 3 Year 4

Amount of debt (US$) $1,000 $1,000 $1,000 $1,000 0
A$ currency 0.50 0.75 0.80 0.70 0.65
A$ value of debt $2,000 $1,333 $1,250 $1,428 $1,538
Tax treatment under 0 $667 gain $83 gain $178 loss $110 loss*
the foreign exchange ($2,000 – ($1,333 – ($1,250 –
retranslation method $1,333) $1,250) $1,428)
* Subdivision 230-G balancing adjustment applies when the financial arrangement ceases.
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.
MODULE 7
Hedging method (Subdivision 230-E)

This method broadly ensures that gains and losses from hedging financial arrangements
are included in taxable income at the same time as those made from the hedged items are
recognised for tax purposes. In simple terms, it matches the tax classification and consequences
between the two. Tax-hedge treatment is limited to ‘hedging financial arrangements’ being
defined as a financial arrangement that is a ‘derivative financial arrangement’ or a ‘foreign
currency hedge’ (ITAA97, s. 230-335).
Example 7.28: Hedging method

HedgeCo has made a hedging financial arrangement method election. It takes out a series of foreign
exchange forward contracts to hedge the exchange rate risk in relation to certain foreign interests
(subsidiaries). Under the method elected, the time of recognition of gains and losses will be when
a dividend is paid by the foreign subsidiary, part of the loan principal is repaid or there is a capital
return from the investment.
Reliance on financial reports method (Subdivision 230-F)

This method allows a taxpayer to rely on financial reports to calculate the gains and losses from
financial arrangements by reference to relevant accounting standards (s. 230-420). There are
further conditions for making this method election (s. 230-395). This method seeks to align the
tax treatment of financial arrangements to the accounting treatment of those arrangements,
which in turn is intended to reduce administration and compliance costs.
Study guide | 519
Example 7.29: Reliance on financial reports method

ReporterCo approaches auditors to prepare detailed financial reports for the company. Assuming a
valid election to rely on financial reports has been made, ReporterCo can rely on the auditors’ financial
reports for the purposes of complying with its tax obligations in respect of relevant Division 230
financial arrangements.
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.
Outside the taxation of financial arrangements

regime
Accruals regime: Qualifying securities
There is some interaction between the accruals method discussed earlier, and the accruals rule
in Division 16E of ITAA36. This division operates to determine the timing of the assessability of
income and deductions for qualifying securities. Division 16E applies to qualifying securities,
being securities as defined in s. 159GP(1) of ITAA36.
Broadly, a qualifying security is a security that at the time of issue:
• will, or is reasonably likely to, exceed one year
• is reasonably likely to result in the sum of the payments (excluding periodic interest) exceeding
the issue price (ATO 2016c).
The return on this is brought to account on a compounding accruals basis. That is, Division 16E
MODULE 7
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.
Asset and project financing arrangements

Hire purchase arrangements
Division 240 of ITAA97 provides that:
for income tax purposes, some arrangements (such as hire purchase agreements) are
recharacterised as a sale of property, combined with a loan, by the notional seller to the
notional buyer, to finance the purchase price (ITAA97, s. 240-1).
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 agreement’ is:

a contract for the hire of goods where:
(a) the hirer has the right, obligation or contingent obligation to buy the goods; and
…
(b) the charge … exceeds the price of the goods; and

(c) title in the goods does not pass to the hirer until the option referred to in subparagraph (a)(i)
is exercised (ITAA97, s. 995-1).
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)).
Study guide | 521
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.
Example 7.30: Hire purchase

Farm Pty Ltd (Farm) enters into a hire purchase agreement to purchase an item of machinery.
The agreement is for a term of six years with an amount of rent payable under the agreement of
$20 000 per annum. The retail cost of the machinery is approximately $95 000. Farm will purchase the
machinery at the end of the agreement for market value.
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.
Sale and leaseback arrangements

The TOFA regime in Division 230 of ITAA97 does not apply to sale and leaseback transactions.
A sale and leaseback arrangement exists where the owner of the asset disposes of the
asset to another party, but continues to use the asset under a lease arrangement from the
purchaser (lessor).
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
MODULE 7
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
Large project financing: Limited recourse debt

Limited recourse debt arrangements are subject to specific rules in Division 243 of ITAA97.
The TOFA regime in Division 230 of ITAA97 does not apply to these arrangements.
A limited recourse debt is an obligation imposed by law on an entity (the debtor) to pay an amount
to another entity (the creditor) where the rights of the creditor as against the debtor in the event of
default in payment of the debt or of interest are limited [by contractual terms or by the effect of the
arrangement] (ITAA97, s. 243-20(1)).
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).
Example 7.31: Limited recourse borrowing arrangement

and hire purchase
On 1 July 2014, BuildCo purchases property for $100 000 from HireCo under a hire purchase
arrangement. BuildCo is able to depreciate the property (ITAA97, Division 40) and a decline in value
is calculated using the prime cost method. This method is used until 30 June 2017.
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
MODULE 7
balancing adjustment of $10 000).
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.
MODULE 7
MODULE 7
Suggested answers | 525
Suggested answers
Suggested answers
Question 7.1
(a) Is the interest a debt or equity interest? Debt
(b) Show how you arrived at your answer. Equity test

Because the interest is a share, it is an equity interest
if it is not a debt interest.
Debt test
The interest is a debt interest because it meets the four
elements of the debt test set out in Figure 7.1:
MODULE 7
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.
Return to Question 7.1 to continue reading.

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.
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.

MODULE 7
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.
The result for OztralCo is $6 million.
Step 1a. Reduce the result of step 1 by the average value,

for that year, of all the excluded equity interests in the entity.
The average value of excluded entity interests is nil, so the

result is $6 million.
Step 2. Reduce the result of step 1a by the average value,

for that year, of all the associate entity debt of the entity.
This is nil, so the result is $6 million.

Suggested answers | 527
Step 3. Reduce the result of step 2 by the average value,

for that year, of all the associate entity equity of the entity.
This is $2 million, reducing the amount to $4 million.
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.
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.
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.
$4 000 000 – $1 400 000 = $2 600 000
Step 7. Multiply the result of step 6 by 3/5.
$2 600 000 × 60% = $1 560 000
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.
The safe harbour debt amount is $1.56 million.
Source: Based on Income Tax Assessment Act 1997 (Cwlth), s. 820-95, Federal Register of Legislation,
MODULE 7
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:
$50 000 000 – $45 000 000 = $5 000 000
This amount is then divided by the average debt capital

to work out the proportion to be disallowed:
$5 000 000 / 55 000 000 = 0.0909
The debt deductions disallowed is calculated by

multiplying the proportion to be disallowed (0.0909) by
the debt deductions for the tax year ($5 million):
$5 000 000 × 0.0909 = $454 545

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.

MODULE 7
References | 529
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/.
MODULE 7
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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CPA PROGRAM

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ISBN 978 1 9217 4288 0

CPA Program team

Part A: Debt and equity rules 466

Part B: Value shifting 475

Reduction methodology: Basic case and same asset rollover

Part C: Thin capitalisation 491

Authorised deposit-taking institution entities 509

Part D: Financial arrangements and financial instruments 512

Suggested answers 525

Part A: Debt and equity rules

Test that identifies a debt interest

Figure 7.1: Elements of the debt test

Element 1: There is a scheme that is a financing arrangement.

Element 2: A financial benefit is received, or will be received, under the scheme.

Element 3: There is an effectively non-contingent obligation under the scheme

Source: CPA Australia 2018.

Element 1: Scheme that is a financing arrangement

Section 974-150 of ITAA97 states that:

Element 2: Financial benefit received

Example 7.1: Financial benefit received

Element 3: Effectively non-contingent obligation to provide

An obligation is ‘non-contingent’ if it is not reliant on any event, condition or situation

Example 7.2: Convertible preference shares

Element 4: Value of financial benefit provided at least equal

Example 7.3: Loan amount

Test that determines whether an interest

Figure 7.2: The equity test

Item 1: Item 2: Item 3: Item 4:

Source: CPA Australia 2018.

Item 1: Interest as member or stockholder of company

Item 2: Interest carrying a right to return that is effectively

Economic performance can be broadly considered as profit.

‘A right, or the amount of a return, is contingent on aspects of the economic performance

Example 7.4: Return contingent on economic performance

Item 3: Interest carrying a right to a return that is at the

Section 974-90 further states:

Example 7.5: Discretionary return

Item 4: Interest issued by the company that will or may convert

In relation to connected entities, or a series of related transactions, it is necessary to look at the

An at-call loan will satisfy the debt where:

Non-share equity interests and non-share

Example 7.6: Non-share capital account

(a) Is the interest a debt or equity interest? Debt

(b) Show how you arrived at your answer.

Part B: Value shifting

Direct value shifting rules: Entity interests

Entity interest direct value shift

Example 7.7: Decrease and corresponding increase in value

Lotus Pty Ltd

A class shares: B class shares:

Direct value shift between John

Source: CPA Australia 2018.

Control of target entity test

Participants in scheme test and cause of the value shift

Affected owners of interest in target entity

Example 7.8: De minimis exception

Example 7.9: Direct value shift that will be reversed

Consequences of direct value shifting rules applying

Direct value shifting rules: Created rights

Owner of asset creating a right in their associate

Market value of right and consideration received

Figure 7.4: Non-authorised deposit-taking institution outward investing entity—

Figure 7.6: Worldwide gearing debt amount—outward investor (general) that is

Example 7.19: Outward investing entity (general; non-