Thin Capitalisation Issues - Aus

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					Thin Capitalisation Issues Arising
 from the Adoption of Australian
    Equivalent to International
  Financial Reporting Standards
             (AIFRS)




                              6 April 2006




            Australian Bankers’ Association Inc. ARBN 117 262 978
      (Incorporated in New South Wales). Liability of members is limited.
                             Table of Contents




1.    Background------------------------------------------------------------------------------ 2


2.    Overview of AIFRS thin capitalisation impacts ------------------------------ 2


3.    Treasury shares ------------------------------------------------------------------------ 3


4.    EMVONA ---------------------------------------------------------------------------------- 6


5.    Capitalised software costs/expenditure ---------------------------------------- 9


6.    Equity Based Compensation Plans -------------------------------------------- 10


7.    APRA changes to Defined Benefit Pension Plans ------------------------ 11


8.    Thin Capitalisation AIFRS Transitional Relief Provisions -------------- 12


9.    APRA guidelines to apply on transition -------------------------------------- 14


10.   Further Consultation---------------------------------------------------------------- 15
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                                 2



                         ABA Briefing Note
          Thin Capitalisation Impacts Arising From AIFRS

1.      Background
Since its introduction in 2001, Division 820 of the Income Tax Assessment Act
1997 (the Act) has provided a comprehensive thin capitalisation framework for all
Australian inbound and outbound taxpayers, including Australian banks, life
insurers, finance companies and other financial institutions. The purpose of the
current thin capitalisation rules is broadly to ensure that multinational companies
do not allocate an excessive amount of debt to their Australian operations.

In the case of authorised deposit-taking institutions (ADIs) (including Australian
banks or consolidated tax groups which include an Australian bank) this is
achieved by prescribing a minimum level of capital that needs to be maintained.
The relevant thin capitalisation rules are set out in Subdivision 820-D of the Act
for outward investing ADIs and Subdivision 820-E for inward investing ADIs.

The measure of an ADI's equity capital for the purposes of the thin capitalisation
rules is set with reference to “accounting standards”. The term accounting
standards is defined in Section 995-1 of the Act as having the same meaning as
in the Corporations Act 2001. As a result, the relevant accounting standards are
now based on Australian accounting standards equivalent to International
Financial Reporting Standards (AIFRS).

Most Australian taxpayers seek to comply with the current thin capitalisation rules
by effectively managing their positions with reference to the relevant “safe
harbour” requirements. In the case of ADIs, the relevant safe harbour capital
amount is determined with reference to regulatory capital standards set by the
Australian Prudential Regulation Authority (APRA). APRA is currently reviewing its
regulatory capital standards following the introduction of AIFRS. APRA is also
currently in discussions with the banking industry (and individual banks) on the
application of these new regulatory capital rules, including appropriate transitional
arrangements.

The introduction of AIFRS and APRA’s proposed regulatory capital changes will
potentially give rise to a range of adverse thin capitalisation impacts for
Australian banks.

The purpose of this briefing note is to examine these AIFRS related thin
capitalisation impacts and to also consider the effective operation of the new thin
capitalisation AIFRS transitional rules contained in section 820-45 of the Income
Tax (Transitional Provisions) Act 1997 (“the transitional thin capitalisation rules”).


2.      Overview of AIFRS thin capitalisation impacts
In July 2002, the Financial Reporting Council in Australia formally announced that
Australian reporting entities would be required to comply with AIFRS and other
pronouncements set by the International Accounting Standards Board (IASB) for
financial years commencing on or after 1 January 2005.

Australian companies required to comply with AIFRS will typically need to adopt
these standards for their 2006 financial year.
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                             3



In the case of Australian Banks, AIFRS will give rise to several adverse thin
capitalisation impacts, including a potential reduction in the adjusted average
equity capital of the consolidated tax group as a result of any reduction in
opening retained earnings arising from the adoption of AIFRS.

A number of specific issues warrant particular consideration from a thin
capitalisation perspective namely the AIFRS and APRA treatment of treasury
shares, EMVONA (ie the excess of market value over net assets of life insurance
controlled entities), capitalised software, equity-based compensation plans, and
defined benefit pension plans. These issues will potentially give rise to material
adverse thin capitalisation impacts for Australian banks. These impacts and
appropriate transitional arrangements are discussed further below.


3.      Treasury shares
Under Australian generally accepted accounting principles (AGAAP), direct
investments in a particular bank’s shares by that company’s life insurance
statutory funds are recognised in the group’s balance sheet at market value (ie
recognised within investments relating to the life insurance business). On
transition to AIFRS these assets are reclassified as treasury shares and accounted
for as a deduction from share capital. These adjustments only occur at the
consolidated group level, and do not affect the financial statements of the
underlying life insurance entities.

Similar adjustments can also arise under AIFRS in relation to group entities
holding parent company shares are part of the group’s employee share plan
arrangements.

The typical treasury shares transitional adjustment for a group with a life
insurance subsidiary would comprise the following components:

             a decrease in the investments relating to the life insurance
              business, being the market value of the investments held in the
              parent entity’s shares;

             a decrease in contributed equity, being the cost of the investments;
              and

             an adjustment to retained earnings, being the reversal of the
              cumulative market value adjustment to the carrying value of the
              investments, including any unrealised gains and losses and any
              related tax effects.

This is illustrated in Example 1 below.


Example 1

Background

             Australian Bank Ltd is a publicly listed Australian bank and holds a
              100% interest in Australian Life Co.

             Australian Life Co conducts a life insurance business and various
              policy holder funds are held in specified statutory funds.
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                               4



             One of the statutory funds of Australian Life Co holds shares in
              Australian Bank with a cost and market value of $100, as part of its
              overall investment portfolio.

             Australian Bank and Australian Life Co are part of a consolidated
              tax group, where Australian Bank is the head company.

             Australian Bank also holds several 100% owned foreign subsidiaries
              and is subject to the thin capitalisation rules in Sub-division 820-D.


Diagram

                                 Shareholders

                                 Bank Limited
                                          Issued Capital $1,000



                                  Australian
                                    Bank
                                   Limited


                                                           Treasury Shares $100

                                  Australian
                                   Life Co
                                  Statutory
                                    Fund




Accounting Treatment Under AGAAP

             Under AGAAP direct investment in a parent company shares by the
              Group’s life insurance statutory funds are recognised within
              investments relating to the life insurance business and carried at
              market value.


Accounting Treatment Under AIFRS

             Under AIFRS these investments are classified as treasury shares
              and deducted from share capital in preparing consolidated group
              accounts. No adjustment is made to the financial statements of
              Australian Life Co.
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                                          5




APRA Treatment

APRA has considered the regulatory capital treatment of treasury shares and
stated that:

         “Treasury shares will be allowed in Tier 1 capital whenever (i) these
         shares are direct investments held by a group member (eg a life
         insurance subsidiary) for the benefit of third parties (eg policyholders); or
         (ii) the shares offset the accrued expense of share based compensation
         schemes”1


Thin Capitalisation Issues

From an Australian thin capitalisation perspective, the issue arises whether the
consolidated accounting treatment of treasury shares under AIFRS has any
impact in determining the thin capitalisation position of the relevant Australian
tax group. Specifically for a banking group, in determining the “adjusted average
equity capital” is an adjustment required to eliminate the impact of treasury
shares from issued capital and retained earnings?

The concept of adjusted average equity capital largely turns of the meaning of the
term “equity capital” which is defined in section 995 –1 of the Act. This definition
sets out the various components of equity capital, which are based around
accounting type concepts. In relation to share capital itself which is included in
the measure of “equity capital”, the relevant definition refers to “the issue price
(however described) of each *equity interest in the entity that is still *on issue,
reduced by so much (if any) of the issue price as remains unpaid”.

Based on this definition it would appear that the issue price of a relevant bank’s
shares would continue to form part of the bank’s “equity capital”, as the issue
price of the relevant shares should not be impacted by the nature of the
particular shareholder that holds the interest in those shares. The definition of
“equity capital” also does not prescribe any adjustment to the determination of
the issue price, except to the extent that the relevant equity interest remains
unpaid.

The phase “on issue” is also defined in Section 995-1 of the Act in the following
terms:

         “(b)      an equity interest in an entity:

                   (i)       is on issue from when it is issued until it stops being on
                             issue because of subparagraph (ii); and

                   (ii)      stops being on issue when, ….there is no longer a
                             reasonable likelihood that a substantial *financial benefit
                             will be provided in respect of the interest under the
                             *scheme, or under any of the schemes, that give rise to
                             the interest.”




1
  APRA Paper, “Response to Submissions, Adoption of International Financial Reporting Standards,
Prudential Approach, 1. Fair value and Other Issues”, 29 November 2005.
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                                6



Based on the above definition the treasury shares also clearly remain on issue
regardless of who the actual shareholder is at any particular time and regardless
of any particular accounting conventions that need to be applied to account for
the equity interest at a consolidated group level.

One other relevant consideration is whether the entities that hold the investments
form part of the entity’s tax consolidated group. Often the treasury shares will be
held by entities that, while part of the particular life company (and accounting
consolidated group), do not necessarily form part of the tax consolidated group.
For example, Section 703-20 excludes from being a member of a consolidated
group, a trust that is a “complying superannuation entity”, which in turn is
defined to include “a pooled superannuation trust”.

In applying the thin capitalisation rules to a tax consolidated group, it will be
necessary to calculate the “adjusted average equity capital” for all the members
of the group under the single entity rule. The various members of the
consolidated group will therefore be deemed to be part of the head company for
the purposes of calculating any relevant thin capitalisation values. Therefore if the
relevant entities holding the treasury shares do not form part of the consolidated
group, it would seem relatively clear that no adjustment to the measure of
“adjusted average equity capital” should arise for the treasury shares that exist.
The assets of the group for thin capitalisation purposes would also not include the
investment in the parent company’s shares as the relevant assets would not be
held by a member of the tax consolidated group.

Where the entities holding the treasury shares are part of the consolidated group,
the correct outcome is not as clear. Arguably no reduction in adjusted average
equity capital arises, as the relevant shares are still on issue and fully paid.
However, it is also arguable that an adjustment to the measure of “equity capital”
is required under the single entity rule to eliminate any share capital held by the
entity itself, as the holder of the shares will be treated as part of the head
company.

The potential impact of Section 820-680(1)(c) of the Act, which prescribes the
use of accounting standards in valuing equity capital for thin capitalisation
purposes also needs to be considered, along with APRA’s intention to reverse the
accounting elimination of treasury shares in determining Tier 1 capital for
regulatory capital purposes.


4.      EMVONA
Where a life insurance entity within a group consolidates a controlled entity, any
difference between the values consolidated line by line and the market value of
the controlled entity is recorded in the life insurer’s financial report as EMVONA.

Under AGAAP EMVONA is disclosed as an asset in the group’s balance sheet. The
components of EMVONA are broadly as follows:

             acquired goodwill arising from acquisitions including the value of
              new business (VNB) (ie the net present value of the expected
              distributable profits of a business expected to be written over future
              periods of time) and potential future synergies;
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                              7



             the value of business in force (VBIF) (ie the net present value of
              the expected distributable profits of the business in force at that
              time); and

             increases in the value of the above components since acquisition.

On transition to AIFRS EMVONA is no longer recognised and partly replaced with
any acquired goodwill related to the group’s life insurance operations. The
goodwill is also no longer amortised but subject to an annual impairment test.
Typically the removal of EMVONA and recognition of goodwill will result in a
reduction in shareholder’s equity at the relevant AIFRS transition date, being the
increase in value of EMVONA since acquisition.

This is illustrated in Example 2 below.


Example 2


Background

             Australian Bank Ltd acquired Australian Life Co for $300. At the
              time the net assets of Australian Life Company were $200. EMVONA
              of $100 arose on acquisition, comprising VBIF of $75 and VNB of
              $25.

             The carrying value of EMVONA was subsequently re-valued to $150,
              comprising VBIF of $100 and VNB of $50.


Diagram

                                 Shareholders

                                 Bank Limited



                                   Australian
                                     Bank
                                    Limited


                                          Cost $300

                                                  EMVONA $150
                                   Australian
                                    Life Co       Current VBIF $100
                                 (Net tangible    Current VNB $50
                                 Assets: $200)



                             Net
Accounting Treatment Under AGAAPAssets
                                    $200
             Under AGAAP, EMVONA is recognised and shown as an asset of
              $150 in the balance sheet. The post-acquisition increase in value of
              EMVONA of $50 is also recognised in the profit and loss statement.
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                                      8



Accounting Treatment Under AIFRS

              Under AIFRS the whole of EMVONA ($150) is written off to retained
               earnings and replaced by any acquired goodwill ($100). The
               goodwill recognised does not need to be amortised but will be
               subject to an annual impairment test. This transitional adjustment
               reduces opening retained earnings under AIFRS by $50.


Thin Capitalisation Impact of adopting AIFRS

From an Australian thin capitalisation perspective, the issue arises whether the
net EMVONA adjustment of $50 will reduce the group’s measure of “adjusted
average equity capital”. The retained earnings of Australian Life Co are included in
the calculation of “adjusted average equity capital” of the Australian tax group for
thin capitalisation purposes. Therefore as EMVONA (including the change in value)
is reflected in Australian Bank’s consolidated balance sheet under AGAAP but not
under AIFRS, the transition to AIFRS will result in a net reduction in the
measurement of “adjusted average equity capital” for thin capitalisation purposes
of $50.


APRA Treatment

The other potential thin capitalisation impact of EMVONA relates to the safe
harbour test and the calculation of the safe harbour capital amount for the
purposes of section 820-310 of the Act, in particular the measure of Tier 1
prudential capital deductions.

APRA in its AIFRS discussion paper dated 29 November 2005 2, has confirmed a
proposed change to the Tier 1 capital deduction that arises in relation to
EMVONA. At present Australian banks are required to fully deduct EMVONA from
their regulatory capital position, partly from Tier 1 capital and partly from total
capital. VNB either acquired or self generated is deducted from Tier 1, while VBIF
and net tangible assets at acquisition are deducted from total capital. This change
will be effective from 1 July 2006.

APRA has now proposed that all components of EMVONA should be removed for
Tier 1 regulatory capital purposes and as a result the VBIF at acquisition will need
to be deducted from Tier 1 capital rather than total capital.

In the above example the following changes in regulatory capital will occur:

              under existing APRA regulations VNB of $50 is deducted from Tier 1
               capital, while VBIF of $100 is deducted from total capital; and

              under proposed new APRA regulations, all externally generated
               goodwill will be deducted from Tier 1 capital. As a result the
               quantum of APRA Tier 1 capital prudential deductions will increase
               from $50 to $150 from 1 July 2006.




2
  Refer APRA Paper, “Response to Submissions, Adoption of International Financial Reporting
Standards, Prudential Approach, 1. Fair value and Other Issues”, 29 November 2005.
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                                 9



Thin Capitalisation Impact of Revised APRA position

The proposed change in APRA's treatment of VBIF is very significant from a tax
thin capitalisation perspective, as it will effectively increase the safe harbour
capital amount by the amount previously attributable to VBIF.

In the above example the safe harbour capital amount will be increased by $100
due to the revised APRA treatment of VBIF. This together with the reduction in
the measure of “adjusted average equity capital” discussed above will reduce the
group’s thin capitalisation position by a total of $150.

The above changes to EMVONA from a financial reporting and APRA perspective
could therefore significantly erode the thin capitalisation position of any ADI with
significant life insurance operations.


5.      Capitalised software costs/expenditure
One further issue that warrants specific consideration is the APRA treatment of
capitalised software. Historically, Australian banks have not been required to
reduce the measure of Tier 1 capital by the value of capitalised software. Under
AIFRS it is likely that such capitalised software will be reclassified from a tangible
asset to an intangible asset. This potential change in accounting treatment has
lead APRA to give further consideration to the regulatory capital treatment of
capitalised software. As a result APRA has recently confirmed that Australian
banks will be required to deduct the cost of capitalised software from the measure
of Tier 1 capital (refer APRA Statement set out in Attachment A).

APRA has invited submissions on its proposed treatment of capitalised software
and has also indicated that it will consider providing transitional relief for banks
adversely impacted by this change. The deduction of capitalised software from
Tier 1 capital will give rise to a significant adverse thin capitalisation impact for
Australian banks.

This is illustrated in Example 3 below.


Example 3


Background

             Australian Bank capitalises software costs and these costs are
              amortised over 3 years. The current carrying value of capitalised
              software is $100.


Accounting Treatment Under AGAAP

             Under AGAAP, capitalised software is carried at amortised cost and
              included in “Other Assets” in the group’s balance sheet.


Accounting Treatment Under AIFRS

             Under AIFRS capitalised software is reclassified as an intangible
              asset.
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                                               10



APRA Treatment

                  Under existing APRA regulations, while a Tier 1 capital deduction
                   arises for certain capitalised expenses, this adjustment does not
                   include capitalised software.

                  APRA in its most recent statement on the regulatory capital
                   treatment of capitalised software has indicated that such
                   expenditure is required to be deducted from Tier 1 capital. As a
                   result the level of Tier 1 capital deductions applicable to Australian
                   Bank will increase by $100.


Thin Capitalisation Issues

As capitalised software is deducted by APRA from Tier 1 capital, the applicable
safe harbour capital amount for thin capitalisation purposes will be increased by
$100.

The total capitalised software expenditure carried by the Australian banking
industry is currently estimated to be $1.8 billion 3. This change in treatment by
APRA will therefore have a significant impact on the banking industry from a
regulatory capital and thin capitalisation perspective.


6.          Equity Based Compensation Plans
The adoption of AIFRS has resulted in a change in treatment to equity based
compensation (e.g. shares) and this will negatively impact the thin capitalisation
calculation for ADIs. The new treatment results in the expensing of the equity
based payments and the increase in equity. Under AGAAP these amounts would
not have been expensed. This new treatment results in a reduction in current
year profits as there is no increase in equity capital until such equity is issued.
The amount expensed therefore cannot be reflected as equity capital for thin
capitalisation purposes until that time, and secondly the booking of this expense
as share capital may result in share capital tainting. This outcome therefore
negatively impacts the ADI’s adjusted Average Equity Capital. The impact of this
AIFRS treatment on Thin Capitalisation calculations is not a one off event, but an
impact for each year that an ADI provides equity based payments.


Example 4


Background

                  The Australian Bank grants rights to equity based compensation
                   (say share options) to various staff.




3
    Source: Deutsche Bank: Australian Banking & Finance Research Bulletin dated 10 February 2006
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                             11



Accounting Treatment Under AGAAP

             Under AGAAP this amount would not be expensed. The later
              exercise of the options would result in one of three outcomes:
              either the option is out of the money and is not exercised or expires
              worthless; or the option is exercised and due to the rights
              associated with the option a payment is required for the share by
              the option holder (at a discount to market) and this payment
              results in an increase in share capital; or the option is exercised
              and due to the rights associated with the option, no payment is
              required the total share capital on issue remains unchanged,
              however the number of shares on issue increases.


Accounting Treatment Under AIFRS

             Under AIFRS, the granting of the right to future shares will be
              expensed and the amount may be booked to an equity account
              resulting in a reduction in current year profit.


Thin Capitalisation Issues

             As no shares or other equity will have been issued at the time of
              the expensing of the equity compensation, the amount booked as
              equity may not be share capital or true equity. This approach under
              AIFRS may result in a reduction to Adjusted Average Equity Capital
              under section 820-305(3).


Thin Capitalisation Calculations for 2006 and future years

             Where an ADI is required to expense equity based compensation
              and not permitted under AIFRS to immediately reflect a
              corresponding increase in equity capital, the Australian Bank is
              permitted to adjust the Adjusted Equity Capital by adding back the
              amount expensed.


7.      APRA changes to Defined Benefit Pension Plans
Under proposed APRA guidelines on defined benefit pension plans that will take
effect from 1 July 2006, there will be a material negative impact to an ADI’s thin
capitalisation calculation.


Accounting Treatment Under AGAAP

             Under AGAAP the accounting treatment can vary between banks,
              however there is minimal impact on the accounts as a result of any
              surplus or deficit in the defined pension plan. Any deficit is not a
              Tier 1 deduction and any surplus is Tier 1 capital.


Accounting Treatment Under AIFRS

             The impact as a result of AIFRS is two fold:
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                               12



              –   Any defined pension plan surplus or deficit must be reset on
                  transition to the actuarial measurement of the accounting
                  surplus or deficit, most likely reducing tier 1 capital where there
                  is a surplus; and

              –   Effective 1 July 2006, any surplus will no longer be counted as
                  tier 1 capital and any deficit will now be a new Tier 1 deduction.

             The impact for the Australian Bank when calculating its thin
              capitalisation position is that any future defined pension plan deficit
              will be a Tier 1 deduction that will impact the minimum safe
              harbour capital (see calculation under section 820-310). Also, the
              exclusion of the surplus from Tier 1 capital will reduce the ADI’s
              Adjusted Average Equity Capital.


Thin Capitalisation Calculations for 2006

             ADIs may elect to exclude from Tier 1 capital deductions amounts
              that relate to deficits in any defined pension plans and also add
              back any surplus in the defined pension plan to the ADI’s Adjusted
              Average Equity Capital.


8.      Thin Capitalisation AIFRS Transitional Relief Provisions
The Government has enacted the transitional thin capitalisation rules to provide
thin capitalisation transitional relief for taxpayers adversely impacted by the
introduction of AIFRS. As noted above, the relevant transitional rules are set out
in section 820-45 of the Income Tax (Transitional Provisions) Act 1997.

Under the transitional relief provisions, taxpayers can elect to use AGAAP for thin
capitalisation purposes for a three year transitional period, broadly covering the
income years 2005-06, 2006-07, and 2007–08. The election applies to each year
of income, regardless of whether any such election has been made in a prior
year.    In the case of ADIs, they will be required to apply both AGAAP and
prudential standards as at 31 December 2004 to determine amounts used in the
relevant thin capitalisation calculations.

A number of practical difficulties arise for taxpayers seeking to apply the
transitional thin capitalisation rules. The main problem for taxpayers will be
having access to the information needed to continue to determine their thin
capitalisation position under AGAAP principles and APRA regulatory capital
standards as at 31 December 2004.

From a financial reporting perspective, companies will only have AGAAP and
AIFRS comparative information for their 2005 year. From their 2006 year all
required financial reporting will be under AIFRS, so relevant AGAAP financial
information will not be readily available.      Significant compliance costs will
therefore exist for taxpayers in the event that it becomes necessary to maintain
separate systems to produce the AGAAP information that would not otherwise be
required.

A similar issue will exist with the calculation of an ADI’s capital adequacy position
under APRA’s regulatory capital standards. The relevant calculations prepared
going forward by an ADI will be based on the rules in force at each particular
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                                 13



balance date and not the rules as at 31 December 2004. APRA has indicated that
ADI’s will be required to commence reporting under AIFRS from 1 July 2006. As a
result further compliance costs will arise for ADI’s in the event that it becomes
necessary to maintain separate systems to produce regulatory capital calculations
based on 31 December 2004 regulatory capital standards for thin capitalisation
purposes.

The transitional thin capitalisation rules confirm that taxpayers are not required to
maintain a full set of accounts based on AGAAP and a full set of capital adequacy
calculations based on prudential standards at 31 December 2004. 4

The Explanatory Memorandum to the transitional thin capitalisation rules also
provides the following guidance at paragraph 4.36:

            “For the purposes of undertaking calculations under the thin capitalisation
            transitional arrangements, authorised deposit-taking institutions must
            use figures that are reasonable approximations for figures that would
            have been produced using AGAAP and prudential standards at 31
            December 2004. Authorised deposit-taking institutions must keep
            sufficient records to be able to demonstrate how they determined the
            figures they are using for thin capitalisation calculations under the
            transitional arrangements. What is sufficient will depend on the
            materiality of any differences between values based on AGAAP and AIFRS
            and the relevant prudential standards.”

It is understood that the ATO is currently preparing a draft practice statement in
order to provide additional guidance on the record keeping requirements of
taxpayers seeking to use the transitional thin capitalisation rules. The ABA
considers it essential that the practice statement acknowledge the practical
difficulties for taxpayers wishing to rely on the transitional thin capitalisation
rules. As a result it will be important for the practice statement to confirm that for
ADIs the thin capitalisation impacts calculated at the time of transition to AIFRS
will represent “reasonable approximations” for figures that would have been
produced using AGAAP and prudential standards as at 31 December 2004.

Importantly ADI’s should be permitted to use the thin capitalisation adjustments
calculated on transition to AIFRS over the entire 3 year thin capitalisation
transitional period, without the need to recalculate these impacts each year. The
suggested approach for ADI’s wishing to use the transitional thin capitalisation
rules is illustrated in the example below.


Example 5


Background

                  As at 1 October 2005, Australian Bank Ltd commenced to report
                   under AIFRS.

                  As at 1 July 2006 Australian Bank commenced reporting to APRA
                   under AIFRS and new regulatory capital standards. Under
                   transitional reporting arrangements with APRA, the group is not


4
    Refer Note 1 to section 820-45 Income Tax (Transitional Provisions) Act 1997
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                              14



                require to be reduce its Tier 1 capital for any existing capitalised
                software. The required Tier 1 deduction is limited to software
                acquired and capitalised after 1 July 2006.

               As at 30 September 2006, the Australian Bank tax consolidated
                group has a thin capitalisation deficit of $200, using current AIFRS
                financial reporting standards and APRA prudential rules.

               Australian Bank Ltd elects to determine its thin capitalisation
                position under the transitional thin capitalisation rules.


Thin Capitalisation Calculation as at 30 September 2006

               The adjusted average equity capital of the consolidated group is
                increased by $150 comprising the following amounts:

            –    reversal of AIFRS treasury shares adjustment of $100 (refer
                 Example 1)

            –    reversal of AIFRS EMVONA impact of $50 (refer Example 2)

               Australian Bank Ltd’s safe harbour capital amount is reduced by
                $100, as the group’s Tier 1 prudential capital deductions for thin
                capitalisation purposes excludes the additional Tier 1 deduction of
                $100 attributable to VBIF (refer Example 3).

               As a result of the above adjustments, the consolidated group has a
                thin capitalisation surplus of $50 under the transitional thin
                capitalisation rules.


Thin Capitalisation Calculation as at 30 September 2007

               For the year ended 30 September 2007, the Australian Bank
                consolidated group also elects to apply the thin capitalisation
                transitional rules.

               Australian Bank is permitted to use the same adjustments
                calculated as at 30 September 2006 in determining its thin
                capitalisation position as at 30 September 2007.


9.      APRA guidelines to apply on transition
APRA proposes to release new guidelines to deal with AIFRS. It is expected that
these proposed guidelines will apply from 1 July 2006. As outlined in point 8
above, in order to calculate a “reasonable approximation” of AGAAP financial
results a comparison will be required between the AGAAP and AIFRS numbers on
transition. This will enable the variance identified, including material reasons for
the variance between the two numbers on transition, to be used to adjust future
AIFRS numbers back to an AGAAP estimate. In order to ensure the comparison
being made starts from the same baseline AIFRS calculation as will be applied
after 1 July 2006, it is essential that the AIFRS numbers used to determine this
variance are calculated under the same rules as those that will be used in later
years (post 2006). The ADI therefore will need the ability to elect to apply the
revised APRA guidelines on transition.
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                               15



Thin Capitalisation Calculations for 2006

             ADIs when calculating their thin capitalisation position may elect to
              apply the APRA guidelines to their AIFRS thin capitalisation
              calculations on transition.


10.     Further Consultation
In order to assist the banking industry to comply with the thin capitalisation
provisions during the transitional period, the ABA requests that the ATO give
consideration to the following matters in finalising the draft practice statement,
namely:

             confirmation of the thin capitalisation treatment of treasury shares,
              namely whether the adjusted average equity of a consolidated tax
              group is impacted by the accounting elimination of treasury shares
              under AIFRS, and whether the inclusion of treasury shares by APRA
              in the measure of Tier 1 capital has any impact of the measure of
              the safe harbour capital amount for ADI’s;

             confirmation whether any adverse thin capitalisation impacts arising
              from AIFRS/APRA adjustments to Treasury shares, EMVONA and
              capitalised software will be covered by the transitional thin
              capitalisation arrangements set out in Section 820-45 of the
              Income Tax (Transitional Provisions) Act 1997;

             assuming that transitional thin capitalisation relief is available for
              the items discussed in this paper, confirmation of the supporting
              documentation required to be maintained in relation to these
              specific adjustments, including whether the required adjustments
              can be calculated at a single point of time (ie the relevant transition
              date), without the need to recalculate these adjustments over the
              three year transitional period;

             permit the adding back to Adjusted Average Equity Capital of the
              amount expensed as a result of equity compensation payments;

             permit the ADI the option to elect to exclude from the Tier 1
              deduction calculation as part of Step 3 of the safe harbour capital
              calculation under section 820-310, any deduction that relates to a
              deficit in the defined pension plan and further to increase the
              Adjusted Average Equity Capital by the amount of any surplus
              where that surplus is not included as capital of the ADI;

             permit the ADI the option to elect to apply the APRA guidelines to
              apply from 1 July 2006 on AIFRS transition to ensure treatment of
              AIFRS accounts pre and post 1 July 2006 are consistent; and

             in the event that an ADI is able to satisfy the safe harbour capital
              test having made a limited number of specific adjustments (such as
              EMVONA, treasury shares and capitalised software, etc),
              confirmation whether the transitional thin capitalisation rules can be
              limited to these specific adjustments or whether it is necessary to
              make further thin capitalisation adjustments for other AIFRS
              impacts disclosed in the relevant entity’s financial accounts.
AUSTRALIAN BANKERS’ ASSOCIATION INC.                                               16



As highlighted above, a number of significant adverse thin capitalisation
implications will arise for Australian banks as a result of the introduction of AIFRS
and the related changes to regulatory capital standards imposed by APRA. Many
of these potential impacts remain uncertain at present but are likely to be
clarified in the short term as further accounting and regulatory capital guidance
becomes available.

In this environment, the ABA would welcome the opportunity to have continuing
engagement with the ATO in relation to the matters outlined in this paper. The
ABA believes it would be particularly beneficial if a meeting could be organised to
discuss these matters further, prior to the finalisation of the proposed practice
statement on the operation of the transitional thin capitalisation rules.