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.