An entity can choose to adopt an arm's length debt amount as its maximum allowable debt. It would do so only if its adjusted average debt is more than its safe harbour debt amount. In many cases the arm's length debt amount will be less than the safe harbour debt amount.
The arm's length debt amount test focuses on the entity's Australian business and investments. The arm's length debt amount is determined by conducting an analysis with regard to certain factual assumptions and relevant factors. The factual assumptions include some conditions that actually exist during the income year and some conditions that replace what actually happened during that period.
The assumptions are, broadly, that:
- the entity's only commercial activities are those of its Australian business – Australian business has a wide meaning
- the entity's Australian business was independent of any guarantee, security or other support provided by any of the entity's associates or by the use of the assets that are attributable to the entity's overseas permanent establishments.
Certain factors, outlined below, must be taken into account when doing this analysis. All the factors must be taken into account and must be considered in the context of the above assumptions. The factors should not be considered in isolation from each other. The weight given to each factor in analysing a particular entity may vary, depending on the facts and circumstances of each case.
The factors are:
- the functions the entity performed, the assets used and the risks it assumed in relation to its Australian business throughout the year
- the terms and conditions of loans (such as interest rate, repayment amount and the duration of the loan) the entity actually had in relation to its Australian business throughout the year
- the nature of, and title to, any of the entity's assets attributable to the Australian business that were available to the entity to provide as security for the loans of the business throughout the year
- the purpose of entering into the loan arrangements in relation to the Australian business throughout the year
- the entity's capacity to repay both the interest and principal components of the debt, in addition to all its other liabilities, in relation to its Australian business throughout the year
- the entity's profitability and the return on its capital in relation to the Australian business, whether during that year or at any other time
- the debt to equity ratio of the entity, of the entity in relation to its Australian business, to each of the entity's associate entities that engage in commercial activities similar to the Australian business and each other entity that the entity has a direct or indirect interest
- commercial practices adopted by independent parties dealing with each other at arm's length in the industry in which the entity operated its Australian business throughout the year, whether in Australia or in comparable markets elsewhere
- the general state of the Australian economy throughout the year
- all the above factors that existed when the entity previously entered into a scheme that gave rise to an actual debt interest attributable to the Australian business that remained on issue throughout the year
- any other relevant factors that must be considered as set out in the regulations made for the purposes of the arm's length debt amount test.
If an entity is relying on an arm's length debt amount, it must keep records documenting the application of the factual assumptions and relevant factors. These records must be prepared before the entity lodges its tax return.
If the entity has not appropriately taken into account the factual assumptions and the relevant factors to calculate the arm's length amount, we have the power to substitute a different arm's length amount which we consider to better reflect those assumptions and relevant factors.
- Taxation Ruling TR 2020/4
- Practical Compliance Guideline PCG 2020/7
- section 820-215 of the ITAA 1997.
Once you have worked out the entity's arm's length debt amount, compare it to the entity's 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. You do not have to complete any further calculations.
However, if the entity's adjusted average debt is more than the arm's length debt amount, worldwide gearing debt amount and the safe harbour debt amount, you must complete step 6.To check if you meet the requirements under the rules if you are an inward investing financial entity (non-ADI).