How to apply step 3
If the ADI's average equity capital is less than its safe harbour capital amount, it can choose to adopt an arm's length capital amount as its minimum capital amount. It would generally do so only if the arm's length capital amount is less than the safe harbour capital amount.
The arm's length capital test focuses on the ADI's Australian business. The arm's length capital amount is determined by conducting an analysis about certain factual assumptions and relevant factors. The factual assumptions include some conditions that exist during the income year and some conditions that replace what happened during that period.
The result of the analysis is a notional amount of capital that represents what would reasonably be expected to have been the ADI's minimum capital amount throughout the year in relation to its Australian business. The Australian business is treated as if it were a separate entity – independent and operating at arm's length from the other parts of the ADI.
Broadly, the assumptions are that the ADI's:
- commercial activities are those of its Australian business – Australian business has a wide meaning
- Australian business was independent of any guarantee, security or other support provided by any of the entity's associates or using the assets that are attributable to the entity's overseas permanent establishments.
Relevant factors
Certain factors, outlined below, must be considered when doing the analysis. All the factors must be considered 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 ADI may vary, depending on the facts and circumstances of each case.
The factors are:
- the functions performed, the assets used and the risks assumed in relation to the ADI and its Australian business throughout the year
- the ADI's credit rating and the effect of that rating on the ADI's ability to borrow in relation to its Australian business, the interest rate of such a borrowing and the gross profit margin in relation to that business
- the capital ratios of the ADI, the ADI's Australian business and the ADI's associate entities that engage in commercial activities similar to the Australian business of the ADI
- the ADI's purpose of entering the loan arrangements in relation to itself and its Australian business throughout the year
- the profitability of the ADI and the ADI in relation to its Australian business
- commercial practices adopted by independent parties dealing with each other at arm's length in the industry in which the ADI 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
- any other relevant factors that must be considered as set out in the regulations made for the purposes of the arm's length capital amount test.
If an ADI is relying on an arm's length capital 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 ADI has not appropriately considered 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 that we consider to better reflect those assumptions and relevant factors.
For more information, see section 820-410 of the ITAA 1997.
Once you have worked out the ADI's arm's length capital amount, compare it to the ADI's average equity capital.
If the ADI's average equity capital is equal to or more than the arm's length capital amount, the ADI is not disallowed any debt deductions under the thin capitalisation rules. You do not have to complete any more calculations.
If the ADI's average equity capital is less than its arm's length capital amount and its safe harbour capital amount, you must complete step 4.