Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 10 - The arms length tests for non-ADIs and ADIs
Outline of chapter
10.1 This chapter provides an explanation of the arms length tests contained in sections 820-105, 820-215, 820-315 and 820-410. The chapter discusses the calculation of the arms length capital amount for ADIs (which are mainly banks) separately to the calculation of the arms length debt amount for non-ADIs. An arms length test for minimum capital and maximum debt requirements is available to all taxpayers. In practice taxpayers will only choose to apply the arms length test where the relevant safe harbour level has been breached.
Context of reform
10.2 The new thin capitalisation rules will contain an arms length test. Taxpayers will be able to use this test where they fail the safe harbour test but their gearing could otherwise be justified or acceptable.
10.3 The point of the test is to examine the circumstances of the taxpayer to determine whether the Australian operations, when viewed independently from the foreign operations could, on an arms length basis, have been undertaken with the actual amount of debt or equity used by the taxpayer.
10.4 The test will be of most use in those industries where it is common practice to operate with higher debt to equity ratios. The test creates the opportunity for taxpayers to claim a higher level of debt, or lower amount of equity, than would otherwise be allowable.
Summary of new law
10.5 Non-ADIs are required to compare their adjusted average debt for a year, to their maximum allowable debt for the year. The arms length debt amount for the year is one amount that can be used to determine the taxpayers maximum allowable debt. When the non-ADIs adjusted average debt is compared with its arms length debt amount this is called the arms length test. Similarly, the arms length capital amount is relevant for ADIs.
10.6 The arms length test for non-ADIs focuses on what the business acting at arms length would borrow and what independent commercial lenders would lend to the business on arms length terms. The arms length debt amount that is determined may be different to the safe harbour debt amount.
10.7 Likewise, the arms length minimum capital amount for an ADI may be different to the minimum capital amount calculated under the safe harbour test. The arms length test for ADIs focuses on what would be the minimum amount of equity capital required by the bank to undertake its Australian business.
10.8 Additional documentation is required to be kept where the taxpayer relies on the arms length test.
| New law | Current law |
|---|---|
| The new regime includes an arms length test, to be applied at the entitys option. | There is a limited arms length test dealing only with guaranteed foreign debt in certain circumstances. |
Detailed explanation of new law
What is the arms length rule for outward and inward investing entities that are not ADIs?
10.9 The arms length debt amount can replace the safe harbour debt amount as an entitys maximum allowable debt for a period. A non-ADI may choose to adopt an arms length debt amount as its maximum allowable debt amount where it can demonstrate that the amount satisfies the requirements set out in section 820-105 or 820-215.
10.10 The focus of the arms length debt analysis is on the Australian operations of the investing entity. The analysis looks to the assets of those operations as the source of cash flows to meet the debt repayments and the other liabilities of the operations. To sustain a high level of debt, the entity needs to consider what would have happened at arms length under certain assumptions, and to demonstrate that continued sound operations under those assumptions could be reasonably expected.
10.11 The arms length debt amount is determined by conducting an analysis of certain facts and circumstances. The analysis results in a notional amount that represents what would reasonably be expected to have been the entitys average interest-bearing debt amount during the period, having regard to certain factual assumptions and relevant factors. Those assumptions and factors establish a scenario that would have existed if the entitys Australian operations were independent from any other operations that the entity or its associates had during the period, and had been financed by an acceptable mix of equity and debt funding. [Schedule 2, item 8, definition of arms length debt amount in subsection 995-1(1)]
10.12 An acceptable mix of debt and equity funding for the Australian operations of the entity is determined by conducting an analysis that considers the investment expectations of both the borrower (the investment entity) and the lenders (the notional lenders) as independent parties dealing at arms length with each other with respect to the type of Australian business operations being funded. The analysis assumes that the lenders are prudent commercial institutions (such as ADIs) and are independent of the borrower.
10.13 The analysis involves a consideration of the factors that an entity would consider when arranging the finance for its operations, and the factors that a prudent commercial lender would consider when deciding whether to provide the finance, and on what terms it would provide that finance.
10.14 The objective of the analysis will be to establish the notional amount of debt that the entity would reasonably be expected to have held throughout the period, and that independent commercial lenders would have provided on arms length terms and conditions [Schedule 1, item 1, subsections 820-105(1) and 820-215(1)] . Establishing this requires the consideration of whether an independent party would have borrowed the same amount and whether independent lenders would have provided the debt capital on the same, or similar, terms.
10.15 It is possible that an entitys arms length debt amount can be an amount that is greater than its safe harbour debt amount, but lower than its debt capital amount. In this circumstance, the arms lengthdebt amountbecomes the entitys maximum allowable debt, and the entitys debt deductions would be reduced in proportion to the difference between that amount and its actual debt capital amount (the excess debt ).
10.16 In determining whether an independent party would have borrowed the same amount to finance its Australian operations, and an independent lender would have provided the same amount on the same terms, a comparison is required. What has to be compared are the conditions that would exist if an independent entity dealing at arms length with other parties had funded the Australian operations and the actual conditions that exist in the entitys funding of the Australian operations.
10.17 In determining how an independent entity dealing at arms length with other parties would fund the Australian operations, the effect of any financial or credit support from its associates is ignored, as are foreign assets it may hold. The analysis is then conducted as if the taxpayer were an independent entity that finances its Australian operations without the benefit of any financial or credit support from its associates.
10.18 Subsection 820-105(2) (for outward investing entities) and subsection 820-215(2) (for inward investing entities) contains the factualassumptions that must be made to establish the circumstances in which the arms length debt analysis is conducted. The factualassumptions include some conditions that actually did exist during the period, and some conditions that replace what actually happened during the period.
10.19 The combination of the factual assumptions creates the basis on which the arms length analysis must be conducted. That scenario is that which would exist if the entity had been dealing with independent commercial lenders without the financial backing of other parties. Under that scenario, it is assumed that the entity and the notional lenders can only consider the assets and income of the entitys Australian operations or Australian investments when conducting the required analysis.
Identifying the Australian operations
10.20 The Australian operations are in general, identified by reference to the assets that the entity uses or has available for deriving its income other than through foreign subsidiaries or branches. The principal purpose of the first assumption is to isolate the entitys Australian operations from its foreign operations. In doing so it is necessary that the design of the assumption differs slightly between inward and outward investing entities. However, the object of focusing only on the Australian operations is the same for both. Associate entity debt is disregarded because it is deducted in the adjusted average debt calculation (in subsection 820-85(3) or 820-185(3)) with which the arms length amount has to be compared. [Schedule 1, item 1, paragraphs 820-105(2)(a) and 820-215(2)(a)]
10.21 The second assumption is that the Australian operations had been carried on as they actually were during the period [Schedule 1, item 1, paragraphs 820-105(2)(b) and 820-215(2)(b)] . The third assumption is that the nature of the entitys assets and liabilities that are attributable to the Australian operations had been as they were during the period [Schedule 1, item 1, paragraphs 820-105(2)(c) and 820-215(2)(c)] . The fourth assumption is that the entity carried on business in the same circumstances as what actually happened during that year [Schedule 1, item 1, paragraphs 820-105(2)(d) and 820-215(2)(d)] .
10.22 The second, third and fourth assumptions require that the analysis assume that the entity performed the same functions (other than those disregarded by the first assumption), faced the same risks (apart from those relating to its debt and gearing), operated in the same circumstances in the industry with the same competitors, customers and suppliers, had the same income and expenses (apart from debt deductions), and had the same management.
Arms length financial arrangements
10.23 The fifth assumption is critical to the arms length analysis because it raises the possibility of an alternative scenario to that which actually occurred. It does that by specifying a fundamental condition in relation to the raising of the entitys debt.
10.24 The fifth assumption requires that the notional amount of debt be provided to the entity in relation to the Australian business without any guarantee, security or other credit support being provided by any party other than the entity itself. This assumes that the entity was capitalised with an adequate amount of equity funding, given its Australian operations, and (after analysing the relevantfactors) that the owners were concerned to receive an adequate amount of return on that equity. [Schedule 1, item 1, paragraphs 820-105(2)(e) and 820-215(2)(e)]
10.25 It is recognised that prudent commercial lenders usually look at the consolidated financial position of the group to which the borrower belongs and the resources on which it could draw within that group to fund interest charges and capital repayments. However, when applying the arms length test to a single entity it is necessary to limit the extent to which the wider group is taken into account by specifying that relationships with associates that are not part of the Australian operations are to be disregarded. Any credit support from the non-Australian business operations of the entity are also disregarded. Where the arms length test is applied to a group, the resources of the members of the group could be called upon for support but not those of associates outside the group.
10.26 All of the factors set out in subsection 820-105(3) (for outward investing entities) and 820-215(3) (for inward investing entities) must be taken into account in an analysis of whether or not an amount satisfies subsection 820-105(1) or 820-215(1). It may be possible that in some circumstances factors other than those listed could also be taken into account.
10.27 The relevantfactors are those that would be considered by a prudent independent party that was contemplating borrowing the notional amount on the same terms and those a prudent independent lender would consider when contemplating whether to provide the debt on the same terms. Unless the factors are taken into account, such an analysis would be incomplete and it would not be possible to conclude that an amount satisfies subsection 820-105(1) or 820-215(1).
10.28 The relevant factors must be considered in the context of the factual assumptions that are created by subsection 820-105(2) or 820-215(2). The weight given to each factor in the analysis of a particular entity may vary, depending on the facts and circumstances of the case.
10.29 In determining whether an independent commercial lender (such as a bank) would have provided the debt on the same terms, a credit analysis is usually required. A credit analysis includes consideration of the applicants capacity to repay (over the full term of the borrowings) and whether the applicant has sufficient security to support all its debts and other expenses.
10.30 A prudent independent commercial lender would not provide funds unless it was satisfied that the borrower met these criteria. However, it is understood that lenders revise their view of an acceptable level of gearing or income cover for particular entities or groups at different times or often reserve the capacity to do so when setting terms and conditions.
10.31 Consequently, it is possible to say that although a particular debt to equity ratio meets the arms length standard at a particular point in time, it may not a few years later. An arms length debt analysis must therefore be conducted in respect of each income year. However, where there is no change in circumstances from one year to the next, it would be reasonable to expect that the results of an arms length debt analysis remained relevant. Moreover, the capacity of the borrower and lenders to alter their arrangements should also be considered.
10.32 The terms of the loans actually transacted and entered into will usually be the starting point for an arms length debt analysis, and any adjustment or amendment to them would only be made in exceptional cases and would need to be clearly justifiable. Generally, the only justifiable circumstance would be where the arrangements made in respect of the loans differ from those that would have been adopted by the independent Australian operations behaving in a commercially rational manner.
10.33 An entity would not be able to reasonably state that simply being willing to pay a higher interest rate would give justification for a higher debt level. The starting point will always be the actual terms of its loans. Such a statement would need to be supported by an analysis of all of the factors set out in subsection 820-105(3) or 820-215(3).
10.34 The factors in subsection 820-105(3) or 820-215(3) should not be considered in isolation from each other. For example, the terms and conditions that apply to the entitys debt capital for a period (paragraph 820-105(3)(b)) have a direct effect on the profitability of the entity (including the return on its capital) for a period (paragraph 820-105(3)(f)) and on its capacity to repay all of its liabilities that are due to be paid during the period (paragraph 820-105(3)(e)).
10.35 In taking into account the nature of the business that the entity conducts throughout the period, the principal functions performed by the Australian operations should be identified. It will also be relevant in identifying the functions performed, to consider the assets that were employed and the risks assumed by the entity. The functions carried out (taking into account the assets used and the risks assumed) will determine to some extent the allocation of risks between the entity and the notional lenders, and therefore the conditions each party would expect in arms length dealings. [Schedule 1, item 1, paragraphs 820-105(3)(a) and 820-215(3)(a)]
10.36 The analysis would also extend to the entitys Australian equity investments, including in associates. A prudent lender would look through the equity held to the actual assets represented by the equity. It would also consider the gearing of those entities in which the equity is held. A high debt level in those entities could weaken an argument that the holding entity could have a higher gearing. This should be balanced by the need for the borrowers debt capacity to be determined on a stand alone basis.
10.37 In the open market, the assumption of increased risk by a lender will be compensated by an increase in the expected return. It is expected that this would have a direct impact on the terms (such as interest rate, repayment amount, and duration of loan) actually agreed and entered into between independent parties. Accordingly, it could be found that for the level of risks assumed by the notional lenders, they may not have provided as much debt at the entitys actual interest rates as the entity has actually borrowed. [Schedule 1, item 1, paragraphs 820-105(3)(b) and 820-215(3)(b)]
10.38 For example, where a lender faces unusual risks in respect of a loan provided to an entity, consideration should be given to whether any special covenants were included in the loan contracts. Covenants could include the requirement to inject equity over time, so as to improve the gearing ratio of an entity, or to require the entity to meet gearing and income cover targets at specified intervals.
10.39 An important consideration here is that the actual terms (e.g. interest rate and period of loan) that were entered into may have been struck after having regard to other than just the Australian operations. The arms length debt analysis isolates the Australian operations so that foreign operations cannot be used as justification for a higher debt level. It needs to be recognised that the terms of the arrangements actually entered into, particularly with the entitys associates, may not be the same as those that would be entered into under arms length dealing.
10.40 An appraisal of the security available (after taking into account the assumptions) to support the borrowing is always required in an arms length debt analysis. This includes anything pledged or deposited in support of a loan and over which the lender has taken a charge or mortgage. In commercial banking, security is usually taken for the following reasons:
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- to ensure the full commitment of the borrower to its operations;
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- to provide protection should the borrower deviate from the planned course of action outlined at the time credit is extended (or for unexpected or unforeseen reasons); and
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- to provide insurance should the borrower default.
10.41 However, it is important to note that security is not a substitute for repayment ability. When making a credit assessment, lenders first check whether there is sufficient servicing capacity and only then do they proceed to check that the borrower has sufficient security available.
10.42 Accordingly, the nature of, and title to, any assets that might provide security for the loans will be an important factor to take into account. [Schedule 1, item 1, paragraphs 820-105(3)(c) and 820-215(3)(c)]
10.43 The purpose of entering into the loan will always be an important factor to take into account in an arms length debt analysis. It would be expected that an independent party would only enter into a loan arrangement if it were satisfied that it would earn enough income to repay all of its borrowings, to cover all of its other operating expenses, and to leave an adequate profit for the equity investors. It may take several years for operations to become profitable, and losses may be acceptable in the early years of start-up operations. [Schedule 1, item 1, paragraphs 820-105(3)(d) and 820-215(3)(d)]
10.44 Accordingly, the projected future income cover in relation to its future repayment obligations (interest and principal) and other expense obligations will usually be a critical factor to consider. In the normal case, the Australian operations would need to be earning enough income to service the repayments on the loans, to cover all other expenses related to those operations and to generate an adequate return on capital invested in those operations. Related to this will be the quality of the cash flow including historical and projected cash flows.
10.45 For example, where the future income is ensured by a contract, there is high reliability and certainty that it will eventuate. However, where it is merely a forecast, it will be less reliable unless it is supported by a comprehensive historical or comparability analysis. A better idea of the income to be generated from a new investment could be obtained from the experience of comparable independent parties that were operating under arms length conditions.
10.46 For a borrower to repay debt, it must have the capacity (i.e. the cash flow) to repay both the interest and principal components of the debt, in addition to all its other liabilities.
10.47 Servicing capacity does not just mean profitability (reported profits do not necessarily represent cash flows). Thus, the profit cycle of a borrower can differ from the cash flow cycle. This is especially true where a borrowers profitability is largely comprised of unrealised capital gains.
10.48 As debts must be repaid from cash flows, it is imperative that a credit assessor establishes that the borrower has a satisfactory servicing capacity. The borrowers income statement and forecasted cash flow statement can be used for this purpose. After-tax cash flows are used to reflect cash actually available. As this approach concentrates on the after-tax cash flows available to service both principal and interest, it is superior to the interest cover ratio in assessing repayment capacity, as that ratio merely examines the borrowers ability to meet interest payments. [Schedule 1, item 1, paragraphs 820-105(3)(e) and (f) and 820-215(3)(e) and (f)]
10.49 The gearing level of the taxpayer (its debt to equity ratio), prior to and after entering into new loan arrangements, will also be a critical factor to consider. High gearing levels are indicative that an entity has reached the limit of its borrowing capacity.
10.50 Similarly, the gearing level of the group of which the taxpayer is a part can be a critical factor in the analysis. For example, where a global group is geared at a relatively low level, it would be extremely difficult to justify that the group could, under arms length conditions, load debt into similar Australian operations so that they were comparatively highly geared. Of course, allowances may have to be made if the group engages in activities different to the Australian business in other locations. [Schedule 1, item 1, paragraphs 820-105(3)(g) and 820-215(3)(g)]
10.51 Commercial practices in the industry in which the taxpayer operates may be an important indicator of whether an independent lender would advance funds at a particular time and for a particular purpose (independent commercial lenders may apply different lending criteria to different industries). Care should be taken to ensure that the industry practices being used as a benchmark should evidence the kind of arms length behaviour that is required in this analysis and take account of differences in markets. Likewise, this consideration may also play an important role in the approach that the entity takes when arranging its finances. [Schedule 1, item 1, paragraphs 820-105(3)(h) and 820-215(3)(h)]
10.52 For an outward investing entity, how it finances its non-Australian business is relevant because the analysis is made in respect of the Australian operations only. The focus of an arms length debt analysis will be the entitys repayment capacity and the security available in Australia to support the borrowing. The analysis looks at the Australian operations as the source of the funds for the repayments, and the way in which the foreign operations are financed will have implications for this part of the analysis.
10.53 In particular, the arms length debt analysis needs to consider whether the way in which the entity has financed its foreign operations can prevent it from demonstrating that its adjusted debt amount is an arms length debt amount. Therefore, the entity must ensure that the equity allocated to its foreign branches gives a result that is consistent with the arms length principle (contained in business profits article of Australias DTAs and Division 13, Part III of the ITAA 1936), and acknowledge that if its foreign subsidiaries are over-capitalised , that could lead to the Australian operations being under-capitalised . [Schedule 1, item 1, paragraph 820-105(3)(i)]
State of the Australian economy
10.54 The general state of the Australian economywill also have a bearing on what independent parties would do in respect of borrowing and lending arrangements. For instance, it is not considered likely that a prudent commercial lending institution would enter high-risk arrangements in times of economic downturn. [Schedule 1, item 1, paragraphs 820-105(3)(j) and 820-215(3)(i)]
Application of analysis of relevant factors in year when debt capital raised
10.55 The analysis of the relevant factors in the year the entity last raised debt capital may be the most important analysis in some circumstances. Specifically, where the entity has not raised debt capital in the intervening time and the relevant factor analysis for the year in which debt was last raised and the current year would be similar, the entity may rely on that earlier analysis.
10.56 The purpose of adopting this factor is to eliminate the compliance burden of doing a comprehensive arms length analysis every year when it is clear that nothing has materially changed. For example, it would be expected that the same Australian business is operating, the nature of the assets is substantially the same, its equity funding is the same and the entity still has the same or similar capacity to repay its liabilities.
10.57 Examples of where this may be useful could include situations where the only change is a decrease in the accounting value of the assets or there has been a negative movement in the exchange rates that impacts on asset or liability values. Each case would of course need to be examined on its facts. [Schedule 1, item 1, paragraphs 820-105(3)(k) and 820-215(3)(j)]
10.58 The relevance of this factor calls for judgement and it would be expected that an entity relying on this factor would have documentation supporting the application of this factor in accordance with section 820-980.
10.59 Other relevant factors that are required to be considered in an arms length debt analysis may be provided for in the regulations. [Schedule 1, item 1, paragraphs 820-105(3)(l) and 820-215(3)(k)]
10.60 Consideration of these critical factors may demonstrate that the entity satisfies the arms length test. Alternatively, it could lead to the following conclusions:
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- that the taxpayer had borrowed more than would have been borrowed if it were an independent party dealing at arms length with independent commercial lending institutions; or
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- that independent parties dealing on arms length terms would not have entered the loan arrangements at all (the purpose of the loan may be particularly relevant here).
10.61 In either of these alternative cases, it would not be considered that the taxpayer had demonstrated that its actual adjusted average debt level was an arms length debt amount for its Australian business. However, it may have been demonstrated that the arms length debtamountwas higher than thesafe harbour debt amount,so that the taxpayer could justify a higher amount of debt than the safe harbour debt amount.
10.62 The Commissioner has the power to substitute an amount worked out by the entity as its arms length debt amount. This would occur where the Commissioner considers an amount worked out by the entity does not appropriately take into account the factual assumptions and the relevant factors. The substituted amount must better reflect those assumptions and factors. [Schedule 1, item 1, subsections 820-105(4) and 820-215(4)]
10.63 As the exercise of these powers will directly affect an entitys assessment, a person who is dissatisfied with a decision may object against the decision under Part IVC of the TAA 1953.
What is the arms length rule for outward and inward investing entities that are ADIs?
The arms length capital amount
10.64 The arms length capital amount for ADIsis determined in a similar but not identical manner to the arms length debt amount for non-ADIs. In the case of ADIs, the analysis results in the quantification of a notional amount that represents what would reasonably be expected to have been the entitys minimum capital amount throughout the year in relation to its Australian operations. [Schedule 2, item 7, definition of arms length capital amount in subsection 995-1(1)]
10.65 The arms length test should determine a level of capital attributed to Australian operations that is consistent with the arms length, separate enterprise principle (contained in the business profits articles of Australias DTAs and Division 13 of Part III of the ITAA 1936). Under that principle, an enterprise could not operate without an adequate capital level. An adequate capital level is determined after taking into account the nature and extent of the business operations of the ADI, including the assets attributable to, and the risks associated with, the Australian operations.
10.66 The arms length capital amount for a period is determined by conducting an analysis of certain factual assumptions and relevant factors. The analysis results in the minimum amount of capital that the Australian operations would reasonably be expected to have held throughout the period. The assumptions and factors establish a scenario that would have existed if the ADIs Australian operations were a separate entity, independent and operating at arms length from the other parts of the entity. [Schedule 1, item 1, subsections 820-315(1) and 820-410(1)]
10.67 The arms length capital amount is required in order to achieve a level of profit expected to be found in a distinct and separate entity, undertaking the same or similar activities under the same or similar conditions.
10.68 It may be that the ADIs arms length capital amount is less than its safe harbour capital amount, but more than its equity capital amount. In this circumstance, the arms length capital amount becomes the minimum capital amount, and the entitys debt deductions would be reduced in proportion to the difference between that amount and its actual equity capital amount (the capital shortfall ). [Schedule 1, item 1, sections 820-325 and 820-415]
10.69 The factual assumptions that must be made in determining an arms length capital amountare contained in subsection 820-315(2) or 820-410(2).
10.70The first assumption isolates the Australian operations from the rest of the ADI. It is then assumed that the Australian business was carried on as it actually was and with the same remaining assets and liabilities.
10.71 As the relevant factors are almost identical for both inward and outward ADIs they are dealt with here together .
10.72 The relevant factors that must be taken into account in an analysis of the arms length capital amount are contained in subsection 820-315(3) or 820-410(3). These factors ensure that an arms length analysis is a comprehensive analysis that covers all issues that are required to be considered in order to arrive at a result consistent with the arms length principle.
10.73 All of the relevant factors must be taken into account in an analysis of whether or not an amount satisfies subsection 820-315(1) or 820-410(1), and of whether the equity capital of the Australian operations is an arms length capital amount. However, the weight given to each factor in the analysis of a particular entity may vary, depending on the facts and circumstances of the case.
10.74 The relevant factors should not be considered in isolation from each other. For example, the capital ratio of a foreign bank and its Australian branch (paragraph 820-410(3)(c)) has an effect on the credit rating of the bank and the interest rates that apply to the banks debt for a period (paragraph 820-410(3)(b)).
10.75 The relevant factors are those which would be considered by a prudent independent party that was evaluating the creditworthiness of an entity that was undertaking the Australian banking business, including its capacity to meet its financial obligations in a timely manner. Unless the factors are taken into account, such an analysis would be incomplete and it would not be possible to conclude that an amount satisfies section 820-315 or 820-410.
10.76 The relevant factors must be considered in the context of the arms length separate enterprise principle and the actual assumptions that are created. For example, the arms length separate enterprise principle requires that an appropriate level of equity capital of a foreign bank be allocated to the Australian branch as part of the profit attribution calculation. The assumptions contained in subsection 820-410(2) ensure that the arms length capital amount is determined from a consideration of the circumstances that would ordinarily occur between unrelated entities that are dealing at arms length.
10.77 It is possible that, although a particular level of equity capital meets the arms length standard at a particular point in time, it may not a few years later. An arms length analysis must, therefore, be conducted in respect of each income year if it is to be relied on as the minimum capital amount.
10.78 The amount of equity capital that is attributed to the Australian operations needs to take into account the different functions performed, assets used and risks assumed by both the bank and the Australian operationsduring the year. It will also be useful to take into account the credit rating of the bank throughout the year. [Schedule 1, item 1, paragraphs 820-315(3)(a) and (b) and 820-410(3)(a) and (b)]
10.79 Risk weighting assets, in accordance with the Basel Capital Adequacy Framework, would be an appropriate way to compare the relative functions, assets and risks that a foreign bank and its Australian branch assumed throughout a year. Given the general acceptance of a fixed credit rating between different parts of a foreign bank, except for any differences in country ratings, the level of equity capital funding in each part of the bank would be expected to be broadly consistent on a risk-adjusted basis. Such an approach would take into account the different functions performed, assets used and risks assumed by each part. Other methods for comparing the relative functions, assets and risks could also be justified where the results are consistent with the arms length separate enterprise hypothesis.
10.80 Another factor of particular importance to the analysis to determine the arms length capital amount for the Australian operations is the capital ratio of the bank, its Australian operations and relevant associate entities throughout the year [Schedule 1, item 1, paragraphs 820-315(3)(c) and 820-410(3)(c)] . The thin capitalisation rules are intended to ensure that taxpayers do not reduce their Australian tax liabilities by using an excessive amount of debt to finance their Australian operations. It will for example be difficult to justify, without sound commercial reasons, that the Australian branch of a foreign bank should be funded with a higher proportion of debt and a lower capital ratio than other parts of the banks operations.
10.81 Rules for calculating the capital ratio are contained in APRAs Prudential Standards (APS) & Guidance Notes for Authorised Deposit Taking Institutions and in particular APS 110 and 111. The capital ratio of a foreign bank would be that calculated in accordance with the guidelines of its own regulatory authority.
10.82 The purposes for which certain debt and equity capital arrangements were entered into by the bank may also be relevant in determining the appropriate arms length capital amount of its Australian operations for a period. For example, if a foreign bank raised an identifiable amount of equity capital because it planned to acquire a funds management business in another country, and it only held those funds until it carried out that transaction, then that equity capital may not be relevant to the arms length capital analysis of the banks Australian operations. This would be particularly so where the holding of that equity capital did not improve the banks overall credit rating or borrowing costs (because it already had a high credit rating). [Schedule 1, item 1, paragraphs 820-315(3)(d) and 820-410(3)(d)]
10.83 The profitability of the ADI and its Australian operations throughout a period are inexorably linked to the amount of equity capital funding that is attributed to each of those enterprises. The amount of equity capital directly impacts on the profits of the Australian operations because it bears on the amount of interest expense allocated to the operation. Accordingly, it will always be necessary to consider the profitability of the Australian operations in determining whether its equity capital level is an arms length capital amount. [Schedule 1, item 1, paragraphs 820-315(3)(e) and 820-410(3)(e)]
10.84 The commercial practices adopted by independent parties dealing at arms length in the banking industry in Australia (and relevant foreign countries) will also be relevant to an arms length capital analysis. For example, the capital ratios of comparable banks operating in those markets may be indicative of the capital ratio that could be expected in a foreign bank branch. The general state of the Australian economy during a year may have a bearing on the capital ratios which banks are prepared (or required) to operate at. [Schedule 1, item 1, paragraphs 820-315(3)(f) and (h) and 820-410(3)(f) and (g)]
Method of financing foreign operations
10.85 For outward ADIs, the arms length capital analysis needs to consider whether the way in which the bank has financed its foreign operations can prevent it from demonstrating that its adjusted equity capital is an arms length capital amount. Therefore, the bank should ensure that the equity allocated to its foreign branches gives a result that is consistent with the arms length separate enterprise principle (contained in the business profits article of Australias DTAs and Division 13 of Part III of the ITAA 1936). It also needs to be remembered that if foreign subsidiaries of the bank are over-capitalised, that could lead to the Australian operations being under-capitalised. [Schedule 1, item 1, paragraph 820-315(3)(g)]
10.86 The Commissioner has the power to substitute an amount worked out by the entity under section 820-315 or 820-410. This would occur where the Commissioner considers an amount worked out by the entity does not appropriately take into account the factual assumptions and the relevant factors. The substituted amount must better reflect those assumptions and factors. [Schedule 1, item 1, subsections 820-315(4) and 820-410(4)]
10.87 As the exercise of these powers will directly affect an entitys assessment, a person who is dissatisfied with a decision may object against the decision under Part IVC of the TAA 1953.
10.88 Where an entity is relying on an arms length amount, records documenting the application of the factual assumptions and relevant factors must be kept by the entity. [Schedule 1, item 1, section 820-980]
10.89 Section 262A of the ITAA 1936 is being amended to include this record keeping requirement. [Schedule 1, items 10 and 11, subsections 262A(2AA) and (3)]
Application and transitional provisions
10.90 The provisions for the calculation of the arms length amounts are subject to the same application and transition provisions as for the rest of the thin capitalisation regime [Schedule 1, item 22, subsection 820-10(1)] . The amendments to section 262A of ITAA 1936 also apply for income years beginning on or after 1 July 2001 [Schedule 1, item 26] .
Consequential amendments
10.91 The only consequential amendments related to the subject of this chapter are in section 262A of the ITAA 1936 and are discussed in paragraphs 10.89 and 10.90.
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