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Australia: Minor updates to ATO guidance on arm's length debt test

Australia: ATO guidance on arm's length debt test

The Australian Taxation Office (ATO) in November 2020 made minor amendments to the guidance concerning the arm’s length debt test.

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The arm's length debt test is one of the tests available to establish an entity's maximum allowable debt for thin capitalisation purposes. The test focuses on identifying an amount of debt a notional stand-alone Australian business would reasonably be expected to borrow, and what independent commercial lenders would reasonably be expected to lend on arm's length terms and conditions. An entity's debt deductions are reduced to the extent that its adjusted average debt exceeds its maximum allowable debt.

The arm's length debt test may be used to support debt deductions for commercially justifiable levels of debt. In practice, the test is typically only used when an entity is unable to satisfy the safe harbour and worldwide gearing tests (given that the compliance burden of applying these tests is generally lower). It is not common for independent Australian businesses to gear in excess of 60% of their net assets, and historically, relatively few entities have applied the arm's length debt test.  Use of the arm's length debt test carries with it the necessity to undertake more rigorous analysis than the safe harbour and worldwide gearing tests.

Practical Compliance Guideline (PCG) 2020/7 (as finalized in August 2020) provides a risk assessment framework that outlines the ATO’s compliance approach to an application of the arm’s length debt test.

The amendments (made 5 November 2020 and described as “minor”) include:

  • A reference to removal of the Clean Energy Finance Corporation
  • A correction to formulas
  • A correction to citations

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