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Edited version of private advice
Authorisation Number: 1051972541719
Date of advice: 27 April 2022
Subject: Scheme and non-arm's length income
Will the SMSF derive non-arm's length income as a beneficiary of the Trust in accordance with subsection 295-550(5) of the Income Tax Assessment Act 1997 (ITAA 1997)?
This ruling applies for the following periods:
DD/MM/YYYY to DD/MM/YYYY
Relevant facts and circumstances
The self-managed superannuation fund (SMSF) has two members.
The member is employed by an entity related to Trust A.
The SMSF is proposing to subscribe for shares in Trust A.
Trust A will be a widely held trust with one class of units, being ordinary units.
No individual investor will have more than a 10% holding in Trust A.
None of the investors in Trust A jointly receive income.
The investors of Trust A will comprise private companies, individuals, trustees of discretionary trusts and other SMSFs.
Each unit holder in Trust A will receive their income entitlement based on their fixed interest in Trust A.
Should Trust A derive income in the form of a capital gain in the future, it will be distributed proportionately to each unit holder based on their subscribed unit holding.
Trust A does not expect to derive any income for several years.
The SMSF and the members, will not hold more than 50% of the units in Trust A.
The Manager of Trust A will not charge any investment fees to investors of Trust A on the basis that:
• It is encouraging third party investment.
• Investors could have alternatively invested their personal funds elsewhere and they should be compensated as the investment is high risk, illiquid and has a long-term horizon.
• It is common practice in the private equity industry.
Relevant legislative provisions
Income Tax Assessment Act 1997 subsection 295-550(1)
Income Tax Assessment Act 1997 subsection 295-550(5)
Other relevant documents
Taxation Ruling TR 2006/7: Income tax: special income derived by a complying superannuation fund, a complying approved deposit fund or a pooled superannuation trust in relation to the year of income.
Reasons for decision
Non-arm's length income
Section 295-550 of the ITAA 1997 sets out rules as to when a complying superannuation fund will derive non-arm's length income (NALI).
Subsection 295-550(5) of the ITAA 1997 provides that 'Other income derived by the entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust is NALI where:
• there is a scheme in which the parties were not dealing with each other at arm's length, and
• the fund incurs a loss, outgoing or expenditure of an amount in acquiring the entitlement or in gaining or producing the income, and
• the amount of the loss, outgoing or expenditure is less than the amount that the fund might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme.
The income is also NALI if the fund does not incur a loss, outgoing or expenditure that the fund might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme.
The term 'scheme' is defined in subsection 995-1(1) of the ITAA 1997 to mean:
a) any arrangement; or
b) any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.
The term 'arrangement' is also defined in subsection 995-1(1) of the ITAA 1997 to mean 'any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings'.
The definition of a scheme is broad enough to capture the SMSF's investment in the Trust A, the investment activities of the Trust, as well as the derivation of income by the SMSF in its capacity of beneficiary of the Trust.
Reference should be made to paragraphs 76-78 of TR 2006/7, with regard to the arrangement you have described.
Not dealing with each other at arm's length
76. The Commissioner considers that parties are dealing with each other at arm's length in relation to a transaction if the independent minds and wills of the parties are applied to the transaction and their dealing is a matter of real bargaining. If this is not the case, the Commissioner will consider that the parties are not dealing with each at arm's length in relation to the transaction.
77. If the relationship of the parties is such that one party has the ability to influence or control the other, this will suggest that the parties may not be dealing at arm's length, but it will not be determinative.
78. Parties that are not at arm's length can deal with each other at arm's length in relation to a transaction and parties that are at arm's length can deal with each other in a way that is not at arm's length. An amount of income can only be special income under subsection 273(4) if, in relation to the particular transaction, the parties are not dealing with each other at arm's length.
Therefore, the fact that a trust is not related to an SMSF, will not preclude income derived from that investment being NALI where the parties are not making transactions with each other at arm's length.
In this case Trust A is not considered to be a related party of the SMSF.
Each unit holder in Trust A will receive their income and capital gain entitlement based on their fixed interest in Trust A, albeit there is not expected to be any distributions from Trust A for several years.
The Manager of Trust A will not be applying any investment/management fees to the SMSF during this period, subsequently paragraph 295-550(5)(c) of the ITAA 1997, relating to non-arm's length expenditure, needs to be considered.
It has been stated that management fees are not applied for the following reasons:
• The Manager is encouraging third party investment.
• Investors could have alternatively invested their personal funds elsewhere and they should be compensated as the investment is high risk, illiquid and has a long term horizon.
• It is common practice in the private equity industry.
Taking the above into account and the fact that:
• fees are not being charged to any of the unrelated investors in Trust A, and
• the trustee of the SMSF is not in a position to influence the Manager of Trust A,
it is reasonable to conclude that the transactions between the SMSF and Trust A are being conducted on commercial terms.
As expenditure transactions relating to the SMSF's investment will be conducted on an arm's length basis, then any income derived by the fund will not result in non-arm's length income under subsection 295-550(5) of the ITAA 1997.