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Edited version of private advice
Authorisation Number: 1052001447376
Date of advice: 20 July 2022
Subject: Non-arm's length expenditure
Will the Fund derive any non-arm's length income under section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997) in relation to the acquisition and operation of the property?
This ruling applies for the following period:
1 July 20XX to 30 June 20XX
Relevant facts and circumstances
• You are trustees of a self-managed superannuation fund (Fund).
• The Fund Members own farming land (Property).
• The Property is used wholly in the dairy farming business of a trust (Trust). The Members are trustees and beneficiaries of the Trust.
• You have stated that the Property has the potential to be mined for metal by a mining company (Miner). A lease has been drafted awaiting signature by the Members. The Miner is not an associated entity of the Members.
• The Property is estimated to be worth $XXX, subject to confirmation by a valuer. Royalties will be paid for the metal that is mined from the site and the estimated income is in the vicinity of $XXX to $XXX per annum. No lease income or royalty income has yet been earned from the land.
• You intend to acquire the Property from the Members with money borrowed under a limited recourse borrowing arrangement (LRBA).
• The Fund will acquire the Property during the 20XX-XX income year.
• A property valuation will be obtained just prior to the acquisition from a qualified valuer who is duly experienced in land mining leases and royalty payments.
• An LRBA with a related party lender will conform with the safe harbour terms of PCG 2016/5: Income tax - arm's length terms for Limited Recourse Borrowing Arrangements established by self-managed superannuation funds.
Relevant legislative provisions
Income Tax Assessment Act 1997 section 295-545
Income Tax Assessment Act 1997 section 295-550
Income Tax Assessment Act 1997 subsection 995-1(1)
Superannuation Industry (Supervision) Act 1993 subsection 10(1)
Superannuation Industry (Supervision) Act 1993 section 66
We followed these ATO view 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.
Law Companion Ruling LCR 2021/2: Non-arm's length income - expenditure incurred under a non-arm's length arrangement
Reasons for Decision
Section 295-545 of the ITAA 1997 provides that the taxable income of a complying superannuation fund is split into a non-arm's length component and a low tax rate component. The note to subsection 295-545(1) explains that a concessional rate of tax applies to the low tax component, while the non-arm's length component is taxed at the highest marginal rate.
Subsection 295-545(2) of the ITAA 1997 provides that the non-arm's length component for an income year is the entity's non-arm's length income (NALI) for that year less any deductions to the extent that they are attributable to that income. The definition of NALI is given by section 295-550.
Subsection 295-550(1) of the ITAA 1997 states:
An amount of ordinary income or statutory income is non-arm's length income of a complying superannuation entity if, as a result of a scheme the parties to which were not dealing with each other at arm's length in relation to the scheme, one or more of the following applies:
a) the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm's length in relation to the scheme;
b) in gaining or producing the income, the entity incurs a loss, outgoing or expenditure of an amount that is less than the amount of a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme;
c) in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm's length in relation to the scheme.
One of the essential elements of subsection 295-550(1) of the ITAA 1997 is for the parties to not have been dealing with each other at arm's length in relation to the scheme.
Subsection 995-1(1) of the ITAA 1997 when defining arm's length, states:
"...in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance..."
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 Fund's acquisition of the Property, as well as the derivation of income by the Fund from the mining lease and royalties from the Miner.
Paragraphs 76-77 of 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, states:
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.
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.
A primary issue in this matter is whether the Fund's expenditure in acquiring the Property is less than its market value.
Where a superannuation fund purchases an asset at less than market value under a scheme where the parties were not dealing at arm's length, the fund incurs non-arm's length expenditure for the purposes of applying the non-arm's length expenditure provisions. Non-arm's length expenditure incurred to acquire the asset will have a sufficient nexus to all ordinary or statutory income derived by the superannuation fund in respect of that asset. Law Companion Ruling LCR 2021/2: Non-arm's length income - expenditure incurred under a non-arm's length arrangement provides the following example at paragraphs 22-23:
Example 1 - non-arm's length expenditure was incurred to acquire an asset - NALI
22. During the 2019-20 income year, Armin holds commercial property with a market value of $800,000. During the income year, he sells the commercial property to himself acting as trustee of his self-managed superannuation fund (SMSF) for $200,000. The SMSF leases the property to a third party.
23. For the purposes of subsection 295-550(1), the scheme involves the SMSF acquiring the commercial property from Armin for an amount that is less than its market value. There is a sufficient nexus between the non-arm's length expenditure incurred in acquiring that property and the rental income the SMSF derives from leasing the property for the rental income to be NALI. Further, there will be a sufficient nexus between the non-arm's length expenditure and any capital gain derived on the disposal of the property for the capital gain to be NALI.
You intend to acquire the Property from the Members, who are related parties of the Fund as defined in subsection 10(1) of the Superannuation Industry (Supervision) Act 1993 (SISA). The parties will not be at arm's length in accordance with subsection 995-1(1) of the ITAA 1997.
The Property has the potential to be mined for blue metal, which may provide significant returns for the owner of the land. Subsequently, any sale of the property would need to take this into consideration to meet the market value requirements for a related party acquisition.
Immediately prior to acquiring the Property, you will be obtaining a market valuation from a suitably qualified valuer. Based on normal commercial practice this would be consistent with an arm's length dealing. As the Fund will be paying the current market rate for the Property, in accordance with the valuation, it will not incur non-arm's length expenditure for the purposes of applying paragraph 295-550(1)(b) of the ITAA 1997.
Limited recourse borrowing arrangement
You intend to enter into an LRBA with a related entity to purchase the Property.
When a self-managed superannuation fund (SMSF) acquires an asset under an LRBA, subsection 295-550(1) of the ITAA 1997 may apply to ordinary or statutory income generated from the asset if the terms of the LRBA are not consistent with an arm's length dealing.
The ATO has provided guidance in Practical Compliance Guideline PCG 2016/5: arm's length terms for Limited Recourse Borrowing Arrangements established by SMSFs, where a related party is loaning money to an SMSF under an LRBA to acquire real property.
PCG 2016/5 sets out the 'Safe Harbour' terms on which SMSF trustees may structure their LRBAs consistent with an arm's length dealing. That is, for income tax compliance purposes, the Commissioner accepts that an LRBA structured in accordance with PCG 2016/5 is consistent with an arm's length dealing and that the non-arm's length income provisions do not apply purely because of the terms of the borrowing arrangement.
It should be noted that if SMSF trustees have entered into an arrangement which does not meet all of the safe harbour terms set out in PCG 2016/5, whilst the trustees are unable to be assured that the Commissioner will accept the arrangement to be consistent with an arm's length dealing, it does not mean that the arrangement is deemed not to be on arm's length terms. It merely means that there is no certainty provided under PCG 2016/5. The trustees will need to be able to otherwise demonstrate that the arrangement was entered into and maintained on terms consistent with an arm's length dealing.
You have stated that the LRBA with the related entity will be on terms commensurate with PCG 2016/5. Provided this is the case, the Commissioner will accept that the Safe Harbour will apply and the LRBA arrangement is consistent with an arm's length dealing. The non-arm's length income provisions will not be enlivened due to the borrowing arrangement.
Other relevant matters
Section 66 of the SISA prohibits the acquisition of an asset from a related party of a superannuation fund, unless it meets a specified exception.
A member is a related party of a fund.
One of the limited exceptions to this rule allows a fund trustee to acquire business real property from a related party at market value. Farming land used wholly and exclusively in a primary production business would generally meet the business real property definition.
Based on the information provided the Fund will acquire property that meets the definition of business real property at market value.