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Ruling

Subject: Non arm's length income

Question 1

Will the income received by the trustees of the Fund from the lease of the Property to the Partnership be non-arm's length income in the 2012-13 income year, in accordance with subsection 295-550(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2013.

The scheme commences on:

1 July 2012

Relevant facts and circumstances

The Fund is a regulated self managed superannuation fund, with X members/trustees.

Y members of the Fund are currently receiving income streams from the Fund.

The current assets of the Fund consist of listed securities and managed funds in a diversified port folio.

Z member owns farming land in their own name.

One of these properties, (the Property), consists of several titles.

The property is currently being used in the farming partnership, (the Partnership). All X members of the SMSF are equal partners of this partnership.

The trustees are currently considering how the SMSF will have suitable cash flow to fund income streams for members as they continue to transition into retirement. In particular, they are considering the impact of Y members ceasing to actively contribute cash into the SMSF, and the impact the current financial downturn has had on their return from investments. They would like to utilise the property to generate this cash flow.

Z member is intending to grant a life interest over the Property to the Fund. The life interest will be measured over the lives of the member and their spouse, who is also a member and trustee of the Fund.

It is that member's intention to grant the life interest to the Fund partially as an in-specie contribution of business real property (as the superannuation contribution caps allow), with the balance of the life interest to be paid for from the Fund's cash reserves.

The exact value of the life interest for the purposes of determining the value of the life interest will be determined by a suitably qualified actuary, with the life interest being measured by the greater of the member and their spouse's life expectancies. Supporting this calculation will be an independent valuation of the Property from a qualified valuer.

Likewise, the lease payments from the Partnership will be based on an independent valuation of the expected rental for such a property in the region. A written lease agreement will be entered into between the Fund and the Partnership as well.

A properly drafted lease agreement will be put in place between the Fund and the Partnership, to ensure that the rights and obligations of each party are clearly defined and have legal enforcement.

The trustees will obtain regular valuations for a suitably qualified valuer to determine an appropriate market value lease appropriate for the type of farming land and its location.

This is to ensure that the value of lease payments being made is neither excessive (to ensure the SMSF is not receiving income in excess of what it would have received if the property had been leased to a unrelated party); or undervalued (to prevent the Partnership from receiving financial assistance through reduced rental costs).

It is intended that the member will retain the remainder interest in the Property.

As per the trust deed, the purpose of the Fund is to provide retirement benefits to its members.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 273

Income Tax Assessment Act 1997 subsection 6-5(1).

Income Tax Assessment Act 1997 section 295-550.

Income Tax Assessment Act 1997 section 295-550(1).

Income Tax Assessment Act 1997 paragraph 295-550(1)(a).

Income Tax Assessment Act 1997 section 295-550(1)(b).

Income Tax Assessment Act 1997 section 995-1.

Superannuation Industry (Supervision) Act 1993 section 45

Reasons for decision

In accordance with section 295-545 of the Income Tax Assessment Act 1997 (ITAA 1997), from 1 July 2007, the income of a complying superannuation fund, complying approved deposit fund or pooled superannuation trust is split into a non-arm's length component and a low tax component.

Non-arm's length income is defined in subsection 295-550 (1) of the ITAA 1997 as including:

An amount of ordinary income or statutory income is non-arm's length income of a complying superannuation fund, a complying approved deposit fund or a pooled superannuation trust (other than an amount to which subsection (2) applies or an amount derived by the entity in the capacity of beneficiary of a trust) if:

(a) it is derived from a scheme the parties to which were not dealing with each other at arm's length in relation to the scheme; and

(b) that amount 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.

The Commissioner considers that the income received by the trustees of the Fund from the lease of the Property to the Partnership will be ordinary income while ATO records show that the Fund is a complying superannuation fund.

Section 995-1 of the ITAA 1997 defines 'arm's length' to mean: 'in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance'.

In this case there is a connection between the parties as the members of the Partnership are also trustees and members of the Fund.

Having established that the provisions of subsection 295-550 (1) apply; it must be established if the conditions outlined paragraphs 295-550 (1)(a) and 295-550(1)(b) of the ITAA 1997 are met.

There are three requirements that must be satisfied in order for an amount of income to be non-arm's length income under paragraphs 295-550 (1)(a) and 295-550(1)(b) of the ITAA 1997:

· there must be a scheme;

· the parties to the scheme must not have been dealing with each other at arm's length; and

· the income derived from the scheme must be greater than the income that might have been expected if the parties were dealing with each other at arm's length.

There must be a scheme

'Scheme' is defined in section 995-1 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.

'Arrangement' is further defined in section 995-1 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.

At paragraphs 19-21 of Self Managed Superannuation Funds Ruling 2009/4 Self Managed Superannuation Funds: the meaning of 'asset', 'loan', 'investment in', 'lease' and 'lease arrangement' in the definition of an 'in-house asset' in the Superannuation Industry (Supervision) Act 1993, the Commissioner provides his views on what constitutes a lease:

19 The term 'lease' is not defined in the Act and therefore is given its ordinary meaning.

20 In respect of real property, a lease is a 'demise' that grants a leasehold estate in the property to the lessee for a term. That is, the lessee has an interest in the land (a 'chattel real'). This can be contrasted with a licence to enter land, which does not confer any interest in the real property. Of particular importance to determining whether an agreement amounts to a lease or a licence agreement, is whether exclusive possession is granted to the property. That is, the tenant has not only the right to occupy the premises, but to exclude access to all others, including the legal owner of the land.

21 It is the Commissioner's view therefore that a lease in respect of real property will occur where the lessee is granted exclusive possession of the property, generally in exchange for a rent.

Applying the definitions of 'scheme' and 'arrangement' and the Commissioner's view to the facts of the case, it can therefore be said that the intended lease between the Partnership and the trustees of the Fund will constitute a scheme for the purposes of paragraph 295-550(1)(a) of ITAA 1997.

The parties to the scheme must not have been dealing with each other at arm's length

If, as is the case in this instance, the relationship between the parties to a transaction is such that one party has the ability to influence or control the other, the Commissioner considers that the parties are not at arm's length.

However, the Commissioner also considers that 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.

The Commissioner has issued 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 (TR 2006/7). Although TR 2006/7 refers to the former section 273 of the Income Tax Assessment Act 1936, it provides useful guidance on the factors to be considered in the interpretation of section 295-550 of the ITAA 1997.

At paragraphs 76-78 of TR 2006/7, 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.

In this case, the issue of whether or not the parties are dealing with each other at arm's length can only be determined by taking into account the value placed on the Property, the respective life interests in the Property and the value of the lease.

Under section 995-1 and subdivision 960-S of the ITAA 1997 the expression 'market value' most commonly retains its ordinary meaning.

The phrase 'market value' is defined in subsection 10(1) of the Superannuation Industry (Supervision) Act 1993 (SISA) to mean:

... the amount that a willing buyer of the asset could reasonably be expected to pay to acquire the asset from a willing seller if the following assumptions were made:

(a) that the buyer and seller dealt with each other at arm's length in relation to the sale;

(b) that the sale occurred after making proper marketing of the asset;

(c) that the buyer and the seller acted knowledgeably and prudentially in relation to the sale.

In this case there is obviously a connection between the parties, however the SISA allows self managed superannuation fund (SMSF) trustees to acquire business real property from related parties and lease it back; as is the case here.

In this case therefore, it is imperative in assessing whether a transaction is on an arm's length basis, the trustee or investment manager should consider whether:

· the asking price is a fair price given the expected return on the asset, the risks to which the asset is exposed, and the relative liquidity of the asset;

· the projected returns of income and/or capital are in line with market expectations;

· the contract or agreement adequately protects the interests of the superannuation entity, with clear legal identification of all parties and their rights and obligations; and

· valuations have been obtained, where appropriate.

In this case, the required valuations are complex and you have already indicated your intention to use professionals to arrive at market value calculations for the values of the life interest in the Property and the value of the Property and the lease.

The Commissioner considers that the use of qualified valuers and actuaries, in determining appropriate values for these matters, is a necessary requirement that will help satisfy the market value requirements of the proposed transactions.

In this regard, the Commissioner notes that under the proposed arrangement, if the persons on whom the value of the life interest is calculated were to die shortly after the scheme was entered into, the Fund stands to lose a high percentage of its investment in the life interest, said life interest terminating on the latter of those deaths, with none of the amount paid to acquire the life interest refundable.

While this arrangement is acceptable to all the parties in a non-arm's length context, if the arrangement was to be entered into between parties genuinely at arm's length, the purchaser of the life interest would take into account this chance of a large loss in their negotiations.

In the context of using qualified valuers and actuaries to determine the value of the life interest, the Commissioner would expect this factor to be taken into account in any arm's length valuation of the life interest, unless other factors existed to mitigate the loss, such as appropriate insurance against the lives of the relevant persons held by the Fund.

Further, vigilance, through the use of qualified professionals, must also be displayed by the trustees in maintaining the arm's length relationship to ensure that appropriate market values are applied at all times during the leasing period.

The income derived from the scheme must be greater than the income that might have been expected if the parties were dealing with each other at arm's length.

At paragraph 79 of TR 2006/7, the Commissioner considers that the final requirement for an amount of income to be special income under subsection 273(4) is that the amount of income derived from the transaction must be greater than the amount of income that might have been expected if the parties were dealing with each other at arm's length in relation to the transaction.

This is a question of fact which is equally applicable to subsection 295-550 (1) of ITAA 1997. When considering this issue, the Commissioner will take into account all relevant matters. The level of investment risk that the superannuation entity is exposed to will be a relevant matter.

It has been contended on your behalf that you consider that in order to show the dealings were on an arm's length basis, all parties would need to be acting as one would expect a prudent person acting with due regard to their own commercial interests.

In this situation:

· A properly drafted lease agreement will be put in place between the SMSF and the partnership, to ensure that the rights and obligations of each party are clearly defined and have legal enforcement;

· The trustees will obtain regular valuations for a suitably qualified valuer to determine an appropriate market value lease appropriate for the type of farming land and its location.

This is to ensure that the value of lease payments being made is neither:

· excessive (to ensure the SMSF is not receiving income in excess of what it would have received if the property had been leased to a unrelated party);

· or undervalued (to prevent the partnership from receiving financial assistance through reduced rental costs).

Therefore, you believe that both the SMSF and the Partnership are taking the steps one would expect a prudent landlord and a prudent tenant to undertake to protect their respective interests.

You also believe by obtaining appropriate regular valuations, the leasing income will not meet the requirement in subsection (b), and thus will not be non-arm's length income of the SMSF.

The Commissioner accepts your contentions in this matter. Taking into account all the relevant facts and the level of investment risk that the Fund is exposed to, and, having regard to the matters listed in paragraphs 295-550(1)(a) and 295-550(1)(b) of the ITAA 1997, the Commissioner is of the opinion that the income received by the trustees of the Fund from the lease of the Property to the Partnership will not be non-arm's length income in the 2012-13 income year.

Other relevant comments

Valuation guidelines for SMSF's may be found on the ATO website at:

http://www.ato.gov.au/superfunds/content.aspx?doc=/content/00328213.htm

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