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This edited version has been archived due to the length of time since original publication. It should not be regarded as indicative of the ATO's current views. The law may have changed since original publication, and views in the edited version may also be affected by subsequent precedents and new approaches to the application of the law.

You cannot rely on this record in your tax affairs. It is not binding and provides you with no protection (including from any underpaid tax, penalty or interest). In addition, this record is not an authority for the purposes of establishing a reasonably arguable position for you to apply to your own circumstances. For more information on the status of edited versions of private advice and reasons we publish them, see PS LA 2008/4.

Edited version of your private ruling

Authorisation Number: 1012242650046

Ruling

Subject: Commissioners discretion

Non-arm's length income

Questions

1.Does a superannuation fund (the Fund), as a beneficiary of a service trust (the Service Trust), have a fixed entitlement to a share of the income and/or capital of the Service Trust under subsection 272-5(1) of Schedule 2F to the Income Tax Assessment Act 1936 (the ITAA 1936)?

2.If the answer to question 1 is 'no', will the Commissioner exercise the discretion under subsection 272-5(3) of Schedule 2F to the ITAA 1936 to deem a beneficiary of the Service Trust as having a fixed entitlement to the share of the income and/or capital of the Service Trust?

3.Will the income derived by the Fund from the Service Trust, as a beneficiary of the Service Trust, be non-arm's length income of the Fund under section 295-550 of the Income Tax Assessment Act 1997?

Advice/Answers

1.No.

2.No.

3.Yes.

This ruling applies for the following periods:

Income year ended 30 June 2012 and later income years

The scheme commences on:

During the 2010-2011 income year

Relevant facts and circumstances

The Fund is a single-member complying superannuation fund with a corporate trustee (the Fund Trustee). The member of the Fund (the Fund Member) is the sole director of the Fund Trustee.

The Service Trust was constituted in the early 1990s by a deed of settlement (the original deed) and has been conducted by a corporate trustee (the Trustee) as a service entity that provides administration services and premises for its Members, who are practitioners in a specified profession. None of the Members are related parties in relation to each other. None of the Members, or their Eligible Beneficiaries, are related parties of the Service Trust or the Trustee.

The original deed was amended subsequently by a number of supplemental deeds made in the mid-1990s and the late 2000s. Provisions under the original deed and the supplemental deeds (the Deed, collectively) relevant to this private ruling are noted as follows:

Some of the expressions used in the Deed are defined in the Deed. Of relevance are the following:

"Eligible Beneficiaries" in relation to each Member means:

"Net Income" in relation to an accounting period or part thereof means:

From what was disclosed in the Service Trust's financial statements, it would appear that:

Having been an Associate of the Trustee for a period of time, the Fund Member applied to the Trustee in writing during the 2010-11 income year to become a Member of the Service Trust. To meet one of the admission requirements the Fund Member executed a month later a Service Agreement (the Service Agreement), which was to commence in the first quarter of the 2011-12 income year.

Prior to becoming a Member of the Service Trust, the Fund Member carried on a practice as an employee of the Fund Member's own company. The Fund Member also worked as an employee elsewhere and as a partner in a partnership elsewhere.

Provisions in the Service Agreement relevant to this private ruling are noted as follows:

You confirmed that each practitioner is charged the same amounts of service fees under the Service Agreement. You also confirmed that the amount of professional fees collected by the Service Company may differ from practitioner to practitioner and that each practitioner pays an amount equal to a specified percentage of the average amount of professional fees collected per practitioner.

Some of the expressions defined in the Service Agreement and relevant to this private ruling are noted as follows:

As noted before, apart from executing and delivering to the Trustee a Service Agreement, the other admission requirements are the execution of a Bond Agreement and the payment by a Prospective Member of the specified bond amount and premium amount to the Trustee.

Although only a specimen Bond Agreement was provided to us, based on what is stated in your private ruling application, we accept that the Fund Member has executed the requisite Bond Agreement in accordance with the requirements for admission to the Service Trust as a Member.

From the specimen Bond Agreement the following provisions are noted:

In consideration of the payment of the bond and the premium the Trustee agrees to admit the Prospective Member to membership of the Service Trust from the specified date;

Under the Deed, an applicant for membership of the Service Trust is required to pay the bond and the premium. It is noted from your letter to the Australian Taxation Office (the ATO) that:

It is also noted from your private-ruling application that the Fund has paid the bond and the premium, as per the following:

In your letter to the ATO, you advised that:

In the fourth quarter of the 2010-11 income year, a Deed Poll was executed by the Fund Member both in his/her capacity as the Applicant for membership of the Service Trust and in his/her capacity as the sole director and sole company secretary of the Fund Trustee. Under the Deed Poll the Fund Trustee was nominated as the Fund Member's associate for the purpose of receiving all distributions from the Service Trust in relation to the Fund Member's membership with the Service Trust.

The following was noted, among other things, from the Deed Poll:

Introduction

A. The Applicant has requested that upon [him/her] becoming a member of the Trust all distributions of corpus or income be paid to the Nominee on the basis that the Nominee will be an Associate (as defined in the trust deed constituting the Trust) of the Applicant when the Applicant becomes a member of the Trust.

B. [The Service Trust] has agreed to the request of the Applicant referred to in paragraph C above.

Operative clauses

1. Acknowledgements

1.1 The Applicant acknowledges and agrees that:

2. Release

The Applicant and the Nominee each release [the Service Trust] from any action, demand, cost, liability or loss…in respect of the Nominee not being an Associate within the meaning of the Trust Deed or in respect of the taxation treatment of any distributions from [the Service Trust] to the Nominee.

In your letter to the ATO, you advised that:

On this basis the Fund purports to be an Eligible Beneficiary of the Service Trust, to whom the Trustee may distribute the corpus and/or net income of the Service Trust pursuant to the Deed.

Relevant legislative provisions

Corporations Act 2001; Chapter 5C

Income Tax Assessment Act 1936 Schedule 2F, Section 272-5

Income Tax Assessment Act 1936 Schedule 2F, Subsection 272-5(1)

Income Tax Assessment Act 1936 Schedule 2F, Subsection 272-5(2)

Income Tax Assessment Act 1936 Schedule 2F, Subsection 272-5(3)

Income Tax Assessment Act 1997 Schedule 2F, Section 272-65

Income Tax Assessment Act 1997 Section 295-545

Income Tax Assessment Act 1997 Section 295-545

Income Tax Assessment Act 1997 Subsection 295-545(2)

Income Tax Assessment Act 1997 Subsection 295-545(3)

Income Tax Assessment Act 1997 Section 295-550

Income Tax Assessment Act 1997 Subsection 295-550(5)

Income Tax Assessment Act 1997 Subsection 995-1(1)

Income Tax Assessment Act 1997 Section

Income Tax Rate Act 1986 Subsection 26(1)

Superannuation Industry (Supervision) Act 1993 Subsection 65(1)

Reasons for decision

Summary of decision

As an Eligible Beneficiary of the Service Trust, the Fund does not have a fixed entitlement to the corpus or net income of the Service Trust due to the provisions in the Deed that governs the Service Trust. Consequently, any income derived by the Fund from the Service Trust is non-arm's length income of the Fund.

After considering the factors under the income tax legislation, we are of the view that it is not reasonable for the Commissioner to exercise his discretion under that subsection to treat the Eligible Beneficiaries of the Trust as having fixed entitlements to a share of the income and capital of the Service Trust.

Even if the Fund does have a fixed entitlement, any income derived by the Fund from the Service Trust by reason of such an entitlement will be non-arm's length income of the Fund because:

The fact that the Fund paid for the Bond and the Premium and provided a loan to the Service Trust in the Fund Member's stead does not make the dealing between the Member of the Service Trust and the Fund Trustee an arm's length dealing. Rather, it was a non-arm's length dealing in itself.

Detailed reasoning

Non-arm's length income of superannuation fund

Subdivision 295-H of the ITAA 1997 deals specifically with the taxation of superannuation funds and other related entities. Under that Subdivision the taxable income of a complying superannuation fund consists of two components: a non-arm's length component and a low tax component. The non-arm's length component is taxed at 45% for the 2006-2007 income year and later income years, and the low tax component is taxed concessionally at 15%, as per subsection 26(1) of the Income Tax Rates Act 1986.

Subsection 295-545(2) of the ITAA 1997 states that:

Subsection 295-545(3) of the ITAA 1997 states that:

Income of a complying superannuation fund is non-arm's length income of the fund if a relevant subsection of section 295-550 of the ITAA 1997 applies to such income. Relevantly, subsections 295-550(4) and (5) of that section state that:

If the Fund as an Eligible Beneficiary of the Service Trust does not hold a fixed entitlement to the income of the Service Trust, any income to be derived by the Fund from the Service Trust will, by itself, be non-arm's length income of the Fund under subsection 295-550(4) of the ITAA 1997. It is therefore necessary to consider if the Fund holds a fixed entitlement to the income of the Service Trust.

Whether the Fund has a fixed entitlement

In your private-ruling application, you submitted that subsection 295-550(4) of the ITAA 1997 does not apply to income to be derived by the Fund from the Service Trust as an Eligible Beneficiary of the Service Trust because the Fund has a fixed entitlement to the corpus or net income of the Service Trust. Specifically:

A 'fixed trust' is defined in similar terms in subsection 995-1(1) of the ITAA 1997 and section 272-65 of Schedule 2F to the Income Tax Assessment Act 1936 (the ITAA 1936). The latter definition provides that:

In addition, subsection 272-5(2) of Schedule 2F to the ITAA 1936 states that:

The word 'interest' is a word that is capable of many meanings. In the absence of a definition one must infer its meaning from the context in which it is found (see Gartside and Another v Inland Revenue Commissioners (Gartside)1, Commissioner of Stamp Duties (Queensland) v Livingston (1964)2 and CPT Custodian Pty Ltd v Commissioner of State Revenue (Vic)3).

There may be circumstances in which the word 'interest' could be interpreted broadly to include any right or advantage that a person might be able to claim with respect to the income or capital of the trust and/ or in respect of the trustee, whether present or future, ascertained or potential. In the context of Schedule 2F to the ITAA 1936, however, it is clear that for an interest to be recognised as a fixed interest it must be a right with respect to a share of the income or of the capital of the trust that is susceptible to measurement. To adopt the words of Lord Wilberforce in Gartside, the right must have 'the necessary quality of definable extent'.

The term 'vested and indefeasible' is not defined in the taxation legislation. However the Explanatory Memorandum (EM) to the Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1997 does discuss its ordinary meaning at some length, at paragraphs 13.4 to 13.9. In essence:

In Colonial First State Investments Ltd v Federal Commissioner of Taxation4 Justice Stone stated, at paragraph 97 of the judgement, that:

The meaning of the term 'vested and indefeasible' (in the context of Schedule 2F to the ITAA 1936) also appears in subsection 95A(2) of the ITAA 1936 and has been considered in that context by the courts in Estate Mortgage Fighting Fund Trust v Federal Commissioner of Taxation5, Walsh Bay Developments Pty Ltd v Federal Commissioner of Taxation, Dwight v Commissioner of Taxation6 and Harmer v Federal Commissioner of Taxation.

Also relevant are MSP Nominees Pty Ltd v Commissioner of Stamps (SA), Queensland Trustees Ltd v Commissioner of Stamp Duties7 and Glenn v Federal Commissioner of Land Tax (1915).

It is an essential element of subsection 272-5(1) of Schedule 2F to the ITAA 1936 that in order to have a fixed entitlement to a share of income or capital there must be a vested or indefeasible interest "under a trust instrument". In all cases, the determining factor in deciding if fixed entitlements exist will be the terms of the trust instrument under which the trust is constituted. Neither the form of the trust nor the labels that are attached to it can determine this question.

The first step in determining whether a beneficiary has a vested and indefeasible interest in a share of the income or capital of a trust is to ascertain the terms of the trust upon which the relevant trust property is held. As the High Court stated in CPT Custodians Pty Ltd v Commissioner of State Revenue (Vic) and Commissioner of State Revenue (Vic) v Karingal 2 Holdings Pty Ltd8 at [15], in taking this step:

There will be some circumstances in which a trust instrument must be read subject to the operation of a particular legal rule, whether by common law, statute or statutes. For example, if the constitution of a registered managed investment scheme is inconsistent with the provisions of Chapter 5C of the Corporations Act 2001, the latter can have the effect of altering or modifying the former. It is possible for a constitution to be altered or modified by operation of law irrespective of whether the trust instrument itself expressly recognises the relevant common law rule or statute, and the entitlements of a beneficiary under the trust instrument are those as so altered or modified by operation of law.

The important question is whether the vested and indefeasible interests represent 100% of the income and 100% of the capital of the trust. The fact that a power held by the trustee or manager has not yet been exercised is not relevant when determining if the power results in an interest being defeasible. The exercise of the power determines if an interest has in law been defeased, not if it is defeasible. The real question is whether the power, if exercised, would result in a defeasance of some or all of the unitholder's rights to the income and/or capital of the trust.

For the purposes of subsection 272-5(1) of Schedule 2F to the ITAA 1936, the trust instrument in this case consists of the original deed (by which the Service Trust was constituted) as amended by three supplemental deeds (collectively, the Deed). Pursuant to the Deed, which is concerned with declaration of trust:

The provision in a clause of the Deed suggests that the beneficial interest in the Trust Fund is vested in the Members collectively (and not in the Eligible Beneficiaries) and that distributions of the Corpus and Net Income of the Service Trust to Eligible Beneficiaries are in accordance with the Membership Proportion of each of the Members, subject however to the powers of the Trustee and the provisions in the Deed. It is difficult to envisage, from the clause alone, that Eligible Beneficiaries, of which the Fund is one, have a vested interest themselves in the Trust Fund (as the beneficial interest in the Trust Fund is stated in the Deed to be vested in the Members), much less a fixed entitlement.

We have also noted that the Deed contains clauses the effect of which is that an Eligible Beneficiary's interest in a share of the capital or income of the Service Trust may be defeased when the Trustee exercises a power under the Deed. In the subsequent paragraphs we shall look at the effect of the clauses involved.

The definition of 'Eligible Beneficiaries' in a sub-clause of the Deed refers to a Member or an Associate of the Member who is '…selected by the Trustee to receive a Distribution…'. This gives the Trustee the power to determine which Eligible Beneficiary is to receive a distribution. In other words, under the Deed a person is not automatically entitled to distributions from the Service Trust by virtue of being an Eligible Beneficiary (as a Member of the Service Trust or as an Associate of the Member).

The same wording is used in another sub-clause of the Deed, which, in the context of the meaning of the word 'distribute', refers to 'Eligible Beneficiaries selected by the Trustee' (italics added) and which empowers the Trustee to make:

In other words, under the Deed an Eligible Beneficiary is not entitled to any distribution from the Service Trust unless the Eligible Beneficiary is selected by the Trustee to receive a distribution from the Service Trust.

We have also noted that on termination of a Member's membership with the Service Trust, the Trustee will, pursuant to a specified clause of the Deed and among other things, make an interim distribution to the Eligible Beneficiaries of the Member concerned in the amounts and proportions of the net income or part thereof amongst those Eligible Beneficiaries at its absolute and uncontrolled discretion.

When it comes to annual and interim distributions of the net income of the Service Trust, again, the Deed gives the Trustee an absolute and uncontrolled discretion in applying the amounts and proportions of the net income among the Eligible Beneficiaries of each Member in the membership proportion of that Member.

In the Deed Poll executed by the Fund Member in their capacity as Applicant for membership of the Service Trust and in his/her capacity as the sole director of the Fund Trustee, it is noted that:

Based on this Deed Poll it may be argued that as the Fund is to receive all distributions from the Service Trust, the Trustee cannot select any other Eligible Beneficiaries of the Fund Member than the Fund for the purpose of making a distribution, and there is no need for the Trustee to determine the amounts and proportions of the distribution amongst the Eligible Beneficiaries in its absolute and uncontrolled discretion (as there are no other nominated Eligible Beneficiaries apart from the Fund).

Even if the Trustee has noted the Fund Member's request for all distributions from the Service Trust to be made to the Fund, such an argument may not be sustainable due to the following reasons:

Besides, a specified clause in the Deed permits the Trustee to vary the Deed if such variation is approved by the Members of the Service Trust by special resolution. Any such variation may lead to the interests of Members being defeased.

It is, therefore, considered reasonable to conclude, pursuant to subsection 272-5(1) of Schedule 2F to the ITAA 1936, that all Eligible Beneficiaries of the Service Trust (the Fund included) do not have fixed entitlements to the Corpus and/or the Net Income of the Service Trust.

Commissioner's discretion

Where beneficiaries do not have a fixed entitlement, the Commissioner may, under subsection 272-5(3) of Schedule 2F to the ITAA 1936, exercise his discretion to treat such beneficiaries as having a fixed entitlement if, based upon the factors prescribed in paragraph 272-5(3)(b) it is reasonable to do so. The factors under that paragraph are:

The concept of a 'fixed entitlement' was originally introduced in the context of the trust loss measures and should primarily be interpreted in that context. The trust loss measures are an important integrity measure, removing a structural flaw in the tax system. The concept of a 'fixed entitlement' is fundamental to the structure and effectiveness of the trust loss measures.

The EM to the Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1997 states, at paragraph 13.13, in respect of the Commissioner's power in subsection 272-5(3) of the ITAA 1936, that:

This passage seems, however, to indicate that when looking at the facts of a case in the context of the criteria listed in subsection 272-5(3) regard should always be had to whether the absence of a fixed entitlement in these circumstances could result in the transfer of the tax benefit of losses.

The interpretation of the meaning of 'vested and indefeasible' for the purposes of section 272-5 of Schedule 2F to the ITAA 1936 was raised at the March 2006 meeting of the National Tax Liaison Group, which is a consultative forum for the ATO and tax professionals to consider topics of strategic importance and/or concerns with a view to achieving a fair, effective and efficient administration and delivery of Australia's tax and superannuation systems. The issue was referred to its newly formed Trust Consultation Sub-group for discussion. At the Sub-group's meeting on 28 November 2006, the ATO advised that:

In applying the discretion, the ATO would have regard to what the Office understands was the policy that underlay the provisions at the time they were enacted. The Commissioner would also have to apply the statutory tests having regard to the terms of the particular trust deeds and all the surrounding circumstances.

In the absence of any precedential guidelines, taxpayers seeking access to the Commissioner's discretion will be dealt with according to the relevant facts on a case by case basis.

In the case of trusts which are managed investment schemes, it is also appropriate that consideration is given to any potential impacts that the Corporations Act 2001 (as noted above), the regulatory powers of the Australian Securities and Investments Commission, and the actions of the Australian Securities Exchange may have on the administration of trust and the entitlements of beneficiaries.

As we have earlier concluded that Eligible Beneficiaries of the Service Trust do not have a fixed interest in a share of income of the Service Trust pursuant to subsection 272-5(1) of Schedule 2F to the ITAA 1936, it is necessary to consider whether the Commissioner should exercise his discretion under subsection 272-5(3)to treat the Eligible Beneficiaries as having a fixed interest in the income of the Service Trust.

Pursuant to a specified clause of the Deed, beneficial interest in the Trust Fund is vested in the Original Members and the other Persons hereafter becoming registered as Members subject to the Deed. Pursuant to that same clause, the Trustee holds and stands possessed of the corpus and the net income of the Service Trust upon trust for the Eligible Beneficiaries in relation to each Member in the Membership Proportion of that Member, subject to the powers and provisions expressed in the Deed concerning the same.

As noted before, when defining the meaning of the word "distribute", the relevant clause of the Deed includes a reference to "a declaration made by the Trustee that it holds and stands possessed of the net income or corpus (as the case may be) specified in the Resolution for and on behalf of those Eligible Beneficiaries selected by the Trustee". Apart from defining "Eligible Beneficiaries" in relation to each Member as meaning "that Member and the Associates thereof", the relevant clause of the Deed also makes reference to "someone or more of them selected by the Trustee to receive a Distribution". In other words, there is no absolute certainty that a particular Eligible Beneficiary of the Service Trust will receive a distribution from the Service Trust.

It is also noted that the entitlement of Eligible Beneficiaries may be affected by any amendment to the Deed concerning entitlement and/or the Trustee's powers and discretion, which may be proposed as a special resolution in a duly convened general meeting of Members and be passed by a specified percentage of the votes cast by the Members of the Service Trust present.

In view of these circumstances, we do not consider it reasonable for the Commissioner to treat the Eligible Beneficiaries as having a fixed entitlement.

Secondly, the Service Trust is not listed and is not a registered managed investment scheme for the purposes of the Corporations Act 2001. Prima facie it is a closely held trust. There is no external supervision of the operations of the Service Trust, nor is there any fiduciary controls over and above those which apply generally to trustees in accordance with the relevant state trustee legislation. This increases the chance of a defeasance happening resulting from the decisions of the Trustee in relation to the clauses mentioned earlier in these 'Reasons for decision'. The likelihood of such happening will depend on the commercial imperatives of the Trustee and the need for flexibility in the Service Trust's operation.

In the circumstances, we do not consider it reasonable for the Commissioner to treat the Eligible Beneficiaries of the Service Trust as having a fixed entitlement.

Thirdly, the Deed permits an Associate in relation to a Member to be the Member Principal (if the Member is a company), the Specified Relatives of, and/or any other persons associated with, the Member or the Member Principal. An Associate, by definition, is an Eligible Beneficiary. In other words, such provisions in the Deed were designed to allow a Member of the Service Trust, prima facie a closely held trust, to decide whether the Member alone is to receive a distribution from the Service Trust and, if not, who (either in conjunction with the Member or in the Member's stead) is/are to receive a distribution from the Service Trust.

As a Member may, at any time, notify the Trustee of a change in the Associate(s) previously nominated by the Member, there is no certainty that an existing Eligible Beneficiary of the Member will receive a distribution at the end of an income year. This is another unfavourable factor for the Commissioner to treat the Eligible Beneficiaries of the Service Trust as having a fixed entitlement.

To conclude, we are of the view that the Commissioner should not exercise his discretion under subsection 272-5(3) of Schedule 2F to the ITAA 1936 to treat an Eligible Beneficiary of the Service Trust as having a fixed entitlement in the Service Trust.

What if the Fund does have a fixed entitlement

In the alternative, should it be established that the Fund does have a 'fixed entitlement' to the corpus and/or net income of the Service Trust, the question to be asked is whether income to be derived by the Fund through holding such a 'fixed entitlement' is non-arm's length income of the Fund under subsection 295-550(5) of the ITAA 1997.

Taxation Ruling TR 2006/7 explains what amounts are considered to be 'special income' under section 273 of the ITAA 1936. Though section 273 was repealed in 2007 and re-written as section 295-550 of the ITAA 1997, and the term "special income" has since been substituted by "non-arm's length income", TR 2006/7 continues to have effect because the EM to the Tax Laws Amendment (Simplified Superannuation) Bill 2006 states, in paragraph 3.1, that:

In the following paragraphs, TR 2006/7 also explains when income derived by a complying superannuation fund as a beneficiary of a trust by virtue of holding a fixed entitlement to the income of the trust is special income of the fund:

The word "scheme" in subsection 295-550(5) of the ITAA 1997 is defined in subsection 995-1(1) as meaning:

"Arrangement" means, according to subsection 995-1(1) of the ITAA 1997:

A scheme may comprise the whole of an agreement, arrangement, etc or one or more steps within the arrangement. The following statement was made by the High Court in Federal Commissioner of Taxation v Hart9 in the context of Part IVA of the ITAA 1936 which defines 'scheme' in comparable terms:

As a 'scheme' or 'arrangement' embraces agreement, promise, undertaking and steps within an arrangement, for the purposes of subsection 295-550(5) of the ITAA 1997 we now consider what the 'scheme' or 'arrangement' that the Fund Member put in place is and how it was put in place.

Constituted by deed in the early 1990s, the Service Trust provides administration services and working areas for practitioners in the specified profession who are either Members of the Service Trust, or Associates (being Practitioners who are not Members of the Service Trust but practise in conjunction with the Service Trust). The Service Trust charges:

Service Fees collected by the Service Trust have been the main source of the Service Trust's income. After paying out all costs, expenses and other outgoings, the Trustee:

For a number of years the Beneficiaries Accounts of the Members received distributions from the Service Trust as their share of profit.

At any time and from time to time before the Vesting Day, the Trustee may also distribute the corpus of the Trust Fund that comprises the Premium Account Balance of each Member, or the corpus other than the Premium Account, for the time being in excess of the immediate requirements of the Service Trust to the Eligible Beneficiaries of that Member by payment in cash or other Property.

As noted before, 'Eligible Beneficiaries' in relation to each Member means "that Member and the Associate thereof or some one or more of them selected by the Trustee". You have advised that the Fund is an Associate of the Fund Member (in their capacity as a Member of the Service Trust) by reference to the relevant clause of the Deed. When the Fund Member becomes a Member of the Service Trust, the Fund as an Associate of the Fund Member becomes an Eligible Beneficiary of the Service Trust.

Prior to becoming a Member of the Service Trust, the Fund Member was an Associate of the Service Trust, i.e. a practitioner who was a party to an Associate Agreement with the Service Trust.

Within this background, the following events, or steps, took place:

While the Deed permits a Member to have one or more Associates hence one or more Eligible Beneficiaries, through the Deed Poll the Fund Member nominated the Fund as the sole Eligible Beneficiary in relation to his/her Membership of the Service Trust.

In our view, all these events, or steps, were for the ultimate objective of putting in place a scheme or an arrangement whereby the Fund, rather than the Fund Member himself/herself or any other potential Associates of his/hers, will, by holding a purportedly "fixed entitlement" to the corpus or net income of the Service Trust, derive income from the Service Trust in future income years.

On the question of whether parties are dealing with each other at arm's length or otherwise, it was stated in paragraphs 76 to 78 of TR 2006/7 that:

The term 'arm's length' is not defined. However, subsection 995-1(1) of the ITAA 1997 states that:

The view expressed in paragraph 76 of TR 2006/7 is based on the Federal Court's decisions in Re Hains (deceased), Barnsdall v Commissioner of Taxation; Trustee for Estate of AW Furse No. 5 Will Trust v Commissioner of Taxation; and Granby Pty Ltd v Commissioner of Taxation and the examples in the EM to the Superannuation Legislation Amendment Bill (No. 2) 1999, which, as enacted, inserted subsections 273(6) to (8) of the ITAA 1936.

These cases were also relied upon in Allen (As Trustees for Allens Asphalt Staff Superannuation Fund v Commissioner of Taxation (Allen), in which the Federal Court held that a distribution from a fixed trust to a superannuation fund in consequence of the superannuation fund holding a fixed entitlement to 100% of the income of the fixed trust constituted special income in the hands of the superannuation fund for the purposes of subsection 273(7) of the ITAA 1936. In that case, Justice Collier said, in paragraph 90, that:

The Federal Court's decision in Allen that the distribution from the fixed trust to the superannuation fund was special income of the fund was affirmed by the Full Federal Court.

At all material times the Fund Member is:

As a Member of the Service Trust, the Fund Member nominated the Fund as their Associate and requested the Trustee to pay all distributions (payable in respect of their Membership of the Service Trust) to the Fund.

In view of the close relationship, the Fund Member in his/her capacity as a Member of the Service Trust and in his/her capacity as the sole director of the Fund Trustee are non-arm's length parties in relation to the Fund's interest in the corpus and/or net income of the Service Trust. Although the nature of the relationship between parties is relevant in determining whether dealings between them are at arm's length, parties that are not at arm's length can still deal with each other at arm's length in relation to a particular dealing.

As it is possible for parties that are not at arm's length to deal with each other at arm's length in relation to any particular dealing, the Commissioner has to consider if the following were consistent with an arm's length dealing:

You submitted, in your private-ruling application, that:

The Service Agreement, along with all other Service Agreements struck between the Service Trust and all other Members, has been struck as between arm's length parties and on arm's length basis.

The ATO has prescribed guidelines in Taxation Ruling TR 2006/2 and the April 2006 Booklet for the conduct of trusts such as the Service Trust which requires that the terms of service agreements as between professional practices and trust service provider must be struck on commercial terms. The Fund contends that the Service Trust activities have been, and will continue to be, conducted in accordance with the ATO guidelines.

In practical terms all Members (in the Fund Member's case, the Fund) have an obligation to indemnify the Service Trust.

However, under the Deed, a Practitioner must:

Any dealings pursuant to the Deed are, therefore, necessarily between the Trustee and the Fund Member as a Member of the Service Trust, not between the Trustee and the Fund Trustee on behalf of the Fund.

Under the Service Agreement, again any dealings are necessarily between the Trustee and the Fund Member (the Practitioner), not between the Trustee and the Fund Trustee. This is because pursuant to the Service Agreement:

No analysis has yet been made on whether the Trustee and the Fund Member (in their capacity as a Member of the Service Trust) were dealing with each other at arm's length. Even if they were dealing with each other at arm's length, such arm's length dealing between them do not automatically lead to a conclusion that the Fund Member, the Fund Trustee on behalf of the Fund and the Trustee were dealing with each other at arm's length. Indeed, there is no direct relationship between the Trustee and the Fund Trustee on behalf of the Fund, as far as Membership of the Service Trust is concerned (with which the Trustee primarily deals), since the Fund's interest is that of an Eligible Beneficiary only.

It is, therefore, necessary to consider whether the dealings between the Fund Member (in his/her capacity as a Member of the Service Trust) and the Fund Trustee were at arm's length.

Income derived by the Service Trust from Services Fees charged to Members of the Service Trust accounted for almost over 90% of the Service Trust's total income for the income year ended 30 June 2010 according to the Service Trust's Profit and Loss Account for that income year. After meeting all costs and outgoings, this income is distributed (usually annually) to Eligible Beneficiaries who, as is noted before, may be the Members themselves and/or their Associates.

Since it is the personal exertions of a Member of the Service Trust, not those of the Member's Associate, that contribute towards the Service Trust's income, the fact that a Member of the Service Trust nominates an Associate to receive distributions from the Service Trust as an Eligible Beneficiary is intrinsically a gratuitous act on the part of the Member in favour of, and for the benefit of, the Associate and is clearly not an arm's length dealing between the Member and the Associate.

From the Trustee's standpoint, that an Associate should receive a distribution from the Service Trust as an Eligible Beneficiary is simply because the Member concerned wants it to be so for some reason, not because the Associate has paid any consideration to, or has any direct interest in, the Service Trust. Indeed, whether it is necessary or proper for the Trustee to be aware of, or to look upon, the payment made, and the loan provided, by the Fund to the Service Trust as a consideration given by the Fund to secure an entitlement to a share of the Service Trust's income is questionable, since an Eligible Beneficiary does not have to pay any consideration under the Deed for receiving distributions from the Service Trust.

By nominating the Fund as the sole Eligible Beneficiary of the Service Trust, the Fund Member (in his/her capacity as a Member of the Service Trust) and the Fund Trustee were not dealing with each other at arm's length, regardless of whether the Fund's interest in the Service Trust is a fixed entitlement.

Neither the law nor the Deed itself prohibits a superannuation fund, a trust, a company, a partnership or an individual related to a Member of the Service Trust from being nominated by that Member as an Associate of that Member, and through that, as an Eligible Beneficiary of the Service Trust for the purpose of receiving distributions from the Service Trust. However, subsections 295-550(4) and (5) of the ITAA 1997 prima facie treat any distributions so received by a complying superannuation fund from the Service Trust as non-arm's length income of the fund unless the contrary is proved. This is to stop tax concessions given to complying superannuation funds from being abused.

Instead of the Fund Member themself paying the Service Trust for the bond and the premium and providing the Service Trust with the loan, the Fund actually made the payment and provided the loan for the Fund Member. In your private-ruling application you have submitted that:

On the facts [the Fund Member] has created, by agreement with the Trustee, a fixed and indefeasible interest in the Trust in favour of [the Fund]. That fixed entitlement is evidenced by:

With respect, your submissions missed the point that any interest in the Service Trust, whether as a fixed entitlement or otherwise, is primarily that of a Member, created as and when the Member (and not an Associate of the Member) complies with the admission requirements under the relevant clause of the Deed and, following that, is admitted to Membership of the Service Trust. It is the Member, not any Associate nominated by the Member, who is, pursuant to the Deed and contractually bound by the Service Agreement, to carry on a practice in conjunction with the Service Trust, through which practice income is generated for the Service Trust.

Unlike a unit trust where investors become unit holders by acquiring units in the unit trust, the Service Trust was established essentially to facilitate (and perhaps attract more) interested practitioners in the same profession carrying on their practices in conjunction with the Service Trust on a cost and profit-sharing basis, not the Associates (if any) that may be brought into the scene by interested practitioners for the mere purpose of enabling such Associates to receive distributions from the Service Trust.

The Fund is not a practitioner and cannot, therefore, apply for Membership of the Service Trust. Consequently, no rights and obligations pertaining to such Membership attach to the Fund. It is, therefore, difficult to conceive how the Fund, by paying the bond and the premium, as well as providing the loan, for its own account, can enforce (as against the Trustee) any proprietary rights it purports to have acquired or secured through the payment and the loan.

As mentioned before, the Trustee distributes the corpus and/or net income of the Service Trust to Eligible Beneficiaries not because a particular Eligible Beneficiary has secured an entitlement to such corpus or net income by making a certain payment to the Service Trust, but simply because the Member concerned has nominated the particular Eligible Beneficiary as such (for the purpose of receiving distributions from the Service Trust). It is therefore not necessary, or proper at all, for the Fund to pay for the bond and the premium and to provide the loan, which the Fund Member themselves (in their capacity as an Applicant for Membership of the Service Trust) should have paid and provided:

The fact that:

You submitted that the payment and the loan were the consideration given by the Fund in respect of the acquisition of its interest in the Service Trust. As an Eligible Beneficiary of the Service Trust does not have to give the Trustee consideration in order to receive distributions from the Service Trust, 'consideration' must then be understood in the context of the Fund Trustee paying the Fund Member (in their capacity as a Member of the Service Trust) consideration in return for their giving up their entitlement to distributions from the Service Trust in favour of the Fund. But if this was the case, the consideration so given is nevertheless a non-arm's length dealing between the Fund Trustee and the Fund Member because:

In the absence of such a basis or calculation, we have not been persuaded that a one-off payment of a specified amount by the Fund should entitle the Fund to receive annual distributions from the Service Trust for an indefinite period of time. In other words, it has not been demonstrated that the cost to the Fund is not disproportionate to the benefit that the Fund may obtain.

In Syngenta Crop Protection Pty Ltd v. Federal Commissioner of Taxation Justice Gyles of the Federal Court, when discussing arm's length consideration in the context of the transfer pricing provisions, held that the test for determining excessive income was objective, stating:

In view of the above, we have to conclude that:

The last question to be considered is whether any prospective distribution receivable by the Fund from the Service Trust will be more than the amount that the Fund might have been expected to derive if the Fund Trustee and the Fund Member had been dealing with each other at arm's length.

In your private-ruling application, you submitted that:

Irrespective of whether the risks you mentioned are valid, in our view they are not relevant in relation to the question being asked. This is because the Fund is merely an Eligible Beneficiary, not a Member of the Service Trust and, as noted before, should not have been the party, in the first place, that paid for the Bond and the Premium and provided the loan to the Service Trust.

With a view to distinguishing the Fund's case from the superannuation fund in Allen, you submitted in your private-ruling application that subsection 295-550(5) of the ITAA 1997 does not apply to the Fund on the following grounds:

We are unable to accept these grounds as valid for the following reasons:

To summarise, the facts available indicate that:

Based on the Service Trust's past records of distributions, any annual distribution receivable by the Fund would appear to be disproportionate to the amount of its one-off outlay.

In a completely arm's length environment, an entity that incurs a nominal outlay (which, in the Fund's case, is not even required to have been incurred by the Fund in the first place) and that bears no commercial risk cannot expect to receive or derive any income. It follows that the receipt of any distribution by the Fund in these circumstances would be greater than expected if the parties had been dealing with each other on an arm's length basis.

We, therefore, have to conclude that subsection 295-550(5) of the ITAA 1997 applies to treat, as non-arm's length income of the Fund, any distribution that the Fund may receive from the Service Trust as an Eligible Beneficiary thereof.

Further issues for you to consider

By making the payment and providing the loan, the Fund Trustee may have contravened paragraph 65(1)(b) of the Superannuation Industry (Supervision) Act 1993. Subsection 65(1) states that:

1 [1968] AC 553 at 602-602 and 617-618; [1968] 2 WLR 277; [1968] 1 All ER 121

2 (1964) 38 ALJR 197; [1965] ALR 803; [1965] AC 694; [1964] 3 WLR 963; [1964] 3 All ER 692; [1964] TR 351; (1964) 108 Sol J 820; (1964) 43 ATC 325; (1964) 112 CLR 12 at 28-29

3 [2005] HCA 53; (2005) 79 ALJR 1724; (2005) 2005 ATC 4925; (2005) 60 ATR 371; [2005] ALMD 8267; [2005] ALMD 8610; (2005) 221 ALR 196; (2005) 224 CLR 98

4 [2011] FCA 16; (2011) 2011 ATC 20-235; (2011) 192 FCR 298; [2011] ALMD 4786; [2011] ALMD 4787; [2011] ALMD  4788

5 [2000] FCA 981; (2000) 45 ATR 7; (2000) 2000 ATC 4525; (2000) 175 ALR 482; (2000) 102 FCR 15

6 (1992) 37 FCR 178; (1992) 107 ALR 407; (1992) 23 ATR 236; (1992) 92 ATC 4192

7 (1952) 88 CLR 54; (1952) 26 ALJ 389; [1952] ALR 895; [1952] HCA 52

8 2005] HCA 53; (2005) 79 ALJR 1724; (2005) 2005 ATC 4925; (2005) 60 ATR 371; [2005] ALMD 8267; [2005] ALMD 8610; (2005) 221 ALR 196; (2005) 224 CLR 98

9 [2004] HCA 26; (2004) 78 ALJR 875; (2004) 206 ALR 207; (2004) 55 ATR 712; (2004) 2004 ATC 4599; [2004] ALMD 4877; [2004] ALMD 4881; (2004) 217 CLR 216.

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