Edited version of your private ruling

Authorisation Number: 1012396819768

Questions

1. Will a discounted amount of interest (i.e. the difference between interest calculated using an arm's length interest rate and a 0% interest rate) be considered a superannuation contribution received by a superannuation fund (the Fund)?

2. If the answer to question 1 is 'yes', will the superannuation contribution be attributed evenly to the members (the Members) of the Fund or will some other allocation method be imposed?

3. If the answer to question 1 is 'yes', will the superannuation contribution be treated as either a personal concessional or personal non-concessional contribution?

4. Will annual rental income derived by the Fund in respect of a property (the Property), acquired by the Fund with funds borrowed from the Members, be considered non-arm's length income of the Fund under section 295-550 of the Income Tax Assessment Act 1997 (the ITAA 1997)?

5. Will any capital gain realised by the Fund on sale of the Property be considered non-arm's length income of the Fund under section 295-550 of the ITAA 1997?

6. If a 0% interest rate is agreed upon by the parties under the borrowing arrangement, will the borrowing arrangement be deemed a scheme with the dominant purpose of gaining a tax benefit under Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936)?

Advice/Answers

1. No.

2. Question not required to be answered.

3. Question not required to be answered.

4. No.

5. No.

6. No.

This ruling applies for the following period:

1 July 2012 to 30 June 2015

The scheme commences in:

2012

Relevant facts and circumstances

1. Towards the end of the 2008-09 income year the individual trustees (being also the Members) of the Fund entered a contract to purchase an off-the-plan apartment (the Property). The vendor is unrelated to the Fund.

2. Early in the 2009-10 income year a deposit bond of a certain amount was paid from the cash reserves of the Fund.

3. Some time after the contract was exchanged, a private company was appointed as the trustee of the Fund (the Corporate Trustee) in place of the individual trustees, who are now the directors of the Corporate Trustee.

4. The agreed purchase value of the Property, determined at arm's length between the Corporate Trustee and the vendor, is a specified amount. To fund part of the settlement of the Property, which took place in the second quarter of the 2012-13 income year, the Members (in their personal capacity) lent money to the Fund through a borrowing arrangement which purportedly:

(a) satisfies all aspects of section 67A of the Superannuation Industry (Supervision) Act 1993; and

(b) is a genuine loan arrangement between the parties.

5. The following are pertinent details of the loan agreement (the Loan Agreement) between the Members (the Lender) and the Corporate Trustee (the Borrower):

(a) the Principal Sum is a specified amount;

(b) the Term of the loan is the period commencing on the Commencement Date and ending on the Repayment Date;

(c) the Repayment Date is a specified number of years from the Commencement Date or such other date as agreed between the parties;

(d) the Borrower must repay the Principal Sum and all Secured Money then outstanding in full by the Repayment Date, but if the parties agree to a further loan, the outstanding Principal Sum and all Secured Money will be due and payable to the Lender:

(i) at the agreed date; or

(ii) if no date is agreed, on demand by the Lender and in the manner as directed by the Lender in writing;

(e) interest accrues monthly in arrears at the Prescribed Rate on the full amount of the Principal Sum until repayment of the Principal Sum, and the Borrower must pay interest quarterly in arrears;

(f) the Prescribed Rate is as follows:

(i) for the first year of the Term:

(A) and before the Australian Taxation Office (the ATO) provides a private ruling - a specified annual rate of interest from the Commencement Date; and

(B) after the ATO provides the private ruling and for the remainder of the first year of the Term - the rate of interest specified by the ATO; or

(C) if the ATO does not make any determination - the rate of interest to be agreed upon by the parties; and

(ii) for the remaining period of the Term - the rate of interest to be agreed upon by the parties.

6. The Property will be leased by the Fund to an unrelated third party on arm's length terms, as stated in the private-ruling application.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 292.

Income Tax Assessment Act 1997 Section 295-160.

Income Tax Assessment Act 1997 Section 295-385.

Income Tax Assessment Act 1997 Section 295-395.

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

Income Tax Assessment Act 1936 Section 177C.

Income Tax Assessment Act 1936 Section 177D.

Superannuation Industry (Supervision) Act 1993 Section 17A.

Superannuation Industry (Supervision) Act 1993 Section 67A.

Superannuation Industry (Supervision) Regulations 1994 Regulation 7.04.

Reasons for decision

Summary

A discounted amount of interest is not a superannuation contribution as the absence of a requirement under the Loan Agreement for the Corporate Trustee to pay interest to the Members on the loan does not increase the capital of the Fund.

Annual rental income to be received by the Fund in respect of the Property, or any capital gain to be made by the Fund on disposal of the Property, is not non-arm's length income of the Fund.

Detailed reasoning

Whether discounted amount of interest is superannuation contribution

A trustee of a regulated superannuation fund (RSF) may borrow money or maintain a borrowing of money if the borrowing arrangement involved meets all the conditions imposed under section 67A of the Superannuation Industry (Supervision) Act 1993 (SISA). This is so even if the lender under the borrowing arrangement is a related party of the RSF.

Paragraph 4 of Taxation Ruling TR 2010/1 (TR 2010/1) states that:

In the superannuation context, a contribution is anything of value that increases the capital of a superannuation fund provided by a person whose purpose is to benefit one or more particular members of the fund or all of the members in general.

Where an arrangement is put in place to ensure that a superannuation fund does not incur a liability to meet certain expenses, as was illustrated in example 2 under paragraphs 75 and 76, and in example 5 under paragraphs 81 and 82, of TR 2010/1, there is no increase in the capital of the superannuation fund because no forgiveness or extinguishment of any liability is involved. Consequently, no superannuation contribution is made to the superannuation fund under the arrangement.

As is confirmed in the 'ATO initial response' to issues raised by members of the NTLG Superannuation Technical Sub-Group in relation to related party loans under limited recourse borrowing arrangements¹, the absence of a requirement under the Loan Agreement for the Corporate Trustee to pay interest to the Members on money borrowed from the Members does not increase the capital of the Fund.

In other words, any saving by the Fund on interest expense due to a discounted rate of interest being used is similar to the circumstances outlined in the aforementioned examples. As no superannuation contribution is considered to have been made under either of those examples, similarly any saving by the Fund on interest expense will not be treated as a superannuation contribution.

Whether annual rental income of Fund is non-arm's length income

Non-arm's length income

In accordance with section 295-545 of the ITAA 1997, the taxable income of a complying superannuation fund is split into a 'non-arm's length component' and a 'low tax component'.

The non-arm's length component for any income year is a complying superannuation fund's non-arm's length income for that year, less any deductions to the extent that the deductions are attributable to that income, and is then taxed at the highest marginal rate (currently 45%). The remaining part of the fund's taxable income for the income year is the low tax component, which is taxed at a concessional rate (currently 15%).

Pursuant to subsection 295-550(1) of the ITAA 1997, an amount of ordinary income or statutory income is non-arm's length income of a complying superannuation fund if the amount:

(a) 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) is more than the amount that the fund might have been expected to derive if those parties had been dealing with each other at arm's length in relation to the scheme.

Income derived from scheme

'Scheme' and 'arrangement' are defined in subsection 995-1(1) of the ITAA 1997 as follows:

scheme means:

(a) any arrangement; or

(b) any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

arrangement means any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings.

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 the context of Part IVA of the ITAA 1936, which defines 'scheme' in comparable terms;

Th[e] definition is very broad. It encompasses not only a series of steps which together can be said to constitute a "scheme'' or a "plan'' but also (by its reference to "action'' in the singular) the taking of but one step.²

The Federal Court in Allen (As Trustee of the Allen's Asphalt Staff Superannuation Fund) v. Federal Commissioner of Taxation³ (Allen) considered the former section 273 of the ITAA 1936, which was the predecessor to section 295-550 of the ITAA 1997. Though referring to 'special income' rather than non-arm's length income, section 273 of the ITAA 1936 was of similar effect to section 295-550 of the ITAA 1997. Likewise, subsection 273(8) of the ITAA 1936 defined 'arrangement' to incorporate substantially the same terms as 'scheme' in section 295-550 of the ITAA 1997.

The Federal Court found in Allen that, since 'arrangement' was defined widely, there was no justification to interpret the steps which constitute an arrangement narrowly. The Court also held that a liberal interpretation of 'arrangement' was supported by the Explanatory Memorandum for the Superannuation Legislation Amendment Bill (No. 2) 1999 which introduced subsection 273(8). Justice Collier said:

… Indeed the width of the definition of "arrangement" in s 273(8) specifically militates against a narrow interpretation, in that s 273(8) clearly contemplates understandings beyond legally enforceable agreements or instrument...⁴

… The width of the definition of "arrangement" is such that an arrangement may come into being by a sequence of interconnected steps, including, at various stages, incorporation of companies or declaration of trusts. Where the alleged arrangement is characterised by a series of steps it is necessary that the steps be co-ordinated in anticipation of achieving a goal to fall within the definition of "arrangement" in s 273(8), rather than be random steps with no structure or pattern…⁵

Thus, a scheme from which an amount of income is derived by a superannuation fund may comprise a series of interrelated steps, extending beyond a legally enforceable formal agreement, to encompass an informal understanding between the parties.

In our view, the arrangement described in the private-ruling application, which involves the following steps taken by the parties concerned, namely:

(a) the (then) individual trustees of the Fund entering into a contract with an unrelated vendor to purchase the Property;

(b) the Corporate Trustee of the Fund and the Members of the Fund executing the Loan Agreement for a loan from the latter to the Fund to finance part of the purchase; and

(c) the Fund renting the Property to an unrelated party;

is tantamount to a scheme as is defined in subsection 995-1(1) of the ITAA 1997 and as is referred to in subsection 295-550(1).

Whether parties to scheme were not dealing with each other at arm's length

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

in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance.

At all material times, the directors of the Corporate Trustee and the Members are one and the same. In view of their close relationship, they are non-arm's length parties in relation to the Loan Agreement.

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.⁶

The Commissioner has issued Taxation Ruling TR 2006/7 entitled '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'. This ruling explains what amounts are considered to be 'special income' under the former section 273 of the ITAA 1936 and, as the wording of section 273 of the ITAA 1936 is similar to section 295-550 of the ITAA 1997, may also assist in the interpretation of section 295-550 of the ITAA 1997.

Paragraph 76 of TR 2006/7 states that:

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.

This view is based on the decisions in Re Hains; Barnsdall v. Federal Commissioner of Taxation ⁷; Trustee for Estate of AW Furse No 5 Will Trust v. Federal Commissioner of Taxation ⁸; and Granby Pty Ltd v. Commissioner of Taxation ⁹ and the examples in the Explanatory Memorandum 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, where Justice Collier said¹⁰,

…if conduct of parties is not consistent with conduct of independent third parties, because one party is exerting personal influence or control over the other or others, dealings between them cannot be termed 'arm's length'.

We have noted from the private-ruling application that:

(a) the purchase value of the Property was determined on arm's length dealings between the Corporate Trustee and the unrelated vendor;

(b) the dealing between the Corporate Trustee and the Members involves a loan of a certain amount for a specific number of years to the Fund by the Members at a particular initial interest rate per annum and, after the ATO gives this private ruling, at the interest rate that the ATO may specify or, if the ATO does not specify an interest rate, at an interest rate to be agreed between the parties; and

(c) the Corporate Trustee intends to rent the Property to an unrelated party on arm's length terms.

We have also considered the submissions made by the Applicant on behalf of the Corporate Trustee in relation to the aforementioned dealings. We accept that, based on the information provided, there is no indication of the parties involved in any of the aforementioned dealings not dealing with each other at arm's length.

Amount derived is greater than what might have been derived on arm's length basis

Paragraphs 79 and 80 of TR 2006/7 state that:

79. 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.

80. This is a question of fact. 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.

In Syngenta Crop Protection Pty Ltd v. Federal Commissioner of Taxation¹¹ 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:

The question as to whether the consideration is that which might reasonably be expected to have been received or receivable as consideration in either a supply or acquisition if the property had been supplied or acquired under an agreement between independent parties dealing at arm's length is an objective question. It does not depend upon anybody's opinion, save that of the court or body making that decision. It is a matter for evidence.

As the intention of the Corporate Trustee is to rent the Property to an unrelated party on arm's length terms, we accept that the rental income to be received by the Fund will be no more than the amount that the Fund might be expected to receive if the Fund and the unrelated party deal with each other at arm's length.

As regards any capital gain that may be made by the Fund when the Property is disposed of, there is no indication that the terms and conditions of the loan are more favourable to the Members as the Lender. In this context, we also accept that any capital gain so made will be no more than the amount that the Fund might be expected to make if the Corporate Trustee and the Members deal with each other at arm's length in relation to the loan.

This does not, of course, preclude the requirement under section 295-550 of the ITAA 1997 that the Corporate Trustee and any buyer of the Property must nevertheless deal with each other at arm's length when the Property is disposed of, in order that any capital gain derived by the Fund from the disposal will not be treated as non-arm's length income of the Fund.

Whether Part IVA applies if zero interest rate is agreed upon

In section 177D, under Part IVA of the ITAA 1936, it is stated that:

This Part applies to any scheme…where

(a) a taxpayer (in this section referred to as the relevant taxpayer) has obtained, or would but for section 177F obtain, a tax benefit in connection with the scheme; and

(b) having regard to:

(i) the manner in which the scheme was entered into or carried out;

…

it would be concluded that the person, or one of the persons, who entered into or carried out the scheme…did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme or of enabling the relevant taxpayer and another taxpayer or other taxpayers each to obtain a tax benefit…

'Scheme' is defined in subsection 177A(1) of the ITAA 1936 as:

(a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and

(b) any scheme, plan, proposal, action, course of action or course of conduct.

We expressed earlier that the arrangement described in the private-ruling application is a scheme for the purposes of subsection 295-550(1) of the ITAA 1997. As the definition of 'scheme' under Part IVA is similar to that term as defined under subsection 995-1(1) of the ITAA 1997, the arrangement is also a scheme for the purposes of Part IVA of the ITAA 1936.

As there is no indication that the arrangement will result in any person or persons involved in the arrangement obtaining a tax benefit, nor any indication that the sole or dominant purpose of the arrangement is to obtain a tax benefit, we do not consider that Part IVA of the ITAA 1936 applies to the arrangement.

¹ Paragraph 7.4, Superannuation Technical minutes, June 2012.

² Federal Commissioner of Taxation v. Hart [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 per Justices Gummow and Hayne at paragraph 43 ([2004] HCA 26). See also the statements of Justice Callinan at paragraph 89.

³ [2010] FCA 1276; (2010) 2010 ATC 20-225; (2010) 80 ATR 849; [2012] ALMD 2629; [2012] ALMD 2630; [2012] ALMD 2631; [2012] ALMD 2632.

⁴ [2010] FCA 1276 at paragraph 69.

⁵ [2010] FCA 1276 at paragraph 73.

⁶ Trustee for Estate of AW Furse No 5 Will Trust v. Federal Commissioner of Taxation at [36]-[37] (1990) 21 ATR 1123; (1990) 91 ATC 4007; TR 2006/7 paragraphs 76 to 78 and 192 to 199.

⁷ (1988) 88 ATC 4565; (1988) 81 ALR 173; (1988) 19 ATR 1352.

⁸ (1990) 21 ATR 1123; (1990) 91 ATC 4007; also see paragraphs 194 to 198 of TR 2006/7.

⁹ (1995) 129 ALR 503; (1995) 30 ATR 400; (1995) 95 ATC 4240; also see paragraphs 194 to 198 of TR 2006/7.

¹⁰ [2010] FCA 1276 at paragraph 90.

¹¹ [2005] FCA 1646; (2005) 61 ATR 186; [2008] ALMD 422.

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