Edited version of your private ruling

Authorisation Number: 1012591579596

Ruling

Subject: Non-arm's length income and limited recourse borrowing arrangement

Questions

1. Is the provision of a limited recourse loan on interest-free terms to a self-managed superannuation fund by the members of the fund a contribution for the purposes of Division 295 of the Income Tax Assessment Act 1997 (ITAA 1997)

2. Will the interest-free related party borrowing result in any amount being taxed as non-arm's length income of the fund for the purposes of section 295-550 of the ITAA 1997?

Answers

1. No

2. Yes.

This ruling applies for the following period:

Income year ending 30 June 2014

The scheme commences on:

During the income year ending 30 June 2014

Relevant facts and circumstances

The Superannuation Fund (the Fund) is a self-managed superannuation fund.

The trustee of the Fund is Company A (the Corporate Trustee).

The Fund has two members (Member A and Member B).

Member A and Member B are also directors of the Corporate Trustee.

Both members are currently in accumulation phase and are under 60 years of age in the 2013-14 income year.

The Corporate Trustee, on behalf of the Fund, intends to acquire a business real property (the Property) from an unrelated vendor.

The Fund will pay a X% deposit and the balance of the purchase price will be borrowed from Member A and Member B.

The Property will be held on trust by a bare trust (the Bare Trust).

The trustee of the Bare Trust is Company B.

The directors of Company B are Member A and Member B.

The draft loan agreement between Member A and Member B; the Corporate Trustee and Company B includes the following terms:

· Interest is payable by the borrower at the rate of nil%.

· The borrower must pay the Periodic Instalment which is payable monthly.

· Where any sum payable is not paid before the due date for payment, a default interest charge of nil% will accrue on the outstanding amount.

· The borrower may repay the loan, or any part of it, earlier than the Repayment Date.

· The borrower must repay and finally discharge the loan on the Repayment Date.

The Bare Trust Deed provides that it will hold on trust for the absolute benefit and entitlement of the Corporate Trustee:

· funds paid to it on behalf of the Corporate Trustee for the purpose of acquiring the Original Asset;

· the Original Asset;

· any Replacement Asset; and

· any income or capital gain accruing to or arising from the Original Asset or any Replacement Asset.

The Bare Trust Deed also provides that the beneficial interest of the Corporate Trustee in these assets is vested in possession.

The Fund intends to lease the Property to an unlisted public company (the Public Company) that is not a 'related party' of the Fund. The Public Company will pay market rent.

The Fund, together with its related persons and entities, holds approximately Y% of the fully paid ordinary shares on issue in the Public Company.

Relevant legislative provisions

Reasons for decision

Meaning of 'contribution'

The term 'contribution' is not defined in the ITAA 1997. Therefore, consistent with basic principles of statutory interpretation, the term 'contribution' is to be given its ordinary meaning having regard to the context and underlying purpose of the legislative provisions in which the term appears.

The Commissioner's view on the meaning of 'contribution' in the superannuation context is set out in Taxation Ruling TR 2010/1. Paragraph 4 of TR 2010/1 states:

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 illustrated by the examples in paragraphs 75; 76; 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.

Where, under the terms of a loan, no interest is charged on the borrowings of a superannuation fund, no liability to pay interest is incurred. As there is no liability to pay interest in the first instance, there can be no forgiveness or extinguishment of any such liability. As such, the absence of a requirement to pay interest on borrowings does not increase the capital of the superannuation fund.

This view is confirmed by 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 arrangements where it was said:

The absence of a requirement to pay interest on money loaned to the trustee does not increase the capital of the fund. A saving on an expense of an SMSF in the circumstances described is analogous to the circumstances outlined in examples 2 and 5 in Taxation Ruling TR 2010/1 Income tax: superannuation contributions. The purpose of a person in offering a low interest loan to an SMSF does not fall for consideration if there has been no increase in the capital of the fund.

Based on the above, it is considered that the provision of a limited recourse loan on interest-free terms to the Fund by the members of the Fund is not a contribution for the purposes of Division 295 of the ITAA 1997.

Meaning of 'non-arm's length income'

The phrase 'non-arm's length income' has the meaning given by section 295-550 of the ITAA 1997.

In accordance with subsection 295-550(4) of the ITAA 1997, income derived by the entity as a beneficiary of a trust, other than because of holding a fixed entitlement to the income, is non-arm's length income of the entity.

Subsection 295-550(5) provides that:

Other income *derived by the entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust is non-arm's length income of the entity if:

(a) the entity acquired the entitlement under a *scheme, or the income was derived under a scheme, the parties to which were not dealing with each other at *arm's length; and

(b) 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 accordance with subsection 995-1(1) of the ITAA 1997, an entity has a fixed entitlement to a share of the income or capital of a company, partnership or trust if the entity has a fixed entitlement to that share within the meaning of Division 272 in Schedule 2F to the Income Tax Assessment Act 1936 (ITAA 1936).

Subsection 272-5(1) in Schedule 2F of the ITAA 1936 states:

If, under a trust instrument, a beneficiary has a vested and indefeasible interest in a share of income of the trust that the trust derives from time to time, or of the capital of the trust, the beneficiary has a fixed entitlement to that share of the income or capital.

Meaning of 'vested and indefeasible'

The terms 'vested' and 'indefeasible' are not defined in the ITAA 1997. Therefore, the meaning to be given to these terms must be determined according to the ordinary meaning of the words having regard to the context in which they appear.

In Dwight v. Commissioner of Taxation (Dwight) Justice Hill of the Federal Court made the following comments concerning the meaning of the terms 'vested' and 'indefeasible':

The words "vested" and "indefeasible" in the context of trust law are technical legal words of limitation, which have a well understood meaning to property conveyancers. Estates may be vested in interest or vested in possession, the difference being between a present fixed right of future enjoyment where the estate is said to be vested in interest and a present right of present enjoyment of the right, where the estate is said to be vested in possession: Glenn v Federal Comr of Land Tax (1915) 20 CLR 490 at 496 per Griffith CJ at 501 per Isaacs J

An interest is said to be defeasible where it can be brought to an end and indefeasible where it can not. Thus, a beneficiary with an interest which is not contingent but which interest may be brought to an end by the exercise of a power of appointment, would be said to have a vested but defeasible interest: cf Queensland Trustees Ltd v Comr of Stamp Duties (1952) 88 CLR 54 at 63, and Re Kilpatrick's Policies Trusts [1966] Ch 730.

In Walsh Bay Developments Pty Ltd v. Federal Commissioner of Taxation, Justices Beaumont and Sackville of the Federal Court referred to the distinction between vested but defeasible interests and an indefeasible interest as stated in Cheshire's Modern Law of Real Property, where the author said:

An defeasible interest is an interest that is to be defeated by the operation of a subsequent or mixed condition.

An indefeasible interest, or an absolute interest as opposed to a defeasible interest, is one that is not subject to any condition.

The Explanatory Memorandum to the Taxation Laws Amendment (Trust Loss and Other Deductions) Act 1998, which accompanied the enactment of former section 272-5 of the ITAA 1936, states at paragraphs 13.4 to 13.7:

13.4 A person has a vested interest in something if the person has a present right relating to the thing. Stated simply, a vested interest is one that is bound to take effect in possession at some point in time. A vested interest is to be contrasted with a 'contingent' interest which may never fall into possession. If an interest of a beneficiary in income or capital is the subject of a condition precedent, so that an event must occur before the interest becomes vested, the beneficiary does not have a vested interest to the income or capital since such an interest is instead 'contingent' upon the event occurring.

13.5 In traditional legal analysis, a person can be said to be either 'vested in possession' or 'vested in interest'. A present interest, i.e. one that is being enjoyed, is said to be 'vested in possession'; a future interest, i.e. one which gives its holder a present right to future enjoyment, is said to be 'vested in interest'. A person is vested in possession where the person has a right to immediate possession or enjoyment of the thing in question. In the definition of fixed entitlement, 'vested' includes both vested in possession and vested in interest.

13.6 Because vested interests include future interests, a person can have a vested interest in a thing even though the person's actual possession and enjoyment of the thing is delayed until some time in the future.

13.7 A vested interest is indefeasible where, in effect, it is not able to be lost. A vested interest is defeasible where it is subject to a condition subsequent that may lead to the entitlement being divested. A condition subsequent is an event that could occur after the interest is vested that would result in the entitlement being defeated, for example, on the occurrence of an event or the exercise of a power. For example, where a beneficiary's vested interest is able to be taken away by the exercise of a power by the trustee or any other person, the interest will not be a fixed entitlement.

It is an essential element of subsection 272-5(1) in 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.

After considering the terms of the Bare Trust Deed it is our view that the Fund holds a fixed entitlement to all the income and capital of the Bare Trust arising in respect of the Property. This view is based on the facts as stated above in the 'Relevant facts and circumstances'. If that conclusion were wrong, any income derived by the Fund as beneficiary of the Bare Trust would be non-arm's length income of the Fund in accordance with subsection 295-550(4) of the ITAA 1997.

Meaning of 'scheme'

The term 'scheme' is defined in subsection 995-1(1) of the ITAA 1997 to mean:

(a) any *arrangement; or

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

The term 'arrangement' is also defined in subsection 995-1(1) of the ITAA 1997 to mean:

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

The Full Federal Court in Allen v Federal Commissioner of Taxation considered the term 'arrangement' as defined for the purposes of former subsection 273(7) of the Income Tax Assessment Act 1936 (ITAA 1936) - the immediate predecessor of subsection 295-550(5) of the ITAA 1997. That term was defined in terms almost identical to a combination of the definitions of 'scheme' and 'arrangement' in the ITAA 1997. The court held that the series of steps undertaken by the parties that resulted in the acquisition of a fixed interest in the trust estate and the relevant distribution of income from that trust estate were readily seen to be an 'arrangement' to which the various entities were parties, and those results were readily seen to be the consequence of that arrangement.

Applying subsection 295-550(5) of the ITAA 1997 to the present case, it is considered that the 'scheme' is the series of steps undertaken by the parties that result in a fixed entitlement to the income and capital of the Bare Trust and (and any derivation of income by the Fund through holding that entitlement) including:

· the establishment and operation of the limited recourse borrowing arrangement between the Fund and Member A and Member B; and

· the establishment and operation of the Bare Trust in favour of the Fund in respect of the Property.

As such, it is readily concluded that, for the purposes of paragraph 295-550(5)(a) of the ITAA 1997, the Fund would acquire its fixed entitlement to the income of the Bare Trust under a scheme and any income derived through holding that entitlement would be derived under a scheme.

Dealing at 'arm's length'

In accordance with subsection 995-1(1) of the ITAA 1997, in determining whether parties are dealing at arm's length, consideration is to be given to any connection between them and any other relevant circumstances.

In Federal Commissioner of Taxation v AXA Asia Pacific Holdings Ltd Justice Dowsett summarised propositions which emerge from the numerous cases in which the expression 'not dealing with each other at arm's length' or similar expressions have been considered, as follows:

· in determining whether parties have dealt with each other at arm's length in a particular transaction, one may have regard to the relationship between them;

· one must also examine the circumstances of the transaction and the context in which it occurred;

· one should do so with a view to determining whether or not the parties have conducted the transaction in a way which one would expect of parties dealing at arm's length in such a transaction;

· relevant factors which may emerge include existing mutual duties, liabilities, obligations, cross-ownership of assets, or identity of interests which might enable either party to influence or control the other, or induce either party to serve a common interest and so modify the terms on which strangers would deal;

· where the parties are not in an arm's length relationship, one may infer that they did not deal with each other at arm's length, and that the resultant transaction is not at arm's length;

· however related parties may, in some circumstances, so conduct a dealing as to displace any inference based on the relationship;

· un-related parties may, on occasions, deal with each other in such a way that the resultant transaction may not properly be considered to be at arm's length.

In that case Justices Edmonds and Gordon further stated that:

Any assessment of whether parties were dealing at arm's length involves 'an assessment [of] whether in respect of that dealing they dealt with each other as arm's length parties would normally do, so that the outcome of their dealing is a matter of real bargaining': …

It is clear that the parties in this case are not in an arm's length relationship. This is because Member A and Member B are:

· the only members of the Fund (the beneficial owner);

· the directors of the trustee of the Fund (the borrower);

· the directors of the trustee of the Bare Trust (the custodian); and

· the lender.

Further, the Full Federal Court in Allen held that former paragraph 273(7)(a) of the ITAA 1936 - the immediate predecessor of paragraph 295-550(5)(a) of the ITAA 1997 - does not require that the 'dealing' consist only of the actual derivation of the income in question by 'the entity', but that the evident legislative intention of the provisions is to permit regard to be had to the totality of the steps that result in the entity's acquisition of its fixed entitlement to the income of the trust and any derivation of income by the entity through holding that entitlement.

In this case, assessing the circumstances holistically, it is clear that, in respect of the limited recourse borrowing arrangement, the parties will not be dealing with each other as arm's length parties would do. Aspects which, taken together, the Commissioner considers lead to that conclusion include:

· Member A and Member B are not, by way of the charging of interest under the loan agreements, or by any other means, compensated for the opportunity cost in lending the principal or for the additional risk assumed in relation to recovery of the principal in the event of the borrower's default under a loan given the limited recourse nature of the loans; and

· the penalty interest rate if payment is not made by the due date is nil.

Amount of income greater than might be expected if dealing at arm's length

The final requirement of subsection 295-550(5) of the ITAA 1997, which is set out in paragraph 295-550(5)(b), is that the amount of the income (derived by the entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust) is more than the amount that the entity might have been expected to derive if the parties had been dealing with each other at arm's length.

If the parties in this case were dealing with each other at arm's length, the amount of income the Fund might be expected to derive through the Bare Trust is either:

· nil - on the basis that no lending on the proposed terms by Member A and Member B might be expected and therefore no income might be derived by the Fund through the Bare Trust; or

· is less than under the proposed arrangement - on the basis that Member A and Member B might be expected to lend on commercial terms given the limited recourse nature of the loans. The income that might be expected to be derived by the Fund through the Bare Trust would be reduced by the amount of interest payable in respect of the loan.

Either way, the final requirement of subsection 295-550(5) of the ITAA 1997 is satisfied. As such, the income to be derived by the Fund through the Bare Trust is non-arm's length income of the Fund in accordance with subsection 295-550(5).

Other relevant Comments

Legislative intent

This conclusion is entirely consistent with the legislative intent of section 295-550 of the ITAA 1997 and its predecessors.

The earliest predecessor of section 295-550 of the ITAA 1997 - former section 23F of the ITAA 1936 - was introduced in 1964 as a result of the Report of the Commonwealth Committee on Taxation, 1961 (the Ligertwood Report) which recommended legislative amendments to counter the numerous ways identified by the Committee in which a taxpayer could constitute a superannuation fund with income, that would have accrued to the taxpayer in the ordinary course of events, and thus be received virtually tax free.

Of particular relevance to the circumstances of this case was the second example given in the Ligertwood Report of a situation which the recommended legislation was to address:

A director-controlled superannuation fund is set up by a private company, primarily for the benefit of those employees who are also shareholders and directors. The directors then cause the company to make interest-free loans to the fund which invests the proceeds. The income derived by the fund from its investments is exempt under Section 23(j) and when this income is eventually paid to the directors in a lump sum on their retirement, only 5 per cent thereof will be taxed in the hands of the beneficiaries or alternatively the amount may be wholly free from tax.

Further, the Full Federal Court in Darrelen Pty Ltd v Federal Commissioner of Taxation stated that the policy underlying (former) section 273 of the ITAA 1936, and its predecessors, is to enable the Commissioner to deny the concessional taxation of income which has been diverted from taxpayers not enjoying that status.

Similarly, the Explanatory Memorandum to the Superannuation Legislation Amendment Bill (No.2) 1999 which inserted former subsections 273(6) and (7) of the ITAA 1936 - the immediate predecessors of subsections 295-550(4) and (5) of the ITAA 1997 - explained at paragraph 2.13 that:

Section 273 is designed to prevent income from being unduly diverted into superannuation entities as a means of sheltering that income from the normal rates of tax applying to other entities, particularly the marginal rates applying to individual taxpayers.

The main effect of the scheme in this case, being the movement of income producing capital through a non-arm's length dealing from entities who would pay marginal or company tax rates on such income into the concessionally taxed superannuation fund is clearly intended to be addressed by section 295-550 of the ITAA 1997 and its predecessors.

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